Publication 538 (3/2008), Accounting Periods and Methods

IRS Resources

Publication 538 - Main Contents

Table of Contents

Accounting Periods

You must use a tax year to figure your taxable income. 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). You can use the following tax years:

A calendar year; or
A fiscal year (including a 52-53-week tax year).

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 or the Income Tax Regulations. You cannot adopt a tax year by merely:

Filing an application for an extension of time to file an income tax return;
Filing an application for an employer identification number (Form SS-4); or
Paying estimated taxes.

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.

Calendar Year

A calendar year is 12 consecutive months beginning on January 1st and ending on December 31st.

If you adopt the calendar year, you must maintain your books and records and report your income and expenses from January 1st through December 31st 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 obtain approval from the IRS 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, you must adopt the calendar year if:

You keep no books or records;
You have no annual accounting period;
Your present tax year does not qualify as a fiscal year; or
You are required to use a calendar year by a provision in the Internal Revenue Code or the Income Tax Regulations.

Fiscal Year

A fiscal year is 12 consecutive months ending on the last day of any month except December 31st. If you are allowed to adopt a fiscal year, you must maintain your books and records and report your income and expenses using the same tax year.

52-53-Week 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 2006 tax year will end on March 26, 2007.

Election. To make the election for the 52-53-week tax year, attach a statement with the following information to your tax return.

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:
1. Last occurs in the month in (1), above, or
2. 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, 2007, which happens to be a Sunday. For this purpose, a 52-53-week tax year that begins on the last Tuesday of June, which falls on June 26, 2007, is treated as beginning on July 1, 2007.

Short Tax Year

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):

Are not in existence for an entire tax year, or
Change your accounting period.

Tax on a short period tax return is figured differently for each situation.

Not in Existence Entire Year

Even if a taxable entity was not in existence for the entire year, a tax return is required for the time it was 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.

XYZ Corporation was organized on July 1, 2007. It elected the calendar year as its tax year. Therefore, its first tax return was due March 17, 2008. This short period return will cover the period from July 1, 2007, through December 31, 2007.

Example 2.

A calendar year corporation dissolved on July 22, 2007. Its final return is due by October 15, 2007. It will cover the short period from January 1, 2007, through July 22, 2007.

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 that begins on January 1st, and ends on the date of death. In the case of a decedent who dies on December 31st, the last day of the regular tax year, a full calendar-year tax return is required.

Example. Agnes Green was a single, calendar year taxpayer. She died on March 6, 2007. Her final income tax return must be filed by April 15, 2008. It will cover the short period from January 1, 2007, to March 6, 2007.

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.

Figure tax for a short year under the general rule, explained below. 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 must be annualized. 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 (AGI) 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). The result 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. The result 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. The result is your tax for the short tax year.

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 completing the following steps.
1. Multiply the AMTI by 12.
2. 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 AMT for individuals, see the Instructions for Form 6251, Alternative Minimum Tax-Individuals. For information on the AMT for corporations, see Publication 542, or the Instructions to Form 4626, Alternative Minimum Tax-Corporations.

Tax withheld from wages. You can claim 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.

Improper Tax 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.

Change in Tax Year

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.

Individuals

Generally, individuals must adopt the calendar year as their tax 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.

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.

Partnership

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.
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.
The partnership can establish a business purpose for a different tax year.

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.

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.

Year End 12/31:	Year End	Profits Interest	Months of Deferral	Interest × Deferral
A	12/31	0.5	-0-	-0-
B	11/30	0.5	11	5.5
Total Deferral				5.5
Year End 11/30:	Year End	Profits Interest	Months of Deferral	Interest × Deferral
A	12/31	0.5	1	0.5
B	11/30	0.5	-0-	-0-
Total Deferral				0.5

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 2006-46 for automatic approval requests and Revenue Procedure 2002-39 or its successor for ruling requests.

S Corporation

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 Section 444 Election, below for details.
A 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444.
Any other tax year for which the corporation establishes a business purpose.

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 2006-46 for automatic approval requests and Revenue Procedure 2002-39 or its successor for ruling requests.

Personal Service Corporation (PSC)

A PSC must use a calendar tax year unless any of the following apply.

The corporation makes an election under section 444. See Section 444 Election, 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.
The corporation establishes a business purpose for a fiscal year.

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 2006-46 for automatic approval requests and Revenue Procedure 2002-39 or its successor for ruling requests.

Section 444 Election

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:

Three months, or
The deferral period of the tax year being changed. This is the tax year immediately preceding the year for which the partnership, S corporation, or PSC wishes to make the section 444 election.

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. 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, 2007, and is qualified to make a section 444 election to use a September 30 tax year for its tax year beginning September 13, 2007. AB must file Form 8716 by January 15, 2008, which is the due date of the partnership's tax return for the period from September 13, 2007, to September 30, 2007.

Example 2.

The facts are the same as in Example 1 except that AB begins operations on October 21, 2007. AB must file Form 8716 by March 17, 2008, 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, 2007. B qualifies to make a section 444 election to use a September 30 tax year for its tax year beginning September 1, 2007. B must file Form 8716 by December 17, 2007, the due date of the income tax return for the short period from September 1, 2007, to September 30, 2007.

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.

Terminating 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:

The section 444 election is in effect.
The required payment for that year (or any preceding tax year) is more than $500.

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.

Applicable election year. Any tax year a section 444 election is in effect, including the first year, is called an applicable election year. Form 8752 must be filed and the required payment made (or zero amount reported) by May 15th of the calendar year following the calendar year in which the applicable election year begins.

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.”

52-53-Week Tax Year

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 (discussed earlier) 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.

Business Purpose Tax Year

A partnership, S corporation, or PSC establishes the business purpose for a tax year by filing Form 1128. See the Instructions for Form 1128 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 Personal Service Corporation (PSC) must use the required tax year rules, discussed earlier, to establish a tax year. Generally, a corporation that wants to change its tax year must obtain approval from the IRS under either the: (a) automatic approval procedures; or (b) ruling request procedures. See the Instructions for Form 1128 for details.

Accounting Methods

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 refigured under the method that, in the opinion of the IRS, does clearly reflect your 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.

Cash method.
Accrual method.
Special methods of accounting for certain items of income and expenses.
Combination (hybrid) method using elements of two or more of the above.

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. The following publications also discuss special methods of reporting income or expenses.

Publication 225, Farmer's Tax Guide.
Publication 535, Business Expenses.
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 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 each business.

Note.

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.

Cash Method

Most individuals and many small businesses use the cash method of accounting. Generally, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise. See Inventories for exceptions to this rule.

Income

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 (FMV) 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.

You are a calendar year taxpayer. Your bank credited, and made available, interest to your bank account in December 2007. You neither withdraw it nor enter it into your books until 2008. You must include the amount in gross income for 2007, the year that you constructively received it.

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.

Expenses

Under the cash method, generally, you 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. Instead, 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 obtain approval from the IRS before using the general rule and/or the 12-month rule. See Change in Accounting Method, later.

Example 1.

You are a calendar year taxpayer and pay $3,000 in 2007 for a business insurance policy that is effective for three years (36 months), beginning on July 1, 2007. 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, only $500 (6/36 x $3,000) is deductible in 2007, $1,000 (12/36 x $3,000) is deductible in 2008, $1,000 (12/36 x $3,000) is deductible in 2009, and the remaining $500 is deductible in 2010.

Example 2.

You are a calendar year taxpayer and pay $10,000 on July 1, 2007, for a business insurance policy that is effective for only one year beginning on July 1, 2007. The 12-month rule applies. Therefore, the full $10,000 is deductible in 2007.

Excluded Entities

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.

Exceptions

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, for more information. 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 2 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.

Accrual Method

Under an accrual method of accounting, generally you 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.

Income

Generally, you 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.
When title has passed.

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.

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. Generally, one 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 the tax year is a calendar year and that the accrual method of accounting is used.