| Publication 225 |
2008 Tax Year |
You must consistently use an accounting method that clearly shows your income and expenses. You must also figure your taxable
income and file an income tax return for an annual accounting period called a tax year. Only accounting methods are discussed
in this chapter. For information on accounting periods, see Publication 538, Accounting Periods and Methods, and the instructions
for Form 1128, Application To Adopt, Change, or Retain a Tax Year.
Topics - This chapter discusses:
Useful Items - You may want to see:
Form (and Instructions)
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1128
Application To Adopt, Change, or Retain a Tax Year
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3115
Application for Change in Accounting Method
See chapter 16 for information about getting publications and forms.
An accounting method is a set of rules used to determine when and how 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 for your farm business when you file your first income tax return that includes a Schedule
F. However, you cannot use the crop method for any tax return, including your first tax return, unless you receive approval
from the IRS. The crop method of accounting is discussed later under Special Methods of Accounting. How to obtain IRS approval to change an accounting method is discussed later under Change in Accounting Method.
Kinds of methods.
Generally, you can use any of the following accounting methods.
Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business.
However, certain farm corporations and partnerships, and all tax shelters, must use an accrual method of accounting. See Accrual method, below.
Business and personal items.
You can account for business and personal items using different accounting methods. For example, you can figure your
business income 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.
Accrual method.
The following businesses engaged in farming must use an accrual method of accounting.
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A corporation (other than a family corporation) that had gross receipts of more than $1,000,000 for any tax year beginning
after 1975.
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A family corporation that had gross receipts of more than $25,000,000 for any tax year beginning after 1985.
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A partnership with a corporation as a partner.
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A tax shelter.
Note.
Items (1), (2), and (3) do not apply to an S corporation or a business operating a nursery or sod farm, or the raising or
harvesting of trees (other than fruit and nut trees).
Family corporation.
A family corporation is generally a corporation that meets one of the following ownership requirements.
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Members of the same family own at least 50% of the total combined voting power of all classes of stock entitled to vote and
at least 50% of the total shares of all other classes of stock of the corporation.
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Members of two families have owned, directly or indirectly, since October 4, 1976, at least 65% of the total combined voting
power of all classes of voting stock and at least 65% of the total shares of all other classes of the corporation's stock.
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Members of three families have owned, directly or indirectly, since October 4, 1976, at least 50% of the total combined voting
power of all classes of voting stock and at least 50% of the total shares of all other classes of the corporation's stock.
For more information on family corporations, see Internal Revenue Code section 447.
Tax shelter.
A tax shelter is a partnership, noncorporate enterprise, or S corporation that meets either of the following tests.
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Its principal purpose is the avoidance or evasion of federal income tax.
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It is a farming syndicate. A farming syndicate is an entity that meets either of the following tests.
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Interests in the activity have been offered for sale in an offering required to be registered with a federal or state agency
with the authority to regulate the offering of securities for sale.
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More than 35% of the losses during the tax year are allocable to limited partners or limited entrepreneurs.
A “ limited partner” is one whose personal liability for partnership debts is limited to the money or other property the partner contributed
or is required to contribute to the partnership.
A “ limited entrepreneur” is one who has an interest in an enterprise other than as a limited partner and does not actively participate in the management
of the enterprise.
Most farmers use the cash method because they find it easier to keep cash method records. However, certain farm corporations
and partnerships and all tax shelters must use an accrual method of accounting. See Accrual method, earlier.
Under the cash method, include in your gross income all items of income you actually or constructively receive during the
tax year. If you receive property or services, you must include their fair market value (FMV) in income. See chapter 3 for
information on how to report farm income on your income tax return.
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.
Direct payments and counter-cyclical payments.
If you received direct payments or counter-cyclical payments under Subtitle A or C of the Farm Security and Rural
Investment Act of 2002, you will not be considered to have constructively received a payment merely because you had the option
to receive it in the year before it is required to be paid.
Delaying receipt of income.
You cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying
tax on the income. You must report the income in the year the property is received or made available to you without restriction.
Example.
Frances Jones, a farmer, was entitled to receive a $10,000 payment on a grain contract in December 2008. She was told in December
that her payment was available. She requested not to be paid until January 2009. However, she must still include this payment
in her 2008 income because it was made available to her in 2008.
Debts paid by another person or canceled.
If your debts are paid by another person or are canceled by your creditors, you may have to report part or all of
this debt relief as income. If you receive income in this way, you constructively receive the income when the debt is canceled
or paid. See Cancellation of Debt in chapter 3.
Installment sale.
If you sell an item under a deferred payment contract that calls for payment the following year, there is no constructive
receipt in the year of sale. However, see the following example for an exception to this rule.
Example.
You are a farmer who uses the cash method and a calendar tax year. You sell grain in December 2008 under a bona fide arm's-length
contract that calls for payment in 2009. You include the sale proceeds in your 2009 gross income since that is the year payment
is received. However, if the contract states that you have the right to the proceeds from the buyer at any time after the
grain is delivered, you must include the sale price in your 2008 income, regardless of when you actually receive payment.
Repayment of income.
If you include an amount in income; and in a later year you have to repay all or part of it, then you can usually
deduct the repayment in the year in which you make it. If the repayment is more than $3,000, a special rule applies. For details,
see Repayments in chapter 11 of Publication 535, Business 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 or you may be
required to capitalize certain costs, as explained under Uniform Capitalization Rules in chapter 6. See chapter 4 for information on how to deduct farm business expenses on your income tax return.
Prepayment.
Generally, you cannot deduct expenses paid in advance. This rule applies to any expense paid far enough in advance
to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.
Example.
On November 1, 2008, you signed and paid $3,600 for a 3-year (36-month) insurance contract for equipment. In 2008, you are
allowed to deduct only $200 (2/36 x $3,600) of the cost of the policy that is attributable to 2008. In 2009, you'll be able
to deduct $1,200 (12/36 x $3,600); in 2010, you'll be able to deduct $1,200 (12/36 x $3,600); and in 2011 you'll be able to
deduct the remaining balance of $1,000.
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 correctly match income and expenses.
Generally, you include an amount in 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.
If you use an accrual method of accounting, complete Part III of Schedule F (Form 1040).
Inventory.
If you keep an inventory, generally you must use an accrual method of accounting to determine your gross income. See
Farm Inventory, later, for more information.
Under an accrual method of accounting, you generally deduct or capitalize a business expense when both of the following apply.
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The all-events test has been met. This test is met when:
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All events have occurred that fix the fact of liability, and
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The liability can be determined with reasonable accuracy.
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Economic performance has occurred.
Economic performance.
Generally, you 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 as 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.
Jane, who is a farmer, uses a calendar tax year and an accrual method of accounting. She enters into a contract with ABC Farm
Consulting in 2008. The contract states that Jane must pay ABC Farm Consulting $2,000 in December 2008. It further stipulates
that ABC Farm Consulting will develop a plan for integrating her farm with a larger farm operation based in a neighboring
state by January 1, 2009. She pays ABC Farm Consulting $2,000 in December 2008. Integration of operations according to the
plan begins in May 2009 and they complete the integration in December 2009.
Economic performance for Jane's liability in the contract occurs as the property and services are provided. Jane incurs the
$2,000 cost in 2009
An exception to the economic performance rule allows certain recurring items to be treated as incurred during a tax year
even though economic performance has not occurred. For more information, see Economic Performance in Publication 538.
Special rule for related persons.
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.
For more information, see Internal Revenue Code section 267.
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).
If you are required to keep an inventory, you should keep a complete record of your inventory as part of your farm
records. This record should show the actual count or measurement of the inventory. It should also show all factors that enter
into its valuation, including quality and weight, if applicable.
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. Tax shelters must keep an inventory of their farm products because they are not allowed to use the cash method of accounting. See section 447 and Revenue Procedure 2002-28 (modified by Announcement 2004-16) for more information.
After an accounting method is selected, the taxpayer must continue to use that method unless permission to change the method
of accounting for farm products is obtained from the IRS.
Hatchery business.
If you are in the hatchery business, and use the accrual method of accounting, you must include in inventory eggs
in the process of incubation.
Products held for sale.
All harvested and purchased farm products held for sale or for feed or seed, such as grain, hay, silage, concentrates,
cotton, tobacco, etc., must be included in inventory.
Supplies.
Supplies acquired for sale or that become a physical part of items held for sale must be included in inventory. Deduct
the cost of supplies in the year used or consumed in operations. Do not include incidental supplies in inventory as these
are deductible in the year of purchase.
Livestock.
Livestock held primarily for sale must be included in inventory. Livestock held for draft, breeding, or dairy purposes
can either be depreciated or included in inventory. See also Unit-livestock-price method, later. If you are in the business of breeding and raising chinchillas, mink, foxes, or other fur-bearing animals, these
animals are livestock for inventory purposes.
Growing crops.
Generally, growing crops are not required to be included in inventory. However, if the crop has a preproductive period
of more than 2 years, you may have to capitalize (or include in inventory) costs associated with the crop. See Uniform Capitalization Rules in chapter 6.
Items to include in inventory.
Your inventory should include all items held for sale, or for use as feed, seed, etc., whether raised or purchased,
that are unsold at the end of the year.
Required to use accrual method.
The following applies if you are required to use an accrual method of accounting.
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The uniform capitalization rules apply to all costs of raising a plant, even if the preproductive period of raising a plant
is 2 years or less.
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The costs of animals are subject to the uniform capitalization rules.
Inventory valuation methods.
The following methods, described later, are those generally available for valuing inventory.
Cost and lower of cost or market methods.
See Publication 538 for information on these valuation methods.
If you value your livestock inventory at cost or the lower of cost or market, you do not need IRS approval to change to the
unit-livestock-price method. However, if you value your livestock inventory using the farm-price method, then you must obtain
permission from the IRS to change to the unit-livestock-price method.
Farm-price method.
Under this method, each item, whether raised or purchased, is valued at its market price less the direct cost of disposition.
Market price is the current price at the nearest market in the quantities you usually sell. Cost of disposition includes broker's
commissions, freight, hauling to market, and other marketing costs. If you use this method, you must use it for your entire
inventory, except that livestock can be inventoried under the unit-livestock-price method.
Unit-livestock-price method.
This method recognizes the difficulty of establishing the exact costs of producing and raising each animal. You group
or classify livestock according to type and age and use a standard unit price for each animal within a class or group. The
unit price you assign should reasonably approximate the normal costs incurred in producing the animals in such classes. Unit
prices and classifications are subject to approval by the IRS on examination of your return. You must annually reevaluate
your unit livestock prices and adjust the prices upward or downward to reflect increases or decreases in the costs of raising
livestock. IRS approval is not required for these adjustments. Any other changes in unit prices or classifications do require
IRS approval.
If you use this method, include all raised livestock in inventory, regardless of whether they are held for sale or
for draft, breeding, sport, or dairy purposes. This method accounts only for the increase in cost of raising an animal to
maturity. It does not provide for any decrease in the animal's market value after it reaches maturity. Also, if you raise
cattle, you are not required to inventory hay you grow to feed your herd.
Do not include sold or lost animals in the year-end inventory. If your records do not show which animals were sold
or lost, treat the first animals acquired as sold or lost. The animals on hand at the end of the year are considered those
most recently acquired.
You must include in inventory all livestock purchased primarily for sale. You can choose either to include in inventory
or depreciate livestock purchased for draft, breeding, sport or dairy purposes. However, you must be consistent from year
to year, regardless of the method you have chosen. You cannot change your method without obtaining approval from the IRS.
You must include in inventory animals purchased after maturity or capitalize them at their purchase price. If the
animals are not mature at purchase, increase the cost at the end of each tax year according to the established unit price.
However, in the year of purchase, do not increase the cost of any animal purchased during the last 6 months of the year. This
“ no increase” rule does not apply to tax shelters which must make an adjustment for any animal purchased during the year. It also does
not apply to taxpayers that must make an adjustment to reasonably reflect the particular period in the year in which animals
are purchased, if necessary to avoid significant distortions in income.
Uniform capitalization rules.
A farmer can determine costs required to be allocated under the uniform capitalization rules by using the farm-price
or unit-livestock-price inventory method. This applies to any plant or animal, even if the farmer does not hold or treat the
plant or animal as inventory property.
Cash Versus Accrual Method
The following examples compare the cash and accrual methods of accounting.
Example 1.
You are a farmer who uses an accrual method of accounting. You keep your books on the calendar tax year basis. You sell grain
in December 2008 but you are not paid until January 2009 You must both include the sale proceeds and deduct the costs incurred
in producing the grain on your 2008 tax return.
Example 2.
Assume the same facts as in Example 1 except that you use the cash method and there was no constructive receipt of the sale proceeds in 2008 Under this method,
you include the sale proceeds in income for 2009 the year you receive payment. Deduct the costs of producing the grain in
the year you pay for them.
Special Methods of Accounting
There are special methods of accounting for certain items of income and expense.
Crop method.
If you do not harvest and dispose of your crop in the same tax year that you plant it, you can, with IRS approval,
use the crop method of accounting. Under this method, you deduct the entire cost of producing the crop, including the expense
of seed or young plants, in the year you realize income from the crop. See Regulations section 1.162-12 for details on deductible
expenses of farmers.
Other special methods.
Other special methods of accounting apply to the following items.
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Amortization, see chapter 7.
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Casualties, see chapter 11.
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Condemnations, see chapter 11.
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Depletion, see chapter 7.
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Depreciation, see chapter 7.
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Farm business expenses, see chapter 4.
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Farm income, see chapter 3.
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Installment sales, see chapter 10.
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Soil and water conservation expenses, see chapter 5.
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Thefts, see chapter 11.
Generally, you can use any combination of cash, accrual, and special methods of accounting if the combination clearly shows
your income and expenses and you use it consistently. However, the following restrictions apply.
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If you use the cash method for figuring your income, you must use the cash method for reporting your expenses.
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If you use the accrual method for reporting your expenses, you must use the accrual method for figuring your income.
Change in Accounting Method
Once you have set up your accounting method, generally you must receive approval from the IRS before you can change to another
method. A change in your accounting method includes a change in:
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Your overall method, such as from cash to an accrual method, and
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Your treatment of any material item, such as a change in your method of valuing inventory (for example, a change from the
farm-price method to the unit-livestock-price method).
To obtain approval, you must file Form 3115. You may also have to pay a fee. For more information, see the Form 3115 instructions or Revenue Procedure 2008-52.
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