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You must figure your taxable income and file an income tax return for an annual accounting period called a tax year. Also, you must consistently use an accounting method that clearly shows your income and expenses for the tax year.
See chapter 12 for information about getting publications and forms.
When preparing a statement of income and expenses (generally your income tax return), you must use your books and records for a specific interval of time called an accounting period. The annual accounting period for your income tax return is called a tax year. You can use one of the following tax years.
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A calendar tax year.
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A fiscal tax year.
Unless you have a required tax year, you adopt a tax year by filing your first income tax return using that tax year. A required tax year is a tax year required under the Internal Revenue Code or the Income Tax Regulations.
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You do not keep books.
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You have no annual accounting period.
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Your present tax year does not qualify as a fiscal year.
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Your use of the calendar tax year is required under the Internal Revenue Code or the Income Tax Regulations.
An accounting method is a set of rules used to determine when and how income and expenses are reported. Your accounting method includes not only the overall method of accounting you use, but also the accounting treatment you use for any material item.
You choose an accounting method for your business when you file your first income tax return that includes a Schedule C for the business. After that, if you want to change your accounting method, you must generally get IRS approval. See Change in Accounting Method, later.
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Cash method.
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An accrual method.
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Special methods of accounting for certain items of income and expenses.
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Combination method using elements of two or more of the above.
You must use the same accounting method to figure your taxable income and to keep your books. Also, you must use an accounting method that clearly shows your income.
Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash method records. However, if an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases. For more information, see Inventories, later.
Under the cash method, include in your gross income all items of income you actually or constructively receive during your tax year. If you receive property or services, you must include their fair market value in income.
Example.
On December 30, 2007, Mrs. Sycamore sent you a check for interior decorating services you provided to her. You received the check on January 2, 2008. You must include the amount of the check in income for 2008.
Example.
Frances Jones, a service contractor, was entitled to receive a $10,000 payment on a contract in December 2008. She was told in December that her payment was available. At her request, she was not paid until January 2009. She must include this payment in her 2008 income because it was constructively received in 2008.
Under the cash method, you generally deduct expenses in the tax year in which you actually pay them. This includes business expenses for which you contest liability. However, you may not be able to deduct an expense paid in advance or you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules.
Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year.
Under an accrual method, you generally include an amount in your 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.
The following are special rules that apply to advance payments, estimating income, and changing a payment schedule for services.
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Advance payments for service agreements.
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Advance payments under guarantee or warranty contracts.
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Prepaid interest.
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Prepaid rent.
Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply.
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The all-events test has been met. The test has been met when:
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All events have occurred that fix the fact of liability, and
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The liability can be determined with reasonable accuracy.
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Economic performance has occurred.
Example.
You are a calendar year taxpayer and use an accrual method of accounting. You buy office supplies in December 2008. You receive the supplies and the bill in December, but you pay the bill in January 2009. You can deduct the expense in 2008 because all events that fix the fact of liability have occurred, the amount of the liability could be reasonably determined, and economic performance occurred in that year.
Your office supplies may qualify as a recurring expense. In that case, you can deduct them in 2008 even if the supplies are not delivered until 2009 (when economic performance occurs).
You can generally use any combination of cash, accrual, and special methods of accounting if the combination clearly shows your income and expenses and you use it consistently. However, the following restrictions apply.
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If an inventory is necessary to account for your income, you must generally use an accrual method for purchases and sales. (See, however, Inventories, later.) You can use the cash method for all other items of income and expenses.
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If you use the cash method for figuring your income, you must use the cash method for reporting your expenses.
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If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.
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If you use a combination method that includes the cash method, treat that combination method as the cash method.
Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, the following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers can also account for inventoriable items as materials and supplies that are not incidental (discussed later).
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A qualifying taxpayer under Revenue Procedure 2001-10 in Internal Revenue Bulletin 2001-2.
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A qualifying small business taxpayer under Revenue Procedure 2002-28 in Internal Revenue Bulletin 2002-18.
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Your average annual gross receipts for each prior tax year ending on or after December 17, 1998, is $1 million or less. (Your average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year and the 2 preceding tax years and dividing by 3.)
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Your business is not a tax shelter, as defined under section 448(d)(3) of the Internal Revenue Code.
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Your average annual gross receipts for each prior tax year ending on or after December 31, 2000, is more than $1 million but not more than $10 million. (Your average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3.)
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You are not prohibited from using the cash method under section 448 of the Internal Revenue Code.
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Your principal business activity is an eligible business (described in Publication 538 and Revenue Procedure 2002-28).
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Merchandise or stock in trade.
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Raw materials.
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Work in process.
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Finished products.
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Supplies that physically become a part of the item intended for sale.
Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for production or resale activities. Include these costs in the basis of property you produce or acquire for resale, rather than claiming them as a current deduction. You recover the costs through depreciation, amortization, or cost of goods sold when you use, sell, or otherwise dispose of the property.
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Produce real or tangible personal property. For this purpose, tangible personal property includes a film, sound recording, video tape, book, or similar property.
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Acquire property for resale.
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Personal property you acquire for resale if your average annual gross receipts are $10 million or less.
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Property you produce if you meet either of the following conditions.
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Your indirect costs of producing the property are $200,000 or less.
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You use the cash method of accounting and do not account for inventories. For more information, see Inventories, earlier.
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There are special methods of accounting for certain items of income or expense. These include the following.
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Amortization, discussed in chapter 8 of Publication 535, Business Expenses.
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Bad debts, discussed in chapter 10 of Publication 535.
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Depletion, discussed in chapter 9 of Publication 535.
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Depreciation, discussed in Publication 946, How To Depreciate Property.
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Installment sales, discussed in Publication 537, Installment Sales.
Once you have set up your accounting method, you must generally get IRS approval before you can change to another method. A change in your accounting method includes a change in:
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Your overall method, such as from cash to an accrual method, and
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Your treatment of any material item.
To get approval, you must file Form 3115, Application for Change in Accounting Method. You can get IRS approval to change an accounting method under either the automatic change procedures or the advance consent request procedures. You may have to pay a user fee. For more information, see the form instructions.
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