Table of Contents
You must use a tax year to figure your taxable income. A tax year is an annual accounting period for keeping records and reporting income and expenses. An annual accounting period does not include a short tax year (discussed later). You can use the following tax years:
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A calendar year; or
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A fiscal year (including a 52-53-week 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. You cannot adopt a tax year by merely:
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Filing an application for an extension of time to file an income tax return;
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Filing an application for an employer identification number (Form SS-4); or
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Paying estimated taxes.
This section discusses:
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A calendar year.
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A fiscal year (including a period of 52 or 53 weeks).
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A short tax year.
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An improper tax year.
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A change in tax year.
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Special situations that apply to individuals.
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Restrictions that apply to the accounting period of a partnership, S corporation, or personal service corporation.
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Special situations that apply to corporations.
A calendar year is 12 consecutive months beginning on January 1st and ending on December 31st.
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.
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. See Change in Tax Year, later.
Generally, anyone can adopt the calendar year. However, you must adopt the calendar year if:
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You keep no books or records;
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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; or
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You are required to use a calendar year by a provision in the Internal Revenue Code or the Income Tax Regulations.
A fiscal year is 12 consecutive months ending on the last day of any month except December 31st. If you are allowed to adopt a fiscal year, you must maintain your books and records and report your income and expenses using the same 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. If you make this election, your 52-53-week tax year must always end on the same day of the week. Your 52-53-week tax year must always end on:
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Whatever date this same day of the week last occurs in a calendar month, or
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Whatever date this same day of the week falls that is nearest to the last day of the calendar month.
For example, if you elect a tax year that always ends on the last Monday in March, your 2006 tax year will end on March 26, 2007.
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The month in which the new 52-53-week tax year ends.
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The day of the week on which the tax year always ends.
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The date the tax year ends. It can be either of the following dates on which the chosen day:
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Last occurs in the month in (1), above, or
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Occurs nearest to the last day of the month in (1), above.
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Begin on the first day of the calendar month beginning nearest to the first day of the 52-53-week tax year, and
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End on the last day of the calendar month ending nearest to the last day of the 52-53-week tax year.
A short tax year is a tax year of less than 12 months. A short period tax return may be required when you (as a taxable entity):
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Are not in existence for an entire tax year, or
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Change your accounting period.
Tax on a short period tax return is figured differently for each situation.
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. 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.
Example 1.
XYZ Corporation was organized on July 1, 2007. It elected the calendar year as its tax year. Therefore, its first tax return was due March 17, 2008. This short period return will cover the period from July 1, 2007, through December 31, 2007.
Example 2.
A calendar year corporation dissolved on July 22, 2007. Its final return is due by October 15, 2007. It will cover the short period from January 1, 2007, through July 22, 2007.
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. 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.
Figure tax for a short year under the general rule, explained below. You may then be able to use a relief procedure, explained later, and claim a refund of part of the tax you paid.
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Determine your adjusted gross income (AGI) for the short tax year and then subtract your actual itemized deductions for the short tax year. You must itemize deductions when you file a short period tax return.
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Multiply the dollar amount of your exemptions by the number of months in the short tax year and divide the result by 12.
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Subtract the amount in (2) from the amount in (1). The result is your modified taxable income.
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Multiply the modified taxable income in (3) by 12, then divide the result by the number of months in the short tax year. The result is your annualized income.
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Figure the total tax on your annualized income using the appropriate tax rate schedule.
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Multiply the total tax by the number of months in the short tax year and divide the result by 12. The result is your tax for the short tax year.
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Figure the annualized alternative minimum taxable income (AMTI) for the short tax period by completing the following steps.
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Multiply the AMTI by 12.
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Divide the result by the number of months in the short tax year.
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Multiply the annualized AMTI by the appropriate rate of tax under section 55(b)(1). The result is the annualized AMT.
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Multiply the annualized AMT by the number of months in the short tax year and divide the result by 12.
Taxpayers that have adopted an improper tax year must change to a proper tax year under the requirements of Revenue Procedure 85-15 in Cumulative Bulletin 1985-1. 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. See Accounting Periods, earlier, for a description of permissible tax years.
To change to a proper tax year, you must do one of the following.
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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. Attach a completed Form 1128 to the amended tax return. Write “FILED UNDER REV. PROC. 85-15” at the top of Form 1128 and file the forms with the Internal Revenue Service Center where you filed your original return.
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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.
Generally, you must file Form 1128 to request IRS approval to change your tax year. See the Instructions for Form 1128 for exceptions. If you qualify for an automatic approval request, a user fee is not required.
Generally, individuals must adopt the calendar year as their tax year. 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.
Generally, partnerships, S corporations (including electing S corporations), and PSCs must use a required tax year. A required tax year is a tax year that is required under the Internal Revenue Code and Income Tax Regulations. 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. The following discussions provide the rules for partnerships, S corporations, and PSCs.
A partnership must conform its tax year to its partners' tax years unless any of the following apply.
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The partnership makes a section 444 election.
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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.
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The partnership can establish a business purpose for a different tax year.
The rules for the required tax year for partnerships are as follows.
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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.
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If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. A principal partner is one who has a 5% or more interest in the profits or capital of the partnership.
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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.
If a partnership changes to a required tax year because of these rules, it can get automatic approval by filing Form 1128.
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Figure the number of months of deferral for each partner using one partner's tax year. 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.
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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).
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Add the amounts in step (2) to get the aggregate (total) deferral for the tax year used in step (1).
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Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years.
Example.
A and B each have a 50% interest in partnership P, which uses a fiscal year ending June 30. A uses the calendar year and B uses a fiscal year ending November 30. 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.
Year End
12/31: |
Year
End |
Profits
Interest |
Months
of Deferral |
Interest
× Deferral |
A | 12/31 | 0.5 | -0- | -0- |
B | 11/30 | 0.5 | 11 | 5.5 |
Total Deferral | 5.5 | |||
Year End
11/30: |
Year
End |
Profits
Interest |
Months
of Deferral |
Interest
× Deferral |
A | 12/31 | 0.5 | 1 | 0.5 |
B | 11/30 | 0.5 | -0- | -0- |
Total Deferral | 0.5 |
All S corporations, regardless of when they became an S corporation, must use a permitted tax year. A permitted tax year is any of the following.
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The calendar year.
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A tax year elected under section 444. See Section 444 Election, below for details.
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A 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444.
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Any other tax year for which the corporation establishes a business purpose.
If an electing S corporation wishes to adopt a tax year other than a calendar year, it must request IRS approval using Form 2553, Election by a Small Business Corporation, instead of filing Form 1128. For information about changing an S corporation's tax year, see the Instructions for Form 1128. See also Revenue Procedure 2006-46 for automatic approval requests and Revenue Procedure 2002-39 or its successor for ruling requests.
A PSC must use a calendar tax year unless any of the following apply.
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The corporation makes an election under section 444. See Section 444 Election, below for details.
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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.
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The corporation establishes a business purpose for a fiscal year.
See the Instructions for Form 1120 for general information about PSCs. For information on adopting or changing tax years for PSCs, see the Instructions for Form 1128. See also Revenue Procedure 2006-46 for automatic approval requests and Revenue Procedure 2002-39 or its successor for ruling requests.
A partnership, S corporation, electing S corporation, or PSC can elect under section 444 to use a tax year other than its required tax year. Certain restrictions apply to the election. 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). 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.
A partnership, S corporation, or PSC can make a section 444 election if it meets all the following requirements.
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It is not a member of a tiered structure (defined in section 1.444-2T of the regulations).
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It has not previously had a section 444 election in effect.
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It elects a year that meets the deferral period requirement.
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Three months, or
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The deferral period of the tax year being changed. This is the tax year immediately preceding the year for which the partnership, S corporation, or PSC wishes to make the section 444 election.
Example 1.
BD Partnership uses a calendar year, which is also its required tax year. BD cannot make a section 444 election because the deferral period is zero.
Example 2.
E, a newly formed partnership, began operations on December 1, 2002. E is owned by calendar year partners. E wants to make a section 444 election to adopt a September 30 tax year. E's deferral period for the tax year beginning December 1, 2002, is 3 months, the number of months between September 30 and December 31.
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The due date (not including extensions) of the income tax return for the tax year resulting from the section 444 election, or
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The 15th day of the 6th month of the tax year for which the election will be effective. For this purpose, count the month in which the tax year begins, even if it begins after the first day of that month.
Example 1.
AB, a partnership, begins operations on September 13, 2007, and is qualified to make a section 444 election to use a September 30 tax year for its tax year beginning September 13, 2007. AB must file Form 8716 by January 15, 2008, which is the due date of the partnership's tax return for the period from September 13, 2007, to September 30, 2007.
Example 2.
The facts are the same as in Example 1 except that AB begins operations on October 21, 2007. AB must file Form 8716 by March 17, 2008, the 15th day of the 6th month of the tax year for which the election will first be effective.
Example 3.
B is a corporation that first becomes a PSC for its tax year beginning September 1, 2007. B qualifies to make a section 444 election to use a September 30 tax year for its tax year beginning September 1, 2007. B must file Form 8716 by December 17, 2007, the due date of the income tax return for the short period from September 1, 2007, to September 30, 2007.
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The entity changes to its required tax year.
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The entity liquidates.
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The entity becomes a member of a tiered structure.
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The IRS determines that the entity willfully failed to comply with the required payments or distributions.
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An S corporation's S election is terminated. However, if the S corporation immediately becomes a PSC, the PSC can continue the section 444 election of the S corporation.
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A PSC ceases to be a PSC. If the PSC elects to be an S corporation, the S corporation can continue the election of the PSC.
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The section 444 election is in effect.
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The required payment for that year (or any preceding tax year) is more than $500.
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May 15 of the calendar year following the calendar year in which the applicable election year begins.
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60 days after the partnership or S corporation has been notified by the IRS that the business year request has been denied.
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).
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. 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.
A new corporation establishes its tax year when it files its first tax return. 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. An S corporation or a Personal Service Corporation (PSC) must use the required tax year rules, discussed earlier, to establish a tax year. 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. See the Instructions for Form 1128 for details.
An accounting method is a set of rules used to determine when income and expenses are reported. Your accounting method includes not only your overall method of accounting, but also the accounting treatment you use for any material item.
You choose an accounting method when you file your first tax return. If you later want to change your accounting method, you must get IRS approval. See Change in Accounting Method, later.
No single accounting method is required of all taxpayers. You must use a system that clearly reflects your income and expenses and you must maintain records that will enable you to file a correct return. In addition to your permanent books of account, you must keep any other records necessary to support the entries on your books and tax returns.
You must use the same accounting method from year to year. An accounting method clearly reflects income only if all items of gross income and expenses are treated the same from year to year.
If you do not regularly use an accounting method that clearly reflects your income, your income will be refigured under the method that, in the opinion of the IRS, does clearly reflect your income.
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Cash method.
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Accrual method.
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Special methods of accounting for certain items of income and expenses.
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Combination (hybrid) method using elements of two or more of the above.
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Publication 225, Farmer's Tax Guide.
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Publication 535, Business Expenses.
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Publication 537, Installment Sales.
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Publication 946, How To Depreciate Property.
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If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales. See Exceptions under Inventories, later. Generally, you can use the cash method for all other items of income and expenses. See Inventories, later.
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If you use the cash method for reporting 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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Any combination that includes the cash method is treated as the cash method for purposes of section 448.
Note.
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.
Most individuals and many small businesses use the cash method of accounting. Generally, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise. See Inventories for exceptions to this rule.
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 (FMV) in 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.
Under the cash method, generally, you 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. Instead, you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules.
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12 months after the right or benefit begins, or
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The end of the tax year after the tax year in which payment is made.
Example 1.
You are a calendar year taxpayer and pay $3,000 in 2007 for a business insurance policy that is effective for three years (36 months), beginning on July 1, 2007. 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, only $500 (6/36 x $3,000) is deductible in 2007, $1,000 (12/36 x $3,000) is deductible in 2008, $1,000 (12/36 x $3,000) is deductible in 2009, and the remaining $500 is deductible in 2010.
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.)
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A corporation (other than an S corporation) with average annual gross receipts exceeding $5 million. See Gross receipts test, below.
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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.
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A tax shelter.
The following entities are not prohibited from using the cash method of accounting.
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Any corporation or partnership, other than a tax shelter, that meets the gross receipts test for all tax years after 1985.
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A qualified personal service corporation (PSC).
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Adding the gross receipts for that tax year and the 2 preceding tax years; and
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Dividing the total by 3.
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Employees performing services for the corporation in a field qualifying under the function test.
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Retired employees who had performed services in those fields.
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The estate of an employee described in (1) or (2).
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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.
Under an accrual method of accounting, generally you 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.
Generally, you include an amount as 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. Under this rule, you report an amount in your gross income on the earliest of the following dates.
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When you receive payment.
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When the income amount is due to you.
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When you earn the income.
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When title has passed.
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. 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. However, you cannot postpone including any payment beyond that tax year.
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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.
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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.
Example 1.
You manufacture, sell, and service computers. You received payment in 2007 for a one-year contingent service contract on a computer you sold. You can postpone including in income the part of the payment you did not earn in 2007 if, in the normal course of your business, you offer computers for sale without a contingent service contract.
Example 2.
You are in the television repair business. You received payments in 2007 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. You include the payments in gross income as you earn them.
Example 3.
You own a dance studio. On October 1, 2007, you receive payment for a one-year contract for 48 one-hour lessons beginning on that date. You give eight lessons in 2007. Under this method of including advance payments, you must include one-sixth (8/48) of the payment in income for 2007, and five-sixths (40/48) of the payment in 2008, even if you do not give all the lessons by the end of 2008.
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. 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. An agreement includes a gift certificate that can be redeemed for goods. Amounts due and payable are considered received.
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Include advance payments in gross receipts under the method of accounting you use for tax purposes, or
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Include any part of advance payments in income for financial reports under the method of accounting used for those reports. Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements.
Example 1.
You are a retailer. You use an accrual method of accounting and account for the sale of goods when you ship the goods. You use this method for both tax and financial reporting purposes. 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. However, see Exception for inventory goods, later.
Example 2.
You are a calendar year taxpayer. You manufacture household furniture and use an accrual method of accounting. Under this method, you accrue income for your financial reports when you ship the furniture. For tax purposes, you do not accrue income until the furniture has been delivered and accepted.
In 2007, you received an advance payment of $8,000 for an order of furniture to be manufactured for a total price of $20,000. You shipped the furniture to the customer in December 2007, but it was not delivered and accepted until January 2008. For tax purposes, you include the $8,000 advance payment in gross income for 2007; and include the remaining $12,000 of the contract price in gross income for 2008.
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Total advance payments received in the current tax year.
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Total advance payments received in earlier tax years and not included in income before the current tax year.
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Total payments received in earlier tax years included in income for the current tax year.
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You account for the advance payment under the alternative method (discussed earlier).
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You have received a substantial advance payment on the agreement (discussed next).
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You have enough substantially similar goods on hand, or available through your normal source of supply, to satisfy the agreement.
Note.
You must report any advance payments you receive after the second year in the year received. No further deferral is allowed.
Example.
You are a calendar year, accrual method taxpayer who accounts for advance payments under the alternative method. In 2004, you entered into a contract for the sale of goods properly includible in your inventory. The total contract price is $50,000 and you estimate that your total inventoriable costs for the goods will be $25,000. You receive the following advance payments under the contract.
2004 | $17,500 |
2005 | 10,000 |
2006 | 7,500 |
2007 | 5,000 |
2008 | 5,000 |
2009 | 5,000 |
Total contract price | $50,000 |
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 is 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.
Generally, you cannot deduct or capitalize a business expense until economic performance occurs. 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. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.
Example.
You are a calendar year taxpayer. You buy office supplies in December 2007. You receive the supplies and the bill in December, but you pay the bill in January 2008. You can deduct the expense in 2007 because all events have occurred to fix the fact of liability, the liability can be determined, and economic performance occurred in 2007.
Your office supplies may qualify as a recurring item, discussed later. If so, you can deduct them in 2007, even if the supplies are not delivered until 2008 (when economic performance occurs).
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The all-events test, discussed earlier, is met.
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Economic performance occurs by the earlier of the following dates.
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8½ months after the close of the year.
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The date you file a timely return (including extensions) for the year.
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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.
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Either:
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The item is not material, or
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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.
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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.
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12 months after the right or benefit begins, or
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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. See Expense paid in advance under Cash Method, earlier, for examples illustrating the application of the general and 12-month rules.
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. Determine the relationship for this rule as of the end of the tax year for which the expense or interest would otherwise be deductible. See section 267 and Publication 542, Corporations, for the definition of related person.
An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales. However, see Exceptions, next. See also Accrual Method, earlier.
To figure taxable income, you must value your inventory at the beginning and end of each tax year. To determine the value, you need a method for identifying the items in your inventory and a method for valuing these items. See Identifying Cost and Valuing Inventory, later.
The rules for valuing inventory are not the same for all businesses. The method you use must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Your inventory practices must be consistent from year to year.
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.
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.
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).
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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). Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $1 million or less.
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You are not a tax shelter as defined under section 448(d)(3).
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Step 1. List each of the test years. For qualifying taxpayers under Revenue Procedure 2001-10, the test years are each prior tax year ending on or after December 17, 1998. For 2007, the test years are 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005, and 2006 for a calendar year taxpayer.
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Step 2. Determine your average annual gross receipts for each test year listed in Step 1. 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. For example, if gross receipts are $200,000 for 1998, $800,000 for 1999, and $1,100,000 for 2000, the average annual gross receipts for 2000 are $700,000 (($200,000 + $800,000 + $1,100,000) ÷ 3 = $700,000). See section 5 of Revenue Procedure 2001-10 for more information.
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Step 3. 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.
Table 1. 2007 Gross Receipts Test for Qualifying Taxpayers under Revenue Procedure 2001-10
Step 1. Test year (prior tax years ending on or after December 17, 1998). | Step 2. Determine your average annual gross receipts for each test year. |
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1998 | (1996 + 1997 + 1998) ÷ 3 |
1999 | (1997 + 1998 + 1999) ÷ 3 |
2000 | (1998 + 1999 + 2000) ÷ 3 |
2001 | (1999 + 2000 + 2001) ÷ 3 |
2002 | (2000 + 2001 + 2002) ÷ 3 |
2003 | (2001 + 2002 + 2003) ÷ 3 |
2004 | (2002 + 2003 + 2004) ÷ 3 |
2005 | (2003 + 2004 + 2005) ÷ 3 |
2006 | (2004 + 2005 + 2006) ÷ 3 |
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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). Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $10 million or less.
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You are not prohibited from using the cash method under section 448.
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Your principle business activity is an eligible business. See Eligible business, later.
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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.
Note.
Revenue Procedure 2002-28 does not apply to a farming business of a qualifying small business taxpayer. A taxpayer engaged in the trade or business of farming generally is allowed to use the cash method for any farming business. See Special rules for farming businesses under Cash Method, earlier.
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Step 1. List each of the test years. 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. For 2007, the test years are 2000, 2001, 2002, 2003, 2004, 2005, and 2006 for a calendar year taxpayer.
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Step 2. Determine your average annual gross receipts for each test year listed in Step 1. 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. For example, if gross receipts are $6 million for 2005, $9 million for 2006, and $12 million for 2007, the average annual gross receipts for 2007 are $9 million (($6 million + $9 million + $12 million) ÷ 3 = $9 million). See section 5 of Revenue Procedure 2002-28 for more information.
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Step 3. 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.
Table 2. 2007 Gross Receipts Test for Qualifying Small Business Taxpayers under Revenue Procedure 2002-28
Step 1. Test year (prior tax years ending on or after December 31, 2000). | Step 2. Determine your average annual gross receipts for each test year. |
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2000 | (1998 + 1999+ 2000) ÷ 3 |
2001 | (1999 + 2000 + 2001) ÷ 3 |
2002 | (2000 + 2001 + 2002) ÷ 3 |
2003 | (2001 + 2002 + 2003) ÷ 3 |
2004 | (2002 + 2003 + 2004) ÷ 3 |
2005 | (2003 + 2004 + 2005) ÷ 3 |
2006 | (2004 + 2005 + 2006) ÷ 3 |
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Your principal business activity is described in a North American Industry Classification System (NAICS) code other than any of the following.
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NAICS codes 211 and 212 (mining activities).
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NAICS codes 31-33 (manufacturing).
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NAICS code 42 (wholesale trade).
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NAICS codes 44-45 (retail trade).
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NAICS codes 5111 and 5122 (information industries).
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Your principal business activity is the provision of services, including the provision of property incident to those services.
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Your principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications.
Your inventory should include all of the following.
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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.
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Purchased merchandise if title has passed to you, even if the merchandise is in transit or you do not have physical possession for another reason.
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Goods under contract for sale that you have not yet segregated and applied to the contract.
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Goods out on consignment.
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Goods held for sale in display rooms, merchandise mart rooms, or booths located away from your place of business.
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Goods you have sold, but only if title has passed to the buyer.
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Goods consigned to you.
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Goods ordered for future delivery if you do not yet have title.
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Land, buildings, and equipment used in your business.
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Notes, accounts receivable, and similar assets.
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Real estate held for sale by a real estate dealer in the ordinary course of business.
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Supplies that do not physically become part of the item intended for sale.
Special rules apply to the cost of inventory or property imported from a related person. See the regulations under section 1059A.
Use the specific identification method when you can identify and match the actual cost to the items in inventory.
Use the FIFO or LIFO method, explained next, if:
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You cannot specifically identify items with their costs.
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The same type of goods are intermingled in your inventory and they cannot be identified with specific invoices.
The FIFO (first-in first-out) method assumes the items you purchased or produced first are the first items you sold, consumed, or otherwise disposed of. The items in inventory at the end of the tax year are matched with the costs of similar items that you most recently purchased or produced.
The LIFO (last-in first-out) method assumes the items of inventory you purchased or produced last are the first items you sold, consumed, or otherwise disposed of. Items included in closing inventory are considered to be from the opening inventory in the order of acquisition and from those acquired during the tax year.
Each method produces different income results, depending on the trend of price levels at the time. In times of inflation, when prices are rising, LIFO will produce a larger cost of goods sold and a lower closing inventory. Under FIFO, the cost of goods sold will be lower and the closing inventory will be higher. However, in times of falling prices, the opposite will hold.
The value of your inventory is a major factor in figuring your taxable income. The method you use to value the inventory is very important.
The following methods, described below, are those generally available for valuing inventory.
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Cost.
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Lower of cost or market.
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Retail.
To properly value your inventory at cost, you must include all direct and indirect costs associated with it. The following rules apply.
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For merchandise on hand at the beginning of the tax year, cost means the ending inventory price of the goods.
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For merchandise purchased during the year, cost means the invoice price minus appropriate discounts plus transportation or other charges incurred in acquiring the goods. It can also include other costs that have to be capitalized under the uniform capitalization rules of section 263A.
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For merchandise produced during the year, cost means all direct and indirect costs that have to be capitalized under the uniform capitalization rules.
Under the lower of cost or market method, compare the market value of each item on hand on the inventory date with its cost and use the lower of the two as its inventory value.
This method applies to the following.
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Goods purchased and on hand.
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The basic elements of cost (direct materials, direct labor, and certain indirect costs) of goods being manufactured and finished goods on hand.
This method does not apply to the following. They must be inventoried at cost.
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Goods on hand or being manufactured for delivery at a fixed price on a firm sales contract (that is, not legally subject to cancellation by either you or the buyer).
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Goods accounted for under the LIFO method.
Example.
Under the lower of cost or market method, the following items would be valued at $600 in closing inventory.
Item | Cost | Market | Lower |
R | $300 | $500 | $300 |
S | 200 | 100 | 100 |
T | 450 | 200 | 200 |
Total | $950 | $800 | $600 |
You must value each item in the inventory separately. You cannot value the entire inventory at cost ($950) and at market ($800) and then use the lower of the two figures.
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Specific purchases or sales you or others made in reasonable volume and in good faith.
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Compensation amounts paid for cancellation of contracts for purchase commitments.
Under the retail method, the total retail selling price of goods on hand at the end of the tax year in each department or of each class of goods is reduced to approximate cost by using an average markup expressed as a percentage of the total retail selling price.
To figure the average markup, apply the following steps in order.
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Add the total of the retail selling prices of the goods in the opening inventory and the retail selling prices of the goods you bought during the year (adjusted for all markups and markdowns).
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Subtract from the total in (1) the cost of goods included in the opening inventory plus the cost of goods you bought during the year.
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Divide the balance in (2) by the total selling price in (1). The result is the average markup percentage.
Then determine the approximate cost in three steps.
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Subtract the sales at retail from the total retail selling price. The result is the closing inventory at retail.
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Multiply the closing inventory at retail by the average markup percentage. The result is the markup in closing inventory.
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Subtract the markup in (2) from the closing inventory at retail. The result is the approximate closing inventory at cost.
Example.
Your records show the following information on the last day of your tax year.
Retail | ||
Item | Cost | Value |
Opening inventory | $52,000 | $60,000 |
Purchases | 53,000 | 78,500 |
Sales | 98,000 | |
Markups | 2,000 | |
Markdowns | 500 | |
Using the retail method, determine your closing inventory as follows.
Retail | ||
Item | Cost | Value |
Opening inventory | $52,000 | $60,000 |
Plus: Purchases | 53,000 | 78,500 |
Net markups | ||
($2,000 - $500 markdowns) | 1,500 | |
Total | $105,000 | $140,000 |
Minus: Sales | 98,000 | |
Closing inventory at retail | $42,000 | |
Minus: Markup* (.25 × $42,000) | 10,500 | |
Closing inventory at cost | $31,500 | |
* See Markup percentage, next, for an explanation of how the markup percentage (25%) was figured for this example. |
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State that you are using the retail method on your tax return.
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Keep accurate records.
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Use this method each year unless the IRS allows you to change to another method.
You can figure the cost of goods on hand by either a perpetual or book inventory if inventory is kept by following sound accounting practices. Inventory accounts must be charged with the actual cost of goods purchased or produced and credited with the value of goods used, transferred, or sold. Credits must be determined on the basis of the actual cost of goods acquired during the year and their inventory value at the beginning of the tax year.
You claim a casualty or theft loss of inventory, including items you hold for sale to customers, through the increase in the cost of goods sold by properly reporting your opening and closing inventories. You cannot claim the loss again as a casualty or theft loss. Any insurance or other reimbursement you receive for the loss is taxable.
You can choose to claim the loss separately as a casualty or theft loss. If you claim the loss separately, adjust opening inventory or purchases to eliminate the loss items and avoid counting the loss twice.
If you claim the loss separately, reduce the loss by the reimbursement you receive or expect to receive. If you do not receive the reimbursement by the end of the year, you cannot claim a loss for any amounts you reasonably expect to recover.
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.
Special uniform capitalization rules apply to a farming business. See chapter 6 in Publication 225.
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Produce real or tangible personal property.
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Acquire property for resale. However, this rule does not apply to personal property if your average annual gross receipts are $10 million or less.
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Resellers of personal property with average annual gross receipts of $10 million or less (small resellers).
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Property produced to use as personal or nonbusiness property or for uses not connected with a trade or business or an activity conducted for profit.
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Research and experimental expenditures deductible under section 174.
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Intangible drilling and development costs of oil and gas or geothermal wells or any amortization deduction allowable under section 59(e) for intangible drilling, development, or mining exploration expenditures.
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Property produced under a long-term contract, except for certain home construction contracts described in section 460(e)(1).
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Timber and certain ornamental trees raised, harvested, or grown, and the underlying land.
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Qualified creative expenses paid or incurred as a free-lance (self-employed) writer, photographer, or artist that are otherwise deductible on your tax return.
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Costs allocable to natural gas acquired for resale to the extent these costs would otherwise be allocable to cushion gas stored underground.
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Property produced if substantial construction occurred before March 1, 1986.
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Property provided to customers in connection with providing services. It must be de minimus in amount and not be included in inventory in the hands of the service provider.
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Loan origination.
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The costs of certain producers who use a simplified production method and whose total indirect costs are $200,000 or less. See section 1.263A-2(b)(3)(iv) of the regulations for more information.
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A writer is an individual who creates a literary manuscript, a musical composition (including any accompanying words), or a dance score.
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A photographer is an individual who creates a photograph or photographic negative or transparency.
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An artist is an individual who creates a picture, painting, sculpture, statue, etching, drawing, cartoon, graphic design, or original print item. The originality and uniqueness of the item created and the predominance of aesthetic value over utilitarian value of the item created are taken into account.
Generally, you can choose any permitted accounting method when you file your first tax return. You do not need to obtain IRS approval to choose the initial accounting method. You must, however, use the method consistently from year to year and it must clearly reflect your income. See Accounting Methods, earlier.
Once you have set up your accounting method and filed your first return, generally, you must receive approval from the IRS before you change the method. In general, you must file a current Form 3115 to request a change in either an overall accounting method or the accounting treatment of any item.
A change in your accounting method includes a change not only in your overall system of accounting but also in the treatment of any material item. A material item is one that affects the proper time for inclusion of income or allowance of a deduction. Although an accounting method can exist without treating an item consistently, an accounting method is not established for that item, in most cases, unless the item is treated consistently.
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A change from the cash method to an accrual method or vice versa.
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A change in the method or basis used to value inventory.
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A change in the depreciation or amortization method (except for certain permitted changes to the straight-line method).
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Correction of a math or posting error.
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Correction of an error in figuring tax liability (such as an error in figuring a credit).
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An adjustment of any item of income or deduction that does not involve the proper time for including it in income or deducting it.
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Certain adjustments in the useful life of a depreciable or amortizable asset.
You can get help with unresolved tax issues, order free publications and forms, ask tax questions, and get information from the IRS in several ways. By selecting the method that is best for you, you will have quick and easy access to tax help.
Internet. You can access the IRS website at www.irs.gov 24 hours a day, 7 days a week to:
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E-file your return. Find out about commercial tax preparation and e-file services available free to eligible taxpayers.
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Check the status of your 2007 refund. Click on Where's My Refund. Wait at least 6 weeks from the date you filed your return (3 weeks if you filed electronically). Have your 2007 tax return available because you will need to know your social security number, your filing status, and the exact whole dollar amount of your refund.
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Download forms, instructions, and publications.
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Order IRS products online.
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Research your tax questions online.
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Search publications online by topic or keyword.
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View Internal Revenue Bulletins (IRBs) published in the last few years.
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Figure your withholding allowances using the withholding calculator online at
www.irs.gov/individuals. -
Determine if Form 6251 must be filed using our Alternative Minimum Tax (AMT) Assistant.
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Sign up to receive local and national tax news by email.
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Get information on starting and operating a small business.
Phone. Many services are available by phone.
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Ordering forms, instructions, and publications. Call 1-800-829-3676 to order current-year forms, instructions, and publications, and prior-year forms and instructions. You should receive your order within 10 days.
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Asking tax questions. Call the IRS with your tax questions at 1-800-829-1040 (for individuals) or 1-800-829-4933 (for businesses).
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Solving problems. You can get face-to-face help solving tax problems every business day in IRS Taxpayer Assistance Centers. An employee can explain IRS letters, request adjustments to your account, or help you set up a payment plan. Call your local Taxpayer Assistance Center for an appointment. To find the number, go to www.irs.gov/localcontacts or look in the phone book under United States Government, Internal Revenue Service.
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TTY/TDD equipment. If you have access to TTY/TDD equipment, call 1-800-829-4059 to ask tax questions or to order forms and publications.
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TeleTax topics. Call 1-800-829-4477 to listen to pre-recorded messages covering various tax topics.
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Refund information. To check the status of your 2007 refund, call 1-800-829-4477 and press 1 for automated refund information or call 1-800-829-1954. Be sure to wait at least 6 weeks from the date you filed your return (3 weeks if you filed electronically). Have your 2007 tax return available because you will need to know your social security number, your filing status, and the exact whole dollar amount of your refund.
Evaluating the quality of our telephone services. To ensure IRS representatives give accurate, courteous, and professional answers, we use several methods to evaluate the quality of our telephone services. One method is for a second IRS representative to listen in on or record random telephone calls. Another is to ask some callers to complete a short survey at the end of the call.
Walk-in. Many products and services are available on a walk-in basis.
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Products. You can walk in to many post offices, libraries, and IRS offices to pick up certain forms, instructions, and publications. Some IRS offices, libraries, grocery stores, copy centers, city and county government offices, credit unions, and office supply stores have a collection of products available to print from a CD or photocopy from reproducible proofs. Also, some IRS offices and libraries have the Internal Revenue Code, regulations, Internal Revenue Bulletins, and Cumulative Bulletins available for research purposes.
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Services. You can walk in to your local Taxpayer Assistance Center every business day for personal, face-to-face tax help. An employee can explain IRS letters, request adjustments to your tax account, or help you set up a payment plan. If you need to resolve a tax problem, have questions about how the tax law applies to your individual tax return, or you're more comfortable talking with someone in person, visit your local Taxpayer Assistance Center where you can spread out your records and talk with an IRS representative face-to-face. No appointment is necessary, but if you prefer, you can call your local Center and leave a message requesting an appointment to resolve a tax account issue. A representative will call you back within 2 business days to schedule an in-person appointment at your convenience. To find the number, go to www.irs.gov/localcontacts or look in the phone book under United States Government, Internal Revenue Service.
Mail. You can send your order for forms, instructions, and publications to the address below. You should receive a response within 10 days after your request is received.
National Distribution Center
P.O. Box 8903
Bloomington, IL 61702-8903
CD/DVD for tax products. You can order Publication 1796, IRS Tax Products CD/DVD, and obtain:
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Current-year forms, instructions, and publications.
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Prior-year forms, instructions, and publications.
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Bonus: Historical Tax Products DVD - Ships with the final release.
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Tax Map: an electronic research tool and finding aid.
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Tax law frequently asked questions.
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Tax Topics from the IRS telephone response system.
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Fill-in, print, and save features for most tax forms.
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Internal Revenue Bulletins.
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Toll-free and email technical support.
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The CD which is released twice during the year.
- The first release will ship the beginning of January 2008.
- The final release will ship the beginning of March 2008.
Purchase the CD/DVD from National Technical Information Service (NTIS) at www.irs.gov/cdorders for $35 (no handling fee) or call 1-877-CDFORMS (1-877-233-6767) toll free to buy the CD/DVD for $35 (plus a $5 handling fee). Price is subject to change.
CD for small businesses. Publication 3207, The Small Business Resource Guide CD for 2007, is a must for every small business owner or any taxpayer about to start a business. This year's CD includes:
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Helpful information, such as how to prepare a business plan, find financing for your business, and much more.
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All the business tax forms, instructions, and publications needed to successfully manage a business.
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Tax law changes for 2007.
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Tax Map: an electronic research tool and finding aid.
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Web links to various government agencies, business associations, and IRS organizations.
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“Rate the Product” survey—your opportunity to suggest changes for future editions.
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A site map of the CD to help you navigate the pages of the CD with ease.
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An interactive “Teens in Biz” module that gives practical tips for teens about starting their own business, creating a business plan, and filing taxes.
An updated version of this CD is available each year in early April. You can get a free copy by calling 1-800-829-3676 or by visiting www.irs.gov/smallbiz.
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