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Taxmap/pubs/p538-003.htm#TXMP10363ba9 Cash Method

Cash Method

Most individuals and many small businesses use the cash method of accounting. Generally, however, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise. See Exceptions on page 21 for exceptions to this rule.

Taxmap/pubs/p538-003.htm#TXMP699aa7bb Income

Income

Under the cash method, you include in your gross income all items of income you actually or constructively receive during the tax year. If you receive property and services, you must include their fair market value in income.

Taxmap/pubs/p538-003.htm#TXMP32b47699 Constructive receipt.

Income is constructively received when an amount is credited to your account or made available to you without restriction. You need not have possession of it. If you authorize someone to be your agent and receive income for you, you are considered to have received it when your agent receives it. Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations.

Taxmap/pubs/p538-003.htm#TXMP072186cd
Example 1.

Interest is credited to your bank account in December 2003, but you do not withdraw it or enter it into your passbook until 2004. You must include the amount in gross income for 2003, not 2004.

Taxmap/pubs/p538-003.htm#TXMP3e152d18
Example 2.

You have interest coupons that mature and become payable in 2003, but you do not cash them until 2004. You must include the interest in gross income for 2003, the year of constructive receipt. You must include the interest in your 2003 income, even if you later exchange the coupons for other property, instead of cashing them.

Taxmap/pubs/p538-003.htm#TXMP2354ec09 Delaying receipt of income.

You cannot hold checks or postpone taking possession of similar property from one tax year to another to postpone paying tax on the income. You must report the income in the year the property is received or made available to you without restriction.

Taxmap/pubs/p538-003.htm#TXMP6e380815 Expenses

Expenses

Under the cash method, you generally deduct expenses in the tax year in which you actually pay them. This includes business expenses for which you contest liability. However, you may not be able to deduct an expense paid in advance and you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules.

Taxmap/pubs/p538-003.htm#TXMP0b8f460b Expense 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."

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.

• 12 months after the right or benefit begins, or
• The end of the tax year after the tax year in which payment is made.

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. See Change in Accounting Method, later, for information on how to get IRS approval.

Taxmap/pubs/p538-003.htm#TXMP6af43721
Example 1.

You are a calendar year taxpayer and you pay $3,000 in 2004 for a business insurance policy that is effective for three years, beginning July 1, 2004. 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. Therefore, $500 is deductible in 2004, $1,000 is deductible in 2005, $1,000 is deductible in 2006, and $500 is deductible in 2007.

Taxmap/pubs/p538-003.htm#TXMP11d82476
Example 2.

You are a calendar year taxpayer and you pay $10,000 on July 1, 2004, for a business insurance policy that is effective for one year beginning July 1, 2004. The 12-month rule applies. Therefore, the full $10,000 is deductible in 2004.

Taxmap/pubs/p538-003.htm#TXMP422dcfc3 Excluded Entities

The following entities cannot use the cash method, including any combination of methods that includes the cash method. (See Special rules for farming businesses, later.)

• A corporation (other than an S corporation) with average annual gross receipts exceeding $5 million. See Gross receipts test below.
• 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. See Gross receipts test below.
• A tax shelter.

Taxmap/pubs/p538-003.htm#TXMP78f7f165 Exceptions

The following entities are not prohibited from using the cash method of accounting.

• Any corporation or partnership, other than a tax shelter, that meets the gross receipts test for all tax years after 1985.
• A qualified personal service corporation (PSC).

Taxmap/pubs/p538-003.htm#TXMP4eb89cd9 Gross receipts test.

A corporation or partnership, other than a tax shelter, that meets the gross receipts test can generally use the cash method. 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. 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. See Gross receipts test for qualifying taxpayers on page 21 for more information on the gross receipts test. Generally, a partnership applies the test at the partnership level. Gross receipts for a short tax year are annualized.

Taxmap/pubs/p538-003.htm#TXMP4697a74f Aggregation rules.

Organizations that are members of an affiliated service group or a controlled group of corporations treated as a single employer for tax purposes are required to aggregate their gross receipts to determine whether the gross receipts test is met.

Taxmap/pubs/p538-003.htm#TXMP636e9e47 Change to accrual method.

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.

Taxmap/pubs/p538-003.htm#TXMP5d6e829d Special rules for farming businesses.

Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business. 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. 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). 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. For family corporations (defined in section 447(d)(2)(C)) engaged in farming, the exception applies if gross receipts were $25 million or less for each prior tax year after 1985. See section 447 and chapter 3 of Publication 225, Farmer's Tax Guide, for more information.

Taxmap/pubs/p538-003.htm#TXMP3759ee2e Qualified PSC.

A PSC that meets the following function and ownership tests can use the cash method.

Taxmap/pubs/p538-003.htm#TXMP2a2e44f7 Function test.

A corporation meets the function test if at least 95% of its activities are in the performance of services in the fields of health, veterinary services, law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts, or consulting.

Taxmap/pubs/p538-003.htm#TXMP3ab8d455 Ownership test.

A corporation meets the ownership test if at least 95% of its stock is owned, directly or indirectly, at all times during the year by one or more of the following.

1. Employees performing services for the corporation in a field qualifying under the function test.
2. Retired employees who had performed services in those fields.
3. The estate of an employee described in (1) or (2).
4. Any other person who acquired the stock by reason of the death of an employee referred to in (1) or (2), but only for the 2-year period beginning on the date of death.

Indirect ownership is generally taken into account if the stock is owned indirectly through one or more partnerships, S corporations, or qualified PSCs. Stock owned by one of these entities is considered owned by the entity's owners in proportion to their ownership interest in that entity. Other forms of indirect stock ownership, such as stock owned by family members, are generally not considered when determining if the ownership test is met.

For purposes of the ownership test, a person is not considered an employee of a corporation unless that person performs more than minimal services for the corporation.

Taxmap/pubs/p538-003.htm#TXMP532e2684 Change to accrual method.

A corporation that fails to meet the function test for any tax year or fails to meet the ownership test at any time during any tax year must change to an accrual method of accounting, effective for the year in which the corporation fails to meet either test. A corporation that fails to meet the function test or the ownership test is not treated as a qualified PSC for any part of that tax year.

Previous Page:  Publication 538 - Accounting Periods and Methods - Accounting Methods Next Page:  Publication 538 - Accounting Periods and Methods - Accrual Method Use     to find additional instances of index items.