For exceptions to 3 a, b, e, and f, see Revenue Procedure 2000-11.

Corporations that qualify and want to change their tax year using this automatic procedure must also comply with the following conditions.

1. The short period required to effect the tax year change must begin with the day following the close of the previous tax year and must end with the day preceding the first day of the new tax year.
2. The corporation must file a tax return for the short period by the due date, including extensions.
3. The books of the corporation must be closed as of the last day of the new tax 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 new tax year. The corporation must figure its income and keep its books and records, including financial reports and statements for credit purposes, on the basis of the new tax year.
4. Taxable income of the corporation for the short period must be figured on an annual basis (except for a real estate investment trust or a regulated investment company) and the tax must be figured as shown under Figuring Tax for Short Year, earlier.
5. If the corporation has a net operating loss (NOL) in the short period required to effect the change, the NOL generally cannot be carried back. However, a short period NOL can be carried back or forward if it:
   1. Is $50,000 or less.
   2. Results from a short period of 9 or more months and is less than the NOL for a full 12-month period beginning with the first day of the short period.
6. 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 2000-11 for more information.

Form 1128.   To make this change, a corporation must file Form 1128 with the director of the Internal Revenue Service Center where it files its income tax return. It should mark the envelope Attention: ENTITY CONTROL. The form must be filed by the due date (including extensions) of the short period return required for the change. It should type or print FILED UNDER REV. PROC. 2000-11 at the top of Form 1128. If the request is denied, the service center will return Form 1128 with an explanation of the denial.

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.

Accounting Methods

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.

Methods you can use.   Subject to the preceding rules, you can compute your taxable income under any of the following accounting methods.

1. Cash method.
2. Accrual method.
3. Special methods of accounting for certain items of income and expenses.
4. 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.

1. Publication 225, Farmer's Tax Guide.
2. Publication 537, Installment Sales.
3. 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.

1. If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales. See, however, Cash Method of Accounting for Qualifying Taxpayers, later. You can use the cash method for all other items of income and expenses. See Inventories, later.
2. If you use the cash method for figuring your income, you must use the cash method for reporting your expenses.
3. If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.
4. 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.

Cash Method

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 Cash Method of Accounting for Qualifying Taxpayers, later, for an exception to this rule.

Income

Under the cash method, you include in your gross income all items of income you actually or constructively receive during the tax year. If you receive property and services, you must include their fair market value 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 2001, but you do not withdraw it or enter it into your passbook until 2002. You must include the amount in gross income for 2001, not 2002.

Example 2.   You have interest coupons that mature and become payable in 2001, but you do not cash them until 2002. You must include the interest in gross income for 2001, the year of constructive receipt. You must include the interest in your 2001 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.

Expenses

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 2001 for a business insurance policy that is effective for one year, beginning July 1st. You can deduct $500 in 2001 and $500 in 2002.

Excluded Entities

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

1. A corporation (other than an S corporation) with average annual gross receipts exceeding $5 million.
2. A partnership with a corporation (other than an S corporation) as a partner, and with the partnership having average annual gross receipts exceeding $5 million.
3. A tax shelter.

Exceptions

The following entities can use the cash method of accounting.

1. A family farming corporation with gross receipts of $25 million or less for each prior tax year beginning after 1985.
2. A qualified personal service corporation.

See Publication 225 for more information on family farming corporations.

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.

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.

1. Employees performing services for the corporation in a field qualifying under the function test.
2. Retired employees who had performed services in those fields.
3. The estate of an employee described in (1) or (2).
4. 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.

Cash Method of Accounting for Qualifying Taxpayers

Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. For tax years ending on or after December 17, 1999, qualifying taxpayers can use the cash method of accounting, even if they produce, purchase, or sell merchandise. Qualifying taxpayers can also choose to not keep an inventory, even if they do not change to the cash method.

Qualifying taxpayers.   You are a qualifying taxpayer only if you meet the gross receipts test for each tax year ending after December 16, 1998. To qualify, 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 and 1999 to see if you qualify to use the cash method and not keep an inventory for 2000. You qualify if your average annual gross receipts for 1996, 1997, and 1998 are $1,000,000 or less (1998 test) and your average annual gross receipts for 1997, 1998, and 1999 are $1,000,000 or less (1999 test). A tax shelter cannot be a qualifying taxpayer.

If you did not own your business for all of the 3-tax-year period, include the period of any predecessor. If your business has not been in existence for 3 tax years, base your average on the period it has existed including any short tax years, annualizing the short tax year's gross receipts.

Not keeping an inventory.   If you choose to not keep an inventory, you will deduct the cost of the items you would otherwise include in inventory in the year you sell the items, or the year you pay for them, whichever is later. If you are a producer, you can use any reasonable method to estimate the raw material in your work in process and finished goods on hand at the end of the year to determine the raw material used to produce finished goods that were sold during the year.

Changing methods.   If you qualify and want to change to the cash method, you must file Form 3115, Application for Change in Accounting Method. You must follow the provisions in Revenue Procedure 99-49 in Cumulative Bulletin 1999-2, as modified by Revenue Procedure 2001-10, for an automatic change in accounting method. Those provisions also apply if you no longer want to keep inventories. You may file one Form 3115 if you choose to make both changes.

More information.   For more information, see Revenue Procedure 2001-10 in Internal Revenue Bulletin 2001-2.

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