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Snaptax

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Snaptax

Snaptax 2. Snaptax   Source of Income Table of Contents Introduction Topics - This chapter discusses: Resident Aliens Nonresident AliensInterest Income Dividends Guarantee of Indebtedness Personal Services Transportation Income Scholarships, Grants, Prizes, and Awards Pensions and Annuities Rents or Royalties Real Property Personal Property Community Income Introduction After you have determined your alien status, you must determine the source of your income. Snaptax This chapter will help you determine the source of different types of income you may receive during the tax year. Snaptax This chapter also discusses special rules for married individuals who are domiciled in a country with community property laws. Snaptax Topics - This chapter discusses: Income source rules, and Community income. Snaptax Resident Aliens A resident alien's income is generally subject to tax in the same manner as a U. Snaptax S. Snaptax citizen. Snaptax If you are a resident alien, you must report all interest, dividends, wages, or other compensation for services, income from rental property or royalties, and other types of income on your U. Snaptax S. Snaptax tax return. Snaptax You must report these amounts from sources within and outside the United States. Snaptax Nonresident Aliens A nonresident alien usually is subject to U. Snaptax S. Snaptax income tax only on U. Snaptax S. Snaptax source income. Snaptax Under limited circumstances, certain foreign source income is subject to U. Snaptax S. Snaptax tax. Snaptax See Foreign Income in chapter 4. Snaptax The general rules for determining U. Snaptax S. Snaptax source income that apply to most nonresident aliens are shown in Table 2-1. Snaptax The following discussions cover the general rules as well as the exceptions to these rules. Snaptax Not all items of U. Snaptax S. Snaptax source income are taxable. Snaptax See chapter 3. Snaptax Interest Income Generally, U. Snaptax S. Snaptax source interest income includes the following items. Snaptax Interest on bonds, notes, or other interest-bearing obligations of U. Snaptax S. Snaptax residents or domestic corporations. Snaptax Interest paid by a domestic or foreign partnership or foreign corporation engaged in a U. Snaptax S. Snaptax trade or business at any time during the tax year. Snaptax Original issue discount. Snaptax Interest from a state, the District of Columbia, or the U. Snaptax S. Snaptax Government. Snaptax The place or manner of payment is immaterial in determining the source of the income. Snaptax A substitute interest payment made to the transferor of a security in a securities lending transaction or a sale-repurchase transaction is sourced in the same manner as the interest on the transferred security. Snaptax Exceptions. Snaptax   U. Snaptax S. Snaptax source interest income does not include the following items. Snaptax Interest paid by a resident alien or a domestic corporation on obligations issued before August 10, 2010, if for the 3-year period ending with the close of the payer's tax year preceding the interest payment, at least 80% of the payer's total gross income: Is from sources outside the United States, and Is attributable to the active conduct of a trade or business by the individual or corporation in a foreign country or a U. Snaptax S. Snaptax possession. Snaptax However, the interest will be considered U. Snaptax S. Snaptax source interest income if either of the following apply. Snaptax The recipient of the interest is related to the resident alien or domestic corporation. Snaptax See section 954(d)(3) for the definition of related person. Snaptax The terms of the obligation are significantly modified after August 9, 2010. Snaptax Any extension of the term of the obligation is considered a significant modification. Snaptax Interest paid by a foreign branch of a domestic corporation or a domestic partnership on deposits or withdrawable accounts with mutual savings banks, cooperative banks, credit unions, domestic building and loan associations, and other savings institutions chartered and supervised as savings and loan or similar associations under federal or state law if the interest paid or credited can be deducted by the association. Snaptax Interest on deposits with a foreign branch of a domestic corporation or domestic partnership, but only if the branch is in the commercial banking business. Snaptax Dividends In most cases, dividend income received from domestic corporations is U. Snaptax S. Snaptax source income. Snaptax Dividend income from foreign corporations is usually foreign source income. Snaptax Exceptions to both of these rules are discussed below. Snaptax A substitute dividend payment made to the transferor of a security in a securities lending transaction or a sale-repurchase transaction is sourced in the same manner as a distribution on the transferred security. Snaptax Dividend equivalent payments. Snaptax   U. Snaptax S. Snaptax source dividends also include all dividend equivalent payments. Snaptax Dividend equivalent payments include substitute dividends, payments made pursuant to a specified notional principal contract, and all similar payments that, directly or indirectly, are contingent on or determined by reference to, the payment of a dividend from U. Snaptax S. Snaptax sources. Snaptax    The Internal Revenue Service has issued final regulations that would affect the treatment of dividend equivalent payments and specified notional principal contracts. Snaptax You can view this regulation at www. Snaptax irs. Snaptax gov/irb/2013-52_IRB/ar08. Snaptax html. Snaptax First exception. Snaptax   Dividends received from a domestic corporation are not U. Snaptax S. Snaptax source income if the corporation elects to take the American Samoa economic development credit. Snaptax Second exception. Snaptax   Part of the dividends received from a foreign corporation is U. Snaptax S. Snaptax source income if 25% or more of its total gross income for the 3-year period ending with the close of its tax year preceding the declaration of dividends was effectively connected with a trade or business in the United States. Snaptax If the corporation was formed less than 3 years before the declaration, use its total gross income from the time it was formed. Snaptax Determine the part that is U. Snaptax S. Snaptax source income by multiplying the dividend by the following fraction. Snaptax   Foreign corporation's gross income connected with a U. Snaptax S. Snaptax trade or business for the 3-year period     Foreign corporation's gross income from all sources for that period   Guarantee of Indebtedness Certain amounts received directly or indirectly, for the provision of a guarantee of indebtedness issued after September 27, 2010, are U. Snaptax S. Snaptax source income. Snaptax They must be paid by a noncorporate resident or U. Snaptax S. Snaptax corporation or by any foreign person if the amounts are effectively connected with the conduct of a U. Snaptax S. Snaptax trade or business. Snaptax For more information, see Internal Revenue Code sections 861(a)(9) and 862(a)(9). Snaptax Personal Services All wages and any other compensation for services performed in the United States are considered to be from sources in the United States. Snaptax The only exceptions to this rule are discussed in chapter 3 under Employees of foreign persons, organizations, or offices, and under Crew members. Snaptax If you are an employee and receive compensation for labor or personal services performed both inside and outside the United States, special rules apply in determining the source of the compensation. Snaptax Compensation (other than certain fringe benefits) is sourced on a time basis. Snaptax Certain fringe benefits (such as housing and education) are sourced on a geographical basis. Snaptax Or, you may be permitted to use an alternative basis to determine the source of compensation. Snaptax See Alternative Basis , later. Snaptax Multi-level marketing. Snaptax   Certain companies sell products through a multi-level marketing arrangement, such that an upper-tier distributor, who has sponsored a lower-tier distributor, is entitled to a payment from the company based on certain activities of that lower-tier distributor. Snaptax Generally, depending on the facts, payments from such multi-level marketing companies to independent (non-employee) distributors (upper-tier distributors) that are based on the sales or purchases of persons whom they have sponsored (lower-tier distributors) constitute income for the performance of personal services in recruiting, training, and supporting the lower-tier distributors. Snaptax The source of such income is generally based on where the services of the upper-tier distributor are performed, and may, depending on the facts, be considered multi-year compensation, with the source of income determined over the period to which such compensation is attributable. Snaptax Self-employed individuals. Snaptax   If you are self-employed, you determine the source of compensation for labor or personal services from self-employment on the basis that most correctly reflects the proper source of that income under the facts and circumstances of your particular case. Snaptax In many cases, the facts and circumstances will call for an apportionment on a time basis as explained next. Snaptax Time Basis Use a time basis to figure your U. Snaptax S. Snaptax source compensation (other than the fringe benefits discussed later). Snaptax Do this by multiplying your total compensation (other than the fringe benefits discussed later) by the following fraction:   Number of days you performed services in the United States during the year     Total number of days you performed services during the year   You can use a unit of time less than a day in the above fraction, if appropriate. Snaptax The time period for which the compensation is made does not have to be a year. Snaptax Instead, you can use another distinct, separate, and continuous time period if you can establish to the satisfaction of the IRS that this other period is more appropriate. Snaptax Example 1. Snaptax Christina Brooks, a resident of the Netherlands, worked 240 days for a U. Snaptax S. Snaptax company during the tax year. Snaptax She received $80,000 in compensation. Snaptax None of it was for fringe benefits. Snaptax Christina performed services in the United States for 60 days and performed services in the Netherlands for 180 days. Snaptax Using the time basis for determining the source of compensation, $20,000 ($80,000 × 60/240) is her U. Snaptax S. Snaptax source income. Snaptax Example 2. Snaptax Rob Waters, a resident of South Africa, is employed by a corporation. Snaptax His annual salary is $100,000. Snaptax None of it is for fringe benefits. Snaptax During the first quarter of the year he worked entirely within the United States. Snaptax On April 1, Rob was transferred to Singapore for the remainder of the year. Snaptax Rob is able to establish that the first quarter of the year and the last 3 quarters of the year are two separate, distinct, and continuous periods of time. Snaptax Accordingly, $25,000 of Rob's annual salary is attributable to the first quarter of the year (. Snaptax 25 × $100,000). Snaptax All of it is U. Snaptax S. Snaptax source income because he worked entirely within the United States during that quarter. Snaptax The remaining $75,000 is attributable to the last three quarters of the year. Snaptax During those quarters, he worked 150 days in Singapore and 30 days in the United States. Snaptax His periodic performance of services in the United States did not result in distinct, separate, and continuous periods of time. Snaptax Of this $75,000, $12,500 ($75,000 × 30/180) is U. Snaptax S. Snaptax source income. Snaptax Multi-year compensation. Snaptax   The source of multi-year compensation is generally determined on a time basis over the period to which the compensation is attributable. Snaptax Multi-year compensation is compensation that is included in your income in one tax year but that is attributable to a period that includes two or more tax years. Snaptax   You determine the period to which the compensation is attributable based on the facts and circumstances of your case. Snaptax For example, an amount of compensation that specifically relates to a period of time that includes several calendar years is attributable to the entire multi-year period. Snaptax   The amount of compensation treated as from U. Snaptax S. Snaptax sources is figured by multiplying the total multi-year compensation by a fraction. Snaptax The numerator of the fraction is the number of days (or unit of time less than a day, if appropriate) that you performed labor or personal services in the United States in connection with the project. Snaptax The denominator of the fraction is the total number of days (or unit of time less than a day, if appropriate) that you performed labor or personal services in connection with the project. Snaptax Geographical Basis Compensation you receive as an employee in the form of the following fringe benefits is sourced on a geographical basis. Snaptax Housing. Snaptax Education. Snaptax Local transportation. Snaptax Tax reimbursement. Snaptax Hazardous or hardship duty pay as defined in Regulations section 1. Snaptax 861-4(b)(2)(ii)(D)(5). Snaptax Moving expense reimbursement. Snaptax The amount of fringe benefits must be reasonable and you must substantiate them by adequate records or by sufficient evidence. Snaptax Principal place of work. Snaptax   The above fringe benefits, except for tax reimbursement and hazardous or hardship duty pay, are sourced based on your principal place of work. Snaptax Your principal place of work is usually the place where you spend most of your working time. Snaptax This could be your office, plant, store, shop, or other location. Snaptax If there is no one place where you spend most of your working time, your main job location is the place where your work is centered, such as where you report for work or are otherwise required to “base” your work. Snaptax   If you have more than one job at any time, your main job location depends on the facts in each case. Snaptax The more important factors to be considered are: The total time you spend at each place, The amount of work you do at each place, and How much money you earn at each place. Snaptax Housing. Snaptax   The source of a housing fringe benefit is determined based on the location of your principal place of work. Snaptax A housing fringe benefit includes payments to you or on your behalf (and your family's if your family resides with you) only for the following. Snaptax Rent. Snaptax Utilities (except telephone charges). Snaptax Real and personal property insurance. Snaptax Occupancy taxes not deductible under section 164 or 216(a). Snaptax Nonrefundable fees for securing a leasehold. Snaptax Rental of furniture and accessories. Snaptax Household repairs. Snaptax Residential parking. Snaptax Fair rental value of housing provided in kind by your employer. Snaptax   A housing fringe benefit does not include: Deductible interest and taxes (including deductible interest and taxes of a tenant-stockholder in a cooperative housing corporation), The cost of buying property, including principal payments on a mortgage, The cost of domestic labor (maids, gardeners, etc. Snaptax ), Pay television subscriptions, Improvements and other expenses that increase the value or appreciably prolong the life of property, Purchased furniture or accessories, Depreciation or amortization of property or improvements, The value of meals or lodging that you exclude from gross income, or The value of meals or lodging that you deduct as moving expenses. Snaptax Education. Snaptax   The source of an education fringe benefit for the education expenses of your dependents is determined based on the location of your principal place of work. Snaptax An education fringe benefit includes payments only for the following expenses for education at an elementary or secondary school. Snaptax Tuition, fees, academic tutoring, special needs services for a special needs student, books, supplies, and other equipment. Snaptax Room and board and uniforms that are required or provided by the school in connection with enrollment or attendance. Snaptax Local transportation. Snaptax   The source of a local transportation fringe benefit is determined based on the location of your principal place of work. Snaptax Your local transportation fringe benefit is the amount that you receive as compensation for local transportation for you or your spouse or dependents at the location of your principal place of work. Snaptax The amount treated as a local transportation fringe benefit is limited to actual expenses incurred for local transportation and the fair rental value of any employer-provided vehicle used predominantly by you, your spouse, or your dependents for local transportation. Snaptax Actual expenses do not include the cost (including interest) of any vehicle purchased by you or on your behalf. Snaptax Tax reimbursement. Snaptax   The source of a tax reimbursement fringe benefit is determined based on the location of the jurisdiction that imposed the tax for which you are reimbursed. Snaptax Moving expense reimbursement. Snaptax   The source of a moving expense reimbursement is generally based on the location of your new principal place of work. Snaptax However, the source is determined based on the location of your former principal place of work if you provide sufficient evidence that such determination of source is more appropriate under the facts and circumstances of your case. Snaptax Sufficient evidence generally requires an agreement between you and your employer, or a written statement of company policy, which is reduced to writing before the move and which is entered into or established to induce you or other employees to move to another country. Snaptax The written statement or agreement must state that your employer will reimburse you for moving expenses that you incur to return to your former principal place of work regardless of whether you continue to work for your employer after returning to that location. Snaptax It may contain certain conditions upon which the right to reimbursement is determined as long as those conditions set forth standards that are definitely ascertainable and can only be fulfilled prior to, or through completion of, your return move to your former principal place of work. Snaptax Alternative Basis If you are an employee, you can determine the source of your compensation under an alternative basis if you establish to the satisfaction of the IRS that, under the facts and circumstances of your case, the alternative basis more properly determines the source of your compensation than the time or geographical basis. Snaptax If you use an alternative basis, you must keep (and have available for inspection) records to document why the alternative basis more properly determines the source of your compensation. Snaptax Also, if your total compensation from all sources is $250,000 or more, check “Yes” to both questions on line K on page 5 of Form 1040NR, and attach a written statement to your tax return that sets forth all of the following. Snaptax Your name and social security number (written across the top of the statement). Snaptax The specific compensation income, or the specific fringe benefit, for which you are using the alternative basis. Snaptax For each item in (2), the alternative basis of allocation of source used. Snaptax For each item in (2), a computation showing how the alternative allocation was computed. Snaptax A comparison of the dollar amount of the U. Snaptax S. Snaptax compensation and foreign compensation sourced under both the alternative basis and the time or geographical basis discussed earlier. Snaptax Transportation Income Transportation income is income from the use of a vessel or aircraft or for the performance of services directly related to the use of any vessel or aircraft. Snaptax This is true whether the vessel or aircraft is owned, hired, or leased. Snaptax The term “vessel or aircraft” includes any container used in connection with a vessel or aircraft. Snaptax All income from transportation that begins and ends in the United States is treated as derived from sources in the United States. Snaptax If the transportation begins or ends in the United States, 50% of the transportation income is treated as derived from sources in the United States. Snaptax For transportation income from personal services, 50% of the income is U. Snaptax S. Snaptax source income if the transportation is between the United States and a U. Snaptax S. Snaptax possession. Snaptax For nonresident aliens, this only applies to income derived from, or in connection with, an aircraft. Snaptax For information on how U. Snaptax S. Snaptax source transportation income is taxed, see chapter 4. Snaptax Scholarships, Grants, Prizes, and Awards Generally, the source of scholarships, fellowship grants, grants, prizes, and awards is the residence of the payer regardless of who actually disburses the funds. Snaptax However, see Activities to be performed outside the United States , later. Snaptax For example, payments for research or study in the United States made by the United States, a noncorporate U. Snaptax S. Snaptax resident, or a domestic corporation, are from U. Snaptax S. Snaptax sources. Snaptax Similar payments from a foreign government or foreign corporation are foreign source payments even though the funds may be disbursed through a U. Snaptax S. Snaptax agent. Snaptax Payments made by an entity designated as a public international organization under the International Organizations Immunities Act are from foreign sources. Snaptax Activities to be performed outside the United States. Snaptax   Scholarships, fellowship grants, targeted grants, and achievement awards received by nonresident aliens for activities performed, or to be performed, outside the United States are not U. Snaptax S. Snaptax source income. Snaptax    These rules do not apply to amounts paid as salary or other compensation for services. Snaptax See Personal Services, earlier, for the source rules that apply. Snaptax Pensions and Annuities If you receive a pension from a domestic trust for services performed both in and outside the United States, part of the pension payment is from U. Snaptax S. Snaptax sources. Snaptax That part is the amount attributable to earnings of the pension plan and the employer contributions made for services performed in the United States. Snaptax This applies whether the distribution is made under a qualified or nonqualified stock bonus, pension, profit-sharing, or annuity plan (whether or not funded). Snaptax If you performed services as an employee of the United States, you may receive a distribution from the U. Snaptax S. Snaptax Government under a plan, such as the Civil Service Retirement System, that is treated as a qualified pension plan. Snaptax Your U. Snaptax S. Snaptax source income is the otherwise taxable amount of the distribution that is attributable to your total U. Snaptax S. Snaptax Government basic pay other than tax-exempt pay for services performed outside the United States. Snaptax Rents or Royalties Your U. Snaptax S. Snaptax source income includes rent and royalty income received during the tax year from property located in the United States or from any interest in that property. Snaptax U. Snaptax S. Snaptax source income also includes rents or royalties for the use of, or for the privilege of using, in the United States, intangible property such as patents, copyrights, secret processes and formulas, goodwill, trademarks, franchises, and similar property. Snaptax Real Property Real property is land and buildings and generally anything built on, growing on, or attached to land. Snaptax Gross income from sources in the United States includes gains, profits, and income from the sale or other disposition of real property located in the United States. Snaptax Natural resources. Snaptax   The income from the sale of products of any farm, mine, oil or gas well, other natural deposit, or timber located in the United States and sold in a foreign country, or located in a foreign country and sold in the United States, is partly from sources in the United States. Snaptax For information on determining that part, see section 1. Snaptax 863-1(b) of the regulations. Snaptax Table 2-1. Snaptax Summary of Source Rules for Income of Nonresident Aliens Item of income Factor determining source Salaries, wages, other compensation Where services performed Business income:   Personal services Where services performed Sale of inventory—purchased Where sold Sale of inventory—produced Allocation Interest Residence of payer Dividends Whether a U. Snaptax S. Snaptax or foreign corporation* Rents Location of property Royalties:   Natural resources Location of property Patents, copyrights, etc. Snaptax Where property is used Sale of real property Location of property Sale of personal property Seller's tax home (but see Personal Property , later, for exceptions) Pension distributions attributable to contributions Where services were performed that earned the pension Investment earnings on pension contributions Location of pension trust Sale of natural resources Allocation based on fair market value of product at export terminal. Snaptax For more information, see section 1. Snaptax 863-1(b) of the regulations. Snaptax *Exceptions include: a) Dividends paid by a U. Snaptax S. Snaptax corporation are foreign source if the corporation elects the  American Samoa economic development credit. Snaptax  b) Part of a dividend paid by a foreign corporation is U. Snaptax S. Snaptax source if at least 25% of the  corporation's gross income is effectively connected with a U. Snaptax S. Snaptax trade or business for the  3 tax years before the year in which the dividends are declared. Snaptax Personal Property Personal property is property, such as machinery, equipment, or furniture, that is not real property. Snaptax Gain or loss from the sale or exchange of personal property generally has its source in the United States if you have a tax home in the United States. Snaptax If you do not have a tax home in the United States, the gain or loss generally is considered to be from sources outside the United States. Snaptax Tax home. Snaptax   Your tax home is the general area of your main place of business, employment, or post of duty, regardless of where you maintain your family home. Snaptax Your tax home is the place where you permanently or indefinitely work as an employee or a self-employed individual. Snaptax If you do not have a regular or main place of business because of the nature of your work, then your tax home is the place where you regularly live. Snaptax If you do not fit either of these categories, you are considered an itinerant and your tax home is wherever you work. Snaptax Inventory property. Snaptax   Inventory property is personal property that is stock in trade or that is held primarily for sale to customers in the ordinary course of your trade or business. Snaptax Income from the sale of inventory that you purchased is sourced where the property is sold. Snaptax Generally, this is where title to the property passes to the buyer. Snaptax For example, income from the sale of inventory in the United States is U. Snaptax S. Snaptax source income, whether you purchased it in the United States or in a foreign country. Snaptax   Income from the sale of inventory property that you produced in the United States and sold outside the United States (or vice versa) is partly from sources in the United States and partly from sources outside the United States. Snaptax For information on making this allocation, see section 1. Snaptax 863-3 of the regulations. Snaptax   These rules apply even if your tax home is not in the United States. Snaptax Depreciable property. Snaptax   To determine the source of any gain from the sale of depreciable personal property, you must first figure the part of the gain that is not more than the total depreciation adjustments on the property. Snaptax You allocate this part of the gain to sources in the United States based on the ratio of U. Snaptax S. Snaptax depreciation adjustments to total depreciation adjustments. Snaptax The rest of this part of the gain is considered to be from sources outside the United States. Snaptax   For this purpose, “U. Snaptax S. Snaptax depreciation adjustments” are the depreciation adjustments to the basis of the property that are allowable in figuring taxable income from U. Snaptax S. Snaptax sources. Snaptax However, if the property is used predominantly in the United States during a tax year, all depreciation deductions allowable for that year are treated as U. Snaptax S. Snaptax depreciation adjustments. Snaptax But there are some exceptions for certain transportation, communications, and other property used internationally. Snaptax   Gain from the sale of depreciable property that is more than the total depreciation adjustments on the property is sourced as if the property were inventory property, as discussed above. Snaptax   A loss is sourced in the same way as the depreciation deductions were sourced. Snaptax However, if the property was used predominantly in the United States, the entire loss reduces U. Snaptax S. Snaptax source income. Snaptax   The basis of property usually means the cost (money plus the fair market value of other property or services) of property you acquire. Snaptax Depreciation is an amount deducted to recover the cost or other basis of a trade or business asset. Snaptax The amount you can deduct depends on the property's cost, when you began using the property, how long it will take to recover your cost, and which depreciation method you use. Snaptax A depreciation deduction is any deduction for depreciation or amortization or any other allowable deduction that treats a capital expenditure as a deductible expense. Snaptax Intangible property. Snaptax   Intangible property includes patents, copyrights, secret processes or formulas, goodwill, trademarks, trade names, or other like property. Snaptax The gain from the sale of amortizable or depreciable intangible property, up to the previously allowable amortization or depreciation deductions, is sourced in the same way as the original deductions were sourced. Snaptax This is the same as the source rule for gain from the sale of depreciable property. Snaptax See Depreciable property , earlier, for details on how to apply this rule. Snaptax   Gain in excess of the amortization or depreciation deductions is sourced in the country where the property is used if the income from the sale is contingent on the productivity, use, or disposition of that property. Snaptax If the income is not contingent on the productivity, use, or disposition of the property, the income is sourced according to your tax home as discussed earlier. Snaptax If payments for goodwill do not depend on its productivity, use, or disposition, their source is the country in which the goodwill was generated. Snaptax Sales through offices or fixed places of business. Snaptax   Despite any of the earlier rules, if you do not have a tax home in the United States, but you maintain an office or other fixed place of business in the United States, treat the income from any sale of personal property (including inventory property) that is attributable to that office or place of business as U. Snaptax S. Snaptax source income. Snaptax However, this rule does not apply to sales of inventory property for use, disposition, or consumption outside the United States if your office or other fixed place of business outside the United States materially participated in the sale. Snaptax   If you have a tax home in the United States but maintain an office or other fixed place of business outside the United States, income from sales of personal property, other than inventory, depreciable property, or intangibles, that is attributable to that foreign office or place of business may be treated as U. Snaptax S. Snaptax source income. Snaptax The income is treated as U. Snaptax S. Snaptax source income if an income tax of less than 10% of the income from the sale is paid to a foreign country. Snaptax This rule also applies to losses if the foreign country would have imposed an income tax of less than 10% had the sale resulted in a gain. Snaptax Community Income If you are married and you or your spouse is subject to the community property laws of a foreign country, a U. Snaptax S. Snaptax state, or a U. Snaptax S. Snaptax possession, you generally must follow those laws to determine the income of yourself and your spouse for U. Snaptax S. Snaptax tax purposes. Snaptax But you must disregard certain community property laws if: Both you and your spouse are nonresident aliens, or One of you is a nonresident alien and the other is a U. Snaptax S. Snaptax citizen or resident and you do not both choose to be treated as U. Snaptax S. Snaptax residents as explained in chapter 1. Snaptax In these cases, you and your spouse must report community income as explained later. Snaptax Earned income. Snaptax   Earned income of a spouse, other than trade or business income and a partner's distributive share of partnership income, is treated as the income of the spouse whose services produced the income. Snaptax That spouse must report all of it on his or her separate return. Snaptax Trade or business income. Snaptax   Trade or business income, other than a partner's distributive share of partnership income, is treated as the income of the spouse carrying on the trade or business. Snaptax That spouse must report all of it on his or her separate return. Snaptax Partnership income (or loss). Snaptax   A partner's distributive share of partnership income (or loss) is treated as the income (or loss) of the partner. Snaptax The partner must report all of it on his or her separate return. Snaptax Separate property income. Snaptax   Income derived from the separate property of one spouse (and which is not earned income, trade or business income, or partnership distributive share income) is treated as the income of that spouse. Snaptax That spouse must report all of it on his or her separate return. Snaptax Use the appropriate community property law to determine what is separate property. Snaptax Other community income. Snaptax   All other community income is treated as provided by the applicable community property laws. Snaptax Prev  Up  Next   Home   More Online Publications
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The Snaptax

Snaptax 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. Snaptax Hybrid method. Snaptax Cash Method Accrual Method Inventories Change in Accounting Method How To Get Tax HelpLow Income Taxpayer Clinics (LITCs). Snaptax Accounting Periods You must use a tax year to figure your taxable income. Snaptax A tax year is an annual accounting period for keeping records and reporting income and expenses. Snaptax An annual accounting period does not include a short tax year (discussed later). Snaptax You can use the following tax years: A calendar year; or A fiscal year (including a 52-53-week tax year). Snaptax Unless you have a required tax year, you adopt a tax year by filing your first income tax return using that tax year. Snaptax A required tax year is a tax year required under the Internal Revenue Code or the Income Tax Regulations. Snaptax 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. Snaptax This section discusses: A calendar year. Snaptax A fiscal year (including a period of 52 or 53 weeks). Snaptax A short tax year. Snaptax An improper tax year. Snaptax A change in tax year. Snaptax Special situations that apply to individuals. Snaptax Restrictions that apply to the accounting period of a partnership, S corporation, or personal service corporation. Snaptax Special situations that apply to corporations. Snaptax Calendar Year A calendar year is 12 consecutive months beginning on January 1st and ending on December 31st. Snaptax 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. Snaptax 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. Snaptax See Change in Tax Year, later. Snaptax Generally, anyone can adopt the calendar year. Snaptax 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. Snaptax Fiscal Year A fiscal year is 12 consecutive months ending on the last day of any month except December 31st. Snaptax 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. Snaptax 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. Snaptax If you make this election, your 52-53-week tax year must always end on the same day of the week. Snaptax 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. Snaptax 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. Snaptax Election. Snaptax   To make the election for the 52-53-week tax year, attach a statement with the following information to your tax return. Snaptax The month in which the new 52-53-week tax year ends. Snaptax The day of the week on which the tax year always ends. Snaptax The date the tax year ends. Snaptax 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. Snaptax   When you figure depreciation or amortization, a 52-53-week tax year is generally considered a year of 12 calendar months. Snaptax   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. Snaptax Example. Snaptax Assume a tax provision applies to tax years beginning on or after July 1, 2012, which happens to be a Sunday. Snaptax 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. Snaptax Short Tax Year A short tax year is a tax year of less than 12 months. Snaptax 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. Snaptax Tax on a short period tax return is figured differently for each situation. Snaptax 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. Snaptax 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. Snaptax Example 1. Snaptax XYZ Corporation was organized on July 1, 2012. Snaptax It elected the calendar year as its tax year. Snaptax Therefore, its first tax return was due March 15, 2013. Snaptax This short period return will cover the period from July 1, 2012, through December 31, 2012. Snaptax Example 2. Snaptax A calendar year corporation dissolved on July 23, 2012. Snaptax Its final return is due by October 15, 2012. Snaptax It will cover the short period from January 1, 2012, through July 23, 2012. Snaptax Death of individual. Snaptax   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. Snaptax The decedent's final return will be a short period tax return that begins on January 1st, and ends on the date of death. Snaptax 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. Snaptax Example. Snaptax   Agnes Green was a single, calendar year taxpayer. Snaptax She died on March 6, 2012. Snaptax Her final income tax return must be filed by April 15, 2013. Snaptax It will cover the short period from January 1, 2012, to March 6, 2012. Snaptax 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. Snaptax 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. Snaptax Figure tax for a short year under the general rule, explained below. Snaptax You may then be able to use a relief procedure, explained later, and claim a refund of part of the tax you paid. Snaptax General rule. Snaptax   Income tax for a short tax year must be annualized. Snaptax However, self-employment tax is figured on the actual self-employment income for the short period. Snaptax Individuals. Snaptax   An individual must figure income tax for the short tax year as follows. Snaptax Determine your adjusted gross income (AGI) for the short tax year and then subtract your actual itemized deductions for the short tax year. Snaptax You must itemize deductions when you file a short period tax return. Snaptax Multiply the dollar amount of your exemptions by the number of months in the short tax year and divide the result by 12. Snaptax Subtract the amount in (2) from the amount in (1). Snaptax The result is your modified taxable income. Snaptax Multiply the modified taxable income in (3) by 12, then divide the result by the number of months in the short tax year. Snaptax The result is your annualized income. Snaptax Figure the total tax on your annualized income using the appropriate tax rate schedule. Snaptax Multiply the total tax by the number of months in the short tax year and divide the result by 12. Snaptax The result is your tax for the short tax year. Snaptax Relief procedure. Snaptax   Individuals and corporations can use a relief procedure to figure the tax for the short tax year. Snaptax It may result in less tax. Snaptax Under this procedure, the tax is figured by two separate methods. Snaptax 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. Snaptax For more information, see section 443(b)(2) of the Internal Revenue Code. Snaptax Alternative minimum tax. Snaptax   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. Snaptax Multiply the AMTI by 12. Snaptax Divide the result by the number of months in the short tax year. Snaptax Multiply the annualized AMTI by the appropriate rate of tax under section 55(b)(1) of the Internal Revenue Code. Snaptax The result is the annualized AMT. Snaptax Multiply the annualized AMT by the number of months in the short tax year and divide the result by 12. Snaptax   For information on the AMT for individuals, see the Instructions for Form 6251, Alternative Minimum Tax–Individuals. Snaptax For information on the AMT for corporations, see the Instructions to Form 4626, Alternative Minimum Tax–Corporations. Snaptax Tax withheld from wages. Snaptax   You can claim a credit against your income tax liability for federal income tax withheld from your wages. Snaptax Federal income tax is withheld on a calendar year basis. Snaptax The amount withheld in any calendar year is allowed as a credit for the tax year beginning in the calendar year. Snaptax Improper Tax Year Taxpayers that have adopted an improper tax year must change to a proper tax year. Snaptax 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. Snaptax See Accounting Periods, earlier, for a description of permissible tax years. Snaptax To change to a proper tax year, you must do one of the following. Snaptax 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. Snaptax Attach a completed Form 1128 to the amended tax return. Snaptax Write “FILED UNDER REV. Snaptax PROC. Snaptax 85-15” at the top of Form 1128 and file the forms with the Internal Revenue Service Center where you filed your original return. Snaptax 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. Snaptax Change in Tax Year Generally, you must file Form 1128 to request IRS approval to change your tax year. Snaptax See the Instructions for Form 1128 for exceptions. Snaptax If you qualify for an automatic approval request, a user fee is not required. Snaptax Individuals Generally, individuals must adopt the calendar year as their tax year. Snaptax 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. Snaptax Partnerships, S Corporations, and Personal Service Corporations (PSCs) Generally, partnerships, S corporations (including electing S corporations), and PSCs must use a required tax year. Snaptax A required tax year is a tax year that is required under the Internal Revenue Code and Income Tax Regulations. Snaptax 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). Snaptax The following discussions provide the rules for partnerships, S corporations, and PSCs. Snaptax Partnership A partnership must conform its tax year to its partners' tax years unless any of the following apply. Snaptax 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. Snaptax 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. Snaptax The partnership can establish a business purpose for a different tax year. Snaptax The rules for the required tax year for partnerships are as follows. Snaptax 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. Snaptax If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. Snaptax A principal partner is one who has a 5% or more interest in the profits or capital of the partnership. Snaptax 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. Snaptax If a partnership changes to a required tax year because of these rules, it can get automatic approval by filing Form 1128. Snaptax Least aggregate deferral of income. Snaptax   The tax year that results in the least aggregate deferral of income is determined as follows. Snaptax Figure the number of months of deferral for each partner using one partner's tax year. Snaptax 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. Snaptax 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). Snaptax Add the amounts in step (2) to get the aggregate (total) deferral for the tax year used in step (1). Snaptax Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years. Snaptax   The partner's tax year that results in the lowest aggregate (total) number is the tax year that must be used by the partnership. Snaptax 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. Snaptax However, if one of the tax years that qualifies is the partnership's existing tax year, the partnership must retain that tax year. Snaptax Example. Snaptax A and B each have a 50% interest in partnership P, which uses a fiscal year ending June 30. Snaptax A uses the calendar year and B uses a fiscal year ending November 30. Snaptax 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. Snaptax Year End 12/31: Year End Profits Interest Months of Deferral Interest × Deferral A 12/31 0. Snaptax 5 -0- -0- B 11/30 0. Snaptax 5 11 5. Snaptax 5 Total Deferral 5. Snaptax 5 Year End 11/30: Year End Profits Interest Months of Deferral Interest × Deferral A 12/31 0. Snaptax 5 1 0. Snaptax 5 B 11/30 0. Snaptax 5 -0- -0- Total Deferral 0. Snaptax 5 When determination is made. Snaptax   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. Snaptax However, the IRS can require the partnership to use another day or period that will more accurately reflect the ownership of the partnership. Snaptax This could occur, for example, if a partnership interest was transferred for the purpose of qualifying for a particular tax year. Snaptax Short period return. Snaptax   When a partnership changes its tax year, a short period return must be filed. Snaptax 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. Snaptax   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. Snaptax The short period return must indicate at the top of page 1, “FILED UNDER SECTION 1. Snaptax 706-1. Snaptax ” More information. Snaptax   For more information about changing a partnership's tax year, and information about ruling requests, see the Instructions for Form 1128. Snaptax S Corporation All S corporations, regardless of when they became an S corporation, must use a permitted tax year. Snaptax A permitted tax year is any of the following. Snaptax The calendar year. Snaptax A tax year elected under section 444 of the Internal Revenue Code. Snaptax See Section 444 Election, below for details. Snaptax A 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444. Snaptax Any other tax year for which the corporation establishes a business purpose. Snaptax 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. Snaptax For information about changing an S corporation's tax year and information about ruling requests, see the Instructions for Form 1128. Snaptax Personal Service Corporation (PSC) A PSC must use a calendar tax year unless any of the following apply. Snaptax The corporation makes an election under section 444 of the Internal Revenue Code. Snaptax See Section 444 Election, below for details. Snaptax 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. Snaptax The corporation establishes a business purpose for a fiscal year. Snaptax See the Instructions for Form 1120 for general information about PSCs. Snaptax For information on adopting or changing tax years for PSCs and information about ruling requests, see the Instructions for Form 1128. Snaptax 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. Snaptax Certain restrictions apply to the election. Snaptax 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). Snaptax 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. Snaptax A partnership, S corporation, or PSC can make a section 444 election if it meets all the following requirements. Snaptax It is not a member of a tiered structure (defined in section 1. Snaptax 444-2T of the regulations). Snaptax It has not previously had a section 444 election in effect. Snaptax It elects a year that meets the deferral period requirement. Snaptax Deferral period. Snaptax   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. Snaptax Retaining tax year. Snaptax   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. Snaptax This deferral period is the number of months between the beginning of the retained year and the close of the first required tax year. Snaptax Adopting or changing tax year. Snaptax   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. Snaptax 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. Snaptax This is the tax year immediately preceding the year for which the partnership, S corporation, or PSC wishes to make the section 444 election. Snaptax If the partnership, S corporation, or PSC's tax year is the same as its required tax year, the deferral period is zero. Snaptax Example 1. Snaptax BD Partnership uses a calendar year, which is also its required tax year. Snaptax BD cannot make a section 444 election because the deferral period is zero. Snaptax Example 2. Snaptax E, a newly formed partnership, began operations on December 1. Snaptax E is owned by calendar year partners. Snaptax E wants to make a section 444 election to adopt a September 30 tax year. Snaptax E's deferral period for the tax year beginning December 1 is 3 months, the number of months between September 30 and December 31. Snaptax Making the election. Snaptax   Make a section 444 election by filing Form 8716 with the Internal Revenue Service Center where the entity will file its tax return. Snaptax 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. Snaptax For this purpose, count the month in which the tax year begins, even if it begins after the first day of that month. Snaptax Note. Snaptax If the due date falls on a Saturday, Sunday, or legal holiday, file on the next business day. Snaptax   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. Snaptax Example 1. Snaptax 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. Snaptax 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. Snaptax Example 2. Snaptax The facts are the same as in Example 1 except that AB begins operations on October 21, 2012. Snaptax AB must file Form 8716 by March 17, 2013. Snaptax Example 3. Snaptax B is a corporation that first becomes a PSC for its tax year beginning September 1, 2012. Snaptax B qualifies to make a section 444 election to use a September 30 tax year for its tax year beginning September 1, 2012. Snaptax 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. Snaptax Note. Snaptax The due dates in Examples 2 and 3 are adjusted because the dates fall on a Saturday, Sunday or legal holiday. Snaptax Extension of time for filing. Snaptax   There is an automatic extension of 12 months to make this election. Snaptax See the Form 8716 instructions for more information. Snaptax Terminating the election. Snaptax   The section 444 election remains in effect until it is terminated. Snaptax If the election is terminated, another section 444 election cannot be made for any tax year. Snaptax   The election ends when any of the following applies to the partnership, S corporation, or PSC. Snaptax The entity changes to its required tax year. Snaptax The entity liquidates. Snaptax The entity becomes a member of a tiered structure. Snaptax The IRS determines that the entity willfully failed to comply with the required payments or distributions. Snaptax   The election will also end if either of the following events occur. Snaptax An S corporation's S election is terminated. Snaptax However, if the S corporation immediately becomes a PSC, the PSC can continue the section 444 election of the S corporation. Snaptax A PSC ceases to be a PSC. Snaptax If the PSC elects to be an S corporation, the S corporation can continue the election of the PSC. Snaptax Required payment for partnership or S corporation. Snaptax   A partnership or an S corporation must make a required payment for any tax year: The section 444 election is in effect. Snaptax The required payment for that year (or any preceding tax year) is more than $500. Snaptax    This payment represents the value of the tax deferral the owners receive by using a tax year different from the required tax year. Snaptax   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. Snaptax 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. Snaptax 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. Snaptax Applicable election year. Snaptax   Any tax year a section 444 election is in effect, including the first year, is called an applicable election year. Snaptax 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. Snaptax Required distribution for PSC. Snaptax   A PSC with a section 444 election in effect must distribute certain amounts to employee-owners by December 31 of each applicable year. Snaptax If it fails to make these distributions, it may be required to defer certain deductions for amounts paid to owner-employees. Snaptax The amount deferred is treated as paid or incurred in the following tax year. Snaptax   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). Snaptax Back-up election. Snaptax   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. Snaptax If the request is denied, the back-up section 444 election must be activated (if the partnership, S corporation, or PSC otherwise qualifies). Snaptax Making back-up election. Snaptax   The general rules for making a section 444 election, as discussed earlier, apply. Snaptax When filing Form 8716, type or print “BACK-UP ELECTION” at the top of the form. Snaptax 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. Snaptax Activating election. Snaptax   A partnership or S corporation activates its back-up election by filing the return required and making the required payment with Form 8752. Snaptax The due date for filing Form 8752 and making the payment is the later of the following dates. Snaptax May 15 of the calendar year following the calendar year in which the applicable election year begins. Snaptax 60 days after the partnership or S corporation has been notified by the IRS that the business year request has been denied. Snaptax   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. Snaptax ” 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). Snaptax 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. Snaptax 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. Snaptax Business Purpose Tax Year A partnership, S corporation, or PSC establishes the business purpose for a tax year by filing Form 1128. Snaptax See the Instructions for Form 1128 for details. Snaptax Corporations (Other Than S Corporations and PSCs) A new corporation establishes its tax year when it files its first tax return. Snaptax 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. Snaptax An S corporation or a PSC must use the required tax year rules, discussed earlier, to establish a tax year. Snaptax 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. Snaptax See the Instructions for Form 1128 for details. Snaptax Accounting Methods An accounting method is a set of rules used to determine when income and expenses are reported on your tax return. Snaptax Your accounting method includes not only your overall method of accounting, but also the accounting treatment you use for any material item. Snaptax You choose an accounting method when you file your first tax return. Snaptax If you later want to change your accounting method, you must get IRS approval. Snaptax See Change in Accounting Method, later. Snaptax No single accounting method is required of all taxpayers. Snaptax 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. Snaptax In addition to your permanent accounting books, you must keep any other records necessary to support the entries on your books and tax returns. Snaptax You must use the same accounting method from year to year. Snaptax An accounting method clearly reflects income only if all items of gross income and expenses are treated the same from year to year. Snaptax 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. Snaptax Methods you can use. Snaptax   In general, you can compute your taxable income under any of the following accounting methods. Snaptax Cash method. Snaptax Accrual method. Snaptax Special methods of accounting for certain items of income and expenses. Snaptax A hybrid method which combines elements of two or more of the above accounting methods. Snaptax The cash and accrual methods of accounting are explained later. Snaptax Special methods. Snaptax   This publication does not discuss special methods of accounting for certain items of income or expenses. Snaptax 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. Snaptax The following publications also discuss special methods of reporting income or expenses. Snaptax Publication 225, Farmer's Tax Guide. Snaptax Publication 535, Business Expenses. Snaptax Publication 537, Installment Sales. Snaptax Publication 946, How To Depreciate Property. Snaptax Hybrid method. Snaptax   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. Snaptax However, the following restrictions apply. Snaptax If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales. Snaptax See Exceptions under Inventories, later. Snaptax Generally, you can use the cash method for all other items of income and expenses. Snaptax See Inventories, later. Snaptax If you use the cash method for reporting your income, you must use the cash method for reporting your expenses. Snaptax If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income. Snaptax Any combination that includes the cash method is treated as the cash method for purposes of section 448 of the Internal Revenue Code. Snaptax Business and personal items. Snaptax   You can account for business and personal items using different accounting methods. Snaptax 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. Snaptax Two or more businesses. Snaptax   If you operate two or more separate and distinct businesses, you can use a different accounting method for each business. Snaptax No business is separate and distinct, unless a complete and separate set of books and records is maintained for each business. Snaptax Note. Snaptax 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. Snaptax Cash Method Most individuals and many small businesses use the cash method of accounting. Snaptax Generally, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise. Snaptax See Inventories, later, for exceptions to this rule. Snaptax Income Under the cash method, you include in your gross income all items of income you actually or constructively receive during the tax year. Snaptax If you receive property and services, you must include their fair market value (FMV) in income. Snaptax Constructive receipt. Snaptax   Income is constructively received when an amount is credited to your account or made available to you without restriction. Snaptax You need not have possession of it. Snaptax 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. Snaptax Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations. Snaptax Example. Snaptax You are a calendar year taxpayer. Snaptax Your bank credited, and made available, interest to your bank account in December 2012. Snaptax You did not withdraw it or enter it into your books until 2013. Snaptax You must include the amount in gross income for 2012, the year you constructively received it. Snaptax You cannot hold checks or postpone taking possession of similar property from one tax year to another to postpone paying tax on the income. Snaptax You must report the income in the year the property is received or made available to you without restriction. Snaptax Expenses Under the cash method, generally, you deduct expenses in the tax year in which you actually pay them. Snaptax This includes business expenses for which you contest liability. Snaptax However, you may not be able to deduct an expense paid in advance. Snaptax Instead, you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules. Snaptax Expense paid in advance. Snaptax   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. Snaptax   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. Snaptax 12 months after the right or benefit begins, or The end of the tax year after the tax year in which payment is made. Snaptax   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. Snaptax See Change in Accounting Method, later. Snaptax Example 1. Snaptax 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. Snaptax 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. Snaptax 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. Snaptax Example 2. Snaptax 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. Snaptax The 12-month rule applies. Snaptax Therefore, the full $10,000 is deductible in 2012. Snaptax Excluded Entities The following entities cannot use the cash method, including any combination of methods that includes the cash method. Snaptax (See Special rules for farming businesses, later. Snaptax ) A corporation (other than an S corporation) with average annual gross receipts exceeding $5 million. Snaptax See Gross receipts test, below. Snaptax 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. Snaptax See Gross receipts test, below. Snaptax A tax shelter. Snaptax Exceptions The following entities are not prohibited from using the cash method of accounting. Snaptax Any corporation or partnership, other than a tax shelter, that meets the gross receipts test for all tax years after 1985. Snaptax A qualified personal service corporation (PSC). Snaptax Gross receipts test. Snaptax   A corporation or partnership, other than a tax shelter, that meets the gross receipts test can generally use the cash method. Snaptax 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. Snaptax    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. Snaptax See Gross receipts test for qualifying taxpayers, for more information. Snaptax Generally, a partnership applies the test at the partnership level. Snaptax Gross receipts for a short tax year are annualized. Snaptax Aggregation rules. Snaptax   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. Snaptax Change to accrual method. Snaptax   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. Snaptax Special rules for farming businesses. Snaptax   Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business. Snaptax 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. Snaptax 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). Snaptax   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. Snaptax For family corporations engaged in farming, the exception applies if gross receipts were $25 million or less for each prior tax year after 1985. Snaptax See chapter 2 of Publication 225, Farmer's Tax Guide, for more information. Snaptax Qualified PSC. Snaptax   A PSC that meets the following function and ownership tests can use the cash method. Snaptax Function test. Snaptax   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. Snaptax Ownership test. Snaptax   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. Snaptax Employees performing services for the corporation in a field qualifying under the function test. Snaptax Retired employees who had performed services in those fields. Snaptax The estate of an employee described in (1) or (2). Snaptax 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. Snaptax   Indirect ownership is generally taken into account if the stock is owned indirectly through one or more partnerships, S corporations, or qualified PSCs. Snaptax Stock owned by one of these entities is considered owned by the entity's owners in proportion to their ownership interest in that entity. Snaptax 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. Snaptax   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. Snaptax Change to accrual method. Snaptax   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. Snaptax 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. Snaptax 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. Snaptax The purpose of an accrual method of accounting is to match income and expenses in the correct year. Snaptax 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. Snaptax Under this rule, you report an amount in your gross income on the earliest of the following dates. Snaptax When you receive payment. Snaptax When the income amount is due to you. Snaptax When you earn the income. Snaptax When title has passed. Snaptax Estimated income. Snaptax   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. Snaptax Change in payment schedule. Snaptax   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. Snaptax Continue this procedure until you complete the services, then account for the difference. Snaptax 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. Snaptax 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. Snaptax However, you cannot postpone including any payment beyond that tax year. Snaptax Service agreement. Snaptax   You can postpone reporting income from an advance payment you receive for a service agreement on property you sell, lease, build, install, or construct. Snaptax This includes an agreement providing for incidental replacement of parts or materials. Snaptax However, this applies only if you offer the property without a service agreement in the normal course of business. Snaptax Postponement not allowed. Snaptax   Generally, one cannot postpone including an advance payment in income for services if either of the following applies. Snaptax 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. Snaptax 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. Snaptax Examples. Snaptax   In each of the following examples, assume the tax year is a calendar year and that the accrual method of accounting is used. Snaptax Example 1. Snaptax You manufacture, sell, and service computers. Snaptax You received payment in 2012 for a one-year contingent service contract on a computer you sold. Snaptax 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. Snaptax Example 2. Snaptax You are in the television repair business. Snaptax 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. Snaptax You include the payments in gross income as you earn them. Snaptax Example 3. Snaptax You own a dance studio. Snaptax On October 1, 2012, you receive payment for a one-year contract for 48 one-hour lessons beginning on that date. Snaptax You give eight lessons in 2012. Snaptax 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. Snaptax Example 4. Snaptax Assume the same facts as in Example 3, except the payment is for a two-year contract for 96 lessons. Snaptax You must include the entire payment in income in 2012 since part of the services may be performed after the following year. Snaptax Guarantee or warranty. Snaptax   Generally, you cannot postpone reporting income you receive under a guarantee or warranty contract. Snaptax Prepaid rent. Snaptax   You cannot postpone reporting income from prepaid rent. Snaptax Prepaid rent does not include payment for the use of a room or other space when significant service is also provided for the occupant. Snaptax 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. Snaptax Books and records. Snaptax   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. Snaptax Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements. Snaptax IRS approval. Snaptax   You must file Form 3115 to obtain IRS approval to change your method of accounting for advance payment for services. Snaptax 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. Snaptax 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. Snaptax An agreement includes a gift certificate that can be redeemed for goods. Snaptax Amounts due and payable are considered received. Snaptax How to report payments. Snaptax   Generally, include an advance payment in income in the year in which you receive it. Snaptax However, you can use the alternative method, discussed next. Snaptax Alternative method of reporting. Snaptax   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. Snaptax Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements. Snaptax Example 1. Snaptax You are a retailer. Snaptax You use an accrual method of accounting and account for the sale of goods when you ship the goods. Snaptax You use this method for both tax and financial reporting purposes. Snaptax 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. Snaptax However, see Exception for inventory goods, later. Snaptax Example 2. Snaptax You are a calendar year taxpayer. Snaptax You manufacture household furniture and use an accrual method of accounting. Snaptax Under this method, you accrue income for your financial reports when you ship the furniture. Snaptax For tax purposes, you do not accrue income until the furniture has been delivered and accepted. Snaptax 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. Snaptax You shipped the furniture to the customer in December 2012, but it was not delivered and accepted until January 2013. Snaptax 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. Snaptax Information schedule. Snaptax   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. Snaptax Total advance payments received in the current tax year. Snaptax Total advance payments received in earlier tax years and not included in income before the current tax year. Snaptax Total payments received in earlier tax years included in income for the current tax year. Snaptax Exception for inventory goods. Snaptax   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. Snaptax You account for the advance payment under the alternative method (discussed earlier). Snaptax You have received a substantial advance payment on the agreement (discussed next). Snaptax You have enough substantially similar goods on hand, or available through your normal source of supply, to satisfy the agreement. Snaptax 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. Snaptax   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. Snaptax You must also deduct in that second year all actual or estimated costs for the goods required to satisfy the agreement. Snaptax If you estimated the cost, you must take into account any difference between the estimate and the actual cost when the goods are delivered. Snaptax Note. Snaptax You must report any advance payments you receive after the second year in the year received. Snaptax No further deferral is allowed. Snaptax Substantial advance payments. Snaptax   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. Snaptax Example. Snaptax You are a calendar year, accrual method taxpayer who accounts for advance payments under the alternative method. Snaptax In 2008, you entered into a contract for the sale of goods properly includible in your inventory. Snaptax The total contract price is $50,000 and you estimate that your total inventoriable costs for the goods will be $25,000. Snaptax You receive the following advance payments under the contract. Snaptax 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. Snaptax In your 2010 closing inventory, you had on hand enough of the type of goods specified in the contract to satisfy the contract. Snaptax 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. Snaptax   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. Snaptax 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. Snaptax If no such goods are on hand, then estimate the cost necessary to satisfy the contract. Snaptax   No further deferral is allowed. Snaptax You must include in gross income the advance payment you receive each remaining year of the contract. Snaptax Take into account the difference between any estimated cost of goods sold and the actual cost when you deliver the goods in 2015. Snaptax IRS approval. Snaptax   You must file Form 3115 to obtain IRS approval to change your method of accounting for advance payments for sales. Snaptax Expenses Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply. Snaptax The all-events test has been met. Snaptax The test is met when: All events have occurred that fix the fact of liability, and The liability can be determined with reasonable accuracy. Snaptax Economic performance has occurred. Snaptax Economic Performance Generally, you cannot deduct or capitalize a business expense until economic performance occurs. Snaptax 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. Snaptax If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. Snaptax Example. Snaptax You are a calendar year taxpayer. Snaptax You buy office supplies in December 2012. Snaptax You receive the supplies and the bill in December, but you pay the bill in January 2013. Snaptax 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. Snaptax Your office supplies may qualify as a recurring item, discussed later. Snaptax If so, you can deduct them in 2012, even if the supplies are not delivered until 2013 (when economic performance occurs). Snaptax Workers' compensation and tort liability. Snaptax   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. Snaptax 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. Snaptax Taxes. Snaptax   Economic performance generally occurs as estimated income tax, property taxes, employment taxes, etc. Snaptax are paid. Snaptax However, you can elect to treat taxes as a recurring item, discussed later. Snaptax You can also elect to ratably accrue real estate taxes. Snaptax See chapter 5 of Publication 535 for information about real estate taxes. Snaptax Other liabilities. Snaptax   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. Snaptax Interest. Snaptax   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. Snaptax Compensation for services. Snaptax   Generally, economic performance occurs as an employee renders service to the employer. Snaptax 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. Snaptax For information on employee benefit programs, see Publication 15-B, Employer's Tax Guide to Fringe Benefits. Snaptax Vacation pay. Snaptax   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. Snaptax If you pay it later than this, you must deduct it in the year actually paid. Snaptax An amount is vested if your right to it cannot be nullified or cancelled. Snaptax Exception for recurring items. Snaptax   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. Snaptax The exception applies if all the following requirements are met. Snaptax The all-events test, discussed earlier, is met. Snaptax Economic performance occurs by the earlier of the following dates. Snaptax 8½ months after the close of the year. Snaptax The date you file a timely return (including extensions) for the year. Snaptax 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. Snaptax 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. Snaptax This exception does not apply to workers' compensation or tort liabilities. Snaptax Amended return. Snaptax   You may be able to file an amended return and treat a liability as incurred under the recurring item exception. Snaptax 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. Snaptax Recurrence and consistency. Snaptax   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. Snaptax 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. Snaptax Materiality. Snaptax   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. Snaptax   An item considered material for financial statement purposes is also considered material for tax purposes. Snaptax However, in certain situations an immaterial item for financial accounting purposes is treated as material for purposes of economic performance. Snaptax Matching expenses with income. Snaptax   Costs directly associated with the revenue of a period are properly allocable to that period. Snaptax 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. Snaptax fasab. Snaptax gov/accepted. Snaptax html) are an important factor. Snaptax   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. Snaptax 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. Snaptax However, the matching requirement is considered met for certain types of expenses. Snaptax These expenses include taxes, payments under insurance, warranty, and service contracts, rebates, refunds, awards, prizes, and jackpots. Snaptax 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. Snaptax 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. Snaptax 12 months after the right or benefit begins, or The end of the tax year after the tax year in which payment is made. Snaptax 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. Snaptax See Change in Accounting Method, later, for information on how to get IRS approval. Snaptax See Expense paid in advance under Cash Method, earlier, for examples illustrating the application of the general and 12-month rules. Snaptax 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. Snaptax Determine the relationship for this rule as of the end of the tax year for which the expense or interest would otherwise be deductible. Snaptax See section 267 of the Internal Revenue Code and Publication 542, Corporations, for the definition of related person. Snaptax Inventories An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. Snaptax If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales. Snaptax However, see Exceptions, next. Snaptax See also Accrual Method, earlier. Snaptax To figure taxable income, you must value your inventory at the beginning and end of each tax year. Snaptax To determine the value, you need a method for identifying the items in your inventory and a method for valuing these items. Snaptax See Identifying Cost and Valuing Inventory, later. Snaptax The rules for valuing inventory are not the same for all businesses. Snaptax The method you use must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Snaptax Your inventory practices must be consistent from year to year. Snaptax 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. Snaptax Exceptions The following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. Snaptax These taxpayers can also account for inventoriable items as materials and supplies that are not incidental (discussed later). Snaptax A qualifying taxpayer under Revenue Procedure 2001-10 on page 272 of Internal Revenue Bulletin 2001-2, available at www. Snaptax irs. Snaptax gov/pub/irs-irbs/irb01–02. Snaptax pdf. Snaptax A qualifying small business taxpayer under Revenue Procedure 2002-28, on page 815 of Internal Revenue Bulletin 2002-18, available at www. Snaptax irs. Snaptax gov/pub/irs-irbs/irb02–18. Snaptax pdf. Snaptax 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). Snaptax Qualifying taxpayer. Snaptax   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). Snaptax Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $1 million or less. Snaptax You are not a tax shelter as defined under section 448(d)(3) of the Internal Revenue Code. Snaptax Gross receipts test for qualifying taxpayers. Snaptax   To determine if you meet the gross receipts test for qualifying taxpayers, use the following steps: Step 1. Snaptax List each of the test years. Snaptax For qualifying taxpayers under Revenue Procedure 2001-10, the test years are each prior tax year ending on or after December 17, 1998. Snaptax Step 2. Snaptax Determine your average annual gross receipts for each test year listed in Step 1. Snaptax 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. Snaptax Step 3. Snaptax 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. Snaptax Qualifying small business taxpayer. Snaptax   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). Snaptax Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $10 million or less. Snaptax You are not prohibited from using the cash method under section 448 of the Internal Revenue Code. Snaptax Your principle business activity is an eligible business. Snaptax See Eligible business, later. Snaptax 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. Snaptax Note. Snaptax Revenue Procedure 2002-28 does not apply to a farming business of a qualifying small business taxpayer. Snaptax A taxpayer engaged in the trade or business of farming generally is allowed to use the cash method for any farming business. Snaptax See Special rules for farming businesses under Cash Method, earlier. Snaptax Gross receipts test for qualifying small business taxpayers. Snaptax   To determine if you meet the gross receipts test for qualifying small business taxpayers, use the following steps: Step 1. Snaptax List each of the test years. Snaptax 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. Snaptax Step 2. Snaptax Determine your average annual gross receipts for each test year listed in Step 1. Snaptax 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. Snaptax Step 3. Snaptax 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. Snaptax Eligible business. Snaptax   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. Snaptax You have an eligible business if you meet any of the following requirements. Snaptax 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). Snaptax NAICS codes 31-33 (manufacturing). Snaptax NAICS code 42 (wholesale trade). Snaptax NAICS codes 44-45 (retail trade). Snaptax NAICS codes 5111 and 5122 (information industries). Snaptax Your principal business activity is the provision of services, including the provision of property incident to those services. Snaptax Your principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications. Snaptax   Information about the NAICS codes can be found at http://www. Snaptax census. Snaptax gov/naics or in the instructions for your federal income tax return. Snaptax Gross receipts. Snaptax   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. Snaptax See the definit