| Pub. 538, Accounting Periods and Methods |
2005 Tax Year |
Publication 538 - Main Contents
The IRS charges a user fee for certain requests to change an accounting period or method. The fee is reduced in certain situations,
such as a
request for identical accounting method changes for members of a consolidated group, a request involving a personal tax issue
from a person with gross
income of less than $250,000, and a request involving a business-related tax issue from a person with gross income of less
than $1 million. No fee is
charged for changes permitted to be made by a published automatic change revenue procedure.
For information about user fees charged to change an accounting period, see the Form 1128 instructions. For information about
user fees charged to
change an accounting method, see the Form 3115 instructions. See also Revenue Procedure 2004–1, in Internal Revenue Bulletin
No. 2004–1,
or its successor, for more information. For information on user fees for tax-exempt organizations, see Revenue Procedure 2004–8,
in Internal
Revenue Bulletin No. 2004–1, or its successor.
You must figure taxable income on the basis of a tax year. A “tax year” is an annual accounting period for keeping records and reporting
income and expenses. An annual accounting period does not include a short tax year (discussed later). The tax years you can
use are:
Unless you have a required tax year, you adopt a tax year by filing your first income tax return using that tax year. A required
tax year is a tax
year required under the Internal Revenue Code and the Income Tax Regulations. You have not adopted a tax year if you merely did any of the
following.
-
Filed an application for an extension of time to file an income tax return.
-
Filed an application for an employer identification number.
-
Paid estimated taxes for that tax year.
This section discusses:
-
A calendar year.
-
A fiscal year (including a period of 52 or 53 weeks).
-
A short tax year.
-
An improper tax year.
-
A change in tax year.
-
Special situations that apply to individuals.
-
Restrictions that apply to the accounting period of a partnership, S corporation, or personal service corporation.
-
Special situations that apply to corporations.
A calendar year is 12 consecutive months beginning January 1 and ending December 31.
If you adopt the calendar year, you must maintain your books and records and report your income and expenses from January
1 through December 31 of
each year.
If you file your first tax return using the calendar tax year and you later begin business as a sole proprietor, become a
partner in a partnership,
or become a shareholder in an S corporation, you must continue to use the calendar year unless you get IRS approval to change
it or are otherwise
allowed to change it without IRS approval. See Change in Tax Year, later.
Generally, anyone can adopt the calendar year. However, if any of the following apply, you must adopt the calendar year.
-
You keep no books.
-
You have no annual accounting period.
-
Your present tax year does not qualify as a fiscal year.
-
You are required to use a calendar year by a provision of the Internal Revenue Code or the Income Tax Regulations.
A fiscal year is 12 consecutive months ending on the last day of any month except December. A 52-53-week tax year is a fiscal
year that varies from
52 to 53 weeks but may not end on the last day of a month.
If you adopt a fiscal year, you must maintain your books and records and report your income and expenses using the same tax
year.
You can elect to use a 52-53-week tax year if you keep your books and records and report your income and expenses on that
basis. If you make this
election, your 52-53-week tax year must always end on the same day of the week. Your 52-53-week tax year must always end on:
-
Whatever date this same day of the week last occurs in a calendar month, or
-
Whatever date this same day of the week falls that is nearest to the last day of the calendar month.
For example, if you elect a tax year that always ends on the last Monday in March, your 2002 tax year will end on March 31,
2003. If you elect a
tax year ending on the Thursday nearest to the end of April, your 2002 tax year will end on May 1, 2003.
Election.
To make the election, attach a statement with the following information to your tax return for the 52-53-week tax
year.
-
The month in which the new 52-53-week tax year ends.
-
The day of the week on which the tax year always ends.
-
The date the tax year ends. It can be either of the following dates on which the chosen day:
-
Last occurs in the month in (1), above, or
-
Occurs nearest to the last day of the month in (1), above.
When you figure depreciation or amortization, a 52-53-week tax year is generally considered a year of 12 calendar
months.
To determine an effective date (or apply provisions of any law) expressed in terms of tax years beginning, including,
or ending on the first or
last day of a specified calendar month, a 52-53-week tax year is considered to:
-
Begin on the first day of the calendar month beginning nearest to the first day of the 52-53-week tax year, and
-
End on the last day of the calendar month ending nearest to the last day of the 52-53-week tax year.
Example.
Assume a tax provision applies to tax years beginning on or after July 1, 2003. For this purpose, a 52-53-week tax year beginning
on June 25, 2003,
is treated as beginning on July 1, 2003.
Change to or from a 52-53-week tax year.
You must get IRS approval if you want to make the following changes.
-
From your current tax year to a 52-53-week tax year, even if such 52-53-week tax year ends with reference to the same calendar
month as your
current tax year.
-
From one 52-53-week tax year to another 52-53-week tax year.
-
From a 52-53-week tax year to any other tax year.
See Change in Tax Year, later, for information on getting IRS approval.
Example.
You want to change from a 52-53-week tax year ending on the Thursday closest to December 31 to a 52-53-week tax year ending
on the Friday closest
to December 31. You must get IRS approval to make this change in your tax year.
You can get approval for certain 52-53-week tax year changes automatically if you qualify under any of the revenue procedures
listed in the general
discussion on automatic approval under Change in Tax Year, later.
A short tax year is a tax year of less than 12 months. A short period tax return may be required when you (as a taxable entity):
Tax on a short period tax return is figured differently for each situation.
Not in Existence Entire Year
Even if you (a taxable entity) were not in existence for the entire year, a tax return is required for the time you were in
existence. Requirements
for filing the return and figuring the tax are generally the same as the requirements for a return for a full tax year (12
months) ending on the last
day of the short tax year.
Example 1.
Corporation X was organized on July 1, 2002. It elected the calendar year as its tax year and its first tax return was due
March 17, 2003. This
short period return will cover the period from July 1, 2002, through December 31, 2002.
Example 2.
A calendar year corporation dissolved on July 23, 2003. Its final return is due by October 15, 2003, and it will cover the
short period from
January 1, 2003, to July 23, 2003.
Example 3.
Partnership YZ was formed on September 4, 2002, and elected to use a fiscal year ending November 30. Partnership YZ must file
its first tax return
by March 17, 2003. It will cover the short period from September 4, 2002, to November 30, 2002.
Death of individual.
When an individual dies, a tax return must be filed for the decedent by the 15th day of the 4th month after the close
of the individual's regular
tax year. The decedent's final return will be a short period tax return unless he or she dies on the last day of the regular
tax year.
Example.
Agnes Green was a single, calendar year taxpayer. She died on March 6, 2003. Her final tax return must be filed by April 15,
2004. It will cover
the short period from January 1, 2003, to March 6, 2003.
Figuring Tax for Short Year
If the IRS approves a change in your tax year or you are required to change your tax year, you must figure the tax and file
your return for the
short tax period. The short tax period begins on the first day after the close of your old tax year and ends on the day before
the first day of your
new tax year.
You figure tax for a short year under the general rule, explained next. You may then be able to use a relief procedure, explained
later, and claim
a refund of part of the tax you paid.
General rule.
Income tax for a short tax year is figured on an annual basis. However, self-employment tax is figured on the actual
self-employment income for the
short period.
Individuals.
An individual must figure income tax for the short tax year as follows.
-
Determine your adjusted gross income for the short tax year and then subtract your actual itemized deductions for the short
tax year. (You
must itemize deductions when you file a short period tax return.)
-
Multiply the dollar amount of your exemptions by the number of months in the short tax year and divide the result by 12.
-
Subtract the amount in (2) from the amount in (1). This is your modified taxable income.
-
Multiply the modified taxable income in (3) by 12, then divide the result by the number of months in the short tax year. This
is your
annualized income.
-
Figure the total tax on your annualized income using the appropriate tax rate schedule.
-
Multiply the total tax by the number of months in the short tax year and divide the result by 12. This is your tax for the
short tax
year.
Example.
Mike and Sara Smith have an adjusted gross income of $48,000 for their short tax year. Their itemized deductions for January
1 through September
30, 2002, total $12,400 and they can claim exemptions for themselves, and their two children. Each exemption is $3,000. They
figure the tax on their
joint return for that period as follows.
-
$48,000 - $12,400 = $35,600
-
$3,000 × 4 × 9/12 = $9,000
-
$35,600 - $9,000 = $26,600 (modified taxable income)
-
$26,600 × 12/9 = $35,467 (annualized income)
-
Tax on $35,467 = $4,720 (from 2002 tax rate schedule)
-
$4,720 × 9/12 = $3,540 (tax for short tax year)
Corporations.
A corporation figures tax for the short tax year under the general rule described earlier for individuals except there
is no adjustment for
personal exemptions.
Example.
Because a calendar year corporation changed its tax year, it must file a short period tax return for the 6-month period ending
June 30, 2002. For
the short tax year, it had income of $40,000 and no deductions. The corporation's annualized income is $80,000 ($40,000 ×
12/6). The tax on
$80,000 is $15,450. The tax for the short tax year is $7,725 ($15,450 × 6/12).
52-53-week tax year.
If you change the month in which your 52-53-week tax year ends, you must file a return for the short tax year if it
covers more than 6 but fewer
than 359 days.
If the short period created by the change is 359 days or more, treat it as a full tax year. If the short period created
is 6 days or fewer, it is
not a separate tax year. Include it as part of the following year.
For example, if you use a calendar year and the IRS approves your change to a 52-53-week tax year ending on the Monday
nearest to September 30, you
must file a return for the short period from January 1 to September 30.
Figure the tax for the short tax year as shown previously, except that you prorate on a daily basis, rather than
monthly. Use 365 days (regardless
of the number of days in the calendar year) instead of 12 months and the number of days in the short tax year instead of the
number of months.
Relief procedure.
Individuals and corporations can use a relief procedure to figure the tax for the short tax year. It may result in
less tax. Under this procedure,
the tax is figured by two separate methods. If the tax figured under both methods is less than the tax figured under the general
rule, you can file a
claim for a refund of part of the tax you paid. For more information, see section 443(b)(2).
Alternative minimum tax.
To figure the alternative minimum tax (AMT) due for a short tax year:
-
Figure the annualized alternative minimum taxable income (AMTI) for the short tax period by doing the following.
-
Multiply the AMTI by 12.
-
Divide the result by the number of months in the short tax year.
-
Multiply the annualized AMTI by the appropriate rate of tax under section 55(b)(1). The result is the annualized AMT.
-
Multiply the annualized AMT by the number of months in the short tax year and divide the result by 12.
For information on the alternative minimum tax for individuals, see the instructions for Form 6251, Alternative Minimum
Tax–Individuals. For information on the alternative minimum tax for corporations, see Publication 542, or the instructions to Form 4626,
Alternative Minimum Tax–Corporations.
Tax withheld from wages.
You can take a credit against your income tax liability for federal income tax withheld from your wages. Federal income
tax is withheld on a
calendar year basis. The amount withheld in any calendar year is allowed as a credit for the tax year beginning in the calendar
year.
Taxpayers that have adopted an improper tax year must change to a proper tax year under the requirements of Revenue Procedure
85–15 in
Cumulative Bulletin 1985–1. For example, if a taxpayer began business on March 15 and adopted a tax year ending on March 14
(a period of exactly
12 months), this would be an improper tax year. See Accounting Periods, earlier, for a description of permissible tax years.
To change to a proper tax year, you must do one of the following.
-
If you are requesting a change to a calendar tax year, file an amended income tax return based on a calendar tax year
that corrects the most recently filed tax return that was filed on the basis of an improper tax year. Attach a completed Form
1128 to the amended tax
return. Write “FILED UNDER REV. PROC. 85–15” at the top of Form 1128 and file the forms with the Internal Revenue Service Center where you
filed your original return.
-
If you are requesting a change to a fiscal tax year, file Form 1128 in accordance with the form instructions to request IRS
approval for the
change.
Generally, you must file Form 1128 to request IRS approval to change your tax year. See the instructions for Form 1128 for
exceptions. If you
qualify for an automatic approval request, a user fee is not required. If you do not qualify for automatic approval, a ruling
must be requested and a
user fee is required. See the instructions for Form 1128 for information about user fees if you are requesting a ruling.
Certain taxpayers can get automatic approval to change their tax year by filing Form 1128. You should determine whether you
can get approval
automatically before submitting an application under the ruling request procedures, discussed next. You can get approval automatically
if you qualify
under any of the following.
-
Revenue Procedure 2003–62, which provides automatic approval procedures for certain individuals.
-
Revenue Procedure 2002–37, which provides automatic approval procedures for certain corporations.
-
Revenue Procedure 2002–38, which provides automatic approval procedures for certain partnerships, S corporations, electing
S
corporations, and personal service corporations.
-
Revenue Procedure 85–58 and Revenue Procedure 76–10, as modified by Revenue Procedure 79–3, which provide automatic
approval procedures for certain exempt organizations.
Revenue Procedure 2003–62 is in Internal Revenue Bulletin 2003–32. Revenue Procedures 2002–37 and 2002–38 are in
Internal Revenue Bulletin 2002–22. Revenue Procedure 85–58 is in Internal Revenue Bulletin 1985–18. Revenue Procedure 76–10
is
in Cumulative Bulletin 1976–1. Revenue Procedure 79–3 is in Cumulative Bulletin 1979–1.
For information on the procedures by which certain individuals, pass-through entities, and corporations can get automatic
approval to change their
tax year, see the specific discussions on automatic approval for each of those entities, later.
File a current Form 1128 with the IRS national office in Washington, DC, no earlier than the day following the end of the
short period and no later
than the due date (not including extensions) of the tax return for the short period. (The short period begins on the first
day after the end of your
present tax year and ends on the day before the first day of your new tax year.) You must file the return for the short period
within the time that
applies for filing a return for a full tax year (12 months) ending on the last day of the short tax period. See Revenue Procedure
2002–39, in
Internal Revenue Bulletin 2002–22, for more information. See also Revenue Procedure 2003–34, in Internal Revenue Bulletin
2003–18,
which modifies the restrictions in Revenue Procedure 2002–39 against carrying back net operating losses and capital losses
generated in the
short period.
You must include the correct user fee, if any, with Form 1128. See User Fees at the beginning of this publication. See also the
instructions for Form 1128 for information on where to file Form 1128.
A Form 1128 received within 90 days after the due date may qualify for an extension and be considered timely filed. An extension
request, however,
must be filed under section 301.9100–3 of the regulations (see Revenue Procedure 2004–1). For more information, see the form
instructions
and Revenue Procedure 2004–1, in Internal Revenue Bulletin 2004–1, or any successor.
Your application must contain all requested information. Do not change your tax year until the IRS has approved your request.
If your application
is approved, you must file an income tax return for the short period. There are special rules for figuring tax when you file
a short period return
because you changed your tax year. See Figuring Tax for Short Year, earlier.
Example.
Steve Adams, a sole proprietor, files his return using a calendar year. For business purposes, he wants to change his tax
year to a fiscal year
ending June 30. Steve will have a short tax year for the period from January 1 to June 30. He must file Form 1128 by October
15, the 15th day of the
4th calendar month after the close of the short tax year, which is the due date for the short period return.
Most individuals adopt the calendar year. An individual can adopt a fiscal year provided that the individual maintains his
or her books and records
on the basis of the adopted fiscal year.
Individuals that want to change their tax year must generally file Form 1128 to get IRS approval either under the automatic
approval procedures or
the ruling request procedures.
Special rule for newlyweds.
A husband and wife who have different tax years cannot file a joint return, except for a husband and wife whose tax
years begin on the same date
and end on different dates because of the death of either or both. However, a newly married husband or wife with a different
tax year is permitted to
change his or her tax year to be the same as the other spouse in order to file a joint return. The spouse making this change
is not required to file
Form 1128. They can file a joint return for the first tax year ending after the date of marriage if both of the following
conditions are met.
-
The due date for filing the required separate short period tax return of the spouse changing tax years falls on or after the
date of the
marriage. The due date for the short period tax return is the 15th day of the 4th month following the end of the short tax
year.
-
The spouse changing tax years files a timely short period tax return. It must include a statement that the tax year is being
changed under
section 1.442–1(d) of the regulations.
If the due date for filing the required short period tax return passed before the date the couple marries, they cannot
file a joint return until
the end of the second tax year after the date of marriage. They can file a joint return for the second tax year only if the
spouse changing his or her
tax year files a timely short period tax return.
Example.
John and Jane were married on July 30, 2002. John filed his return for the fiscal year ending June 30, 2002. Jane uses the
calendar year, but wants
to change to John's fiscal year so they can file a joint return. If Jane files a separate return by October 15, 2002, for
the short period January 1,
2002, through June 30, 2002, she will have changed her accounting period to a fiscal year ending June 30. Then she and John
can file a joint return
for their tax year ending June 30, 2003.
Automatic approval.
An individual (which includes both spouses in the case of a husband and wife filing jointly) can use automatic approval
procedures to change from a
fiscal year to a calendar year. However, these procedures are generally not available to individuals deriving income from
interests in pass-through
entities. This includes individuals who are members of a partnership, beneficiaries of a trust or estate, or S corporation
shareholders.
However, interests in pass-through entities will be disregarded in certain circumstances. For example, an interest
in a pass-through entity will be
disregarded if the pass-through entity would be required under the Internal Revenue Code or Income Tax Regulations to change
its tax year to the new
calendar year of the individual. See Revenue Procedure 2003–62 in Internal Revenue Bulletin 2003–32 for other circumstances
in which
interests in pass-through entities will be disregarded.
In addition, individuals that qualify and want to change their tax year using these automatic procedures must comply
with the following conditions.
-
If the individual has a net operating loss (NOL) in the short period required to effect the change, the NOL generally cannot
be carried back
but must be carried over. However, a short period NOL can be carried back or carried over if it is either:
-
$50,000 or less, or
-
Less than the NOL for the full 12-month period beginning with the first day of the short period.
-
If there is any unused credit for the short period, the individual must carry the unused credit(s) forward. Unused credit(s)
cannot be
carried back.
-
If an individual's interest in a pass-through entity is disregarded as mentioned earlier in this discussion because the related
entity will
be required to change its tax year to the individual's new calendar tax year, the related entity must concurrently change
its tax year under the
applicable automatic approval procedures.
Form 1128.
To get automatic approval to change its tax year to a calendar year, an individual must file Form 1128 by the due
date (including extensions) for
filing the tax return for the short period required to effect such change.
Form 1128 must be filed with the Director, Internal Revenue Service Center, Attention: ENTITY CONTROL, where the individual's
return is filed. At
the top of page 1 of the Form 1128, type or print “ FILED UNDER REV. PROC. 2003–62.” No copies of Form 1128 are to be sent to the
IRS national office. However, a copy must be attached to the tax return filed for the short period required to effect the
change.
Ruling request.
Individuals that do not qualify for automatic approval to change their tax year must get IRS approval under Revenue
Procedure 2002–39, in
Internal Revenue Bulletin 2002–22, as modified by Revenue Procedure 2003–34 in Internal Revenue Bulletin 2003–18. In addition,
see
the general discussion under Ruling request on page 5.
Partnerships, S Corporations, and Personal Service Corporations (PSCs)
Generally, partnerships, S corporations (including electing S corporations), and PSCs must use a “required tax year.” A required tax year is a
tax year that is required under the Internal Revenue Code and Income Tax Regulations. The entity does not have to use the
required tax year if it
receives IRS approval to use another permitted tax year or makes an election under section 444. The following discussions
provide the rules for
partnerships, S corporations, and PSCs.
A partnership must conform its tax year to its partners' tax years unless any of the following apply.
-
The partnership makes a section 444 election. (See page 8 for details.)
-
The partnership elects to use a 52-53-week tax year that ends with reference to either its required tax year or a tax year
elected under
section 444. (See page 10 for details.)
-
The partnership can establish a business purpose for a different tax year. (See page 10 for details.)
The rules for the required tax year for partnerships are as follows.
-
If one or more partners having the same tax year own a majority interest (more than 50%) in partnership profits and capital,
the partnership
must use the tax year of those partners.
-
If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. A principal
partner is one
who has a 5% or more interest in the profits or capital of the partnership.
-
If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally
must use a tax
year that results in the least aggregate deferral of income to the partners.
If a partnership changes to a required tax year because of these rules, it can get automatic approval by filing Form 1128.
See Automatic
Approval on page 11 for information on the applicable filing requirements.
Least aggregate deferral of income.
The tax year that results in the least aggregate deferral of income is determined as follows.
-
Figure the number of months of deferral for each partner using one partner's tax year. Find the months of deferral by counting
the months
from the end of that tax year forward to the end of each other partner's tax year.
-
Multiply each partner's months of deferral figured in step (1) by that partner's share of interest in the partnership profits
for the year
used in step (1).
-
Add the amounts in step (2) to get the aggregate (total) deferral for the tax year used in step (1).
-
Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years.
The partner's tax year that results in the lowest aggregate (total) number is the tax year that must be used by the
partnership. If the calculation
results in more than one tax year qualifying as the tax year with the least aggregate deferral, the partnership can choose
any one of those tax years
as its tax year. However, if one of the tax years that qualifies is the partnership's existing tax year, the partnership must
retain that tax year.
Example.
A and B each have a 50% interest in partnership P, which uses a fiscal year ending June 30. A uses the calendar year and B
uses a fiscal year
ending November 30. P must change its tax year to a fiscal year ending November 30 because this results in the least aggregate
deferral of income to
the partners, as shown in the following table.
When determination is made.
The determination of the tax year under the least aggregate deferral rules must generally be made at the beginning
of the partnership's current tax
year. However, the IRS can require the partnership to use another day or period that will more accurately reflect the ownership
of the partnership.
This could occur, for example, if a partnership interest was transferred for the purpose of qualifying for a particular tax
year.
Short period return.
When a partnership changes its tax year, a short period return must be filed. The short period return covers the months
between the end of the
partnership's prior tax year and the beginning of its new tax year.
If a partnership changes to the tax year resulting in the least aggregate deferral, it must file a Form 1128 with
the short period return showing
the computations used to determine that tax year. The short period return must indicate at the top of page 1, “ FILED UNDER SECTION
1.706–1.”
More information.
For more information about accounting periods for partnerships, see the instructions for Form 1128. For information
about changing a partnership's
tax year, see Revenue Procedure 2002–38 for automatic approval requests and Revenue Procedure 2002–39 for ruling requests.
All S corporations, regardless of when they became an S corporation, must use a “permitted tax year.” A permitted tax year is any of the
following.
-
The calendar year.
-
A tax year elected under section 444. (See below for details.)
-
A 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444. (See page 10 for
details.)
-
Any other tax year for which the corporation establishes a business purpose. (See page 10 for details.)
If an electing S corporation wishes to adopt a tax year other than a calendar year, it must request IRS approval using Form 2553,
Election by a Small Business Corporation, instead of filing Form 1128. For information about changing an S corporation's tax year, see the
instructions for Form 1128. See also Revenue Procedure 2002–38 for automatic approval requests and Revenue Procedure 2002–39
for ruling
requests.
Personal Service Corporation
A PSC must use a calendar tax year unless any of the following apply.
-
The corporation makes an election under section 444. (See below for details.)
-
The corporation elects to use a 52-53-week tax year ending with reference to the calendar year or a tax year elected under
section 444. (See
page 10 for details.)
-
The corporation establishes a business purpose for a fiscal year. (See page 10 for details.)
See the instructions for Form 1120 for general information about PSCs. For information on adopting or changing tax years for
PSCs, see the
instructions for Form 1128. See also Revenue Procedure 2002–38 for automatic approval requests and Revenue Procedure 2002–39
for ruling
requests.
A partnership, S corporation, electing S corporation, or PSC can elect under section 444 to use a tax year other than its
required tax year.
Certain restrictions apply to the election. A partnership or an S corporation that makes a section 444 election must make
certain required payments
and a PSC must make certain distributions (discussed later). The section 444 election does not apply to any partnership, S
corporation, or PSC that
establishes a business purpose for a different period, explained later.
A partnership, S corporation, or PSC can make a section 444 election if it meets all the following requirements.
-
It is not a member of a tiered structure (defined in section 1.444-2T of the regulations).
-
It has not previously had a section 444 election in effect.
-
It elects a year that meets the deferral period requirement.
Deferral period.
The determination of the deferral period depends on whether the partnership, S corporation, or PSC is retaining its
tax year or adopting or
changing its tax year with a section 444 election.
Retaining tax year.
Generally, a partnership, S corporation, or PSC can make a section 444 election to retain its tax year only if the
deferral period of the new tax
year is 3 months or less. This deferral period is the number of months between the beginning of the retained year and the
close of the first required
tax year.
Adopting or changing tax year.
If the partnership, S corporation, or PSC is adopting or changing to a tax year other than its required year, the
deferral period is the number of
months from the end of the new tax year to the end of the required tax year. The IRS will allow a section 444 election only
if the deferral period of
the new tax year is less than the shorter of:
If the partnership, S corporation, or PSC's tax year is the same as its required tax year, the deferral period is zero.
Example 1.
BD Partnership uses a calendar year, which is also its required tax year. BD cannot make a section 444 election because the
deferral period is
zero.
Example 2.
E, a newly formed partnership, began operations on December 1, 2002. E is owned by calendar year partners. E wants to make
a section 444 election
to adopt a September 30 tax year. E's deferral period for the tax year beginning December 1, 2002, is 3 months, the number
of months between September
30 and December 31.
Making the election.
You make a section 444 election by filing Form 8716, Election To Have a Tax Year Other Than a Required Tax Year,
with the Internal Revenue Service Center where the entity will file its tax return. Form 8716 must be filed by the
earlier of:
-
The due date (not including extensions) of the income tax return for the tax year resulting from the section 444 election,
or
-
The 15th day of the 6th month of the tax year for which the election will be effective. For this purpose, count the month
in which the tax
year begins, even if it begins after the first day of that month.
Attach a copy of Form 8716 to Form 1065, Form 1120S, or Form 1120 for the first tax year for which the election is
made.
Example 1.
AB, a partnership, begins operations on September 13, 2003, and is qualified to make a section 444 election to use a September
30 tax year for its
tax year beginning September 13, 2003. AB must file Form 8716 by January 15, 2004, which is the due date of the partnership's
tax return for the
period from September 13, 2003, to September 30, 2003.
Example 2.
The facts are the same as in Example 1 except that AB begins operations on October 21, 2003. AB must file Form 8716 by March 15, 2004,
the 15th day of the 6th month of the tax year for which the election will first be effective.
Example 3.
B is a corporation that first becomes a PSC for its tax year beginning September 1, 2003. B qualifies to make a section 444
election to use a
September 30 tax year for its tax year beginning September 1, 2003. B must file Form 8716 by December 15, 2003, the due date
of the income tax return
for the short period from September 1, 2003, to September 30, 2003.
Extension of time for filing.
There is an automatic extension of 12 months to make this election. See the Form 8716 instructions for more information.
Ending the election.
The section 444 election remains in effect until it is terminated. If the election is terminated, another section
444 election cannot be made for
any tax year.
The election ends when any of the following applies to the partnership, S corporation, or PSC.
-
The entity changes to its required tax year.
-
The entity liquidates.
-
The entity becomes a member of a tiered structure.
-
The IRS determines that the entity willfully failed to comply with the required payments or distributions.
The election will also end if either of the following events occur.
-
An S corporation's S election is terminated. However, if the S corporation immediately becomes a PSC, the PSC can continue
the section 444
election of the S corporation.
-
A PSC ceases to be a PSC. If the PSC elects to be an S corporation, the S corporation can continue the election of the PSC.
Required payment for partnership or S corporation.
A partnership or an S corporation must make a “ required payment” for any tax year:
This payment represents the value of the tax deferral the owners receive by using a tax year different from the required
tax year.
Form 8752, Required Payment or Refund Under Section 7519,
must be filed each year the section 444 election is in effect, even if no payment is due. If the required payment is
more than $500 (or the required payment for any prior year was more than $500), the payment must be made when Form 8752 is
filed. If the required
payment is $500 or less and no payment was required in a prior year, Form 8752 must be filed showing a zero amount.
Form 8752 must be filed and the required payment made (or zero amount reported) by May 15 of the calendar year following
the calendar year in which
the applicable election year begins. Any tax year a section 444 election is in effect, including the first year, is called
an “ applicable election
year.” For example, if a partnership's applicable election year begins July 1, 2003, Form 8752 must be filed by May 17, 2004.
Required distribution for PSC.
A PSC with a section 444 election in effect must distribute certain amounts to employee-owners by December 31 of each
applicable year. If it fails
to make these distributions, it may be required to defer certain deductions for amounts paid to owner-employees. The amount
deferred is treated as
paid or incurred in the following tax year.
For information on the minimum distribution, see the instructions for Part I of Schedule H (Form 1120), Section 280H Limitations for a
Personal Service Corporation (PSC).
Back-up election.
A partnership, S corporation, or PSC can file a back-up section 444 election if it requests (or plans to request)
permission to use a business
purpose tax year, discussed later. If the request is denied, the back-up section 444 election must be activated (if the partnership,
S corporation,
or PSC otherwise qualifies).
Making back-up election.
The general rules for making a section 444 election, as discussed earlier, apply. When filing Form 8716,
type or print “ BACK-UP ELECTION” at the top of the form. However, if Form 8716 is filed on or after the date Form
1128 (or Form 2553) is filed, type or print “ FORM 1128 (or FORM 2553) BACK-UP ELECTION” at the top of Form 8716.
Activating election.
A partnership or S corporation activates its back-up election by filing the return required and making the required
payment with Form 8752.
The due date for filing Form 8752 and making the payment is the later of the following dates.
-
May 15 of the calendar year following the calendar year in which the applicable election year begins.
-
60 days after the partnership or S corporation has been notified by the IRS that the business year request has been denied.
A PSC activates its back-up election by filing Form 8716 with its original or amended income tax return for the tax
year in which the election is
first effective and printing on the top of the income tax return, “ ACTIVATING BACK-UP ELECTION.”
A partnership, S corporation, or PSC can use a tax year other than its required tax year if it elects a 52-53-week tax year
that ends with
reference to either its required tax year or a tax year elected under section 444 (discussed earlier).
A newly formed partnership, S corporation, or PSC can adopt a 52-53-week tax year ending with reference to either its required
tax year or a tax
year elected under section 444 without IRS approval. However, if the entity wishes to change to a 52-53-week tax year or change
from a 52-53-week tax
year that references a particular month to a non-52-53-week tax year that ends on the last day of that month, it must request
IRS approval by filing
Form 1128. For more information, see the discussion on the 52-53-week tax year on page 3. See also Automatic Approval on page 11.
Business Purpose Tax Year
A partnership, S corporation, or PSC establishes the business purpose for a tax year by filing Form 1128. The rules for establishing
business
purpose are different for automatic approval requests and ruling requests.
Automatic approval requests.
For automatic approval requests, the requirement to establish a business purpose for a tax year is satisfied if the
requested tax year coincides
with the entity's required tax year, ownership tax year (for S corporations only), or natural business year. For purposes
of automatic approval
requests, an entity must satisfy the 25-percent gross receipts test to establish a natural business year.
25-percent gross receipts test.
To apply this test, take the following steps.
-
Total the gross receipts from sales and services for the most recent 12-month period that ends with the last month of the
requested tax
year. Figure this for the 12-month period that ends before the filing of the request. Also total the gross receipts from sales
and services for the
last 2 months of that 12-month period.
-
Determine the percentage of the receipts for the 2-month period by dividing the total of the last 2-month period by the total
for the entire
12-month period. Carry the percentage to two decimal places.
-
Figure the percentage following steps (1) and (2) for the two 12-month periods just preceding the 12-month period used in
(1).
If the percentage determined for each of the three years equals or exceeds 25%, the requested tax year is the natural
business year.
If one or more tax years (other than the requested tax year) produce higher averages of the three percentages than
the requested tax year, then the
requested tax year will not qualify as the natural business year under the 25-percent gross receipts test.
To apply the 25-percent gross receipts test for any particular year, the entity must use the method of accounting
used to prepare its tax return.
See Accounting Methods, later.
If the entity (including any predecessor organization) does not have at least 47 months of gross receipts (36-month
period for requested tax year
plus additional 11-month period for comparing requested tax year with other potential tax years), it cannot establish a natural
business year using
the 25-percent gross receipts test.
If the requested tax year is a 52-53-week tax year, the calendar month ending nearest the last day of the 52-53-week
tax year is treated as the
last month of the requested tax year for purposes of computing the 25-percent gross receipts test.
Ownership tax year.
An S corporation or corporation electing to be an S corporation can get automatic approval to adopt, change to, or
retain its ownership tax year.
An ownership tax year is the tax year that, as of the first day of the requested tax year, constitutes the tax year of one
or more shareholders
(including shareholders changing to that tax year) holding more than 50% of the corporation's issued and outstanding shares
of stock. For this
purpose, a shareholder that is tax-exempt under section 501(a) is disregarded if such shareholder is not subject to tax on
any income attributable to
the S corporation. The IRS will not apply this rule to require an S corporation to change its tax year for any tax year beginning
before 2003.
However, a tax-exempt shareholder is not disregarded if the S corporation is wholly owned by such tax-exempt entity. Shareholders
that want to change
their tax year must, when requesting permission, follow section 1.442-1(b) of the regulations, Revenue Procedure 2002–39 in
Internal Revenue
Bulletin 2002–22, or any other applicable IRS administrative procedure.
Ruling requests.
For ruling requests, the requirement to establish a business purpose for a tax year is satisfied if the requested
tax year coincides with the
entity's natural business year. For purposes of ruling requests, the natural business year of an entity can be determined
under any of the following 3
tests:
The entity can also establish a business purpose based on all the relevant facts and circumstances (see Facts and circumstances
test, later). However, the Service anticipates that such entity will be granted permission to adopt, change, or retain a tax year
only in rare
and unusual circumstances.
Annual business cycle test.
Apply this test if the entity's gross receipts from sales and services for the short period and the three immediately
preceding tax years indicate
that the entity has a peak and a non-peak period of business. The natural business year is considered to end at or one month
after the end of the
highest peak period. A business whose income is steady from month to month throughout the year will not meet this test.
Seasonal business test.
Apply this test if the entity's gross receipts from sales and services for the short period and the three immediately
preceding tax years indicate
that the entity's business is operational for only part of the year (due to weather conditions, for example). As a result,
during the period the
business is not operational, it has gross receipts equal to or less than 10% of its total gross receipts for the year. The
natural business year is
considered to end at or one month after the end of operations for the season.
Facts and circumstances test.
A taxpayer can establish a business purpose based on all the relevant facts and circumstances. This method of establishing
a business purpose does
not apply to automatic approval requests. Administrative and convenience business reasons such as the following are not sufficient to
establish a business purpose for a particular tax year.
-
Using a particular year for regulatory or financial accounting purposes.
-
Using a hiring pattern, such as typically hiring staff during certain times of the year.
-
Using a particular year for administrative purposes, such as:
-
Admission or retirement of partners or shareholders.
-
Promotion of staff.
-
Compensation or retirement arrangements with staff, partners, or shareholders.
-
Using a price list, model year, or other item that changes on an annual basis.
-
Deferring income to partners or shareholders.
-
Using a particular year used by related entities and competitors.
For examples of situations in which a business purpose is not shown as well as examples in which a substantial business
purpose has been
established, see Revenue Ruling 87–57 in Cumulative Bulletin 1987–2.
A partnership, S corporation, or PSC can request automatic approval to:
-
Change to a required tax year or to a 52-53-week tax year ending with reference to such required tax year.
-
Change to or retain a natural business year that satisfies the 25-percent gross receipts test or to a 52-53-week tax year
ending with
reference to such natural tax year.
-
Change from a non-52-53-week tax year to a 52-53-week tax year ending with reference to the same calendar month.
-
Change from a 52-53-week tax year that references a particular calendar month to a non-52-53-week tax year that ends on the
last day of the
same calendar month.
An S corporation or electing S corporation can request automatic approval to adopt, change to, or retain its ownership tax
year or a 52-53-week
tax year ending with reference to such ownership tax year. For more information, see pages 7 through 10 of this publication
and section 4.01 of
Revenue Procedure 2002–38.
Eligibility for automatic approval requests.
A partnership, S corporation, or PSC is not eligible to request automatic approval if:
-
It is under examination, unless it obtains IRS consent as provided in section 7.03(1) of Revenue Procedure 2002–38.
-
It is before an appeals office with respect to any income tax issue and its tax year is an issue under consideration by the
appeals
office.
-
It is before a federal court with respect to any income tax issue and its tax year is an issue under consideration by the
federal
court.
-
On the date a partnership or S corporation would otherwise file Form 1128 (or Form 2553), the entity's tax year is an issue
under
consideration in the examination of a partner's or shareholder's federal income tax return or an issue under consideration
by an appeals office or
federal court with respect to a partner's or shareholder's income tax return.
-
It is requesting a change to, or retention of, a natural business year (as discussed earlier) and it has changed its tax year
at any time in
the most recent 48-month period ending with the last month of the requested tax year. For this purpose, prior tax year changes
do not include changes
(1), (3), and (4) listed above, a change to an ownership tax year by an S corporation, or a change in tax year by an S corporation
or PSC to comply
with the common tax year requirements of sections 1.1502-75(d)(3)(v) and 1.1502-76(a)(1) of the regulations.
Filing information.
To get automatic approval, a partnership, S corporation, or electing S corporation must file a tax return for the
short period. The short period
tax return must be filed by the due date, including extensions.
To get automatic approval to adopt, change, or retain its tax year, the entity must file a current Form 1128 or Form
2553 (used by electing S
corporations to request approval to adopt a tax year other than a calendar year). See the instructions for Forms 1128 and
2553 for information on when
and where to file.
Form 1128 must be filed no earlier than the day following the end of the first tax year for which the adoption, change,
or retention is effective
(first effective year) and no later than the due date (including extensions) for filing the tax return for the first effective
year. In the case of a
change, the first effective year is the short period required to effect the change.
If a partnership, S corporation, or PSC is requesting to adopt, change, or retain a tax year and does not qualify for automatic
approval, the
entity can request a ruling under Revenue Procedure 2002–39. The eligibility requirements for an entity to request a ruling
are generally the
same as for automatic approval requests, except that the prior change restriction (the last item listed under Eligibility for automatic approval
requests, earlier) does not apply. See Ruling Request on page 5 for more information. For filing information, see the instructions
for Forms 1128 or 2553 for details.
Corporations (Other Than S Corporations and PSCs)
A new corporation establishes its tax year when it files its first tax return. A newly reactivated corporation that has been
inactive for a number
of years is treated as a new taxpayer for the purpose of adopting a tax year. An S corporation or a PSC must use the required
tax year rules,
discussed earlier, to establish a tax year.
A corporation that wants to change its tax year must generally get IRS approval either under the automatic approval procedures
or the ruling
request procedures.
Automatic approval.
Certain C corporations can get automatic approval for a tax year change, including a change to (or from) a 52-53-week
tax year. The corporation
must, however, meet all the following criteria.
-
It has not changed its annual accounting period within the most recent 48-month period ending with the last month of the requested
tax year.
For a list of changes not considered a change in accounting period, see Revenue Procedure 2002–37.
-
It is not any of the following:
-
A member of a partnership. See Caution, later.
-
A beneficiary of a trust or an estate. See Caution, later.
-
An S corporation (and does not attempt to make an S corporation election for the tax year immediately following the short
period unless
changing to a permitted tax year).
-
A PSC.
-
An interest-charge domestic international sales corporation (IC–DISC) or foreign sales corporation (FSC) or a shareholder
in either.
See Caution, later.
-
A controlled foreign corporation or foreign personal holding company. See Caution, later.
-
A tax-exempt organization, except those exempt under section 521, 526, 527, or 528.
-
A cooperative association with a loss in the short period required to effect the tax year change unless more than 90% of the
patrons of the
association are the same in the year before and after the change and in the short period.
-
A corporation with a section 936 election in effect.
-
A corporation not described in items (2a) through (2i), listed above, that has a required tax year.
For exceptions to items (2a), (2b), (2e), and (2f), listed above, see Revenue Procedure 2002–37.
Note:
A corporation that meets all the criteria listed above except for (2a) or (2b) can nevertheless automatically change to a
natural business year
that meets the 25-percent gross receipts test (discussed earlier under 25-percent gross receipts test).
A controlled foreign corporation that wants to revoke its one-month deferral election under section 898(c)(1)(B) but does
not meet all of the above
criteria can nevertheless automatically change to the majority U.S. shareholder tax year.
Corporations that qualify and want to change their tax year using this automatic procedure must also comply with the
following conditions.
-
The corporation must file a tax return for the short period by the due date, including extensions.
-
The books of the corporation must be closed as of the last day of the first effective year. Returns for later years must be
made on the
basis of a full 12 months (or 52-53 weeks) ending on the last day of the requested tax year. The corporation must figure its
income and keep its books
and records, including financial reports and statements to creditors, on the basis of the requested tax year.
-
Taxable income of the corporation for the short period must be figured on an annual basis and the tax must be figured as shown
under
Figuring Tax for Short Year, earlier.
-
If the corporation has a net operating loss (NOL) or capital loss (CL) in the short period required to effect the change,
the NOL or CL
generally cannot be carried back but must be carried over. However, generally for tax years ending after April 7, 2003, a
short period NOL or CL can
be carried back or carried over if it is either:
-
$50,000 or less, or
-
Less than the NOL or CL for the full 12-month period beginning with the first day of the short period.
-
If there is any unused credit for the short period, the corporation must carry the unused credit(s) forward. Unused credit(s)
cannot be
carried back.
See Revenue Procedure 2002–37 for more information. See also Revenue Procedure 2003–34 in Internal Revenue Bulletin
2003–18,
which modifies the restrictions in Revenue Procedure 2002–37 against carrying back NOLs and CLs generated in the short period.
Form 1128.
To get automatic approval to change its tax year, a corporation must file Form 1128 by the due date (including extensions)
for filing the tax
return for the short period required to effect such change. See the instructions for Forms 1128 for information on when and
where to file.
The request will be denied if Form 1128 is not filed on time or if the corporation fails to meet the requirements
listed earlier. If a corporation
changes its tax year without first meeting all the conditions, the tax year is considered changed without IRS approval.
Ruling request.
If a corporation is requesting to change a tax year and does not qualify for automatic approval, the corporation can
request a ruling under Revenue
Procedure 2002–39. See Ruling Request on page 5 for more information. For filing information, see the instructions for Form 1128 for
details.
An accounting method is a set of rules used to determine when income and expenses are reported. Your accounting method includes
not only your
overall method of accounting, but also the accounting treatment you use for any material item.
You choose an accounting method when you file your first tax return. If you later want to change your accounting method, you
must get IRS approval.
See Change in Accounting Method, later.
No single accounting method is required of all taxpayers. You must use a system that clearly reflects your income and expenses
and you must
maintain records that will enable you to file a correct return. In addition to your permanent books of account, you must keep
any other records
necessary to support the entries on your books and tax returns.
You must use the same accounting method from year to year. An accounting method clearly reflects income only if all items
of gross income and
expenses are treated the same from year to year.
If you do not regularly use an accounting method that clearly reflects your income, your income will be figured under the
method that, in the
opinion of the IRS, does clearly reflect income.
Methods you can use.
In general, except as otherwise required and subject to the preceding rules, you can compute your taxable income under
any of the following
accounting methods.
The cash and accrual methods of accounting are explained later.
Special methods.
This publication does not discuss special methods of accounting for certain items of income or expenses. For information
on reporting income using
one of the long-term contract methods, see section 460 and its regulations. Publication 535, Business Expenses, discusses methods for
deducting amortization and depletion. The following publications also discuss special methods of reporting income or expenses.
-
Publication 225, Farmer's Tax Guide.
-
Publication 537, Installment Sales.
-
Publication 946, How To Depreciate Property.
Combination (hybrid) method.
Generally and except as otherwise required, you can use any combination of cash, accrual, and special methods of accounting
if the combination
clearly reflects your income and you use it consistently. However, the following restrictions apply.
-
If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales. See, however,
Exceptions under Inventories, later. Generally, you can use the cash method for all other items of income and expenses. See
Inventories, later.
-
If you use the cash method for reporting your income, you must use the cash method for reporting your expenses.
-
If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.
-
Any combination that includes the cash method is treated as the cash method for purposes of section 448.
Business and personal items.
You can account for business and personal items using different accounting methods. For example, you can determine
your business income and
expenses under an accrual method, even if you use the cash method to figure personal items.
Two or more businesses.
If you operate two or more separate and distinct businesses, you can use a different accounting method for each. No
business is separate and
distinct, however, unless a complete and separate set of books and records is maintained for the business.
If you use different accounting methods to create or shift profits or losses between businesses (for example, through
inventory adjustments, sales,
purchases, or expenses) so that income is not clearly reflected, the businesses will not be considered separate and distinct.
Most individuals and many small businesses use the cash method of accounting. Generally, however, if you produce, purchase,
or sell merchandise,
you must keep an inventory and use an accrual method for sales and purchases of merchandise. See Exceptions on page 21 for exceptions to
this rule.
Under the cash method, you include in your gross income all items of income you actually or constructively receive during
the tax year. If you
receive property and services, you must include their fair market value in income.
Constructive receipt.
Income is constructively received when an amount is credited to your account or made available to you without restriction.
You need not have
possession of it. If you authorize someone to be your agent and receive income for you, you are considered to have received
it when your agent
receives it. Income is not constructively received if your control of its receipt is subject to substantial restrictions or
limitations.
Example 1.
Interest is credited to your bank account in December 2003, but you do not withdraw it or enter it into your passbook until
2004. You must include
the amount in gross income for 2003, not 2004.
Example 2.
You have interest coupons that mature and become payable in 2003, but you do not cash them until 2004. You must include the
interest in gross
income for 2003, the year of constructive receipt. You must include the interest in your 2003 income, even if you later exchange
the coupons for other
property, instead of cashing them.
Delaying receipt of income.
You cannot hold checks or postpone taking possession of similar property from one tax year to another to postpone
paying tax on the income. You
must report the income in the year the property is received or made available to you without restriction.
Under the cash method, you generally deduct expenses in the tax year in which you actually pay them. This includes business
expenses for which you
contest liability. However, you may not be able to deduct an expense paid in advance and you may be required to capitalize
certain costs, as explained
later under Uniform Capitalization Rules.
Expense paid in advance.
An expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for
the “ 12-month rule.”
Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits
for the taxpayer that do not
extend beyond the earlier of the following.
-
12 months after the right or benefit begins, or
-
The end of the tax year after the tax year in which payment is made.
If you have not been applying the general rule (an expense paid in advance is deductible only in the year to which
it applies) and/or the 12-month
rule to the expenses you paid in advance, you must get IRS approval before using the general rule and/or the 12-month rule.
See Change in
Accounting Method, later, for information on how to get IRS approval.
Example 1.
You are a calendar year taxpayer and you pay $3,000 in 2004 for a business insurance policy that is effective for three years,
beginning July 1,
2004. The general rule that an expense paid in advance is deductible only in the year to which it applies is applicable to
this payment because the
payment does not qualify for the 12-month rule. Therefore, $500 is deductible in 2004, $1,000 is deductible in 2005, $1,000
is deductible in 2006, and
$500 is deductible in 2007.
Example 2.
You are a calendar year taxpayer and you pay $10,000 on July 1, 2004, for a business insurance policy that is effective for
one year beginning July
1, 2004. The 12-month rule applies. Therefore, the full $10,000 is deductible in 2004.
The following entities cannot use the cash method, including any combination of methods that includes the cash method. (See
Special rules for
farming businesses, later.)
-
A corporation (other than an S corporation) with average annual gross receipts exceeding $5 million. See Gross receipts test
below.
-
A partnership with a corporation (other than an S corporation) as a partner, and with the partnership having average annual
gross receipts
exceeding $5 million. See Gross receipts test below.
-
A tax shelter.
The following entities are not prohibited from using the cash method of accounting.
-
Any corporation or partnership, other than a tax shelter, that meets the gross receipts test for all tax years after 1985.
-
A qualified personal service corporation (PSC).
Gross receipts test.
A corporation or partnership, other than a tax shelter, that meets the gross receipts test can generally use the cash
method. A corporation or a
partnership meets the test if, for each prior tax year beginning after 1985, its average annual gross receipts are $5 million
or less. An entity's
average annual gross receipts for a prior tax year is determined by adding the gross receipts for that tax year and the 2
preceding tax years and
dividing the total by 3. See Gross receipts test for qualifying taxpayers on page 21 for more information on the gross receipts test.
Generally, a partnership applies the test at the partnership level. Gross receipts for a short tax year are annualized.
Aggregation rules.
Organizations that are members of an affiliated service group or a controlled group of corporations treated as a single
employer for tax purposes
are required to aggregate their gross receipts to determine whether the gross receipts test is met.
Change to accrual method.
A corporation or partnership that fails to meet the gross receipts test for any tax year is prohibited from using
the cash method and must change
to an accrual method of accounting, effective for the tax year in which the entity fails to meet this test.
Special rules for farming businesses.
Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming
business. However, certain
corporations (other than S corporations) and partnerships that have a partner that is a corporation must use an accrual method
for their farming
business. For this purpose, farming does not include the operation of a nursery or sod farm or the raising or harvesting of
trees (other than fruit
and nut trees). There is an exception to the requirement to use an accrual method for corporations with gross receipts of
$1 million or less for each
prior tax year after 1975. For family corporations (defined in section 447(d)(2)(C)) engaged in farming, the exception applies
if gross receipts were
$25 million or less for each prior tax year after 1985. See section 447 and chapter 3 of Publication 225, Farmer's Tax Guide, for more
information.
Qualified PSC.
A PSC that meets the following function and ownership tests can use the cash method.
Function test.
A corporation meets the function test if at least 95% of its activities are in the performance of services in the
fields of health, veterinary
services, law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts,
or consulting.
Ownership test.
A corporation meets the ownership test if at least 95% of its stock is owned, directly or indirectly, at all times
during the year by one or more
of the following.
-
Employees performing services for the corporation in a field qualifying under the function test.
-
Retired employees who had performed services in those fields.
-
The estate of an employee described in (1) or (2).
-
Any other person who acquired the stock by reason of the death of an employee referred to in (1) or (2), but only for the
2-year period
beginning on the date of death.
Indirect ownership is generally taken into account if the stock is owned indirectly through one or more partnerships,
S corporations, or qualified
PSCs. Stock owned by one of these entities is considered owned by the entity's owners in proportion to their ownership interest
in that entity. Other
forms of indirect stock ownership, such as stock owned by family members, are generally not considered when determining if
the ownership test is met.
For purposes of the ownership test, a person is not considered an employee of a corporation unless that person performs
more than minimal services
for the corporation.
Change to accrual method.
A corporation that fails to meet the function test for any tax year or fails to meet the ownership test at any time
during any tax year must change
to an accrual method of accounting, effective for the year in which the corporation fails to meet either test. A corporation
that fails to meet the
function test or the ownership test is not treated as a qualified PSC for any part of that tax year.
Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in
the year incurred. The
purpose of an accrual method of accounting is to match income and expenses in the correct year.
You generally include an amount as gross income for the tax year in which all events that fix your right to receive the income
have occurred and
you can determine the amount with reasonable accuracy. Under this rule, you report an amount in your gross income on the earliest
of the following
dates.
-
When you receive payment.
-
When the income amount is due to you.
-
When you earn the income.
Example.
You are a calendar year, accrual basis taxpayer. You sold a computer on December 28, 2002. You billed the customer in the
first week of January
2003, but did not receive payment until February 2003. You include the amount received in February for the computer in your
2002 income, the year you
earned the income.
Estimated income.
If you include a reasonably estimated amount in gross income and later determine the exact amount is different, take
the difference into account in
the tax year you make that determination.
Change in payment schedule.
If you perform services for a basic rate specified in a contract, you must accrue the income at the basic rate, even
if you agree to receive
payments at a reduced rate. Continue this procedure until you complete the services, then account for the difference.
Accounts receivable for services.
You may not have to accrue your accounts receivable for services you perform that, based on your experience, you will
not collect. The
nonaccrual-experience method is explained in section 1.448–2T of the regulations.
Advance Payment for Services
Generally, you report an advance payment for services to be performed in a later tax year as income in the year you receive
the payment. However,
if you receive an advance payment for services you agree to perform by the end of the next tax year, you can elect to postpone
including the advance
payment in income until the next tax year. However, you cannot postpone including any payment beyond that tax year.
Service agreement.
You can postpone reporting income from an advance payment you receive for a service agreement on property you sell,
lease, build, install, or
construct. This includes an agreement providing for incidental replacement of parts or materials. However, this applies only
if you offer the property
without a service agreement in the normal course of business.
Postponement not allowed.
You generally cannot postpone including an advance payment in income for services if either of the following applies.
-
You are to perform any part of the service after the end of the tax year immediately following the year you receive the advance
payment.
-
You are to perform any part of the service at any unspecified future date that may be after the end of the tax year immediately
following
the year you receive the advance payment.
Examples.
In each of the following examples, assume you use the calendar year and an accrual method of accounting.
Example 1.
You manufacture, sell, and service computers. You received payment in 2003 for a one-year contingent service contract on a
computer you sold. You
can postpone including in income the part of the payment you did not earn in 2003 if, in the normal course of your business,
you offer computers for
sale without a contingent service contract.
Example 2.
You are in the television repair business. You received payments in 2003 for one-year contracts under which you agree to repair
or replace certain
parts that fail to function properly in television sets manufactured and sold by unrelated parties. You include the payments
in gross income as you
earn them.
In Examples 3 and 4, if you do not perform part of the services by the end of the following tax year (2004), you must still include
advance payments for the unperformed services in gross income for 2004.
Example 3.
You own a dance studio. On November 1, 2003, you receive payment for a one-year contract for 48 one-hour lessons beginning
on that date. You give
eight lessons in 2003. Under this method of including advance payments, you must include one-sixth (8/48) of the payment in
income for 2003, and
five-sixths (40/48) of the payment in 2004, even if you cannot give all the lessons by the end of 2004.
Example 4.
Assume the same facts as in Example 3, except the payment is for a two-year contract for 96 lessons. You must include the entire payment
in income in 2003 since part of the services may be performed after the following year.
Guarantee or warranty.
You generally cannot postpone reporting income you receive under a guarantee or warranty contract.
Prepaid rent.
You cannot postpone reporting income from prepaid rent. Prepaid rent does not include payment for the use of a room
or other space when significant
service is also provided for the occupant. You provide significant service when you supply space in a hotel, boarding house,
tourist home, motor
court, motel, or apartment house that furnishes hotel services.
Books and records.
Any advance payment you include in gross receipts on your tax return for the year you receive payment must not be
less than the payment you include
in gross receipts for your books and records and all your reports. This includes reports (including consolidated financial
statements) to
shareholders, partners, other proprietors or beneficiaries, and for credit purposes.
IRS approval.
You must file Form 3115 to get IRS approval, as discussed later under Change in Accounting Method, on page 28 to change your method of
accounting for advance payments for services.
Advance Payment for Sales
Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods
held primarily for sale
to customers in the ordinary course of your trade or business. However, the rules do not apply to a payment (or part of a
payment) for services that
are not an integral part of the main activities covered under the agreement. An agreement includes a gift certificate that
can be redeemed for goods.
Amounts due and payable are considered received.
How to report payments.
You generally include an advance payment in income in the year in which you receive it. However, you can use the alternative
method, discussed
next.
Alternative method of reporting.
Under the alternative method, you generally include an advance payment in income in the earlier tax year in which:
-
You include advance payments in gross receipts under the method of accounting you use for tax purposes, or
-
You include any part of advance payments in income for financial reports under the method of accounting used for those reports.
Financial
reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated
financial statements.
Example 1.
You are a retailer. You use an accrual method of accounting and you account for the sale of goods when you ship the goods.
You use this method for
both tax and financial reporting purposes. You can include advance payments in gross receipts for tax purposes either in the
tax year you receive the
payments or in the tax year you ship the goods. However, see Exception for inventory goods, later.
Example 2.
You are a calendar year taxpayer. You manufacture household furniture and use an accrual method of accounting. Under this
method, you accrue income
for your financial reports when you ship the furniture. For tax purposes, you do not accrue income until the furniture has
been delivered and
accepted.
In 2003, you received an advance payment of $8,000 for an order of furniture to be manufactured for a total price of $20,000.
You shipped the
furniture to the customer in December 2003, but it was not delivered and accepted until January 2004. For tax purposes, you
include the $8,000 advance
payment in gross income for 2003 and you include the remaining $12,000 of the contract price in gross income for 2004.
Information schedule.
If you use the alternative method of reporting advance payments, you must attach a statement with the following information
to your tax return each
year.
-
Total advance payments received in the current tax year.
-
Total advance payments received in earlier tax years and not included in income before the current tax year.
-
Total payments received in earlier tax years included in income for the current tax year.
Exception for inventory goods.
If you have an agreement to sell goods properly included in inventory, you can postpone including the advance payment
in income until the end of
the second tax year following the year you receive an advance payment if, on the last day of the tax year, you meet the following
requirements.
-
You account for the advance payment under the alternative method (discussed earlier).
-
You have received a substantial advance payment on the agreement (discussed next).
-
You have enough substantially similar goods on hand, or available through your normal source of supply, to satisfy the agreement.
These rules also apply to an agreement, such as a gift certificate, that can be satisfied with goods that cannot be identified
in the tax year
you receive an advance payment.
If you meet these conditions, all advance payments you receive by the end of the second tax year, including payments
received in prior years but
not reported, must be included in income by the second tax year following the tax year of receipt of substantial advance payments. You must
also deduct in that second year all actual or estimated costs for the goods required to satisfy the agreement. If you estimate
the cost, you must take
any difference between the estimate and the actual cost into account when the goods are delivered.
You must report any advance payments you receive after the second year in the year received. No further deferral is
allowed.
Substantial advance payments.
Under an agreement for a future sale, you have substantial advance payments if, by the end of the tax year, the total
advance payments received
during that year and preceding tax years are equal to or more than the total costs reasonably estimated to be includible in
inventory because of the
agreement.
Example.
You are a calendar year, accrual method taxpayer who accounts for advance payments under the alternative method. In 2000,
you entered into a
contract for the sale of goods properly includible in your inventory. The total contract price is $50,000 and you estimate
that your total
inventoriable costs for the goods will be $25,000. You receive the following advance payments under the contract.
Your customer asked you to deliver the goods in 2006. In your 2001 closing inventory, you had on hand enough of the
type of goods specified in the
contract to satisfy the contract. Since the advance payments you had received by the end of 2001 were more than the costs
you estimated, the payments
are substantial advance payments.
Include in income for 2003 all payments you receive by the end of 2003, the second tax year following the tax year
in which you received
substantial advance payments. You must include $40,000 in sales for 2003 and include in inventory the cost of the goods (or
similar goods) on hand. If
no such goods are on hand, then estimate the cost necessary to satisfy the contract.
No further deferral is allowed. You must include in gross income the advance payment you receive each remaining year
of the contract. Take into
account the difference between any estimated cost of goods sold and the actual cost when you deliver the goods in 2006.
IRS approval.
You must file Form 3115 to get IRS approval to change your method of accounting for advance payments for sales.
Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply.
-
The all-events test has been met. The test is met when:
-
All events have occurred that fix the fact of liability, and
-
The liability can be determined with reasonable accuracy.
-
Economic performance has occurred.
You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property
or services
provided to you, or for your use of property, economic performance occurs as the property or services are provided or the
property is used. If your
expense is for property or services you provide to others, economic performance occurs as you provide the property or services.
Example.
You are a calendar year taxpayer. You buy office supplies in December 2003. You receive the supplies and the bill in December,
but you pay the bill
in January 2004. You can deduct the expense in 2003 because all events have occurred to fix the fact of liability, the liability
can be determined,
and economic performance occurred in 2003.
Your office supplies may qualify as a recurring item, discussed later. If so, you can deduct them in 2003, even if the supplies
are not delivered
until 2004 (when economic performance occurs).
Workers' compensation and tort liability.
If you are required to make payments under workers' compensation laws or in satisfaction of any tort liability, economic
performance occurs as you
make the payments. If you are required to make payments to a special designated settlement fund established by court order
for a tort liability,
economic performance occurs as you make the payments.
Taxes.
Economic performance generally occurs as estimated income tax, property taxes, employment taxes, etc. are paid. However,
you can elect to treat
taxes as a recurring item, discussed later. You can also elect to ratably accrue real estate taxes. See chapter 6 of Publication
535 for information
about real estate taxes.
Other liabilities.
Other liabilities for which economic performance occurs as you make payments include liabilities for breach of contract
(to the extent of
incidental, consequential, and liquidated damages), violation of law, rebates and refunds, awards, prizes, jackpots, insurance,
and warranty and
service contracts.
Interest.
Economic performance occurs with the passage of time (as the borrower uses, and the lender forgoes use of, the lender's
money) rather than as
payments are made.
Compensation for services.
Generally, economic performance occurs as an employee renders service to the employer. However, deductions for compensation
or other benefits paid
to an employee in a year subsequent to economic performance are subject to the rules governing deferred compensation, deferred
benefits, and funded
welfare benefit plans. For information on employee benefit programs, see Publication 15-B, Employer's Tax Guide to Fringe Benefits.
Vacation pay.
You can take a current deduction for vacation pay earned by your employees if you pay it during the year or, if the
amount is vested, within 21/ months after the end of the year. If you pay it later than this, you must deduct it in the year
actually paid. An amount is vested if
your right to it cannot be nullified or cancelled.
Exception for recurring items.
An exception to the economic performance rule allows certain recurring items to be treated as incurred during the
tax year even though economic
performance has not occurred. The exception applies if all the following requirements are met.
-
The all-events test, discussed earlier, is met.
-
Economic performance occurs by the earlier of the following dates.
-
8½ months after the close of the year.
-
The date you file a timely return (including extensions) for the year.
-
The item is recurring in nature and you consistently treat similar items as incurred in the tax year in which the all-events
test is
met.
-
Either:
-
The item is not material, or
-
Accruing the item in the year in which the all-events test is met results in a better match against income than accruing the
item in the
year of economic performance.
This exception does not apply to workers' compensation or tort liabilities.
Amended return.
You may be able to file an amended return and treat a liability as incurred under the recurring item exception. You
can do so if economic
performance for the liability occurs after you file your tax return for the year, but within 8½ months after the close of
the tax year.
Recurrence and consistency.
To determine whether an item is recurring and consistently reported, consider the frequency with which the item and
similar items are incurred (or
expected to be incurred) and how you report these items for tax purposes. A new expense or an expense not incurred every year
can be treated as
recurring if it is reasonable to expect that it will be incurred regularly in the future.
Materiality.
Factors to consider in determining the materiality of a recurring item include the size of the item (both in absolute
terms and in relation to your
income and other expenses) and the treatment of the item on your financial statements.
An item considered material for financial statement purposes is also considered material for tax purposes. However,
in certain situations an
immaterial item for financial accounting purposes is treated as material for purposes of economic performance.
Matching expenses with income.
Costs directly associated with the revenue of a period are properly allocable to that period. To determine whether
the accrual of an expense in a
particular year results in a better match with the income to which it relates, generally accepted accounting principles are
an important factor. For
example, if you report sales income in the year of sale, but you do not ship the goods until the following year, the shipping
costs are more properly
matched to income in the year of sale than the year the goods are shipped. Expenses that cannot be practically associated
with income of a particular
period, such as advertising costs, should be assigned to the period the costs are incurred. However, the matching requirement
is considered met for
certain types of expenses. These expenses include taxes, payments under insurance, warranty, and service contracts, rebates
and refunds, and awards,
prizes, and jackpots.
An expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for the “12-month rule.” Under
the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer
that do not extend
beyond the earlier of the following.
-
12 months after the right or benefit begins, or
-
The end of the tax year after the tax year in which payment is made.
If you have not been applying the general rule (an expense paid in advance is deductible only in the year to which it applies)
and/or the 12-month
rule to the expenses you paid in advance, you must get IRS approval before using the general rule and/or the 12-month rule.
See Change in
Accounting Method, later, for information on how to get IRS approval. See Expense paid in advance under Cash Method,
earlier, for examples illustrating the application of the general and 12-month rules.
Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible until you make the
payment and the corresponding amount is includible in the related person's gross income. Determine the relationship for this
rule as of the end of the
tax year for which the expense or interest would otherwise be deductible. If a deduction is denied, the rule will continue
to apply even if your
relationship with the person ends before the expense or interest is includible in the gross income of that person.
Related persons.
For purposes of this rule, the following persons are related.
-
Members of a family, including only brothers and sisters (either whole or half), husband and wife, ancestors, and lineal
descendants.
-
Two corporations that are members of the same controlled group as defined in section 267(f).
-
The fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is
the grantor of
both trusts.
-
A tax-exempt educational or charitable organization and a person (if an individual, including the members of the individual's
family) who
directly or indirectly controls such an organization.
-
An individual and a corporation when the individual owns, directly or indirectly, more than 50% of the value of the outstanding
stock of the
corporation.
-
A fiduciary of a trust and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than
50% in value of
the outstanding stock of the corporation.
-
The grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
-
Any two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation.
-
An S corporation and a corporation that is not an S corporation if the same persons own more than 50% in value of the outstanding
stock of
each corporation.
-
A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation
and more than 50%
of the capital or profits interest in the partnership.
-
A PSC and any employee-owner, regardless of the amount of stock owned by the employee-owner.
Ownership of stock.
To determine whether an individual directly or indirectly owns any of the outstanding stock of a corporation, the
following rules apply.
-
Stock owned directly or indirectly by or for a corporation, partnership, estate, or trust is treated as being owned proportionately
by or
for its shareholders, partners, or beneficiaries.
-
An individual is treated as owning the stock owned directly or indirectly by or for the individual's family (as defined in
item (1) under
Related persons).
-
Any individual owning (other than by applying rule (2)) any stock in a corporation is treated as owning the stock owned directly
or
indirectly by that individual's partner.
-
To apply rule (1), (2), or (3), stock constructively owned by a person under rule (1) is treated as actually owned by that
person. But stock
constructively owned by an individual under rule (2) or (3) is not treated as actually owned by the individual for applying
either rule (2) or (3) to
make another person the constructive owner of that stock.
Reallocation of income and deductions.
Where it is necessary to clearly show income or prevent tax evasion, the IRS can reallocate gross income, deductions,
credits, or allowances
between two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests.
If you use an accrual method of accounting and contest an asserted liability, you can deduct the liability either in the year
you pay it (or
transfer money or other property in satisfaction of it) or in the year you finally settle the contest. However, to take the
deduction in the year of
payment or transfer, you must meet certain conditions.
Conditions to be met.
You must satisfy each of the following conditions to take the deduction in the year of payment or transfer.
Liability must be contested.
You do not have to start a suit in a court of law to contest an asserted liability. However, you must deny its validity
or accuracy by a positive
act. A written protest included with payment of an asserted liability is enough to start a contest. Lodging a protest in accordance
with local law is
also enough to contest an asserted liability for taxes. You do not have to deny the validity or accuracy of an asserted liability
in writing if you
can show by all the facts and circumstances that you have asserted and contested the liability.
Contest must exist.
The contest for the asserted liability must exist after the time of the transfer. If you make payment after the contest
is settled, you must accrue
the liability in the year in which the contest is settled.
Example.
You are a calendar year taxpayer using an accrual method of accounting. You had a $500 liability asserted against you in 2000
for repair work
completed that year. You contested the asserted liability and settled in 2002 for the full $500. You pay the $500 in January
2003. Since you did not
make the payment until after the contest was settled, the liability accrues in 2002 and you can deduct it only in 2002.
Transfer to creditor.
You must transfer to the creditor or other person money or other property to provide for the payment of the asserted
liability. The money or other
property transferred must be beyond your control. If you transfer it to an escrow agent, you have met this requirement if
you give up all authority
over the money or other property. However, buying a bond to guarantee payment of the asserted liability, making an entry on
your books of account,
transferring funds to an account within your control, transferring your indebtedness or your promise to provide services or
property in the future, or
transferring (except to the creditor) your stock or the stock or indebtedness of a related person will not meet this requirement.
Liability deductible.
The liability must have been deductible in the year of payment, or in an earlier year when it would have accrued,
if there had been no contest.
Economic performance rule satisfied.
You generally cannot deduct contested liabilities until economic performance occurs. For workers' compensation or
a tort liability, or a liability
for breach of contract (to the extent of incidental, consequential, and liquidated damages), violation of law, rebates and
refunds, awards, prizes,
jackpots, insurance, warranty and service contracts, and taxes, economic performance occurs as payments are made to the person.
The payment or
transfer of money or other property into escrow to contest an asserted liability is generally not a payment to the claimant
that discharges the
liability. This payment does not satisfy the economic performance test, discussed earlier, except as provided in section
468B or the regulations
thereunder.
Recovered amounts.
An adjustment is usually necessary when you recover any part of a contested liability. This occurs when you deduct
the liability in the year of
payment and recover any part of it in a later tax year when the contest is settled. Include in gross income in the year of
final settlement the part
of the recovered amount that, when deducted, decreased your tax for any tax year.
Foreign taxes and taxes of U.S. possessions.
The rule allowing the deduction of contested liabilities in the tax year of payment does not apply to the deduction for income, war
profits, and excess profits taxes imposed by any foreign government or U.S. possession. This means that an accrual method
taxpayer deducts these
liabilities in the tax year in which the contested foreign tax or U.S. possession tax is finally determined.
Contested foreign taxes accrued for the foreign tax credit are not covered under this provision but relate back to and are credited in
the tax year in which they would have been accrued had they not been contested.
An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing
factor. If you must
account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales. However,
see
Exceptions, next. See also Accrual Method, earlier.
To figure taxable income, you must value your inventory at the beginning and end of each tax year. To determine the value,
you need a method for
identifying the items in your inventory and a method for valuing these items. See Identifying Cost and Valuing
Inventory, later.
The rules for valuing inventory cannot be the same for all kinds of businesses. The method you use must conform to generally
accepted accounting
principles for similar businesses and must clearly reflect income. Your inventory practices must be consistent from year to
year.
The rules discussed here apply only if they do not conflict with the uniform capitalization rules of section 263A and the
mark-to-market rules of
section 475.
The following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers
can also account
for inventoriable items as materials and supplies that are not incidental (discussed later).
In addition to the information provided in this publication, you should see the revenue procedures referenced in the list,
above, and the
instructions for Form 3115 for information you will need to adopt or change to these accounting methods (see Changing methods
, later).
Qualifying taxpayer.
You are a qualifying taxpayer under Revenue Procedure 2001–10 only if:
-
You satisfy the gross receipts test for each prior tax year ending on or after December 17, 1998 (see Gross receipts test for
qualifying taxpayers, next). Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $1 million or
less.
-
You are not a tax shelter as defined under section 448(d)(3).
Gross receipts test for qualifying taxpayers.
To determine if you meet the gross receipts test for qualifying taxpayers, follow the following steps:
-
Step 1. List each of the test years. For qualifying taxpayers under Revenue Procedure 2001–10, the test years are each
prior tax year ending on or after December 17, 1998. For 2003, the test years are 1998, 1999, 2000, 2001, and 2002 for a calendar
year
taxpayer.
-
Step 2. Determine your average annual gross receipts for each test year listed in Step 1. Your average annual gross receipts for
a tax year is determined by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total
by 3. For example, if
gross receipts are $200,000 for 1996, $800,000 for 1997, and $1,100,000 for 1998, the average annual gross receipts for 1998
are $700,000 (($200,000 +
$800,000 + $1,100,000) ÷ 3 = $700,000). See section 5 of Revenue Procedure 2001–10 for more information.
-
Step 3. You meet the gross receipts test for qualifying taxpayers if your average annual gross receipts for each test year listed
in Step 1 is $1 million or less.
See Table 1 for a summary of these rules for 2003.
Table 1. 2003 Gross Receipts Test for Qualifying Taxpayers
| Step 1. Test year (prior tax years ending on or after December 17,
1998.
|
Step 2. Determine your average annual gross receipts for each test
year.
|
| 1998 |
(1996 + 1997 + 1998) ÷ 3 |
| 1999 |
(1997 + 1998 + 1999) ÷ 3 |
| 2000 |
(1998 + 1999 + 2000) ÷ 3 |
| 2001 |
(1999 + 2000 + 2001) ÷ 3 |
| 2002 |
(2000 + 2001 + 2002) ÷ 3 |
| Step 3. If the average annual gross receipts for each test year is $1 million or less, you
meet the gross receipts test for qualifying taxpayers.
|
Qualifying small business taxpayer.
You are a qualifying small business taxpayer under Revenue Procedure 2002–28 only if:
-
You satisfy the gross receipts test for each prior tax year ending on or after December 31, 2000 (see Gross receipts test for
qualifying small business taxpayers, next). Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $10
million or less.
-
You are not prohibited from using the cash method under section 448.
-
Your principle business activity is an eligible business. See Eligible business, later.
-
You have not changed (or have not been required to change) from the cash method because you became ineligible to use the cash
method under
Revenue Procedure 2002–28.
Note: Revenue Procedure 2002–28 does not apply to a farming business of a qualifying small business taxpayer. A taxpayer engaged
in the trade or
business of farming generally is allowed to use the cash method for any farming business. See Special rules for farming businesses under
Cash Method, earlier.
Gross receipts test for qualifying small business taxpayers.
To determine if you meet the gross receipts test for qualifying small business taxpayers, follow the following steps:
-
Step 1. List each of the test years. For qualifying small business taxpayers under Revenue Procedure 2002–28, the test
years are each prior tax year ending on or after December 31, 2000. For 2003, the test years are 2000, 2001, and 2002 for
a calendar year
taxpayer.
-
Step 2. Determine your average annual gross receipts for each test year listed in Step 1. Your average annual gross receipts for
a tax year is determined by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total
by 3. For example, if
gross receipts are $6 million for 1998, $9 million for 1999, and $12 million for 2000, the average annual gross receipts for
2000 are $9 million (($6
million + $9 million + $12 million) ÷ 3 = $9 million). See section 5 of Revenue Procedure 2002–28 for more information.
-
Step 3. You meet the gross receipts test for qualifying small business taxpayers if your average annual gross receipts for each
test year listed in Step 1 is $10 million or less.
See Table 2 for a summary of these rules for 2003.
Table 2. 2003 Gross Receipts Test for Qualifying Small Business Taxpayers
| Step 1. Test year (prior tax years ending on or after December 31,
2002).
|
Step 2. Determine your average annual gross receipts for each test
year.
|
| 2000 |
(1998 + 1999 + 2000) ÷ 3 |
| 2001 |
(1999 + 2000 + 2001) ÷ 3 |
| 2002 |
(2000 + 2001 + 2002) ÷ 3 |
| Step 3. If the average annual gross receipts for each test year is $10 million or less, you
meet the gross receipts test for qualifying small business taxpayers.
|
Eligible business.
An eligible business is any business for which a qualified small business taxpayer can use the cash method and choose
to not keep an inventory. You
have an eligible business if you meet any of the following requirements.
-
Your principal business activity is described in a North American Industry Classification System (NAICS) code other than any
of the
following.
-
NAICS codes 211 and 212 (mining activities).
-
NAICS codes 31–33 (manufacturing).
-
NAICS code 42 (wholesale trade).
-
NAICS codes 44–45 (retail trade).
-
NAICS codes 5111 and 5122 (information industries).
-
Your principal business activity is the provision of services, including the provision of property incident to those services.
-
Your principal business activity is the fabrication or modification of tangible personal property upon demand in accordance
with customer
design or specifications.
Information about the NAICS codes can be found at www.census.gov or in the instructions for your federal income tax return.
Gross receipts.
In general, gross receipts must include all receipts from all your trades or businesses that must be recognized under
the method of accounting you
used for that tax year for federal income tax purposes. See the definition of gross receipts in section 1.448–1T(f)(2)(iv)
of the temporary
regulations for details.
Business not owned or not in existence for 3 years.
If you did not own your business for all of the 3-tax-year period used in determining your average annual gross receipts,
include the period of any
predecessor. If your business has not been in existence for the 3-tax-year period, base your average on the period it has
existed including any short
tax years, annualizing the short tax year's gross receipts.
Materials and supplies that are not incidental.
If you account for inventoriable items as materials and supplies that are not incidental, you will deduct the cost
of the items you would otherwise
include in inventory in the year you sell the items, or the year you pay for them, whichever is later. If you are a qualifying
taxpayer under Revenue
Procedure 2001–10 and a producer, you can use any reasonable method to estimate the raw material in your work in process and
finished goods on
hand at the end of the year to determine the raw material used to produce finished goods that were sold during the year. If
you are a qualifying small
business taxpayer under Revenue Procedure 2002–28, you must use the specific identification method, the first-in first-out
(FIFO) method, or an
average cost method to determine the amount of your allowable deduction for non-incidental materials and supplies consumed
and used in your business.
See section 4.02 in Revenue Procedure 2001–10 or section 4.05 in Revenue Procedure 2002–28 for more information. See also
Example
15 and Example 17 through Example 20 in section 6 of Revenue Procedure 2002–28.
Changing methods.
If you are a qualifying taxpayer or qualifying small business taxpayer and want to change to the cash method or to
account for inventoriable items
as non-incidental materials and supplies, you must file Form 3115. Both changes can be requested under the automatic change
procedures of Revenue
Procedure 2002–9 in Internal Revenue Bulletin 2002–3 (or its successor). For additional guidance, see section 6 of Revenue
Procedure
2001–10 for qualifying taxpayers or section 7 of Revenue Procedure 2002–28 for qualifying small business taxpayers. You can
file one Form
3115 if you choose to request to change to the cash method and to account for inventoriable items as non-incidental materials
and supplies.
More information.
For more information about the qualifying taxpayer exception, see Revenue Procedure 2001–10. For more information
about the qualifying small
business taxpayer exception, see Revenue Procedure 2002–28.
Items Included in Inventory
Your inventory should include all of the following.
Merchandise.
Include the following merchandise in inventory.
-
Purchased merchandise if title has passed to you, even if the merchandise is in transit or you do not have physical possession
for another
reason.
-
Goods under contract for sale that you have not yet segregated and applied to the contract.
-
Goods out on consignment.
-
Goods held for sale in display rooms, merchandise mart rooms, or booths located away from your place of business.
C.O.D. mail sales.
If you sell merchandise by mail and intend payment and delivery to happen at the same time, title passes when payment
is made. Include the
merchandise in your closing inventory until the buyer pays for it.
Containers.
Containers such as kegs, bottles, and cases, regardless of whether they are on hand or returnable, should be included
in inventory if title has not
passed to the buyer of the contents. If title has passed to the buyer, exclude the containers from inventory. Under certain
circumstances, some
containers can be depreciated. See Publication 946.
Merchandise not included.
Do not include the following merchandise in inventory.
-
Goods you have sold, but only if title has passed to the buyer.
-
Goods consigned to you.
-
Goods ordered for future delivery if you do not yet have title.
Assets.
Do not include the following in inventory.
-
Land, buildings, and equipment used in your business.
-
Notes, accounts receivable, and similar assets.
-
Real estate held for sale by a real estate dealer in the ordinary course of business.
-
Supplies that do not physically become part of the item intended for sale.
Special rules apply to the cost of inventory or property imported from a related person. See the regulations under section
1059A.
You can use any of the following methods to identify the cost of items in inventory.
Specific Identification Method
Use the specific identification method when you can identify and match the actual cost to the items in inventory.
Use the FIFO or LIFO method, explained next, if:
The FIFO (first-in first-out) method assumes the items you purchased or produced first are the first items you sold, consumed,
or otherwise
disposed of. The items in inventory at the end of the tax year are matched with the costs of similar items that you most recently
purchased or
produced.
The LIFO (last-in first-out) method assumes the items of inventory you purchased or produced last are the first items you
sold, consumed, or
otherwise disposed of. Items included in closing inventory are considered to be from the opening inventory in the order of
acquisition and from those
acquired during the tax year.
LIFO rules.
The rules for using the LIFO method are very complex. Two are discussed briefly here. For more information on these
and other LIFO rules, see
sections 472 through 474 and the corresponding regulations.
Dollar-value method.
Under the dollar-value method of pricing LIFO inventories, goods and products must be grouped into one or more pools
(classes of items), depending
on the kinds of goods or products in the inventories. See section 1.472–8 of the regulations.
Simplified dollar-value method.
Under this method, you establish multiple inventory pools in general categories from appropriate government price
indexes. You then use changes in
the price index to estimate the annual change in price for inventory items in the pools.
An eligible small business (average annual gross receipts of $5 million or less for the 3 preceding tax years) can
elect the simplified
dollar-value LIFO method.
For more information, see section 474. Taxpayers who cannot use the method under section 474 should see section 1.472–8(e)(3)
of the
regulations for a similar simplified dollar-value method.
Adopting LIFO method.
File Form 970, Application To Use LIFO Inventory Method,
or a statement with all the information required on Form 970 to adopt the LIFO method. You must file the form (or the
statement) with your timely filed tax return for the year in which you first use LIFO.
Differences Between FIFO and LIFO
Each method produces different income results, depending on the trend of price levels at the time. In times of inflation,
when prices are rising,
LIFO will produce a larger cost of goods sold and a lower closing inventory. Under FIFO, the cost of goods sold will be lower
and the closing
inventory will be higher. However, in times of falling prices, the opposite will hold.
The value of your inventory is a major factor in figuring your taxable income. The method you use to value the inventory is
very important.
The following methods, described below, are those generally available for valuing inventory.
-
Cost.
-
Lower of cost or market.
-
Retail.
Goods that cannot be sold.
These are goods you cannot sell at normal prices or they are unusable in the usual way because of damage, imperfections,
shop wear, changes of
style, odd or broken lots, or other similar causes, including secondhand goods taken in exchange. You should value these goods
at their bona fide
selling price minus direct cost of disposition, no matter which method you use to value the rest of your inventory. If these
goods consist of raw
materials or partly finished goods held for use or consumption, you must value them on a reasonable basis, considering their
usability and condition.
Do not value them for less than scrap value. For more information, see section 1.471–2(c) of the regulations.
To properly value your inventory at cost, you must include all direct and indirect costs associated with it. The following
rules apply.
-
For merchandise on hand at the beginning of the tax year, cost means the ending inventory price of the goods.
-
For merchandise purchased during the year, cost means the invoice price minus appropriate discounts plus transportation or
other charges
incurred in acquiring the goods. It can also include other costs that have to be capitalized under the uniform capitalization
rules of section
263A.
-
For merchandise produced during the year, cost means all direct and indirect costs that have to be capitalized under the uniform
capitalization rules.
Discounts.
A trade discount is a discount allowed regardless of when the payment is made. Generally, it is for volume or quantity purchases. You
must reduce the cost of inventory by a trade (or quantity) discount.
A cash discount is a reduction in the invoice or purchase price for paying within a prescribed time period. You can choose either to
deduct cash discounts or include them in income, but you must treat them consistently from year to year.
Lower of Cost or Market Method
Under the lower of cost or market method, compare the market value of each item on hand on the inventory date with its cost
and use the lower of
the two as its inventory value.
This method applies to the following.
-
Goods purchased and on hand.
-
The basic elements of cost (direct materials, direct labor, and certain indirect costs) of goods being manufactured and finished
goods on
hand.
This method does not apply to the following. They must be inventoried at cost.
-
Goods on hand or being manufactured for delivery at a fixed price on a firm sales contract (that is, not legally subject to
cancellation by
either you or the buyer).
-
Goods accounted for under the LIFO method.
Example.
Under the lower of cost or market method, the following items would be valued at $600 in closing inventory.
You must value each item in the inventory separately. You cannot value the entire inventory at cost ($950) and at market ($800)
and then use the
lower of the two figures.
Market value.
Under ordinary circumstances for normal goods, market value means the usual bid price on the date of inventory. This
price is based on the volume
of merchandise you usually buy. For example, if you buy items in small lots at $10 an item and a competitor buys identical
items in larger lots at
$8.50 an item, your usual market price will be higher than your competitor's.
Lower than market.
When you offer merchandise for sale at a price lower than market in the normal course of business, you can value the
inventory at the lower price,
minus the direct cost of disposition. Determine these prices from the actual sales for a reasonable period before and after
the date of your
inventory. Prices that vary materially from the actual prices will not be accepted as reflecting the market.
No market exists.
If no market exists, or if quotations are nominal because of an inactive market, you must use the best available evidence
of fair market price on
the date or dates nearest your inventory date. This evidence could include the following items.
Under the retail method, the total retail selling price of goods on hand at the end of the tax year in each department or
of each class of goods is
reduced to approximate cost by using an average markup expressed as a percentage of the total retail selling price.
To figure the average markup, apply the following steps in order.
-
Add the total of the retail selling prices of the goods in the opening inventory and the retail selling prices of the goods
you bought
during the year (adjusted for all markups and markdowns).
-
Subtract from the total in (1) the cost of goods included in the opening inventory plus the cost of goods you bought during
the
year.
-
Divide the balance in (2) by the total selling price in (1). The result is the average markup percentage.
Then determine the approximate cost in three steps.
-
Subtract the sales at retail from the total retail selling price. The result is the closing inventory at retail.
-
Multiply the closing inventory at retail by the average markup percentage. The result is the markup in closing inventory.
-
Subtract the markup in (2) from the closing inventory at retail. The result is the approximate closing inventory at cost.
Closing inventory.
The following example shows how to figure your closing inventory using the retail method.
Example.
Your records show the following information on the last day of your tax year.
Using the retail method, determine your closing inventory as follows.
Markup percentage.
The markup ($35,000) is the difference between cost ($105,000) and the retail value ($140,000). Divide the markup
by the total retail value to get
the markup percentage (25%). You cannot use arbitrary standard percentages of purchase markup to determine markup. You must
determine it as accurately
as possible from department records for the period covered by your tax return.
Markdowns.
When determining the retail selling price of goods on hand at the end of the year, markdowns are recognized only if
the goods were offered to the
public at the reduced price. Markdowns not based on an actual reduction of retail sales price, such as those based on depreciation
and obsolescence,
are not allowed.
Retail method with LIFO.
If you use LIFO with the retail method, you must adjust your retail selling prices for markdowns as well as markups.
Price index.
If you are using the retail method and LIFO, adjust the inventory value, determined using the retail method, at the
end of the year to reflect
price changes since the close of the preceding year. Generally, to make this adjustment, you must develop your own retail
price index based on an
analysis of your own data under a method acceptable to the IRS. However, a department store using LIFO that offers a full
line of merchandise for sale
can use an inventory price index provided by the Bureau of Labor Statistics. Other sellers can use this index if they can
demonstrate the index is
accurate, reliable, and suitable for their use. For more information, see Revenue Ruling 75–181 in Cumulative Bulletin 1975–1.
Retail method without LIFO.
If you do not use LIFO and have been determining your inventory under the retail method except that, to approximate
the lower of cost or market,
you have followed the consistent practice of adjusting the retail selling prices of goods for markups (but not markdowns),
you can continue that
practice. The adjustments must be bona fide, consistent, and uniform and you must also exclude markups made to cancel or correct
markdowns. The
markups you include must be reduced by markdowns made to cancel or correct the markups.
If you do not use LIFO and you previously determined inventories without eliminating markdowns in making adjustments
to retail selling prices, you
can continue this practice only if you first get IRS approval. You can adopt and use this practice on the first tax return
you file for the business,
subject to IRS approval on examination of your tax return.
Figuring income tax.
Resellers who use the retail method of pricing inventories can determine their tax on that basis.
To use this method, you must do all the following.
You must keep records for each separate department or class of goods carrying different percentages of gross profit.
Purchase records should show
the firm name, date of invoice, invoice cost, and retail selling price. You should also keep records of the respective departmental
or class
accumulation of all purchases, markdowns, sales, stock, etc.
Perpetual or Book Inventory
You can figure the cost of goods on hand by either a perpetual or book inventory if inventory is kept by following sound accounting
practices.
Inventory accounts must be charged with the actual cost of goods purchased or produced and credited with the value of goods
used, transferred, or
sold. Credits must be determined on the basis of the actual cost of goods acquired during the year and their inventory value
at the beginning of the
tax year.
Physical inventory.
You must take a physical inventory at reasonable intervals and the book amount for inventory must be adjusted to agree
with the actual inventory.
You claim a casualty or theft loss of inventory, including items you hold for sale to customers, through the increase in the
cost of goods sold by
properly reporting your opening and closing inventories. You cannot claim the loss again as a casualty or theft loss. Any
insurance or other
reimbursement you receive for the loss is taxable.
You can choose to take the loss separately as a casualty or theft loss. If you take the loss separately, adjust opening inventory
or purchases to
eliminate the loss items and avoid counting the loss twice.
If you take the loss separately, reduce the loss by the reimbursement you receive or expect to receive. If you do not receive
the reimbursement by
the end of the year, you cannot claim a loss for any amounts you reasonably expect to recover.
Creditors or suppliers.
If your creditors forgive part of what you owe them because of your inventory loss, this amount is treated as income
and is taxable.
Disaster loss.
If your inventory loss is due to a disaster in an area determined by the President of the United States to be eligible
for federal assistance, you
can choose to deduct the loss on your return for the immediately preceding year. However, you must also decrease your opening
inventory for the year
of the loss so the loss will not show up again in inventory.
Uniform Capitalization Rules
Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for production
or resale activities.
Include these costs in the basis of property you produce or acquire for resale, rather than claiming them as a current deduction.
You recover the
costs through depreciation, amortization, or cost of goods sold when you use, sell, or otherwise dispose of the property.
Special uniform capitalization rules apply to a farming business. See chapter 7 in Publication 225.
Activities subject to the rules.
You are subject to the uniform capitalization rules if you do any of the following, unless the property is produced
for your use other than in a
trade or business or an activity carried on for profit.
-
Produce real or tangible personal property.
-
Acquire property for resale. However, this rule does not apply to personal property if your average annual gross receipts
are $10 million or
less.
Producing property.
You produce property if you construct, build, install, manufacture, develop, improve, create, raise, or grow the property.
Property produced for
you under a contract is treated as produced by you to the extent you make payments or otherwise incur costs in connection
with the property.
Tangible personal property.
Tangible personal property includes films, sound recordings, video tapes, books, artwork, photographs, or similar
property containing words, ideas,
concepts, images, or sounds. However, free-lance authors, photographers, and artists are exempt from the uniform capitalization
rules if they qualify.
Exceptions.
The uniform capitalization rules do not apply to:
-
Resellers of personal property with average annual gross receipts of $10 million or less (small resellers).
-
Property produced to use as personal or nonbusiness property or for uses not connected with a trade or business or an activity
conducted for
profit.
-
Research and experimental expenditures deductible under section 174.
-
Intangible drilling and development costs of oil and gas or geothermal wells or any amortization deduction allowable under
section 59(e) for
intangible drilling, development, or mining exploration expenditures.
-
Property produced under a long-term contract, except for certain home construction contracts described in section 460(e)(1).
-
Timber and certain ornamental trees raised, harvested, or grown, and the underlying land.
-
Qualified creative expenses paid or incurred as a free-lance (self-employed) writer, photographer, or artist that are otherwise
deductible
on your tax return.
-
Costs allocable to natural gas acquired for resale to the extent these costs would otherwise be allocable to “cushion gas” stored
underground.
-
Property produced if substantial construction occurred before March 1, 1986.
-
Property provided to customers in connection with providing services. It must be de minimus in amount and not be inventory
in the hands of
the service provider.
-
Loan origination.
-
The costs of certain producers who use a simplified production method and whose total indirect costs are $200,000 or less.
See section
1.263A–2(b)(3)(iv) of the regulations for more information.
Qualified creative expenses.
Qualified creative expenses are expenses paid or incurred by a free-lance (self-employed) writer, photographer, or
artist whose personal efforts
create (or can reasonably be expected to create) certain properties. These expenses do not include expenses related to printing,
photographic plates,
motion picture films, video tapes, or similar items.
These individuals are defined as follows.
-
A writer is an individual who creates a literary manuscript, a musical composition (including any accompanying words), or
a dance
score.
-
A photographer is an individual who creates a photograph or photographic negative or transparency.
-
An artist is an individual who creates a picture, painting, sculpture, statue, etching, drawing, cartoon, graphic design,
or original print
item. The originality and uniqueness of the item created and the predominance of aesthetic value over utilitarian value of
the item created are taken
into account.
Personal service corporation.
The exemption for writers, photographers, and artists also applies to an expense of a personal service corporation
that directly relates to the
activities of the qualified employee-owner. A “ qualified employee-owner” is a writer, photographer, or artist who owns, with certain members of
his or her family, substantially all the stock of the corporation.
Inventories.
If you must adopt the uniform capitalization rules, revalue the items or costs included in beginning inventory for
the year of change as if the
capitalization rules had been in effect for all prior periods. When revaluing inventory costs, the capitalization rules apply
to all inventory costs
accumulated in prior periods. An adjustment is required under section 481(a). It is the difference between the original value
of the inventory and the
revalued inventory.
If you must capitalize costs for production and resale activities, you are required to make this change. If you make
the change for the first tax
year you are subject to the uniform capitalization rules, it is an automatic change of accounting method that does not need
IRS approval. Otherwise,
IRS approval is required to make the change.
More information.
For information about the uniform capitalization rules, see the section 263A regulations.
Change in Accounting Method
You can generally choose any permitted accounting method when you file your first tax return. You do not need IRS approval
to choose the initial
method. You must, however, use the method consistently from year to year and it must clearly reflect your income. See Accounting Methods,
earlier.
Once you have set up your accounting method and filed your first return, you generally must get IRS approval before you change
the method. In
general, you must file a current Form 3115 to request a change in either an overall accounting method or the accounting treatment
of any item.
A change in your accounting method includes a change not only in your overall system of accounting but also in the treatment
of any material item.
A material item is one that affects the proper time for inclusion of income or allowance of a deduction. Although an accounting
method can exist
without treating an item consistently, an accounting method is not established for that item, in most cases, unless the item
is treated consistently.
Approval required.
The following are examples of changes in accounting method that require IRS approval.
-
A change from the cash method to an accrual method or vice versa.
-
A change in the method or basis used to value inventory.
-
A change in the depreciation or amortization method (except for certain permitted changes to the straight-line method).
Approval not required.
The following are examples of types of changes that are not changes in accounting methods and do not require IRS approval.
-
Correction of a math or posting error.
-
Correction of an error in figuring tax liability (such as an error in figuring a credit).
-
An adjustment of any item of income or deduction that does not involve the proper time for including it in income or deducting
it.
-
Certain adjustments in the useful life of a depreciable or amortizable asset.
The following are the two ways you can get IRS approval to change an accounting method.
If your current method clearly reflects your income, the IRS will weigh the need for consistency in reporting against the
request for change.
If you do not request IRS approval to change an accounting method, the absence of IRS approval will not be accepted as a defense
to any penalty.
Automatic Change Request Procedures
You may use the automatic change request procedures to make a change in method of accounting if you meet both of the following
conditions.
-
Your accounting method change qualifies for the automatic change request procedures for the requested year of change.
-
You are eligible to use the automatic change request procedures. For further information, see Eligibility for automatic change
requests, later.
Generally, you must use Form 3115 to request an automatic change. The approval is granted for the tax year for which you request
a change (year of
change), if the change is provided in an automatic change request procedure for the requested year of change, you are within
the scope of the
automatic change request procedure, and you comply with all of the provisions of the automatic change request procedure. See
Revenue Procedure
2002–9 in Internal Revenue Bulletin 2002–3, as modified by Announcement 2002–17 in Internal Revenue Bulletin 2002–8, Revenue
Procedure 2002–19 in Internal Revenue Bulletin 2002–13, and Revenue Procedure 2002–54 in Internal Revenue Bulletin 2002–35.
The Appendix to Revenue Procedure 2002–9 describes the various types of accounting method changes that may be made using the
automatic change
request procedures in Revenue Procedure 2002–9 and provides specific guidance on the terms and conditions that must be met
for each specific
type of automatic change. Also, see section 9.22 of Revenue Procedure 2004–1 in Internal Revenue Bulletin 2004–1 (or its successor)
and
the instructions for the current Form 3115. The IRS may occasionally designate in subsequently published guidance additional
accounting method changes
as qualifying for automatic change request procedures.
Filing Form 3115.
In general, you must file Form 3115 to request approval to change your accounting method under the automatic change
request procedures. No user fee
is required. File Form 3115 with your return. Your return must be filed by the due date (including extensions). You must also
file a copy (with
signature) of the completed Form 3115 with the IRS national office no later than when you file the original with your return.
The IRS does not
acknowledge receipt of Form 3115 for automatic change request procedures.
You can get an automatic extension of 6 months to file Form 3115 by filing it with an amended return. The extension
is granted if you file the
amended return within 6 months from the due date of the original return for the year of change (excluding extensions) and
meet the following
conditions.
-
You filed your original return for the year of change by the due date (including extensions).
-
You use the new method of accounting on the amended return.
-
You attach the Form 3115 to the amended return and write “FILED PURSUANT TO REG. 301.9100–2” at the top of the Form
3115.
-
You file a copy of the completed Form 3115 with the IRS national office no later than when you file the original with the
amended
return.
Eligibility for automatic change requests.
The following eligibility limitations do not apply to all automatic changes. For some automatic changes, none of the
following limitations apply.
For other changes, some of the limitations apply or may apply under specific conditions. A list of the automatic changes for
which a Form 3115 must be
filed is provided in the instructions for Form 3115. This list identifies each change and indicates if eligibility limitations
may not apply for that
change. This information is also available in an appendix to Revenue Procedure 2002–9, as modified by later published guidance.
You are not eligible for an automatic change request if any of the following limitations are applicable for the accounting
method change you are
requesting and apply to you, the applicant (see section 4.02 of Revenue Procedure 2002–9 as modified by section 2.03 of Revenue
Procedure
2002–19 for details):
-
Under examination. The applicant is under examination with respect to any income tax issue. This also applies to a member of a
consolidated group if the group is under examination for any tax year during which the applicant was a member of the consolidated
group. The following
exceptions apply to this limitation.
-
90-day window period for filing Form 3115. See section 6.03(2) of Revenue Procedure 2002–9 for details.
-
120-day window period for filing Form 3115. See section 6.03(3) of Revenue Procedure 2002–9 for details.
-
You receive permission from the IRS director. See section 6.03(4) of Revenue Procedure 2002–9 for details.
-
The method to be changed lacks audit protection for years prior to the year of change. See section 6.03(5) of Revenue Procedure
2002–9
for details.
-
The method to be changed is an issue pending for any tax year under examination. See section 2.03 of Revenue Procedure 2002–19
for
details.
-
Partnerships and S corporations. The applicant is a partnership or S corporation requesting to change a method of accounting that
is an issue under consideration in an examination, before an appeals office, or before a federal court, with respect to a
federal tax return of a
partner, member, or shareholder of the entity.
-
Prior change. Within the last 5 tax years (including the year of change), the applicant has made a change in the same method of
accounting (with or without IRS approval), or applied to change the same method of accounting without effecting the change.
-
Section 381(a) transaction. The applicant is a corporation that acquired assets in a transaction as the result of a
reorganization or a liquidation of a subsidiary. See section 4.02(7) of Revenue Procedure 2002–9 for details, including two
exceptions to this
limitation.
-
Final year of trade or business. The requested change is for a tax year that is the applicant's final year of trade or business
and the applicant is required to include the entire amount of the section 481(a) adjustment in computing taxable income for
that year.
If the applicant is not eligible for an automatic change request for reasons other than limitations 1 and 2, above,
request the change under the advance consent request procedures of Revenue Procedure 97–27 (see Advance Consent Request Procedures,
later.
Review of automatic change request.
Any automatic change request may be reviewed by the IRS.
Incomplete Form 3115.
If the IRS reviews your application and determines that your application is not properly completed according to the
instructions for a current Form
3115 or the automatic change request procedures, you will be notified and given 30 days from the date of the notification
letter to furnish the
necessary information. Ordinarily, no extension will be granted to submit information requested on Form 3115. However, the
IRS can grant an extension
of up to 30 days to furnish the information. Your written request for the 30-day extension must be submitted within the initial
30-day period.
Conference.
If the IRS tentatively determines that you changed your accounting method without complying with Revenue Procedure
2002–9, you can request a
conference. See section 10 of Revenue Procedure 2002–9 for more information.
Advance Consent Request Procedures
These are the procedures that you must use to get approval to change your accounting method if you do not qualify to use the
automatic change
request procedures (discussed earlier).
Filing Form 3115.
You must file Form 3115 during the tax year for which the change is requested. Attach the required user fee. You should
file as early in the year
as possible to give the IRS enough time to respond to the form before the due date of the return for the year of change. If
you do not file a Form
3115 during the year of change, an extension to file the form will be granted only in unusual and compelling circumstances.
The IRS normally acknowledges receipt of a completed Form 3115 within 30 days after the applicant's filing date. See
the form instructions if you
do not receive an acknowledgment.
Eligibility for advance consent requests.
If any of the following limitations apply, the applicant is not eligible for an advance consent request (see section
4.02 of Revenue Procedure
2002–9 as modified by section 2.03 of Revenue Procedure 2002–19 for details):
-
Under examination. The applicant is under examination with respect to any income tax issue. This also applies to a member of a
consolidated group if the group is under examination for the tax year that the applicant was a member of the consolidated
group. The following
exceptions apply to this limitation.
-
90-day window period for filing Form 3115. See section 6.01(2) of Revenue Procedure 97–27 for details.
-
120-day window period for filing Form 3115. See section 6.01(3) of Revenue Procedure 97–27 for details.
-
You receive permission from the IRS director. See section 6.01(4) of Revenue Procedure 97–27 for details.
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The method to be changed is an issue pending for tax years under examination. See section 2.03 of Revenue Procedure 2002–19
for
details.
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Partnerships and S corporations. The applicant is a partnership or S corporation requesting to change a method of accounting that
is an issue under consideration in an examination, before an appeals office, or before a federal court, with respect to a
federal tax return of a
partner, member, or shareholder of the entity.
Incomplete Form 3115.
If your application is not properly completed according to the instructions for a current Form 3115 and the provisions
of Revenue Procedure
97–27 and Revenue Procedure 2004–1 (or successor), or if supplemental information is needed, you will be notified and given
21 days from
the date of the notification letter to furnish the necessary information. If you do not submit the required information within
the reply period, the
IRS will not process your Form 3115. Ordinarily, no extension will be granted to submit information requested on Form 3115.
However, the IRS can grant
up to an additional 15 days to furnish the information. Your written request for the 15-day extension must be submitted within
the 21-day period.
Conference.
If you think the IRS may give an unfavorable response to your request to change your accounting method, you can request
a conference when you file
Form 3115. The National Office will arrange one before the IRS formally replies to your Form 3115.
Consent agreement.
Permission to change your accounting method will be provided in a letter ruling that will identify the item(s) being
changed, the section 481(a)
adjustment (if any), and the terms and conditions under which the change is to be effected for the tax year specified in the
letter ruling. If you
agree with the terms and conditions in the letter ruling, you must sign and date the consent agreement copy. The signed copy
of the letter ruling will
constitute a “ consent agreement.” The consent agreement must be returned to the IRS within 45 days of the date of issuance. A copy of the consent
agreement must be attached to your income tax return for the year of change and you must implement the change in accounting
method in accordance with
the terms and conditions of the consent agreement. If you file your income tax return for the year of change before you receive
the letter ruling and
return the signed consent agreement, you should attach the copy of the signed consent agreement to your amended return for
the year of change that you
file to implement the change in accounting method.
More information.
For more information, see the instructions for Form 3115; Revenue Procedure 97–27, as modified by Revenue Procedure
2002–19 and
Revenue Procedure 2002–54; and Revenue Procedure 2004–1, particularly section 9.
You can get help with unresolved tax issues, order free publications and forms, ask tax questions, and get more information
from the IRS in several
ways. By selecting the method that is best for you, you will have quick and easy access to tax help.
Contacting your Taxpayer Advocate.
If you have attempted to deal with an IRS problem unsuccessfully, you should contact your Taxpayer Advocate.
The Taxpayer Advocate independently represents your interests and concerns within the IRS by protecting your rights
and resolving problems that
have not been fixed through normal channels. While Taxpayer Advocates cannot change the tax law or make a technical tax decision,
they can clear up
problems that resulted from previous contacts and ensure that your case is given a complete and impartial review.
To contact your Taxpayer Advocate:
-
Call the Taxpayer Advocate toll free at
1–877–777–4778.
-
Call, write, or fax the Taxpayer Advocate office in your area.
-
Call 1–800–829–4059 if you are a
TTY/TDD user.
-
Visit the website at www.irs.gov/advocate.
For more information, see Publication 1546, The Taxpayer Advocate Service of the IRS.
Free tax services.
To find out what services are available, get Publication 910, Guide to Free Tax Services. It contains a list of free tax publications
and an index of tax topics. It also describes other free tax information services, including tax education and assistance
programs and a list of
TeleTax topics.
Internet. You can access the IRS website 24 hours a day, 7 days a week, at www.irs.gov to:
-
E-file. Access commercial tax preparation and e-file services available for free to eligible taxpayers.
-
Check the amount of advance child tax credit payments you received in 2003.
-
Check the status of your 2003 refund. Click on “Where's My Refund”. Be sure to wait at least 6 weeks from the date you filed your
return (3 weeks if you filed electronically) and have your 2003 tax return available because you will need to know your filing
status and the exact
whole dollar amount of your refund.
-
Download forms, instructions, and publications.
-
Order IRS products online.
-
See answers to frequently asked tax questions.
-
Search publications online by topic or keyword.
-
Figure your withholding allowances using our Form W-4 calculator.
-
Send us comments or request help by email.
-
Sign up to receive local and national tax news by email.
-
Get information on starting and operating a small business.
You can also reach us using File Transfer Protocol at ftp.irs.gov.
Fax. You can get over 100 of the most requested forms and instructions 24 hours a day, 7 days a week, by fax. Just call
703–368–9694 from your fax machine. Follow the directions from the prompts. When you order forms, enter the catalog number for
the form you need. The items you request will be faxed to you.
For help with transmission problems, call 703–487–4608.
Long-distance charges may apply.
Phone. Many services are available by phone.
-
Ordering forms, instructions, and publications. Call 1–800–829–3676 to order current-year forms,
instructions, and publications and prior-year forms and instructions. You should receive your order within 10 days.
-
Asking tax questions. Call the IRS with your tax questions at 1–800–829–4933.
-
Solving problems. You can get face-to-face help solving tax problems every business day in IRS Taxpayer Assistance Centers. An
employee can explain IRS letters, request adjustments to your account, or help you set up a payment plan. Call your local
Taxpayer Assistance Center
for an appointment. To find the number, go to www.irs.gov or look in the phone book under “United States Government, Internal Revenue
Service.”
-
TTY/TDD equipment. If you have access to TTY/TDD equipment, call 1–800–829– 4059 to ask tax or
account questions or to order forms and publications.
-
TeleTax topics. Call 1–800–829–4477 to listen to pre-recorded messages covering various tax
topics.
-
Refund information. If you would like to check the status of your 2003 refund, call 1–800–829 4477 for
automated refund information and follow the recorded instructions or call 1–800–829–1954. Be sure to wait at least 6
weeks from the date you filed your return (3 weeks if you filed electronically) and have your 2003 tax return available because
you will need to know
your filing status and the exact whole dollar amount of your refund.
Evaluating the quality of our telephone services. To ensure that IRS representatives give accurate, courteous, and professional answers,
we use several methods to evaluate the quality of our telephone services. One method is for a second IRS representative to
sometimes listen in on or
record telephone calls. Another is to ask some callers to complete a short survey at the end of the call.
Walk-in. Many products and services are available on a walk-in basis.
-
Products. You can walk in to many post offices, libraries, and IRS offices to pick up certain forms, instructions, and
publications. Some IRS offices, libraries, grocery stores, copy centers, city and county government offices, credit unions,
and office supply stores
have a collection of products available to print from a CD-ROM or photocopy from reproducible proofs. Also, some IRS offices
and libraries have the
Internal Revenue Code, regulations, Internal Revenue Bulletins, and Cumulative Bulletins available for research purposes.
-
Services. You can walk in to your local Taxpayer Assistance Center every business day to ask tax questions or get help with a tax
problem. An employee can explain IRS letters, request adjustments to your account, or help you set up a payment plan. You
can set up an appointment by
calling your local Center and, at the prompt, leaving a message requesting Everyday Tax Solutions help. A representative will
call you back within 2
business days to schedule an in-person appointment at your convenience. To find the number, go to www.irs.gov or look in the phone book
under “United States Government, Internal Revenue Service.”
Mail. You can send your order for forms, instructions, and publications to the Distribution Center nearest to you and receive a
response
within 10 workdays after your request is received. Use the address that applies to your part of the country.
-
Western part of U.S.:
Western Area Distribution Center
Rancho Cordova, CA 95743–0001
-
Central part of U.S.:
Central Area Distribution Center
P.O. Box 8903
Bloomington, IL 61702–8903
-
Eastern part of U.S. and foreign addresses:
Eastern Area Distribution Center
P.O. Box 85074
Richmond, VA 23261–5074
CD-ROM for tax products. You can order IRS Publication 1796, Federal Tax Products on CD-ROM, and obtain:
-
Current-year forms, instructions, and publications.
-
Prior-year forms and instructions.
-
Frequently requested tax forms that may be filled in electronically, printed out for submission, and saved for recordkeeping.
-
Internal Revenue Bulletins.
Buy the CD-ROM from National Technical Information Service (NTIS) on the Internet at www.irs.gov/cdorders for $22 (no handling fee) or
call 1–877–233–6767 toll free to buy the CD-ROM for $22 (plus a $5 handling fee). The first release is available in early
January and the final release is available in late February.
CD-ROM for small businesses. IRS Publication 3207, Small Business Resource Guide, is a must for every small business owner or
any taxpayer about to start a business. This handy, interactive CD contains all the business tax forms, instructions and
publications needed to
successfully manage a business. In addition, the CD provides an abundance of other helpful information, such as how to prepare
a business plan,
finding financing for your business, and much more. The design of the CD makes finding information easy and quick and incorporates
file formats and
browsers that can be run on virtually any desktop or laptop computer.
It is available in early April. You can get a free copy by calling 1–800–829–3676 or by visiting the web site at
www.irs.gov/smallbiz.
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