Publication 538: Accounting Periods and Methods; Publication 538 Main Contents

This is archived information that pertains only to the 2003 Tax Year. If you
are looking for information for the current tax year, go to the Tax Prep Help Area.

User Fees

The IRS charges a user fee for certain requests to change an accounting period or method, certain tax rulings, and determination letters. The fee is reduced in certain situations and for certain requests, such as a request for substantially identical rulings for related entities. No fee is charged for changes permitted to be made by a published automatic change revenue procedure.

See Revenue Procedure 2003–1, in Internal Revenue Bulletin No. 2003–1, or its successor, for more information.

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. 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.

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.

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:

For example, if you elect a tax year that always ends on the last Monday in March, your 2001 tax year will end on March 25, 2002. If you elect a tax year ending on the Thursday nearest to the end of April, your 2001 tax year will end on April 25, 2002.

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:
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, 2002. For this purpose, a 52-53-week tax year beginning on June 24, 2002, is treated as beginning on July 1, 2002.

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.

Automatic approval.

You can get approval for certain 52-53-week tax year changes automatically if you qualify under any of the following.

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 66–50, as modified by Revenue Procedure 81–40, which provides automatic approval procedures for individuals.

Revenue Procedures 2002–37 and 2002–38 are in Internal Revenue Bulletin 2002–22. Revenue Procedure 66–50 is in Cumulative Bulletin 1966–2. Revenue Procedure 81–40 is in Cumulative Bulletin 1981–2.

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):

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.

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, 2002. Her final tax return must be filed by April 15, 2003. It will cover the short period from January 1, 2002, to March 6, 2002.

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, 2001, total $12,400 and they can claim exemptions for themselves, and their two children. Each exemption is $2,900. They figure the tax on their joint return for that period as follows.

$48,000 - $12,400 = $35,600
$2,900 × 4 × 9/12 = $8,700
$35,600 - $8,700 = $26,900 (modified taxable income)
$26,900 × 12/9 = $35,867 (annualized income)
Tax on $35,867 = $5,381 (from 2001 tax rate schedule)
$5,381 × 9/12 = $4,036 (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, 2001. 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.
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 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.

A calendar year is a tax year of 12 months that ends on December 31 and a fiscal year is a tax year of 12 months that ends on the last day of any month other than December. A 52-53-week tax year is also a fiscal year, but may not end on the last day of a month. If you begin business operations on a day other than the first day of a calendar month and adopt a tax year of exactly 12 months from the date operations began, you will have adopted an improper tax year. You do not meet the requirements for a calendar or fiscal tax year.

You must, with certain exceptions, get IRS approval to change your tax year. You can apply for approval using Form 1128.

File a current Form 1128 with the IRS national office 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 include the correct user fee, if any, with Form 1128. See User fees at the beginning of this publication. See also Revenue Procedure 2002–39 in Internal Revenue Bulletin 2002–22, for the address to which Form 1128 should be sent.

A Form 1128 received within 90 days after the due date may qualify for an extension and be considered timely filed. For more information, see the form instructions and Revenue Procedure 2003–1 in Internal Revenue Bulletin 2003–1 (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.

Certain taxpayers can get automatic approval to change their tax year. Even though they can get automatic approval, they must still file Form 1128. The time for filing Form 1128 depends on whether you are a business entity or an individual. Do not file Form 1128 with the IRS national office to get automatic approval. No user fee is required.

Corporations and pass-through entities.

To get approval to change your tax year under the automatic approval procedures for certain corporations and pass-through entities, file a Form 1128 with the Director, Internal Revenue Service Center, Attention: ENTITY CONTROL, where your return is filed by the due date (including extensions) of the tax return for the short period. See Revenue Procedures 2002–37 and 2002–38 in Internal Revenue Bulletin 2002–22. See also Automatic approval, later, under Partnerships, S Corporations, and Personal Service Corporations and Corporations.

Individuals.

If you can get approval to change your tax year under the automatic approval procedures for individuals, file a Form 1128 with the Director, Internal Revenue Service Center, where your return is filed by the 15th day of the 2nd calendar month after the close of the short tax year. See Revenue Procedure 66–50 in Cumulative Bulletin 1966–2, and Revenue Procedure 81–40 in Cumulative Bulletin 1981–2.

Husband and wife.

A husband and wife who have different tax years cannot file a joint return. However, there is an exception to this rule if their tax years begin on the same date and end on different dates because of the death of either or both. If a husband and wife want to use the same tax year so they can file a joint return, the method of changing a tax year depends on whether they are newly married.

Special rule for newlyweds.

A newly married husband and wife with different tax years who wish to file a joint return can get automatic approval to change the tax year of one spouse. 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. (The spouse changing tax years does not have to file Form 1128.)

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, 2001. John filed his return for the fiscal year ending June 30, 2001. 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, 2001, for the short period January 1, 2001, through June 30, 2001, 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, 2002.

Spouses other than newlyweds.

A spouse who does not meet the earlier conditions must get IRS approval to change to the other spouse's tax year in order to file a joint return. The spouse wishing to change tax years generally needs to file Form 1128 and follow the procedures in section 1.442–1(b) of the regulations.

Generally, partnerships, S corporations (including electing S corporations), and personal service corporations 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 establishes a business purpose for a different tax year, makes an election under section 444, or 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. These issues are discussed later.

A partnership must conform its tax year to its partners' tax years unless the partnership can establish a business purpose for a different period, makes a section 444 election, or 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 rules for the required tax year for partnerships are as follows.

If a partnership changes to a required tax year because of these rules, it can get automatic approval to do so. It must file a Form 1128 with the Director, Internal Revenue Service Center, Attention: ENTITY CONTROL, where it files its tax returns and it must attach a copy of the Form 1128 to its return. In order to assist in the processing of the change, the partnership should write at the top of page 1 of Form 1128, “FILED UNDER REV. PROC. 2002–38.” The Form 1128 is due by the due date (including extensions) for filing the short period tax return.

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 on partnerships, see Publication 541.

If it meets the requirements, a small business corporation can elect to be an 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.

A personal service corporation must use a calendar tax year unless any of the following apply.

A corporation is a personal service corporation if all the following conditions are met.

Principal activity.

The principal activity of a corporation is considered to be the performance of personal services if, during the testing period, the corporation's compensation costs for personal service activities are more than 50% of its total compensation costs.

Testing period.

Generally, the testing period for a tax year is the prior tax year.

Example.

Corporation A has been in existence since 1980. It has always used a January 31 fiscal year for its accounting period. To determine whether A is a personal service corporation for its tax year beginning February 1, 2002, the testing period is A's tax year ending January 31, 2002.

New corporations.

The testing period for the first tax year of a new corporation starts with the first day of the tax year and ends on the earlier of the following dates.

The last day of its tax year.
The last day of the calendar year in which the tax year begins.

Example.

B Corporation's first tax year begins June 1, 2002. B wants to use a September 30 fiscal year for its accounting period. B's testing period for its first tax year is from June 1, 2002, through September 30, 2002. If B wants to use a March 31 fiscal year, the testing period is from June 1, 2002, through December 31, 2002.

Performance of personal services.

Any activity that involves the performance of services in the fields of health, veterinary services, law, engineering, architecture, accounting, actuarial science, performing arts, or certain consulting services is considered the performance of personal services.

Employee-owner.

An employee-owner of a corporation is a person who:

Is an employee of the corporation on any day of the testing period, and
Owns any outstanding stock of the corporation on any day of the testing period.

Independent contractor.

A person who owns any outstanding stock of the corporation and who performs personal services for or on behalf of the corporation is treated as an employee of the corporation. This rule applies even if the legal form of the person's relationship to the corporation is such that the person would be considered an independent contractor for other purposes.

More information.

For more information on the tax year of a personal service corporation, see section 1.441-3 of the regulations.

A partnership, S corporation, electing S corporation, or personal service corporation can elect under section 444 to use a tax year other than its required tax year. Certain restrictions apply to the election. In addition, a partnership or S corporation may have to make a payment for the deferral period. See Required payment for partnership or S corporation, later. The section 444 election does not apply to any partnership, S corporation, or personal service corporation that establishes a business purpose for a different period, explained later.

A partnership, S corporation, or personal service corporation can make a section 444 election if it meets all the following requirements.

Deferral period.

The determination of the deferral period depends on whether the partnership, S corporation, or personal service corporation 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 personal service corporation 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 personal service corporation 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 personal service corporation wishes to make the section 444 election.

If the partnership, S corporation, or personal service corporation'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, 2001. 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, 2001, 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 or the appropriate Form 1120 for the first tax year for which the election is made.

Example 1.

AB, a partnership, begins operations on September 11, 2002, and is qualified to make a section 444 election to use a September 30 tax year for its tax year beginning September 11, 2002. AB must file Form 8716 by January 15, 2003, which is the due date of the partnership's tax return for the period from September 11, 2002, to September 30, 2002.

Example 2.

The facts are the same as in Example 1 except that AB begins operations on October 21, 2002. AB must file Form 8716 by March 17, 2003, 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 personal service corporation for its tax year beginning September 1, 2002. B qualifies to make a section 444 election to use a September 30 tax year for its tax year beginning September 1, 2002. B must file Form 8716 by December 16, 2002, the due date of the income tax return for the short period from September 1, 2002, to September 30, 2002.

Extension of time for filing.

There is an automatic extension of 12 months to make this election. See the form instructions for more information.

Effect of election.

A partnership or an S corporation that makes a section 444 election must make certain required payments and a personal service corporation must make certain distributions. These issues are discussed later.

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 personal service corporation.

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 personal service corporation, the personal service corporation can continue the section 444 election of the S corporation.
A personal service corporation ceases to be a personal service corporation. If the personal service corporation elects to be an S corporation, the S corporation can continue the election of the personal service corporation.

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.

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, 2002, Form 8752 must be filed by May 15, 2003.

Required distribution for personal service corporation.

A personal service corporation 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 personal service corporation 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 personal service corporation otherwise qualifies).

Making 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 is filed, type or print “FORM 1128 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 personal service corporation 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 personal service corporation 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 personal service corporation 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. A partnership, S corporation, or personal service corporation within the scope of Revenue Procedure 2002–38 in Internal Revenue Bulletin 2002–22 can get automatic approval to change its tax year to a 52-53-week tax year ending with reference to its required tax year. For more information, see the discussion on the 52-53-week tax year, earlier, under Fiscal Year. See also Automatic approval under Business Purpose Tax Year, next.

A business purpose tax year is an accounting period for which a taxpayer establishes a business purpose. A partnership, S corporation, electing S corporation, or personal service corporation can establish a business purpose for a tax year based on all the relevant facts and circumstances. See Facts and circumstances test, next. However, the Service anticipates that such entity will be granted permission to adopt, change, or retain an annual accounting period only in rare and unusual circumstances. In addition, an entity can establish a business purpose for a tax year if the tax year coincides with its required tax year, natural business year, or ownership tax year. See Natural business year and Ownership tax year, later. In considering whether there is a business purpose for a tax year, significant weight is given to tax factors.

Facts and circumstances test.

A taxpayer can establish a business purpose based on all the relevant facts and circumstances. 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:
1. Admission or retirement of partners or shareholders.
2. Promotion of staff.
3. 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.

Natural business year.

A taxpayer can establish a business purpose for a tax year using a “natural business year.” A natural business year is the annual accounting period encompassing all related income and expenses.

An entity changing its tax year so that it coincides with its natural business year has established a business purpose. The natural business year of an entity can be determined under any of the following tests.

Annual business cycle test.
Seasonal business test.
25-percent gross receipts test.

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.

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.

Automatic approval.

A partnership, an S corporation, or a personal service corporation can get automatic approval to change to a required tax year discussed earlier, or to a 52-53-week tax year ending with reference to such required tax year. A partnership, an S corporation, or a personal service corporation can get automatic approval to retain or change to a natural business year that meets the 25-percent gross receipts test, discussed earlier, or to a 52-53-week tax year ending with reference to such natural 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 (discussed next) or a 52-53-week tax year ending with reference to such ownership tax year. For more information, see Revenue Procedure 2002–38 in Internal Revenue Bulletin 2002–22.

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.

Filing information.

To get automatic approval, a partnership, S corporation, or corporation electing to be an 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, Election by a Small Business Corporation.

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.

A corporation that elects to be an S corporation and requests to adopt, retain, or change its tax year must file Form 2553. The form must be filed when the election to be an S corporation is filed. Generally, such election must be filed at any time during either of the following tax years.

The tax year that immediately precedes the tax year for which the election is to be effective.
The tax year for which the election is to be effective, provided the election is made before the 16th day of the third month of the tax year.

Form 1128 and Form 2553 must be filed with the Director, Internal Revenue Service Center, Attention: ENTITY CONTROL, where the entity files its tax return. At the top of page 1 of the Form 1128 or Form 2553, type or print “FILED UNDER REV. PROC. 2002–38.” No copies of Form 1128 or Form 2553 are to be sent to the IRS national office. However, a copy must be attached to the tax return for the first effective year.

For more information on these tax year requirements, see Revenue Ruling 87–57 in Cumulative Bulletin 1987–2 and Revenue Procedure 2002–38 in Internal Revenue Bulletin 2002–22.

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 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 nonautomatic approval procedures.

Automatic approval.

Certain C corporations can automatically change their tax year. A corporation can automatically change to (or from) a 52-53-week tax year or to a natural business year that meets the 25-percent gross receipts test (discussed earlier under 25-percent gross receipts test). 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 in Internal Revenue Bulletin 2002–22.
It is not any of the following:
1. A member of a partnership. See Caution, later.
2. A beneficiary of a trust or an estate. See Caution, later.
3. 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).
4. A personal service corporation.
5. An interest-charge domestic international sales corporation (IC–DISC) or foreign sales corporation (FSC) or a shareholder in either. See Caution, later.
6. A controlled foreign corporation or foreign personal holding company. See Caution, later.
7. A tax-exempt organization, except those exempt under section 521, 526, 527, or 528.
8. 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.
9. A corporation with a section 936 election in effect.
10. 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.

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. However, a short period NOL or CL can be carried back or carried over if it:
1. Is $50,000 or less.
2. Results from a short period of 9 months or longer and is less than the NOL or CL for a 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 in Internal Revenue Bulletin 2002–22 for more information.

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.

Form 1128 must be filed with the Director, Internal Revenue Service Center, Attention: ENTITY CONTROL, where the corporation's return is filed. At the top of page 1 of the Form 1128, type or print “FILED UNDER REV. PROC. 2002–37.” 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.

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.

Nonautomatic approval.

Corporations that cannot get automatic approval to change their tax year must get IRS approval under section 442 and the related regulations. See also Revenue Procedure 2002–39 in Internal Revenue Bulletin 2002–22.

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 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 shows 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 shows 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 shows 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.

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. 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, you can use any combination of cash, accrual, and special methods of accounting if the combination clearly shows 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. You can use the cash method for all other items of income and expenses. See Inventories, later.
If you use the cash method for figuring 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.

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 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 under Inventories, later, 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 2002, but you do not withdraw it or enter it into your passbook until 2003. You must include the amount in gross income for 2002, not 2003.

Example 2.

You have interest coupons that mature and become payable in 2002, but you do not cash them until 2003. You must include the interest in gross income for 2002, the year of constructive receipt. You must include the interest in your 2002 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 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.

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 or 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 can be deducted only in the year to which it applies.

Example.

You are a calendar year taxpayer and you pay $1,000 in 2002 for a business insurance policy that is effective for one year, beginning July 1st. You can deduct $500 in 2002 and $500 in 2003.

The following entities cannot use the cash method, including any combination of methods that includes the cash method.

Gross receipts test.

Any corporation or partnership, other than a tax shelter, that meets the gross receipts test for all tax years after 1985 can use the cash method. A corporation or a partnership meets the test if its average annual gross receipts are $5 million or less for the 3 tax years ending with the prior tax year (or the period of existence, if shorter). 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 must change to an accrual method of accounting, effective for the tax year in which the entity fails to meet this test.

Qualified personal service corporation.

A personal service corporation 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 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 personal service corporations. 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 personal service corporation 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.

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 that, based on your experience, you will not collect. The nonaccrual-experience method is explained in section 1.448–2T of the regulations.

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 2002 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 2002 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 2002 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 (2003), you must still include advance payments for the unperformed services in gross income for 2003.

Example 3.

You own a dance studio. On November 1, 2002, you receive payment for a one-year contract for 48 one-hour lessons beginning on that date. You give eight lessons in 2002. Under this method of including advance payments, you must include one-sixth (8/48) of the payment in income for 2002, and five-sixths (40/48) of the payment in 2003, even if you cannot give all the lessons by the end of 2003.

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 2002 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 or interest.

You cannot postpone reporting income from prepaid rent or interest. 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 get IRS approval, as discussed later under Change in Accounting Method, to change your method of accounting for advance payments for services.

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 2002, 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 2002, but it was not delivered and accepted until January 2003. For tax purposes, you include the $8,000 advance payment in gross income for 2002 and you include the remaining $12,000 of the contract price in gross income for 2003.

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.
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 the 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 1999, 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.

1999	$17,500
2000	10,000
2001	7,500
2002	5,000
2003	5,000
2004	5,000
Total contract price	$50,000

Your customer asked you to deliver the goods in 2005. In your 2000 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 2000 were more than the costs you estimated, the payments are substantial advance payments.

Include in income for 2002 all payments you receive by the end of 2002, the second tax year following the tax year in which you received substantial advance payments. You must include $40,000 in sales for 2002 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 2005.

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.

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.

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.

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.
1. 8½ months after the close of the year.
2. 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:
1. The item is not material, or
2. 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.

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. Costs directly associated with the revenue of a period are properly allocable to that period.

For example, a sales commission agreement can require certain payments to be made in a year subsequent to the year sales income is reported. In this situation, economic performance for part of the commission expense may not occur until the following year. Nevertheless, deducting the commission expense in the year the sales income is reported will result in a better match of the commission expense with the sales income. Also, if sales income is recognized in the year of sale, but the goods are not shipped 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 such as insurance or rent are generally allocable to a period of time. If you are a calendar year taxpayer and enter into a 12-month insurance contract on July 1 of year 1, allocate half of your expense to year 1 and half to year 2. 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. The matching requirement is satisfied if the period to which the expenses are assigned is the same for tax and financial reporting purposes.

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 personal service corporation 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 1999 for repair work completed that year. You contested the asserted liability and settled in 2001 for the full $500. You pay the $500 in January 2002. Since you did not make the payment until after the contest was settled, the liability accrues in 2001 and you can deduct it only in 2001.

Transfer to creditor.

You must transfer to the creditor or other person enough money or other property to cover 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, or transferring funds to an account within your control 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, 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 not a payment to the claimant that discharges the liability. This payment does not satisfy the economic performance test, discussed earlier.

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 choose to not keep an inventory, even if they do not change to the cash method.

A qualifying small business taxpayer can use the cash method for an “eligible business” (defined later).

Qualifying taxpayer.

You are a qualifying taxpayer only if you meet the gross receipts test for each prior tax year ending after December 16, 1998. To meet the test for a prior tax year, your average annual gross receipts must be $1,000,000 or less for the 3 tax years ending with the prior tax year. For example, you must test 1998, 1999, 2000, and 2001 to see if you are a qualifying taxpayer that can use the cash method and choose to not keep an inventory for 2002. Use Table 1 to determine if you are a qualifying taxpayer for 2002.

Table 1. Are You a Qualifying Taxpayer for 2002?

a) Are your average annual gross receipts $1,000,000 or less for each 3-year period below?			b) Do you meet the test in a) for each tax year below?
(1)	(2)	(3)	Test Year
1999	2000	2001	2001
1998	1999	2000	2000
1997	1998	1999	1999
1996	1997	1998	1998
c) If your answer is Yes to a) and b), you are a qualifying taxpayer for 2002.

In addition, a tax shelter cannot be a qualifying taxpayer.

Publication 538Main Contents

Publication 538
Main Contents