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1040ez2011 Publication 538 - Main Content Table of Contents Accounting PeriodsCalendar Year Fiscal Year Short Tax Year Improper Tax Year Change in Tax Year Individuals Partnerships, S Corporations, and Personal Service Corporations (PSCs) Corporations (Other Than S Corporations and PSCs) Accounting MethodsSpecial methods. 1040ez2011 Hybrid method. 1040ez2011 Cash Method Accrual Method Inventories Change in Accounting Method How To Get Tax HelpLow Income Taxpayer Clinics (LITCs). 1040ez2011 Accounting Periods You must use a tax year to figure your taxable income. 1040ez2011 A tax year is an annual accounting period for keeping records and reporting income and expenses. 1040ez2011 An annual accounting period does not include a short tax year (discussed later). 1040ez2011 You can use the following tax years: A calendar year; or A fiscal year (including a 52-53-week tax year). 1040ez2011 Unless you have a required tax year, you adopt a tax year by filing your first income tax return using that tax year. 1040ez2011 A required tax year is a tax year required under the Internal Revenue Code or the Income Tax Regulations. 1040ez2011 You cannot adopt a tax year by merely: Filing an application for an extension of time to file an income tax return; Filing an application for an employer identification number (Form SS-4); or Paying estimated taxes. 1040ez2011 This section discusses: A calendar year. 1040ez2011 A fiscal year (including a period of 52 or 53 weeks). 1040ez2011 A short tax year. 1040ez2011 An improper tax year. 1040ez2011 A change in tax year. 1040ez2011 Special situations that apply to individuals. 1040ez2011 Restrictions that apply to the accounting period of a partnership, S corporation, or personal service corporation. 1040ez2011 Special situations that apply to corporations. 1040ez2011 Calendar Year A calendar year is 12 consecutive months beginning on January 1st and ending on December 31st. 1040ez2011 If you adopt the calendar year, you must maintain your books and records and report your income and expenses from January 1st through December 31st of each year. 1040ez2011 If you file your first tax return using the calendar tax year and you later begin business as a sole proprietor, become a partner in a partnership, or become a shareholder in an S corporation, you must continue to use the calendar year unless you obtain approval from the IRS to change it, or are otherwise allowed to change it without IRS approval. 1040ez2011 See Change in Tax Year, later. 1040ez2011 Generally, anyone can adopt the calendar year. 1040ez2011 However, you must adopt the calendar year if: You keep no books or records; You have no annual accounting period; Your present tax year does not qualify as a fiscal year; or You are required to use a calendar year by a provision in the Internal Revenue Code or the Income Tax Regulations. 1040ez2011 Fiscal Year A fiscal year is 12 consecutive months ending on the last day of any month except December 31st. 1040ez2011 If you are allowed to adopt a fiscal year, you must consistently maintain your books and records and report your income and expenses using the time period adopted. 1040ez2011 52-53-Week Tax Year You can elect to use a 52-53-week tax year if you keep your books and records and report your income and expenses on that basis. 1040ez2011 If you make this election, your 52-53-week tax year must always end on the same day of the week. 1040ez2011 Your 52-53-week tax year must always end on: Whatever date this same day of the week last occurs in a calendar month, or Whatever date this same day of the week falls that is nearest to the last day of the calendar month. 1040ez2011 For example, if you elect a tax year that always ends on the last Monday in March, your 2012 tax year will end on March 25, 2013. 1040ez2011 Election. 1040ez2011   To make the election for the 52-53-week tax year, attach a statement with the following information to your tax return. 1040ez2011 The month in which the new 52-53-week tax year ends. 1040ez2011 The day of the week on which the tax year always ends. 1040ez2011 The date the tax year ends. 1040ez2011 It can be either of the following dates on which the chosen day: Last occurs in the month in (1), above, or Occurs nearest to the last day of the month in (1), above. 1040ez2011   When you figure depreciation or amortization, a 52-53-week tax year is generally considered a year of 12 calendar months. 1040ez2011   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. 1040ez2011 Example. 1040ez2011 Assume a tax provision applies to tax years beginning on or after July 1, 2012, which happens to be a Sunday. 1040ez2011 For this purpose, a 52-53-week tax year that begins on the last Tuesday of June, which falls on June 26, 2012, is treated as beginning on July 1, 2012. 1040ez2011 Short Tax Year A short tax year is a tax year of less than 12 months. 1040ez2011 A short period tax return may be required when you (as a taxable entity): Are not in existence for an entire tax year, or Change your accounting period. 1040ez2011 Tax on a short period tax return is figured differently for each situation. 1040ez2011 Not in Existence Entire Year Even if a taxable entity was not in existence for the entire year, a tax return is required for the time it was in existence. 1040ez2011 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. 1040ez2011 Example 1. 1040ez2011 XYZ Corporation was organized on July 1, 2012. 1040ez2011 It elected the calendar year as its tax year. 1040ez2011 Therefore, its first tax return was due March 15, 2013. 1040ez2011 This short period return will cover the period from July 1, 2012, through December 31, 2012. 1040ez2011 Example 2. 1040ez2011 A calendar year corporation dissolved on July 23, 2012. 1040ez2011 Its final return is due by October 15, 2012. 1040ez2011 It will cover the short period from January 1, 2012, through July 23, 2012. 1040ez2011 Death of individual. 1040ez2011   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. 1040ez2011 The decedent's final return will be a short period tax return that begins on January 1st, and ends on the date of death. 1040ez2011 In the case of a decedent who dies on December 31st, the last day of the regular tax year, a full calendar-year tax return is required. 1040ez2011 Example. 1040ez2011   Agnes Green was a single, calendar year taxpayer. 1040ez2011 She died on March 6, 2012. 1040ez2011 Her final income tax return must be filed by April 15, 2013. 1040ez2011 It will cover the short period from January 1, 2012, to March 6, 2012. 1040ez2011 Figuring Tax for Short Year If the IRS approves a change in your tax year or you are required to change your tax year, you must figure the tax and file your return for the short tax period. 1040ez2011 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. 1040ez2011 Figure tax for a short year under the general rule, explained below. 1040ez2011 You may then be able to use a relief procedure, explained later, and claim a refund of part of the tax you paid. 1040ez2011 General rule. 1040ez2011   Income tax for a short tax year must be annualized. 1040ez2011 However, self-employment tax is figured on the actual self-employment income for the short period. 1040ez2011 Individuals. 1040ez2011   An individual must figure income tax for the short tax year as follows. 1040ez2011 Determine your adjusted gross income (AGI) for the short tax year and then subtract your actual itemized deductions for the short tax year. 1040ez2011 You must itemize deductions when you file a short period tax return. 1040ez2011 Multiply the dollar amount of your exemptions by the number of months in the short tax year and divide the result by 12. 1040ez2011 Subtract the amount in (2) from the amount in (1). 1040ez2011 The result is your modified taxable income. 1040ez2011 Multiply the modified taxable income in (3) by 12, then divide the result by the number of months in the short tax year. 1040ez2011 The result is your annualized income. 1040ez2011 Figure the total tax on your annualized income using the appropriate tax rate schedule. 1040ez2011 Multiply the total tax by the number of months in the short tax year and divide the result by 12. 1040ez2011 The result is your tax for the short tax year. 1040ez2011 Relief procedure. 1040ez2011   Individuals and corporations can use a relief procedure to figure the tax for the short tax year. 1040ez2011 It may result in less tax. 1040ez2011 Under this procedure, the tax is figured by two separate methods. 1040ez2011 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. 1040ez2011 For more information, see section 443(b)(2) of the Internal Revenue Code. 1040ez2011 Alternative minimum tax. 1040ez2011   To figure the alternative minimum tax (AMT) due for a short tax year: Figure the annualized alternative minimum taxable income (AMTI) for the short tax period by completing the following steps. 1040ez2011 Multiply the AMTI by 12. 1040ez2011 Divide the result by the number of months in the short tax year. 1040ez2011 Multiply the annualized AMTI by the appropriate rate of tax under section 55(b)(1) of the Internal Revenue Code. 1040ez2011 The result is the annualized AMT. 1040ez2011 Multiply the annualized AMT by the number of months in the short tax year and divide the result by 12. 1040ez2011   For information on the AMT for individuals, see the Instructions for Form 6251, Alternative Minimum Tax–Individuals. 1040ez2011 For information on the AMT for corporations, see the Instructions to Form 4626, Alternative Minimum Tax–Corporations. 1040ez2011 Tax withheld from wages. 1040ez2011   You can claim a credit against your income tax liability for federal income tax withheld from your wages. 1040ez2011 Federal income tax is withheld on a calendar year basis. 1040ez2011 The amount withheld in any calendar year is allowed as a credit for the tax year beginning in the calendar year. 1040ez2011 Improper Tax Year Taxpayers that have adopted an improper tax year must change to a proper tax year. 1040ez2011 For example, if a taxpayer began business on March 15 and adopted a tax year ending on March 14 (a period of exactly 12 months), this would be an improper tax year. 1040ez2011 See Accounting Periods, earlier, for a description of permissible tax years. 1040ez2011 To change to a proper tax year, you must do one of the following. 1040ez2011 If you are requesting a change to a calendar tax year, file an amended income tax return based on a calendar tax year that corrects the most recently filed tax return that was filed on the basis of an improper tax year. 1040ez2011 Attach a completed Form 1128 to the amended tax return. 1040ez2011 Write “FILED UNDER REV. 1040ez2011 PROC. 1040ez2011 85-15” at the top of Form 1128 and file the forms with the Internal Revenue Service Center where you filed your original return. 1040ez2011 If you are requesting a change to a fiscal tax year, file Form 1128 in accordance with the form instructions to request IRS approval for the change. 1040ez2011 Change in Tax Year Generally, you must file Form 1128 to request IRS approval to change your tax year. 1040ez2011 See the Instructions for Form 1128 for exceptions. 1040ez2011 If you qualify for an automatic approval request, a user fee is not required. 1040ez2011 Individuals Generally, individuals must adopt the calendar year as their tax year. 1040ez2011 An individual can adopt a fiscal year provided that the individual maintains his or her books and records on the basis of the adopted fiscal year. 1040ez2011 Partnerships, S Corporations, and Personal Service Corporations (PSCs) Generally, partnerships, S corporations (including electing S corporations), and PSCs must use a required tax year. 1040ez2011 A required tax year is a tax year that is required under the Internal Revenue Code and Income Tax Regulations. 1040ez2011 The entity does not have to use the required tax year if it receives IRS approval to use another permitted tax year or makes an election under section 444 of the Internal Revenue Code (discussed later). 1040ez2011 The following discussions provide the rules for partnerships, S corporations, and PSCs. 1040ez2011 Partnership A partnership must conform its tax year to its partners' tax years unless any of the following apply. 1040ez2011 The partnership makes an election under section 444 of the Internal Revenue Code to have a tax year other than a required tax year by filing Form 8716. 1040ez2011 The partnership elects to use a 52-53-week tax year that ends with reference to either its required tax year or a tax year elected under section 444. 1040ez2011 The partnership can establish a business purpose for a different tax year. 1040ez2011 The rules for the required tax year for partnerships are as follows. 1040ez2011 If one or more partners having the same tax year own a majority interest (more than 50%) in partnership profits and capital, the partnership must use the tax year of those partners. 1040ez2011 If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. 1040ez2011 A principal partner is one who has a 5% or more interest in the profits or capital of the partnership. 1040ez2011 If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use a tax year that results in the least aggregate deferral of income to the partners. 1040ez2011 If a partnership changes to a required tax year because of these rules, it can get automatic approval by filing Form 1128. 1040ez2011 Least aggregate deferral of income. 1040ez2011   The tax year that results in the least aggregate deferral of income is determined as follows. 1040ez2011 Figure the number of months of deferral for each partner using one partner's tax year. 1040ez2011 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. 1040ez2011 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). 1040ez2011 Add the amounts in step (2) to get the aggregate (total) deferral for the tax year used in step (1). 1040ez2011 Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years. 1040ez2011   The partner's tax year that results in the lowest aggregate (total) number is the tax year that must be used by the partnership. 1040ez2011 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. 1040ez2011 However, if one of the tax years that qualifies is the partnership's existing tax year, the partnership must retain that tax year. 1040ez2011 Example. 1040ez2011 A and B each have a 50% interest in partnership P, which uses a fiscal year ending June 30. 1040ez2011 A uses the calendar year and B uses a fiscal year ending November 30. 1040ez2011 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. 1040ez2011 Year End 12/31: Year End Profits Interest Months of Deferral Interest × Deferral A 12/31 0. 1040ez2011 5 -0- -0- B 11/30 0. 1040ez2011 5 11 5. 1040ez2011 5 Total Deferral 5. 1040ez2011 5 Year End 11/30: Year End Profits Interest Months of Deferral Interest × Deferral A 12/31 0. 1040ez2011 5 1 0. 1040ez2011 5 B 11/30 0. 1040ez2011 5 -0- -0- Total Deferral 0. 1040ez2011 5 When determination is made. 1040ez2011   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. 1040ez2011 However, the IRS can require the partnership to use another day or period that will more accurately reflect the ownership of the partnership. 1040ez2011 This could occur, for example, if a partnership interest was transferred for the purpose of qualifying for a particular tax year. 1040ez2011 Short period return. 1040ez2011   When a partnership changes its tax year, a short period return must be filed. 1040ez2011 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. 1040ez2011   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. 1040ez2011 The short period return must indicate at the top of page 1, “FILED UNDER SECTION 1. 1040ez2011 706-1. 1040ez2011 ” More information. 1040ez2011   For more information about changing a partnership's tax year, and information about ruling requests, see the Instructions for Form 1128. 1040ez2011 S Corporation All S corporations, regardless of when they became an S corporation, must use a permitted tax year. 1040ez2011 A permitted tax year is any of the following. 1040ez2011 The calendar year. 1040ez2011 A tax year elected under section 444 of the Internal Revenue Code. 1040ez2011 See Section 444 Election, below for details. 1040ez2011 A 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444. 1040ez2011 Any other tax year for which the corporation establishes a business purpose. 1040ez2011 If an electing S corporation wishes to adopt a tax year other than a calendar year, it must request IRS approval using Form 2553, instead of filing Form 1128. 1040ez2011 For information about changing an S corporation's tax year and information about ruling requests, see the Instructions for Form 1128. 1040ez2011 Personal Service Corporation (PSC) A PSC must use a calendar tax year unless any of the following apply. 1040ez2011 The corporation makes an election under section 444 of the Internal Revenue Code. 1040ez2011 See Section 444 Election, below for details. 1040ez2011 The corporation elects to use a 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444. 1040ez2011 The corporation establishes a business purpose for a fiscal year. 1040ez2011 See the Instructions for Form 1120 for general information about PSCs. 1040ez2011 For information on adopting or changing tax years for PSCs and information about ruling requests, see the Instructions for Form 1128. 1040ez2011 Section 444 Election A partnership, S corporation, electing S corporation, or PSC can elect under section 444 of the Internal Revenue Code to use a tax year other than its required tax year. 1040ez2011 Certain restrictions apply to the election. 1040ez2011 A partnership or an S corporation that makes a section 444 election must make certain required payments and a PSC must make certain distributions (discussed later). 1040ez2011 The section 444 election does not apply to any partnership, S corporation, or PSC that establishes a business purpose for a different period, explained later. 1040ez2011 A partnership, S corporation, or PSC can make a section 444 election if it meets all the following requirements. 1040ez2011 It is not a member of a tiered structure (defined in section 1. 1040ez2011 444-2T of the regulations). 1040ez2011 It has not previously had a section 444 election in effect. 1040ez2011 It elects a year that meets the deferral period requirement. 1040ez2011 Deferral period. 1040ez2011   The determination of the deferral period depends on whether the partnership, S corporation, or PSC is retaining its tax year or adopting or changing its tax year with a section 444 election. 1040ez2011 Retaining tax year. 1040ez2011   Generally, a partnership, S corporation, or PSC can make a section 444 election to retain its tax year only if the deferral period of the new tax year is 3 months or less. 1040ez2011 This deferral period is the number of months between the beginning of the retained year and the close of the first required tax year. 1040ez2011 Adopting or changing tax year. 1040ez2011   If the partnership, S corporation, or PSC is adopting or changing to a tax year other than its required year, the deferral period is the number of months from the end of the new tax year to the end of the required tax year. 1040ez2011 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. 1040ez2011 This is the tax year immediately preceding the year for which the partnership, S corporation, or PSC wishes to make the section 444 election. 1040ez2011 If the partnership, S corporation, or PSC's tax year is the same as its required tax year, the deferral period is zero. 1040ez2011 Example 1. 1040ez2011 BD Partnership uses a calendar year, which is also its required tax year. 1040ez2011 BD cannot make a section 444 election because the deferral period is zero. 1040ez2011 Example 2. 1040ez2011 E, a newly formed partnership, began operations on December 1. 1040ez2011 E is owned by calendar year partners. 1040ez2011 E wants to make a section 444 election to adopt a September 30 tax year. 1040ez2011 E's deferral period for the tax year beginning December 1 is 3 months, the number of months between September 30 and December 31. 1040ez2011 Making the election. 1040ez2011   Make a section 444 election by filing Form 8716 with the Internal Revenue Service Center where the entity will file its tax return. 1040ez2011 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. 1040ez2011 For this purpose, count the month in which the tax year begins, even if it begins after the first day of that month. 1040ez2011 Note. 1040ez2011 If the due date falls on a Saturday, Sunday, or legal holiday, file on the next business day. 1040ez2011   Attach a copy of Form 8716 to Form 1065, Form 1120S, or Form 1120 for the first tax year for which the election is made. 1040ez2011 Example 1. 1040ez2011 AB, a partnership, begins operations on September 13, 2012, and is qualified to make a section 444 election to use a September 30 tax year for its tax year beginning September 13, 2012. 1040ez2011 AB must file Form 8716 by January 15, 2013, which is the due date of the partnership's tax return for the period from September 13, 2012, to September 30, 2012. 1040ez2011 Example 2. 1040ez2011 The facts are the same as in Example 1 except that AB begins operations on October 21, 2012. 1040ez2011 AB must file Form 8716 by March 17, 2013. 1040ez2011 Example 3. 1040ez2011 B is a corporation that first becomes a PSC for its tax year beginning September 1, 2012. 1040ez2011 B qualifies to make a section 444 election to use a September 30 tax year for its tax year beginning September 1, 2012. 1040ez2011 B must file Form 8716 by December 17, 2012, the due date of the income tax return for the short period from September 1, 2012, to September 30, 2012. 1040ez2011 Note. 1040ez2011 The due dates in Examples 2 and 3 are adjusted because the dates fall on a Saturday, Sunday or legal holiday. 1040ez2011 Extension of time for filing. 1040ez2011   There is an automatic extension of 12 months to make this election. 1040ez2011 See the Form 8716 instructions for more information. 1040ez2011 Terminating the election. 1040ez2011   The section 444 election remains in effect until it is terminated. 1040ez2011 If the election is terminated, another section 444 election cannot be made for any tax year. 1040ez2011   The election ends when any of the following applies to the partnership, S corporation, or PSC. 1040ez2011 The entity changes to its required tax year. 1040ez2011 The entity liquidates. 1040ez2011 The entity becomes a member of a tiered structure. 1040ez2011 The IRS determines that the entity willfully failed to comply with the required payments or distributions. 1040ez2011   The election will also end if either of the following events occur. 1040ez2011 An S corporation's S election is terminated. 1040ez2011 However, if the S corporation immediately becomes a PSC, the PSC can continue the section 444 election of the S corporation. 1040ez2011 A PSC ceases to be a PSC. 1040ez2011 If the PSC elects to be an S corporation, the S corporation can continue the election of the PSC. 1040ez2011 Required payment for partnership or S corporation. 1040ez2011   A partnership or an S corporation must make a required payment for any tax year: The section 444 election is in effect. 1040ez2011 The required payment for that year (or any preceding tax year) is more than $500. 1040ez2011    This payment represents the value of the tax deferral the owners receive by using a tax year different from the required tax year. 1040ez2011   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. 1040ez2011 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. 1040ez2011 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. 1040ez2011 Applicable election year. 1040ez2011   Any tax year a section 444 election is in effect, including the first year, is called an applicable election year. 1040ez2011 Form 8752 must be filed and the required payment made (or zero amount reported) by May 15th of the calendar year following the calendar year in which the applicable election year begins. 1040ez2011 Required distribution for PSC. 1040ez2011   A PSC with a section 444 election in effect must distribute certain amounts to employee-owners by December 31 of each applicable year. 1040ez2011 If it fails to make these distributions, it may be required to defer certain deductions for amounts paid to owner-employees. 1040ez2011 The amount deferred is treated as paid or incurred in the following tax year. 1040ez2011   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). 1040ez2011 Back-up election. 1040ez2011   A partnership, S corporation, or PSC can file a back-up section 444 election if it requests (or plans to request) permission to use a business purpose tax year, discussed later. 1040ez2011 If the request is denied, the back-up section 444 election must be activated (if the partnership, S corporation, or PSC otherwise qualifies). 1040ez2011 Making back-up election. 1040ez2011   The general rules for making a section 444 election, as discussed earlier, apply. 1040ez2011 When filing Form 8716, type or print “BACK-UP ELECTION” at the top of the form. 1040ez2011 However, if Form 8716 is filed on or after the date Form 1128 (or Form 2553) is filed, type or print “FORM 1128 (or FORM 2553) BACK-UP ELECTION” at the top of Form 8716. 1040ez2011 Activating election. 1040ez2011   A partnership or S corporation activates its back-up election by filing the return required and making the required payment with Form 8752. 1040ez2011 The due date for filing Form 8752 and making the payment is the later of the following dates. 1040ez2011 May 15 of the calendar year following the calendar year in which the applicable election year begins. 1040ez2011 60 days after the partnership or S corporation has been notified by the IRS that the business year request has been denied. 1040ez2011   A PSC activates its back-up election by filing Form 8716 with its original or amended income tax return for the tax year in which the election is first effective and printing on the top of the income tax return, “ACTIVATING BACK-UP ELECTION. 1040ez2011 ” 52-53-Week Tax Year A partnership, S corporation, or PSC can use a tax year other than its required tax year if it elects a 52-53-week tax year (discussed earlier) that ends with reference to either its required tax year or a tax year elected under section 444 (discussed earlier). 1040ez2011 A newly formed partnership, S corporation, or PSC can adopt a 52-53-week tax year ending with reference to either its required tax year or a tax year elected under section 444 without IRS approval. 1040ez2011 However, if the entity wishes to change to a 52-53-week tax year or change from a 52-53-week tax year that references a particular month to a non-52-53-week tax year that ends on the last day of that month, it must request IRS approval by filing Form 1128. 1040ez2011 Business Purpose Tax Year A partnership, S corporation, or PSC establishes the business purpose for a tax year by filing Form 1128. 1040ez2011 See the Instructions for Form 1128 for details. 1040ez2011 Corporations (Other Than S Corporations and PSCs) A new corporation establishes its tax year when it files its first tax return. 1040ez2011 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. 1040ez2011 An S corporation or a PSC must use the required tax year rules, discussed earlier, to establish a tax year. 1040ez2011 Generally, a corporation that wants to change its tax year must obtain approval from the IRS under either the: (a) automatic approval procedures; or (b) ruling request procedures. 1040ez2011 See the Instructions for Form 1128 for details. 1040ez2011 Accounting Methods An accounting method is a set of rules used to determine when income and expenses are reported on your tax return. 1040ez2011 Your accounting method includes not only your overall method of accounting, but also the accounting treatment you use for any material item. 1040ez2011 You choose an accounting method when you file your first tax return. 1040ez2011 If you later want to change your accounting method, you must get IRS approval. 1040ez2011 See Change in Accounting Method, later. 1040ez2011 No single accounting method is required of all taxpayers. 1040ez2011 You must use a system that clearly reflects your income and expenses and you must maintain records that will enable you to file a correct return. 1040ez2011 In addition to your permanent accounting books, you must keep any other records necessary to support the entries on your books and tax returns. 1040ez2011 You must use the same accounting method from year to year. 1040ez2011 An accounting method clearly reflects income only if all items of gross income and expenses are treated the same from year to year. 1040ez2011 If you do not regularly use an accounting method that clearly reflects your income, your income will be refigured under the method that, in the opinion of the IRS, does clearly reflect income. 1040ez2011 Methods you can use. 1040ez2011   In general, you can compute your taxable income under any of the following accounting methods. 1040ez2011 Cash method. 1040ez2011 Accrual method. 1040ez2011 Special methods of accounting for certain items of income and expenses. 1040ez2011 A hybrid method which combines elements of two or more of the above accounting methods. 1040ez2011 The cash and accrual methods of accounting are explained later. 1040ez2011 Special methods. 1040ez2011   This publication does not discuss special methods of accounting for certain items of income or expenses. 1040ez2011 For information on reporting income using one of the long-term contract methods, see section 460 of the Internal Revenue Code and the related regulations. 1040ez2011 The following publications also discuss special methods of reporting income or expenses. 1040ez2011 Publication 225, Farmer's Tax Guide. 1040ez2011 Publication 535, Business Expenses. 1040ez2011 Publication 537, Installment Sales. 1040ez2011 Publication 946, How To Depreciate Property. 1040ez2011 Hybrid method. 1040ez2011   Generally, you can use any combination of cash, accrual, and special methods of accounting if the combination clearly reflects your income and you use it consistently. 1040ez2011 However, the following restrictions apply. 1040ez2011 If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales. 1040ez2011 See Exceptions under Inventories, later. 1040ez2011 Generally, you can use the cash method for all other items of income and expenses. 1040ez2011 See Inventories, later. 1040ez2011 If you use the cash method for reporting your income, you must use the cash method for reporting your expenses. 1040ez2011 If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income. 1040ez2011 Any combination that includes the cash method is treated as the cash method for purposes of section 448 of the Internal Revenue Code. 1040ez2011 Business and personal items. 1040ez2011   You can account for business and personal items using different accounting methods. 1040ez2011 For example, you can determine your business income and expenses under an accrual method, even if you use the cash method to figure personal items. 1040ez2011 Two or more businesses. 1040ez2011   If you operate two or more separate and distinct businesses, you can use a different accounting method for each business. 1040ez2011 No business is separate and distinct, unless a complete and separate set of books and records is maintained for each business. 1040ez2011 Note. 1040ez2011 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. 1040ez2011 Cash Method Most individuals and many small businesses use the cash method of accounting. 1040ez2011 Generally, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise. 1040ez2011 See Inventories, later, for exceptions to this rule. 1040ez2011 Income Under the cash method, you include in your gross income all items of income you actually or constructively receive during the tax year. 1040ez2011 If you receive property and services, you must include their fair market value (FMV) in income. 1040ez2011 Constructive receipt. 1040ez2011   Income is constructively received when an amount is credited to your account or made available to you without restriction. 1040ez2011 You need not have possession of it. 1040ez2011 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. 1040ez2011 Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations. 1040ez2011 Example. 1040ez2011 You are a calendar year taxpayer. 1040ez2011 Your bank credited, and made available, interest to your bank account in December 2012. 1040ez2011 You did not withdraw it or enter it into your books until 2013. 1040ez2011 You must include the amount in gross income for 2012, the year you constructively received it. 1040ez2011 You cannot hold checks or postpone taking possession of similar property from one tax year to another to postpone paying tax on the income. 1040ez2011 You must report the income in the year the property is received or made available to you without restriction. 1040ez2011 Expenses Under the cash method, generally, you deduct expenses in the tax year in which you actually pay them. 1040ez2011 This includes business expenses for which you contest liability. 1040ez2011 However, you may not be able to deduct an expense paid in advance. 1040ez2011 Instead, you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules. 1040ez2011 Expense paid in advance. 1040ez2011   An expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for the 12-month rule. 1040ez2011   Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer that do not extend beyond the earlier of the following. 1040ez2011 12 months after the right or benefit begins, or The end of the tax year after the tax year in which payment is made. 1040ez2011   If you have not been applying the general rule (an expense paid in advance is deductible only in the year to which it applies) and/or the 12-month rule to the expenses you paid in advance, you must obtain approval from the IRS before using the general rule and/or the 12-month rule. 1040ez2011 See Change in Accounting Method, later. 1040ez2011 Example 1. 1040ez2011 You are a calendar year taxpayer and pay $3,000 in 2012 for a business insurance policy that is effective for three years (36 months), beginning on July 1, 2012. 1040ez2011 The general rule that an expense paid in advance is deductible only in the year to which it applies is applicable to this payment because the payment does not qualify for the 12-month rule. 1040ez2011 Therefore, only $500 (6/36 x $3,000) is deductible in 2012, $1,000 (12/36 x $3,000) is deductible in 2013, $1,000 (12/36 x $3,000) is deductible in 2014, and the remaining $500 is deductible in 2015. 1040ez2011 Example 2. 1040ez2011 You are a calendar year taxpayer and pay $10,000 on July 1, 2012, for a business insurance policy that is effective for only one year beginning on July 1, 2012. 1040ez2011 The 12-month rule applies. 1040ez2011 Therefore, the full $10,000 is deductible in 2012. 1040ez2011 Excluded Entities The following entities cannot use the cash method, including any combination of methods that includes the cash method. 1040ez2011 (See Special rules for farming businesses, later. 1040ez2011 ) A corporation (other than an S corporation) with average annual gross receipts exceeding $5 million. 1040ez2011 See Gross receipts test, below. 1040ez2011 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. 1040ez2011 See Gross receipts test, below. 1040ez2011 A tax shelter. 1040ez2011 Exceptions The following entities are not prohibited from using the cash method of accounting. 1040ez2011 Any corporation or partnership, other than a tax shelter, that meets the gross receipts test for all tax years after 1985. 1040ez2011 A qualified personal service corporation (PSC). 1040ez2011 Gross receipts test. 1040ez2011   A corporation or partnership, other than a tax shelter, that meets the gross receipts test can generally use the cash method. 1040ez2011 A corporation or a partnership meets the test if, for each prior tax year beginning after 1985, its average annual gross receipts are $5 million or less. 1040ez2011    An entity's average annual gross receipts for a prior tax year is determined by: Adding the gross receipts for that tax year and the 2 preceding tax years; and Dividing the total by 3. 1040ez2011 See Gross receipts test for qualifying taxpayers, for more information. 1040ez2011 Generally, a partnership applies the test at the partnership level. 1040ez2011 Gross receipts for a short tax year are annualized. 1040ez2011 Aggregation rules. 1040ez2011   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. 1040ez2011 Change to accrual method. 1040ez2011   A corporation or partnership that fails to meet the gross receipts test for any tax year is prohibited from using the cash method and must change to an accrual method of accounting, effective for the tax year in which the entity fails to meet this test. 1040ez2011 Special rules for farming businesses. 1040ez2011   Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business. 1040ez2011 However, certain corporations (other than S corporations) and partnerships that have a partner that is a corporation must use an accrual method for their farming business. 1040ez2011 For this purpose, farming does not include the operation of a nursery or sod farm or the raising or harvesting of trees (other than fruit and nut trees). 1040ez2011   There is an exception to the requirement to use an accrual method for corporations with gross receipts of $1 million or less for each prior tax year after 1975. 1040ez2011 For family corporations engaged in farming, the exception applies if gross receipts were $25 million or less for each prior tax year after 1985. 1040ez2011 See chapter 2 of Publication 225, Farmer's Tax Guide, for more information. 1040ez2011 Qualified PSC. 1040ez2011   A PSC that meets the following function and ownership tests can use the cash method. 1040ez2011 Function test. 1040ez2011   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. 1040ez2011 Ownership test. 1040ez2011   A corporation meets the ownership test if at least 95% of its stock is owned, directly or indirectly, at all times during the year by one or more of the following. 1040ez2011 Employees performing services for the corporation in a field qualifying under the function test. 1040ez2011 Retired employees who had performed services in those fields. 1040ez2011 The estate of an employee described in (1) or (2). 1040ez2011 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. 1040ez2011   Indirect ownership is generally taken into account if the stock is owned indirectly through one or more partnerships, S corporations, or qualified PSCs. 1040ez2011 Stock owned by one of these entities is considered owned by the entity's owners in proportion to their ownership interest in that entity. 1040ez2011 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. 1040ez2011   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. 1040ez2011 Change to accrual method. 1040ez2011   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. 1040ez2011 A corporation that fails to meet the function test or the ownership test is not treated as a qualified PSC for any part of that tax year. 1040ez2011 Accrual Method Under the accrual method of accounting, generally you report income in the year it is earned and deduct or capitalize expenses in the year incurred. 1040ez2011 The purpose of an accrual method of accounting is to match income and expenses in the correct year. 1040ez2011 Income Generally, you include an amount in 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. 1040ez2011 Under this rule, you report an amount in your gross income on the earliest of the following dates. 1040ez2011 When you receive payment. 1040ez2011 When the income amount is due to you. 1040ez2011 When you earn the income. 1040ez2011 When title has passed. 1040ez2011 Estimated income. 1040ez2011   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. 1040ez2011 Change in payment schedule. 1040ez2011   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. 1040ez2011 Continue this procedure until you complete the services, then account for the difference. 1040ez2011 Advance Payment for Services Generally, you report an advance payment for services to be performed in a later tax year as income in the year you receive the payment. 1040ez2011 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. 1040ez2011 However, you cannot postpone including any payment beyond that tax year. 1040ez2011 Service agreement. 1040ez2011   You can postpone reporting income from an advance payment you receive for a service agreement on property you sell, lease, build, install, or construct. 1040ez2011 This includes an agreement providing for incidental replacement of parts or materials. 1040ez2011 However, this applies only if you offer the property without a service agreement in the normal course of business. 1040ez2011 Postponement not allowed. 1040ez2011   Generally, one cannot postpone including an advance payment in income for services if either of the following applies. 1040ez2011 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. 1040ez2011 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. 1040ez2011 Examples. 1040ez2011   In each of the following examples, assume the tax year is a calendar year and that the accrual method of accounting is used. 1040ez2011 Example 1. 1040ez2011 You manufacture, sell, and service computers. 1040ez2011 You received payment in 2012 for a one-year contingent service contract on a computer you sold. 1040ez2011 You can postpone including in income the part of the payment you did not earn in 2012 if, in the normal course of your business, you offer computers for sale without a contingent service contract. 1040ez2011 Example 2. 1040ez2011 You are in the television repair business. 1040ez2011 You received payments in 2012 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. 1040ez2011 You include the payments in gross income as you earn them. 1040ez2011 Example 3. 1040ez2011 You own a dance studio. 1040ez2011 On October 1, 2012, you receive payment for a one-year contract for 48 one-hour lessons beginning on that date. 1040ez2011 You give eight lessons in 2012. 1040ez2011 Under this method of including advance payments, you must include one-sixth (8/48) of the payment in income for 2012, and five-sixths (40/48) of the payment in 2013, even if you do not give all the lessons by the end of 2013. 1040ez2011 Example 4. 1040ez2011 Assume the same facts as in Example 3, except the payment is for a two-year contract for 96 lessons. 1040ez2011 You must include the entire payment in income in 2012 since part of the services may be performed after the following year. 1040ez2011 Guarantee or warranty. 1040ez2011   Generally, you cannot postpone reporting income you receive under a guarantee or warranty contract. 1040ez2011 Prepaid rent. 1040ez2011   You cannot postpone reporting income from prepaid rent. 1040ez2011 Prepaid rent does not include payment for the use of a room or other space when significant service is also provided for the occupant. 1040ez2011 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. 1040ez2011 Books and records. 1040ez2011   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 income for financial reports under the method of accounting used for those reports. 1040ez2011 Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements. 1040ez2011 IRS approval. 1040ez2011   You must file Form 3115 to obtain IRS approval to change your method of accounting for advance payment for services. 1040ez2011 Advance Payment for Sales Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods held primarily for sale to customers in the ordinary course of your trade or business. 1040ez2011 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. 1040ez2011 An agreement includes a gift certificate that can be redeemed for goods. 1040ez2011 Amounts due and payable are considered received. 1040ez2011 How to report payments. 1040ez2011   Generally, include an advance payment in income in the year in which you receive it. 1040ez2011 However, you can use the alternative method, discussed next. 1040ez2011 Alternative method of reporting. 1040ez2011   Under the alternative method, 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 Include any part of advance payments in income for financial reports under the method of accounting used for those reports. 1040ez2011 Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements. 1040ez2011 Example 1. 1040ez2011 You are a retailer. 1040ez2011 You use an accrual method of accounting and account for the sale of goods when you ship the goods. 1040ez2011 You use this method for both tax and financial reporting purposes. 1040ez2011 You can include advance payments in gross receipts for tax purposes in either: (a) the tax year in which you receive the payments; or (b) the tax year in which you ship the goods. 1040ez2011 However, see Exception for inventory goods, later. 1040ez2011 Example 2. 1040ez2011 You are a calendar year taxpayer. 1040ez2011 You manufacture household furniture and use an accrual method of accounting. 1040ez2011 Under this method, you accrue income for your financial reports when you ship the furniture. 1040ez2011 For tax purposes, you do not accrue income until the furniture has been delivered and accepted. 1040ez2011 In 2012, you received an advance payment of $8,000 for an order of furniture to be manufactured for a total price of $20,000. 1040ez2011 You shipped the furniture to the customer in December 2012, but it was not delivered and accepted until January 2013. 1040ez2011 For tax purposes, you include the $8,000 advance payment in gross income for 2012; and include the remaining $12,000 of the contract price in gross income for 2013. 1040ez2011 Information schedule. 1040ez2011   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. 1040ez2011 Total advance payments received in the current tax year. 1040ez2011 Total advance payments received in earlier tax years and not included in income before the current tax year. 1040ez2011 Total payments received in earlier tax years included in income for the current tax year. 1040ez2011 Exception for inventory goods. 1040ez2011   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. 1040ez2011 You account for the advance payment under the alternative method (discussed earlier). 1040ez2011 You have received a substantial advance payment on the agreement (discussed next). 1040ez2011 You have enough substantially similar goods on hand, or available through your normal source of supply, to satisfy the agreement. 1040ez2011 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. 1040ez2011   If you meet these conditions, all advance payments you receive by the end of the second tax year, including payments received in prior years but not reported, must be included in income by the second tax year following the tax year of receipt of substantial advance payments. 1040ez2011 You must also deduct in that second year all actual or estimated costs for the goods required to satisfy the agreement. 1040ez2011 If you estimated the cost, you must take into account any difference between the estimate and the actual cost when the goods are delivered. 1040ez2011 Note. 1040ez2011 You must report any advance payments you receive after the second year in the year received. 1040ez2011 No further deferral is allowed. 1040ez2011 Substantial advance payments. 1040ez2011   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. 1040ez2011 Example. 1040ez2011 You are a calendar year, accrual method taxpayer who accounts for advance payments under the alternative method. 1040ez2011 In 2008, you entered into a contract for the sale of goods properly includible in your inventory. 1040ez2011 The total contract price is $50,000 and you estimate that your total inventoriable costs for the goods will be $25,000. 1040ez2011 You receive the following advance payments under the contract. 1040ez2011 2009 $17,500 2010 10,000 2011 7,500 2012 5,000 2013 5,000 2014 5,000 Total contract price $50,000   Your customer asked you to deliver the goods in 2015. 1040ez2011 In your 2010 closing inventory, you had on hand enough of the type of goods specified in the contract to satisfy the contract. 1040ez2011 Since the advance payments you had received by the end of 2010 were more than the costs you estimated, the payments are substantial advance payments. 1040ez2011   For 2012, include in income all payments you received by the end of 2012, the second tax year following the tax year in which you received substantial advance payments. 1040ez2011 You must include $40,000 in sales for 2012 (the total amounts received from 2009 through 2012) and include in inventory the cost of the goods (or similar goods) on hand. 1040ez2011 If no such goods are on hand, then estimate the cost necessary to satisfy the contract. 1040ez2011   No further deferral is allowed. 1040ez2011 You must include in gross income the advance payment you receive each remaining year of the contract. 1040ez2011 Take into account the difference between any estimated cost of goods sold and the actual cost when you deliver the goods in 2015. 1040ez2011 IRS approval. 1040ez2011   You must file Form 3115 to obtain IRS approval to change your method of accounting for advance payments for sales. 1040ez2011 Expenses Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply. 1040ez2011 The all-events test has been met. 1040ez2011 The test is met when: All events have occurred that fix the fact of liability, and The liability can be determined with reasonable accuracy. 1040ez2011 Economic performance has occurred. 1040ez2011 Economic Performance Generally, you cannot deduct or capitalize a business expense until economic performance occurs. 1040ez2011 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. 1040ez2011 If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. 1040ez2011 Example. 1040ez2011 You are a calendar year taxpayer. 1040ez2011 You buy office supplies in December 2012. 1040ez2011 You receive the supplies and the bill in December, but you pay the bill in January 2013. 1040ez2011 You can deduct the expense in 2012 because all events have occurred to fix the liability, the amount of the liability can be determined, and economic performance occurred in 2012. 1040ez2011 Your office supplies may qualify as a recurring item, discussed later. 1040ez2011 If so, you can deduct them in 2012, even if the supplies are not delivered until 2013 (when economic performance occurs). 1040ez2011 Workers' compensation and tort liability. 1040ez2011   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. 1040ez2011 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. 1040ez2011 Taxes. 1040ez2011   Economic performance generally occurs as estimated income tax, property taxes, employment taxes, etc. 1040ez2011 are paid. 1040ez2011 However, you can elect to treat taxes as a recurring item, discussed later. 1040ez2011 You can also elect to ratably accrue real estate taxes. 1040ez2011 See chapter 5 of Publication 535 for information about real estate taxes. 1040ez2011 Other liabilities. 1040ez2011   Other liabilities for which economic performance occurs as you make payments include liabilities for breach of contract (to the extent of incidental, consequential, and liquidated damages), violation of law, rebates and refunds, awards, prizes, jackpots, insurance, and warranty and service contracts. 1040ez2011 Interest. 1040ez2011   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. 1040ez2011 Compensation for services. 1040ez2011   Generally, economic performance occurs as an employee renders service to the employer. 1040ez2011 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. 1040ez2011 For information on employee benefit programs, see Publication 15-B, Employer's Tax Guide to Fringe Benefits. 1040ez2011 Vacation pay. 1040ez2011   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 2½ months after the end of the year. 1040ez2011 If you pay it later than this, you must deduct it in the year actually paid. 1040ez2011 An amount is vested if your right to it cannot be nullified or cancelled. 1040ez2011 Exception for recurring items. 1040ez2011   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. 1040ez2011 The exception applies if all the following requirements are met. 1040ez2011 The all-events test, discussed earlier, is met. 1040ez2011 Economic performance occurs by the earlier of the following dates. 1040ez2011 8½ months after the close of the year. 1040ez2011 The date you file a timely return (including extensions) for the year. 1040ez2011 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. 1040ez2011 Either: The item is not material, or Accruing the item in the year in which the all-events test is met results in a better match against income than accruing the item in the year of economic performance. 1040ez2011 This exception does not apply to workers' compensation or tort liabilities. 1040ez2011 Amended return. 1040ez2011   You may be able to file an amended return and treat a liability as incurred under the recurring item exception. 1040ez2011 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. 1040ez2011 Recurrence and consistency. 1040ez2011   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. 1040ez2011 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. 1040ez2011 Materiality. 1040ez2011   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. 1040ez2011   An item considered material for financial statement purposes is also considered material for tax purposes. 1040ez2011 However, in certain situations an immaterial item for financial accounting purposes is treated as material for purposes of economic performance. 1040ez2011 Matching expenses with income. 1040ez2011   Costs directly associated with the revenue of a period are properly allocable to that period. 1040ez2011 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 (GAAP; visit www. 1040ez2011 fasab. 1040ez2011 gov/accepted. 1040ez2011 html) are an important factor. 1040ez2011   For example, if you report sales income in the year of sale, but you do not ship the goods until the following year, the shipping costs are more properly matched to income in the year of sale than the year the goods are shipped. 1040ez2011 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. 1040ez2011 However, the matching requirement is considered met for certain types of expenses. 1040ez2011 These expenses include taxes, payments under insurance, warranty, and service contracts, rebates, refunds, awards, prizes, and jackpots. 1040ez2011 Expenses Paid in Advance An expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for the 12-month rule. 1040ez2011 Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer that do not extend beyond the earlier of the following. 1040ez2011 12 months after the right or benefit begins, or The end of the tax year after the tax year in which payment is made. 1040ez2011 If you have not been applying the general rule (an expense paid in advance is deductible only in the year to which it applies) and/or the 12-month rule to the expenses you paid in advance, you must get IRS approval before using the general rule and/or the 12-month rule. 1040ez2011 See Change in Accounting Method, later, for information on how to get IRS approval. 1040ez2011 See Expense paid in advance under Cash Method, earlier, for examples illustrating the application of the general and 12-month rules. 1040ez2011 Related Persons Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible until you make the payment and the corresponding amount is includible in the related person's gross income. 1040ez2011 Determine the relationship for this rule as of the end of the tax year for which the expense or interest would otherwise be deductible. 1040ez2011 See section 267 of the Internal Revenue Code and Publication 542, Corporations, for the definition of related person. 1040ez2011 Inventories An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. 1040ez2011 If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales. 1040ez2011 However, see Exceptions, next. 1040ez2011 See also Accrual Method, earlier. 1040ez2011 To figure taxable income, you must value your inventory at the beginning and end of each tax year. 1040ez2011 To determine the value, you need a method for identifying the items in your inventory and a method for valuing these items. 1040ez2011 See Identifying Cost and Valuing Inventory, later. 1040ez2011 The rules for valuing inventory are not the same for all businesses. 1040ez2011 The method you use must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. 1040ez2011 Your inventory practices must be consistent from year to year. 1040ez2011 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. 1040ez2011 Exceptions The following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. 1040ez2011 These taxpayers can also account for inventoriable items as materials and supplies that are not incidental (discussed later). 1040ez2011 A qualifying taxpayer under Revenue Procedure 2001-10 on page 272 of Internal Revenue Bulletin 2001-2, available at www. 1040ez2011 irs. 1040ez2011 gov/pub/irs-irbs/irb01–02. 1040ez2011 pdf. 1040ez2011 A qualifying small business taxpayer under Revenue Procedure 2002-28, on page 815 of Internal Revenue Bulletin 2002-18, available at www. 1040ez2011 irs. 1040ez2011 gov/pub/irs-irbs/irb02–18. 1040ez2011 pdf. 1040ez2011 In addition to the information provided in this publication, you should see the revenue procedures referenced in the list, above, and the instructions for Form 3115 for information you will need to adopt or change to these accounting methods (see Changing methods, later). 1040ez2011 Qualifying taxpayer. 1040ez2011   You are a qualifying taxpayer under Revenue Procedure 2001-10 only if: You satisfy the gross receipts test for each prior tax year ending on or after December 17, 1998 (see Gross receipts test for qualifying taxpayers, next). 1040ez2011 Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $1 million or less. 1040ez2011 You are not a tax shelter as defined under section 448(d)(3) of the Internal Revenue Code. 1040ez2011 Gross receipts test for qualifying taxpayers. 1040ez2011   To determine if you meet the gross receipts test for qualifying taxpayers, use the following steps: Step 1. 1040ez2011 List each of the test years. 1040ez2011 For qualifying taxpayers under Revenue Procedure 2001-10, the test years are each prior tax year ending on or after December 17, 1998. 1040ez2011 Step 2. 1040ez2011 Determine your average annual gross receipts for each test year listed in Step 1. 1040ez2011 Your average annual gross receipts for a tax year is determined by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3. 1040ez2011 Step 3. 1040ez2011 You meet the gross receipts test for qualifying taxpayers if your average annual gross receipts for each test year listed in Step 1 is $1 million or less. 1040ez2011 Qualifying small business taxpayer. 1040ez2011   You are a qualifying small business taxpayer under Revenue Procedure 2002-28 only if: You satisfy the gross receipts test for each prior tax year ending on or after December 31, 2000 (see Gross receipts test for qualifying small business taxpayers, next). 1040ez2011 Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $10 million or less. 1040ez2011 You are not prohibited from using the cash method under section 448 of the Internal Revenue Code. 1040ez2011 Your principle business activity is an eligible business. 1040ez2011 See Eligible business, later. 1040ez2011 You have not changed (or have not been required to change) from the cash method because you became ineligible to use the cash method under Revenue Procedure 2002-28. 1040ez2011 Note. 1040ez2011 Revenue Procedure 2002-28 does not apply to a farming business of a qualifying small business taxpayer. 1040ez2011 A taxpayer engaged in the trade or business of farming generally is allowed to use the cash method for any farming business. 1040ez2011 See Special rules for farming businesses under Cash Method, earlier. 1040ez2011 Gross receipts test for qualifying small business taxpayers. 1040ez2011   To determine if you meet the gross receipts test for qualifying small business taxpayers, use the following steps: Step 1. 1040ez2011 List each of the test years. 1040ez2011 For qualifying small business taxpayers under Revenue Procedure 2002-28, the test years are each prior tax year ending on or after December 31, 2000. 1040ez2011 Step 2. 1040ez2011 Determine your average annual gross receipts for each test year listed in Step 1. 1040ez2011 Your average annual gross receipts for a tax year is determined by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3. 1040ez2011 Step 3. 1040ez2011 You meet the gross receipts test for qualifying small business taxpayers if your average annual gross receipts for each test year listed in Step 1 is $10 million or less. 1040ez2011 Eligible business. 1040ez2011   An eligible business is any business for which a qualified small business taxpayer can use the cash method and choose to not keep an inventory. 1040ez2011 You have an eligible business if you meet any of the following requirements. 1040ez2011 Your principal business activity is described in a North American Industry Classification System (NAICS) code other than any of the following NAICS subsector codes: NAICS codes 211 and 212 (mining activities). 1040ez2011 NAICS codes 31-33 (manufacturing). 1040ez2011 NAICS code 42 (wholesale trade). 1040ez2011 NAICS codes 44-45 (retail trade). 1040ez2011 NAICS codes 5111 and 5122 (information industries). 1040ez2011 Your principal business activity is the provision of services, including the provision of property incident to those services. 1040ez2011 Your principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications. 1040ez2011   Information about the NAICS codes can be found at http://www. 1040ez2011 census. 1040ez2011 gov/naics or in the instructions for your federal income tax return. 1040ez2011 Gross receipts. 1040ez2011   In general, gross receipts must include all receipts from all your trades or businesses that must be recognized under the method of accounting you used for that tax year for federal income tax purposes. 1040ez2011 See the definit
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1040ez2011 3. 1040ez2011   Gifts Table of Contents If you give gifts in the course of your trade or business, you can deduct all or part of the cost. 1040ez2011 This chapter explains the limits and rules for deducting the costs of gifts. 1040ez2011 $25 limit. 1040ez2011   You can deduct no more than $25 for business gifts you give directly or indirectly to each person during your tax year. 1040ez2011 A gift to a company that is intended for the eventual personal use or benefit of a particular person or a limited class of people will be considered an indirect gift to that particular person or to the individuals within that class of people who receive the gift. 1040ez2011   If you give a gift to a member of a customer's family, the gift is generally considered to be an indirect gift to the customer. 1040ez2011 This rule does not apply if you have a bona fide, independent business connection with that family member and the gift is not intended for the customer's eventual use. 1040ez2011   If you and your spouse both give gifts, both of you are treated as one taxpayer. 1040ez2011 It does not matter whether you have separate businesses, are separately employed, or whether each of you has an independent connection with the recipient. 1040ez2011 If a partnership gives gifts, the partnership and the partners are treated as one taxpayer. 1040ez2011 Example. 1040ez2011 Bob Jones sells products to Local Company. 1040ez2011 He and his wife, Jan, gave Local Company three gourmet gift baskets to thank them for their business. 1040ez2011 They paid $80 for each gift basket, or $240 total. 1040ez2011 Three of Local Company's executives took the gift baskets home for their families' use. 1040ez2011 Bob and Jan have no independent business relationship with any of the executives' other family members. 1040ez2011 They can deduct a total of $75 ($25 limit × 3) for the gift baskets. 1040ez2011 Incidental costs. 1040ez2011   Incidental costs, such as engraving on jewelry, or packaging, insuring, and mailing, are generally not included in determining the cost of a gift for purposes of the $25 limit. 1040ez2011   A cost is incidental only if it does not add substantial value to the gift. 1040ez2011 For example, the cost of gift wrapping is an incidental cost. 1040ez2011 However, the purchase of an ornamental basket for packaging fruit is not an incidental cost if the value of the basket is substantial compared to the value of the fruit. 1040ez2011 Exceptions. 1040ez2011   The following items are not considered gifts for purposes of the $25 limit. 1040ez2011 An item that costs $4 or less and: Has your name clearly and permanently imprinted on the gift, and Is one of a number of identical items you widely distribute. 1040ez2011 Examples include pens, desk sets, and plastic bags and cases. 1040ez2011 Signs, display racks, or other promotional material to be used on the business premises of the recipient. 1040ez2011    Figure B. 1040ez2011 When Are Transportation Expenses Deductible? Most employees and self-employed persons can use this chart. 1040ez2011 (Do not use this chart if your home is your principal place of business. 1040ez2011 See Office in the home . 1040ez2011 ) Please click here for the text description of the image. 1040ez2011 Figure B. 1040ez2011 When Are Local Transportation Expenses Deductible?TAs for Figure B are: Reg 1. 1040ez2011 162-1(a); RR 55–109; RR 94–47 Gift or entertainment. 1040ez2011   Any item that might be considered either a gift or entertainment generally will be considered entertainment. 1040ez2011 However, if you give a customer packaged food or beverages you intend the customer to use at a later date, treat it as a gift. 1040ez2011    If you give a customer tickets to a theater performance or sporting event and you do not go with the customer to the performance or event, you have a choice. 1040ez2011 You can treat the cost of the tickets as either a gift expense or an entertainment expense, whichever is to your advantage. 1040ez2011   You can change your treatment of the tickets at a later date by filing an amended return. 1040ez2011 Generally, an amended return must be filed within 3 years from the date the original return was filed or within 2 years from the time the tax was paid, whichever is later. 1040ez2011    If you go with the customer to the event, you must treat the cost of the tickets as an entertainment expense. 1040ez2011 You cannot choose, in this case, to treat the cost of the tickets as a gift expense. 1040ez2011 Prev  Up  Next   Home   More Online Publications