Ind Accounting

March 13, 2024

9058 / What is inventory accounting? What methods are generally used by taxpayers to account for inventory?

Editor's Note: Under the 2017 tax reform legislation, taxpayers that meet the gross receipts test (see Q <a href="javascript:void(0)">9044</a>) are no longer required to account for inventory under IRC Section 471 and can instead use a method of accounting for inventory that either (1) treats inventory as non-incidental materials and supplies or (2) matches the taxpayer's method of inventory accounting as used for financial accounting purposes.<a href="#_ftn1">1</a> Under prior law, taxpayers were only permitted to account for inventory as materials and supplies that are non-incidental if they had average gross receipts of less than $10 million.<a href="#_ftn2">2</a> Taxpayers that fail the gross receipts test are not eligible for the new rules governing inventory accounting. The $25 million threshold will be indexed annually for inflation; the 2026 amount is $32 million. The new rules governing inventory accounting are effective for tax years beginning after December 31, 2017. Inventory accounting is generally required in any case where the IRS feels it is necessary in order to accurately reflect a taxpayer's income (but see Editor's Note, above). Inventory accounting usually becomes important in cases where the taxpayer's business involves the production and sale of goods or the purchase and resale of goods. As a general principle, IRC Section 471 has historically required that a taxpayer's inventory accounting method must: (1) conform as closely as reasonably possible to the best accounting practice used in the taxpayer's business<a href="#_ftn3">3</a> and (2) clearly reflect the taxpayer's income.<a href="#_ftn4">4</a> Under the regulations, therefore, there is no one particular accounting method that must be used in all circumstances to account for inventory. Instead, the method chosen must reflect the realities of the taxpayer's business. As such, greater weight is given to consistency than to the actual valuation method chosen.<a href="#_ftn5">5</a> There are various methods of inventory accounting, including first-in, first-out (FIFO), last-in, first-out (LIFO) and specific identification methods. The FIFO method of accounting assumes that the first items of inventory purchased by the taxpayer are the first items that are sold. As such, the inventory that remains at the end of the taxpayer's accounting period is valued based on the most recent purchase price.<a href="#_ftn6">6</a> Conversely, under the LIFO method, the most recent items of inventory that are purchased are considered to be the first items sold. Under the LIFO method, inventory is valued based on its cost, rather than its market value.<a href="#_ftn7">7</a> Rather than focusing on the flow of inventory, the specific identification method requires that the taxpayer keep records so that it may assign a specific cost to each item of inventory.<a href="#_ftn8">8</a> Certain taxpayers are either prohibited or are given the option to not use the inventory method of accounting. They include: (1) Real estate dealers – A taxpayer that is in the business of selling real properties is not permitted to use the inventory method;<a href="#_ftn9">9</a>(2) Farmers – A taxpayer engaged in a farming business may use either the inventory or the cash method in reporting income;<a href="#_ftn10">10</a>(3) Real estate investment mortgage units are exclusively governed by Sections 860A through 860G.<a href="#_ftn11">11</a> These entities are not permitted to use the inventory methods under Section 471. Though greater weight is given to consistency than to the method of inventory accounting chosen, certain inventory accounting methods are specifically prohibited under Treasury Regulation Section 1.471-2(f), including the following: (1) Deducting a reserve for price changes or an estimated depreciation in the value of inventory;(2) Carrying inventory at a nominal price or at less than its proper value;(3) Omitting portions of the inventory;(4) Using a base-stock method based on a normal quantity and constant price;(5) Including in-transit goods in inventory where title to such goods is not yet vested in the taxpayer;(6) Using a direct cost method by a manufacturer, under which only direct production costs and variable overhead costs are allocated to inventory; and(7) Using a prime cost method by a manufacturer, under which only direct production costs are allocated to inventory. If a taxpayer has used a prohibited inventory method, IRS consent is still required to change the method unless automatic approval is available under Revenue Procedure 2011-14 (see Q <a href="javascript:void(0)">9042</a>).<a href="#_ftn12">12</a><hr></hr> Planning Point: FIFO or LIFO? Choosing LIFO is enticing in a capital-heavy business when the costs of the goods sold are increasing. This will reduce the current tax burden. However, LIFO often increases administrative time and paperwork. LIFO can affect valuation in the sale of a business as it postpones the inevitable until the sale of the business. Technology businesses often exist in a deflationary world, where the costs of their inventory decrease as computing power (and other technologies) increase year over year. FIFO is also accepted by the International Financial Reporting Standards Board (IFRS), and LIFO is not. <hr></hr><hr align="left" size="1" width="33%"></hr> <a href="#_ftnref1">1</a>. IRC § 471(c)(1). <a href="#_ftnref2">2</a>. IRC § 471. <a href="#_ftnref3">3</a>. Geometric Stamping Co. v. Comm., 26 TC 301 (1956), acq., 1958-1 CB 4 (re: importance of consistency). <a href="#_ftnref4">4</a>. Treas. Reg. § 1.471-2(c). See also Walmart v. Comm., TC Memo 1997-1 (8th Cir. 1998) (upholding the estimate for inventory shrinkage). <a href="#_ftnref5">5</a>. Treas. Reg. § 1.471-2(b). <a href="#_ftnref6">6</a>. Treas. Reg. § 1.471-2(d); ARB No. 43, Chapter 4, Statement 4 (AICPA, 1953) (FASB Accounting Standards Codification 330-10-30). <a href="#_ftnref7">7</a>. IRC § 472(b)(2). <a href="#_ftnref8">8</a>. Treas. Reg. § 1.471-2(d). <a href="#_ftnref9">9</a>. Rev. Rul. 69-536, 1969-2 CB 109, amplified in Rev. Rul. 86-149, 1986-2 CB 67; Atlantic Coast Realty Co. v. Comm., 11 BTA 416 (1928); Miller Development Co. v. Comm., 81 TC 619 (1983). <a href="#_ftnref10">10</a>. Treas. Reg. § 1.471-6(a). <a href="#_ftnref11">11</a>. Rev. Rul. 95-81. <a href="#_ftnref12">12</a>. Treas. Reg. § 1.446-1(e)(2)(i).

March 13, 2024

9053 / What special accounting rules apply in the installment sale context if the sale involves related parties?

<div class="Section1"> Under IRC Section 453(e)(1), if a taxpayer (“first seller”) disposes of property to a related person in an installment sale (“first sale”), and the related party in turn sells the property in a second sale before the first seller receives all payments under the first sale, the amount realized in the second sale will be treated as received by the first seller. This is the case even though the first seller has actually not received all payments due with respect to the first sale.<a href="#_ftn1" name="_ftnref1">1</a> Essentially, the payments received from the second sale are treated as though they were used to pay off the first sale even if, in reality, the second seller has made no payments. The purpose of this treatment is to prevent a taxpayer from improperly deferring gain on the sale of property by using the installment method of accounting. In order for the related party rules to apply, the second sale must occur within two years of the first sale unless the property at issue consists of marketable securities.<a href="#_ftn2" name="_ftnref2">2</a> For purposes of the installment sale rules, “related party” includes the seller’s siblings, ancestors, lineal descendants, certain controlled corporations (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8964">8964</a>) and estates, trusts and partnerships in which the seller has an interest.<a href="#_ftn3" name="_ftnref3">3</a> If the second sale occurs as a result of an involuntary conversion under IRC Section 1033 (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8670">8670</a>), the second sale will not be treated as a “second sale” under these rules if the first sale was made before the threat of the involuntary conversion arose.<a href="#_ftn4" name="_ftnref4">4</a> Further, a second sale will not be deemed to have occurred for purposes of these rules if the sale occurs after the death of either the first seller or the related party who acquires the property in the first sale.<a href="#_ftn5" name="_ftnref5">5</a> If the parties are able to prove that the sales were not motivated by tax avoidance, the related party rules will not apply.<a href="#_ftn6" name="_ftnref6">6</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 453(e). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 453(e)(2). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC §§ 453(f), 318(a), 267(b). <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 453(e)(6). <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 453(e)(6)(C). <a href="#_ftnref6" name="_ftn6">6</a>.  IRC § 453(e)(7). </div></div>

March 13, 2024

9055 / What types of contracts are considered "long-term contracts" for purposes of determining the proper method of accounting?

<div class="Section1"> Editor’s Note: The 2017 tax reform legislation expands the exception for small long-term construction contracts from the requirement to use the percentage-of-completion method. See heading in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9057">9057</a>. A long-term contract is any contract that provides for the manufacture, building, installation, or construction of property that will not be completed within the taxable year that the contract was executed.<a href="#_ftn1" name="_ftnref1">1</a> Despite this general definition, a manufacturing contract is only treated as a long-term contract if it provides for the manufacture of:<a href="#_ftn2" name="_ftnref2">2</a> (1)  Unique items which are not normally carried as finished goods inventory; or (2)  Items which would normally require more than a 12 month production period to complete (regardless of the duration of the actual contract).<a href="#_ftn3" name="_ftnref3">3</a> An item is considered “unique” if it was designed to meet the needs of a specific customer and is generally not suitable for the use of other customers without significant modification.<a href="#_ftn4" name="_ftnref4">4</a> A taxpayer can use the IRS’ safe harbor to show that a product is not unique in the following circumstances: (1)  Short production period. If an item could normally be manufactured within ninety days or less, then it is not considered to be a unique item. If multiple orders are involved, this test is satisfied if each unit can be manufactured within ninety days;<a href="#_ftn5" name="_ftnref5">5</a> (2)  Customized item. An item is not considered unique if 10 percent or less of the total contract cost is attributed to the cost of customizing the item;<a href="#_ftn6" name="_ftnref6">6</a> (3)  Inventoried item. An item that might otherwise be considered unique ceases to be unique when the taxpayer begins to normally include similar items in its finished goods inventory.<a href="#_ftn7" name="_ftnref7">7</a> The item’s production period begins when the taxpayer has incurred at least 5 percent of the total contract cost and ends when the item is ready for sale and all reasonably expected production activities have been completed.<a href="#_ftn8" name="_ftnref8">8</a> Construction contracts, for this purpose, include the improvement or building of real property, reconstruction or rehabilitation of real property, contracts for the installation of an integral component to real property, and contracts for the improvement of real property.<a href="#_ftn9" name="_ftnref9">9</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9056">9056</a> for the rules governing accounting for long-term contracts. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 460(f)(1); Treas. Reg. § 1.460-1(b)(1). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 460(f)(2); Treas. Reg. § 1.460-2(a). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 460(f)(2)(B); Treas. Reg. § 1.460-2(a)(2). <a href="#_ftnref4" name="_ftn4">4</a>.  Treas. Reg. § 1.460-2(b)(1); Sierracin Corp. v. Comm., 90 TC 341 (1988). <a href="#_ftnref5" name="_ftn5">5</a>.  Treas. Reg. § 1.460-2(b)(2)(i). <a href="#_ftnref6" name="_ftn6">6</a>.  Treas. Reg. § 1.460-2(b)(2)(ii). <a href="#_ftnref7" name="_ftn7">7</a>.  Treas. Reg. § 1.460-2(b)(2)(iii). <a href="#_ftnref8" name="_ftn8">8</a>.  Treas. Reg. § 1.460-2(c)(1). <a href="#_ftnref9" name="_ftn9">9</a>.  Treas. Reg. § 1.460-3(a). </div></div>

March 13, 2024

9057 / Are there any exceptions to the rule that a taxpayer must use the percentage of completion method in accounting for long-term contracts?

<div class="Section1"> Editor’s Note: The 2017 tax reform legislation expands the exception for small long-term construction contracts from the requirement to use the percentage-of-completion method. See heading below. Yes. The percentage of completion method ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9056">9056</a>) is not required to be used in the case of (1) construction contracts entered into by small contractors and (2) home construction contracts.<a href="#_ftn1" name="_ftnref1">1</a> The exemption for small contractors will apply if the following criteria are met:<a href="#_ftn2" name="_ftnref2">2</a> (1)  The long-term contract must be a construction contract;<a href="#_ftn3" name="_ftnref3">3</a> (2)  At the time the contract was entered into, it is estimated that the contract will be completed within two years. However, if the contract takes longer than two years to complete due to factors beyond the taxpayer’s control, the small contractor’s exception may still be used;<a href="#_ftn4" name="_ftnref4">4</a> and (3)  The contractor or its predecessor’s average annual gross receipts for the three years preceding the year in which the construction contract was entered into is $31 million or less (in 2025, $30 million in 2024, $29 million for 2023, $27 million for 2022, $26 million for 2019-2021, $25 million for 2018 and $10 million or less prior to 2018).<a href="#_ftn5" name="_ftnref5">5</a> The home construction contract exemption applies to any construction contract under which at least 80 percent of the estimated total contract costs are reasonably attributed to the building construction, reconstruction or rehabilitation of: (1) dwelling units<a href="#_ftn6" name="_ftnref6">6</a> in a building containing four or fewer dwelling units or (2) improvements to real property directly related to such dwelling units and located on the site of such dwelling units.<a href="#_ftn7" name="_ftnref7">7</a> If the construction involves both dwelling units and commercial units, costs must be reasonably allocated to determine the contract costs attributable to the dwelling units in order to determine whether the contract will qualify for the exemption. The 2017 Tax Reform Legislation The 2017 tax reform legislation expanded the exception for small construction contracts from the requirement to use the percentage-of-completion method. Under the new rules, contracts that fall within the exception include those contracts for the construction or improvement of real property if the contract: (1)  is expected (at the time the contract is entered into) to be completed within two years of commencement of the contract, and (2)  is performed by a taxpayer that (during the tax year in which the contract was entered into) meets the gross receipts test.<a href="#_ftn8" name="_ftnref8">8</a> Taxpayers that fail the gross receipts test (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9044">9044</a>) are not eligible for the exception from using the percentage-of-completion method for the tax year. Further, under these rules there is no permitted adjustment under IRC Section 481(a) for contracts entered into before January 1, 2018.<a href="#_ftn9" name="_ftnref9">9</a> The new rules governing accounting for long-term contracts are effective for tax years beginning after December 31, 2017. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 460(e). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 460(e)(1)(B); Treas. Reg. § 1.460-3(b)(1). <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 460(e )(4); Treas. Reg. § <a href="https://advance.lexis.com/GoToContentView?requestid=f480cae-6c22-3097-44ad-74e32a3096a4&crid=85ae9dcc-2d70-c0fd-502a-de382998526c">1.460-3(a)</a>. <a href="#_ftnref4" name="_ftn4">4</a>.  Treas. Reg. §§ 1.460-3(b)(1)(ii), 1.460-1(f)(4). <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 460(e)(1)(B)(ii); Treas. Reg. § 1.460-3(b)(3). <a href="#_ftnref6" name="_ftn6">6</a>.  Dwelling unit is defined in IRC § 168(e)(2)(A)(ii)(I). <a href="#_ftnref7" name="_ftn7">7</a>.  IRC § 460(e)(6)(A); Treas. Reg. § 1.460-3(b)(2)(i). <a href="#_ftnref8" name="_ftn8">8</a>.  IRC §§ 460(e)(1)(B)(ii), 448(c). <a href="#_ftnref9" name="_ftn9">9</a>.  IRC § 460(e)(2)(B). </div></div>

March 13, 2024

9052 / What interest requirements apply when a taxpayer uses the installment method of accounting?

<div class="Section1"> Generally, when a taxpayer uses the installment method of accounting (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9051">9051</a>), if the sale price is over $3,000 and any payment is deferred for more than one year, interest must be charged on payments due more than six months after the sale. Interest must be charged at a rate that is at least 100 percent of the “applicable federal rate,” (AFR) compounded semiannually, or interest will be imputed at that rate.<a href="#_ftn1" name="_ftnref1">1</a> However, the following exceptions to this general rule apply: (1)  If less than 100 percent of the AFR, a rate of no greater than 9 percent, compounded semiannually, will be imputed in the case of sales of property (other than new IRC Section 38 property) if the stated principal amount of the debt instrument does not exceed $7,296,700 in 2025 projected ($7,098,600 in 2024, $6,734,800 in 2023, as indexed annually for inflation);<a href="#_ftn2" name="_ftnref2">2</a> (2)  If less than 100 percent of the AFR, a rate of no greater than 6 percent, compounded semiannually, is imputed on aggregate sales of land during a calendar year between an individual and a member of the individual’s family (i.e., brothers, sisters, spouses, ancestors, and lineal descendants) to the extent the aggregate sales do not exceed $500,000 (the general rule of 100 percent of the AFR, compounded semiannually, applies to the excess);<a href="#_ftn3" name="_ftnref3">3</a> and (3)  A rate of 110 percent of the AFR, compounded semiannually, applies to sales or exchanges of property if, pursuant to a plan, the transferor or any related person leases a portion of the property after the sale or exchange (“sale-leaseback” transactions).<a href="#_ftn4" name="_ftnref4">4</a> The applicable federal rate applied will be the lowest of the AFRs in effect for any month in the 3-month period ending with the first calendar month in which there is a binding contract in writing.<a href="#_ftn5" name="_ftnref5">5</a> All interest received by the taxpayer is taxed as ordinary income.<a href="#_ftn6" name="_ftnref6">6</a> In some cases, depending on the property and amount involved, the interest (or imputed interest) to be paid over the period of the loan must be reported as “original issue discount” that accrues in daily portions; in other cases the interest is allocated among the payments and that much of each payment is treated as interest includable and deductible according to the accounting method of the buyer and seller. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 483. <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 1274A, Rev. Proc. 2023-34, Rev. Proc. 2024-40. <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 483(e)(3). <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 1274(e). <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 1274(d)(2)(B). <a href="#_ftnref6" name="_ftn6">6</a>.  Treas. Reg. § 1.483-1. </div></div>

March 13, 2024

9054 / Is a taxpayer required to use the installment method to account for an installment sale?

<div class="Section1"> In situations where the installment method applies, the taxpayer is required to use the installment method unless an election is made to opt out of this treatment. If the taxpayer does not affirmatively elect out, the installment method is the default method of accounting for transactions covered by the installment sale rules (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9051">9051</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9053">9053</a>). The opt-out election must be made on or before the due date for filing the taxpayer’s return for the year. Once the election is made, the taxpayer may only revoke the election with the IRS’ consent.<a href="#_ftn1" name="_ftnref1">1</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 453(d). </div></div>

March 13, 2024

9056 / How does a taxpayer account for revenue and costs under a long-term contract?

<div class="Section1"> Editor’s Note: The 2017 tax reform legislation expands the exception for small long-term construction contracts from the requirement to use the percentage-of-completion method. See heading in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9057">9057</a>. If the contract is found to be a long-term contract (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9055">9055</a>), the taxpayer will be required to use the percentage of completion method to account for revenue under that contract, unless an exception applies to allow use of the completed contract method. Generally, the completed contract method may only be used for certain home construction and other real estate construction contracts (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9057">9057</a>), so the exception is very limited.<a href="#_ftn1" name="_ftnref1">1</a> The percentage of completion method requires the taxpayer to include the portion of the total contract price that corresponds to the percentage of the entire contract that has been completed during that tax year.<a href="#_ftn2" name="_ftnref2">2</a> The aim of this method is to include a portion of income during each year as the work under the contract progresses. To determine the income that must be recognized under a long-term contract, a taxpayer uses the following steps:<a href="#_ftn3" name="_ftnref3">3</a> (1)  The completion factor for the contract, which is the ratio of the cumulative allocable contract costs that the taxpayer has incurred through the end of the taxable year to the estimated total allocable contract costs that the taxpayer reasonably expects to incur under the contract, is computed; (2)  The amount of cumulative gross receipts from the contract is computed by multiplying the completion factor by the total contract price; (3)  The amount of current-year gross receipts is computed, which is the difference between the amount of cumulative gross receipts for the current taxable year and the amount of cumulative gross receipts for the immediately preceding taxable year (whether positive or negative); and (4)  Both the current-year gross receipts and the allocable contract costs incurred during the current year are taken into account in computing taxable income. If this method does not result in the taxpayer including the total contract price in income by the time the contract is completed, the taxpayer must include any remaining amounts in income for the tax year following the year of completion.<a href="#_ftn4" name="_ftnref4">4</a> A de minimis rule allows a taxpayer to defer recognition of income under a long-term contract for any year in which less than 10 percent of the estimated contract costs have been incurred by the end of the year. This income and related costs must then be recognized in a later year in which at least 10 percent of the contract has been completed.<a href="#_ftn5" name="_ftnref5">5</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 460(a); Treas. Reg. § 1.451-3(b). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 460(b)(1); Treas. Reg. § 1.460-4(b)(1). <a href="#_ftnref3" name="_ftn3">3</a>.  Treas. Reg. § 1.460-4(b)(2). <a href="#_ftnref4" name="_ftn4">4</a>.  Treas. Reg. § 1.460-4(b)(3). <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 460(b)(5). </div></div>

March 13, 2024

9043 / Are there any circumstances that allow a small business taxpayer to change its accounting method without IRS approval?

<div class="Section1"> Yes. The IRS has released guidance providing that small business taxpayers (see below) may make certain tangible property changes in methods of accounting in order to take into account only amounts paid or incurred, and dispositions made, in tax years beginning on or after January 1, 2014. For the tax year beginning on or after January 1, 2014, small business taxpayers are permitted to make such changes without filing Form 3115.<a href="#_ftn1" name="_ftnref1">1</a> For purposes of this exception, a "small business taxpayer" is a taxpayer with one or more distinct trades or businesses that has: (1) Total assets of less than $10 million as of the first day of the tax year for which a change in accounting method under the final tangible property regulations and related guidance is effective; or (2) Average annual gross receipts of $31 million in 2025 ($30 million in 2024, $29 million in 2023, $27 million in 2022, $26 million in 2019-2021, $25 million in 2018 and $10 million prior to 2018) or less for the prior three tax years. This exception applies only to small business taxpayers electing to make changes in accounting methods in order to prospectively apply the final tangible property regulations. While these taxpayers are still permitted to file the Form 3115 in order to make this change, the IRS guidance allows small business taxpayers to simply make the change on a federal income tax return. This guidance is meant to ease the burden of changing accounting methods for small business taxpayers by effectively allowing them to make the change on a cut-off basis. If a small business taxpayer has already filed a Form 3115 with respect to accounting changes applying the tangible property regulations, the taxpayer may withdraw the form by filing an amended return on or before the due date of the original tax return (including extensions).<a href="#_ftn2" name="_ftnref2">2</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Rev. Proc. 2015-20, modifying Rev. Proc. 2015-14. <a href="#_ftnref2" name="_ftn2">2</a>. Rev. Proc. 2015-20. </div>

March 13, 2024

9045 / What is the accrual method of accounting?

<div class="Section1"> Editor’s Note: Under the 2017 tax reform legislation, if the taxpayer uses the accrual method of accounting, the “all events test” with respect to any item of income is not treated as met any later than when the item (or a portion of it) is taken into account as revenue in a financial statement of the taxpayer.<a href="#_ftn1" name="_ftnref1">1</a> See below. Taxpayers who use the accrual method of accounting generally report income in the year that it is earned, rather than in the year it is received.<a href="#_ftn2" name="_ftnref2">2</a> Under this method, income is recognized in the year when (1) all events have occurred to fix the taxpayer’s right to receive the income and (2) the amount of income that the taxpayer will be entitled to receive can be determined with reasonable accuracy. Because the relevant inquiry is when the income is earned, rather than when the income is received, compensation agreed upon with respect to the performance of future services is not recognized until those services have actually been performed (at the time the taxpayer has earned the compensation).<a href="#_ftn3" name="_ftnref3">3</a> <hr> Planning Point: Generally speaking, the accrual method of accounting normalizes, or smooths out, the revenues and expenses of a business, making it easier to do year over year comparisons and forecasts. A company that wins a large deal may get paid an up-front cash amount for products that are delivered for years to come. Accrual tax accounting allows the tax obligations to be paid over longer periods of time, giving the business owner more choice and control over how, and when, taxes are paid. <hr> Pursuant to the “all events test,”<a href="#_ftn4" name="_ftnref4">4</a> income is recognized when all of the events that are required for the taxpayer’s right to the income to be vested have occurred so that the amount of the taxpayer’s entitlement can be determined with reasonable certainty.<a href="#_ftn5" name="_ftnref5">5</a> It is possible for a taxpayer to report income although no payment has yet been received.<a href="#_ftn6" name="_ftnref6">6</a> Under the 2017 tax reform legislation, the “all events test” with respect to any item of income is not treated as met any later than when the item (or a portion of it) is taken into account as revenue in a financial statement of the taxpayer.<a href="#_ftn7" name="_ftnref7">7</a> A financial statement, for this purpose, includes one that is prepared in accordance with GAAP and is a 10(k) that will be filed with the SEC, or an audited financial statement used for credit, reporting or other significant non-tax purposes if there is no 10(k) that will be filed with the SEC.<a href="#_ftn8" name="_ftnref8">8</a> If the taxpayer does not have a 10(k) or an audited financial statement, any financial statement that is filed with a federal agency for non-tax purposes may be used.<a href="#_ftn9" name="_ftnref9">9</a> If the taxpayer does not have a financial statement upon which the item would be reported, the new rule does not apply. Further, it does not apply with respect to items of income that are received in connection with a mortgage servicing contract.<a href="#_ftn10" name="_ftnref10">10</a> The amended provision continues to provide that the all events test will be deemed met when all of the events have occurred that fix the right to the income, and the amount can be determined with reasonable accuracy.<a href="#_ftn11" name="_ftnref11">11</a> As mentioned above, an accrual basis taxpayer’s expenses are deductible for the taxable year in which the liability for payment becomes definite and the amounts payable become ascertainable with reasonable certainty, but only to the extent that economic performance with respect to the item has occurred.<a href="#_ftn12" name="_ftnref12">12</a> In general, an accrual basis taxpayer will include amounts in income upon the earliest of the following events: (1) payment is actually received, (2) the income amount becomes due to the taxpayer, (3) the taxpayer earns the income, or (4) title to property has passed to the taxpayer.<a href="#_ftn13" name="_ftnref13">13</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9046">9046</a> for a discussion of the treatment of advance payments. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 451(b)(1)(A). <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 446(c)(2). <a href="#_ftnref3" name="_ftn3">3</a>.  Treas. Reg. § 1.451-1(a). <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 448(h)(4). <a href="#_ftnref5" name="_ftn5">5</a>.  Treas. Reg. § 1.446-1(c)(1)(ii). <a href="#_ftnref6" name="_ftn6">6</a>.  Comm. v Hansen, 360 U.S. 446 (1959). <a href="#_ftnref7" name="_ftn7">7</a>.  IRC § 451(b)(1)(A). <a href="#_ftnref8" name="_ftn8">8</a>.  IRC § 451(b)(3). <a href="#_ftnref9" name="_ftn9">9</a>.  IRC § 451(b)(3)(A)(iii). <a href="#_ftnref10" name="_ftn10">10</a>.  IRC § 451(b)(1)(B). <a href="#_ftnref11" name="_ftn11">11</a>.  IRC § 451(b)(1)(C). <a href="#_ftnref12" name="_ftn12">12</a>.  IRC § 461(h). <a href="#_ftnref13" name="_ftn13">13</a>.  IRS Pub. 538. </div></div>

March 13, 2024

9049 / Can a taxpayer choose to use both the cash basis and accrual methods of accounting?

<div class="Section1"> Editor’s Note: The 2017 tax reform legislation expanded the gross receipts test discussed below to include entities with annual gross receipts that do not exceed $25 million in 2018, $26 million in 2019-2021, $27 million in 2022, $29 million in 2023, $30 million in 2024 and $31 million in 2025. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9048">9048</a>. Under IRC Section 446(c), a taxpayer may use any combination of the permissible accounting methods to compute taxable income if the combination clearly reflects the taxpayer’s income and is consistently used. For example, a taxpayer is permitted to use the cash basis method to account for income and expenses, but the accrual method to account for purchases and sales. Despite this, a taxpayer is not permitted to use one method to account for income and a different method to account for expenses.<a href="#_ftn1" name="_ftnref1">1</a> Though the regulations require that a taxpayer use the accrual method to account for purchases and sales if inventories are maintained (but see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9058">9058</a> for a discussion of the changes to inventory accounting made by the 2017 tax law), that taxpayer may wish to use the cash basis method for income and expenses because the required calculation may be simpler.<a href="#_ftn2" name="_ftnref2">2</a> A taxpayer is also permitted to use one accounting method to determine tax liability for income arising from a trade or business and another method to account for income that is not related to a trade or business.<a href="#_ftn3" name="_ftnref3">3</a> Taxpayers engaged in different trades or businesses can also use a different method of accounting for each trade or business in which the taxpayer participates.<a href="#_ftn4" name="_ftnref4">4</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.  Treas. Reg. § 1.446-1(c)(1)(iv); Grider v Comm., TC Memo 1999-417. <a href="#_ftnref2" name="_ftn2">2</a>.  Treas. Reg. §§ 1.446-1(a)(4)(i), 1.446-1(c)(2)(i). See also Gustafson v Comm., TC Memo 1988-82. <a href="#_ftnref3" name="_ftn3">3</a>.  Treas. Reg. § 1.446-1(c)(1)(iv)(b). <a href="#_ftnref4" name="_ftn4">4</a>.  Treas. Reg. § 1.446-1(d). </div></div>