Accounting Methods

An accounting method is a set of rules used to determine when and how income and expenses are reported. The term "accounting method" includes not only the overall method of accounting you use, but also the method of accounting you use for any material item. You must file your tax return using the same method you use for your tax records.

You choose your accounting method when you file your first tax return. However, you cannot use the crop method for any tax return, including your first tax return, unless you get IRS approval. The crop method is discussed later. Getting IRS approval to change an accounting method is discussed later in Change in Accounting Method.

You can use any of the following accounting methods.

1. Cash method.
2. An accrual method.
3. Special methods for certain items of income and expenses.
4. Combination (hybrid) method using elements of two or more of the above.

If you have two or more separate and distinct trades or businesses, you can use a different accounting method for each business if you keep a complete and separate set of books and records for each business.

Cash Method

Most farmers use the cash method because they find it easier to keep cash method records. Certain farm corporations and partnerships, or any tax shelter, cannot use the cash method. See Accrual Method, later.

Income

Under the cash method, you include all items of income (whether in the form of cash, property, or services) you actually or constructively received during the year in gross income for that year. If you receive property or services, you must include their fair market value in income.

Constructive receipt. Income is constructively received when an amount is credited to your account or made available to you without restriction. You need not have possession of it. The receipt of a check is constructive receipt of money, even if you do not deposit or cash it in the tax year you receive it. An amount credited to your account at a bank, store, grain elevator, etc., is constructively received in the year it is credited.

Installment sale. If you sell an item under a deferred payment contract that calls for payment the following year, there is no constructive receipt in the year of sale. However, see the following example for an exception to this rule.

Example. You are a farmer who uses the cash method and a calendar year. You sell grain in December 1999 under a bona fide arm's-length contract that calls for payment in 2000. You include the sale proceeds in your 2000 gross income since that is the year payment is received. However, if the contract says that you have the right to the proceeds from the buyer at any time after the grain is delivered, you must include the sale price in your 1999 income, regardless of when you actually receive payment.

Alternative minimum tax. When figuring the alternative minimum tax, a cash basis farmer who sells farm property under the installment method can also use that method to figure his or her alternative minimum taxable income for the year. See the instructions for Form 6251.

Items to include in income. Your gross income for the tax year includes the following.

1. Cash and the value of merchandise or other property you receive during the tax year from the sale of livestock, poultry, vegetables, fruits, etc., that you raised.
2. Your profit from the sale of any livestock or other items purchased.
   1. To find your profit, deduct the cost or other basis of the property, plus selling expenses, from the sale proceeds.
   2. You generally cannot deduct the cost of items purchased for resale in the year paid unless the payment and sale occur in the same year. However, see chapter 5 for information on when to deduct the cost of chickens, seeds, and young plants.
3. Breeding fees, fees from the rent or lease of animals, machinery, or land, and other incidental farm income.
4. All subsidy and conservation payments you receive that are considered income.
5. Your gross income from all other sources.

Crop insurance proceeds can be reported in income in the year following the year of loss under certain conditions. See Crop Insurance and Crop Disaster Payments in chapter 4.

Sales of livestock caused by weather-related conditions can be reported in income in the year following the year of loss or it can be treated as an involuntary conversion under certain conditions. See chapters 4 and 13 for more information.

Expenses

You deduct farm business expenses only in the tax year you pay them. This can include farm business expenses for which you contest the liability. (See Contested liabilities, later.) However, you cannot deduct certain prepaid expenses for supplies until they are actually used or consumed. In addition, you can be required to capitalize certain costs. You cannot use an inventory method to figure income on the cash method or deduct certain prepayments. For more information on prepaid supplies, interest, and other expenses, see chapter 5.

Accrual Method

Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. If you use an accrual method of accounting, you must use an inventory method to figure your gross income. The purpose of this method of accounting is to match income and expenses in the correct year.

Income

You generally include an amount as income for the tax year in which all events have occurred that fix your right to receive the income and you can determine the amount with reasonable accuracy.

Items to include in income. You figure gross income using increases and decreases in inventory values of livestock, produce, feed, etc., between the beginning of the year and the end of the year. A complete inventory of these items is required for reporting income on an accrual method. For more information on an inventory, see Farm Inventory, later.

Do the following to figure gross income on an accrual method.

1. Add the following items.
   1. Hungarian TravellersThe sales price of all livestock and other products, such as milk, held for sale and sold during the year.
   2. Inventory value of livestock and products on hand and not sold at the end of the year.
   3. Miscellaneous items of income you earn during the year, such as breeding fees, fees from renting or leasing animals, machinery, or land, or other incidental farm income.
   4. Subsidy or conservation payments you receive that are considered income.
   5. Your gross income from all other sources.
2. Then subtract the total of the following.
   1. Inventory value of the livestock and products you had on hand and not sold at the beginning of the year.
   2. Cost of any livestock or products you purchased during the year, including livestock held for draft, dairy, or breeding purposes if they are included in inventory.

Expenses

You generally deduct or capitalize an expense in the tax year when all the following apply.

1. The all-events test has been met:
   1. All events have occurred that fix the fact of liability, and
   2. The liability can be determined with reasonable accuracy.
2. Economic performance has occurred.

You generally cannot deduct or capitalize farm business expenses 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 that you provide to others, economic performance occurs as you provide the property or services. See Economic Performance under Accrual Method in Publication 538 for more information.

Example 1. John is a farmer who uses a calendar year and an accrual method of accounting. In December 1999 John buys supplies for $200 that are not acquired for resale and that do not become a physical part of any items held for sale. He receives the supplies and the bill in December 1999, however, he pays the bill in January 2000.

John can deduct the expense in 1999 because all events occurred to fix the liability (the supplies were received but not paid for), the liability can be determined (the unpaid bill was for $200), and economic performance occurred in 1999 (the supplies were provided to John in December 1999).

Example 2. Jane is a farmer who uses a calendar tax year and an accrual method of accounting. She enters into a turnkey contract with Waterworks in 1999. The contract states that Jane must pay Waterworks $200,000 in December 1999 and that they will install a complete irrigation system, including a new well, by the close of the year 2001. She pays Waterworks $200,000 in December 1999, they start the installation in May 2001, and they complete the irrigation system in December 2001.

Economic performance for Jane's liability in the contract occurs as the property and services are provided. Jane incurs the $200,000 cost in the year 2001.

Accrual Method Required

A C corporation or a partnership with a C corporation partner must generally use an accrual method of accounting. (This rule does not apply to S corporations.) See section 448(a) of the Internal Revenue Code.

Tax shelter. A tax shelter farm business is also required to use an accrual method of accounting unless it is excepted from the rule described later in Accrual Method Not Required.

A farm business is a tax shelter if it is a partnership, noncorporate enterprise, or S corporation and:

1. Avoidance or evasion of federal income tax is the principal purpose of the entity, or
2. It is a farming syndicate. An entity is a farming syndicate if:
   1. Interests in the activity have ever been offered for sale in any offering required to be registered with any federal or state agency with the authority to regulate the offering of securities for sale, or
   2. More than 35% of the losses during the tax year are allocable to limited partners or limited entrepreneurs.
      1. A "limited partner" is one whose personal liability for partnership debts is limited to the money or other property the partner contributed or is required to contribute to the partnership.
      2. A "limited entrepreneur" is a person who has an interest in an enterprise other than as a limited partner and does not actively participate in the management of the enterprise.

Accrual Method Not Required

The following entities engaged in farming can generally use the cash method of accounting.

1. An S corporation.
2. A corporation whose gross receipts for each tax year are $1 million or less.
3. A corporation, or partnership with corporate partners, whose trade or business is operating a nursery or sod farm or raising or harvesting trees, other than fruit and nut trees.
4. A family farm corporation whose annual gross receipts for each tax year beginning after 1985 are $25 million or less and it qualifies as one of the following corporations in which:
   1. Members of the same family own at least 50% of the total combined voting power of all classes of stock entitled to vote and at least 50% of the total shares of all other classes of stock of the corporation.
   2. Members of two families owned, directly or indirectly, on October 4, 1976, and since then, at least 65% of the total combined voting power of all classes of stock entitled to vote and at least 65% of the total shares of all other classes of stock of the corporation.
   3. Members of three families owned, directly or indirectly, on October 4, 1976, and since then, at least 50% of the total combined voting power of all classes of stock entitled to vote and at least 50% of the total shares of all other classes of stock of the corporation. Also, substantially all of the remaining stock must be owned by:
      1. Corporate employees,
      2. Their family members, or
      3. A tax-exempt employees' trust for the benefit of the corporation's employees.

Caution:

A corporation (other than an S corporation) that is also engaged in a nonfarming business activity cannot use the cash method for the nonfarming activity if its average annual gross receipts for the 3 prior tax years are more than $5 million. For this purpose, "farming business" does not include processing commodities or products beyond those activities normally incident to the growing, raising, or harvesting of the product. For example, processing grain to produce bread and cereal to sell is not a farming business.

Contested liabilities. If you use the cash method of accounting and contest an asserted liability for any of your farm business expenses, you may claim the deduction only in the year you pay the liability. If you are an accrual method taxpayer, however, you can deduct the expense either in the year you pay the contested liability (or transfer money or other property in satisfaction of it) or in the year you finally settle the contest. However, to be able to take the deduction in the year of payment or transfer, you must meet certain conditions. For more information, see Contested Liability under Accrual Method in Publication 538.

Farm Inventory

You should keep a complete record of your inventory as part of your farm records. This record should show the actual count or measurement of the inventory. It should also show all factors that enter into its valuation, including quality and weight if they are required.

Items to include in inventory. Your inventory should include all items held for sale or use as feed, seed, etc., whether raised or purchased, that are unsold at the end of the year.

Hatchery business. If you are in the hatchery business, you must include eggs in the process of incubation.

Hoofddorp hotelsProducts held for sale. All harvested and purchased farm products held for sale or for feed or seed, such as grain, hay, silage, concentrates, cotton, tobacco, etc., must be included.

Supplies. You must inventory supplies acquired for sale or that become a physical part of items held for sale. Do not include other supplies in inventory. Deduct the cost of the other supplies in the year used or consumed in operations. You can also deduct incidental supplies in the year of purchase.

Fur-bearing animals. If you are in the business of breeding and raising chinchillas, mink, foxes, or other fur-bearing animals, you are a farmer and these animals are livestock. You can use any of the inventory and accounting methods discussed in this chapter.

Growing crops. You are generally not required to inventory growing crops. However, if the crop has a preproductive period of more than 2 years, you may have to capitalize (or include in inventory) costs associated with the crop. You cannot take a current deduction for costs incurred during the preproductive period. See Uniform Capitalization Rules in chapter 7.

ERROR MSGRequired to use accrual method. If you are required to use an accrual method of accounting:

1. The uniform capitalization rules apply to all costs of raising a plant, even if the preproductive period of raising a plant is 2 years or less.
2. All animals are subject to the uniform capitalization rules, regardless of age or whether held primarily for slaughter.

Inventory valuation methods. You can generally use the following methods to value your inventory:

1. Cost.
2. Lower of cost or market.
3. Farm-price method.
4. Unit-livestock-price method for livestock.

Cost and lower of cost or market methods. See Publication 538 for information on these valuation methods.

Farm-price method. Under this method, each item, whether raised or purchased, is valued at its market price less the direct cost of disposition. Market price is the current price at the nearest market in the quantities you usually sell. Cost of disposition includes any broker's commission, freight, hauling to market, and other marketing costs.

If you use this method, you must use it for your entire inventory, except that livestock can be inventoried on the unit-livestock-price method.

Unit-livestock-price method. This method recognizes the difficulty of establishing the exact costs of producing and raising each animal. You group or classify livestock according to type and age and use a standard unit price for each animal within a class or group. The unit price you assign should reasonably approximate the normal costs incurred in producing the animals in such classes. Unit prices and classifications are subject to approval by the IRS on examination of your return. You cannot change them without IRS approval.

If you use this method, you must include all raised livestock in inventory, regardless of whether they are held for sale or for draft, breeding, dairy, or sporting purposes. This method accounts only for the increase in cost of raising an animal to maturity. It does not provide for any decrease in the animal's market value after it reaches maturity. Also, if you raise cattle, you are not required to inventory hay you grow to feed your herd.

Do not include sold or lost animals in the year-end inventory. If your records do not show which animals were sold or lost, treat the first animals acquired as sold or lost. The animals on hand at the end of the year are considered the most recently acquired.

You must include in inventory all livestock purchased primarily for sale. You can include in inventory livestock purchased for draft, breeding, dairy, or sporting purposes or treat them as depreciable assets. However, you must be consistent from year to year, regardless of the practice you have chosen. You cannot change your practice unless you get IRS approval.

You must inventory animals purchased after maturity or capitalize them at their purchase price. If the animals are not mature at purchase, increase the cost at the end of each tax year according to the established unit price. However, in the year of purchase, do not increase the cost of any animal purchased during the last six months of the year. This rule does not apply to tax shelters, which must make an adjustment for any animal purchased during the year.

Uniform capitalization rules. A farmer can determine costs required to be allocated under the uniform capitalization rules by using the farm-price or unit-livestock-price inventory method. This applies to any plant or animal, even if the farmer does not hold or treat the plant or animal as inventory property.

Cash Versus Accrual Method

The following examples compare the cash and accrual methods of accounting.

Example 1. You are a farmer who uses an accrual method of accounting. You keep your books on the calendar year basis. You sell grain in December 1999, but you are not paid until January 2000. You must include both the sale proceeds and your costs incurred in producing the grain on your 1999 tax return. Under an accrual method of accounting, you report your profit or loss for the year in which all events occurred that fix your right to receive income from the transaction and you can determine your profit or loss with reasonable accuracy.

Example 2. Assume the facts in Example 1 except that you use the cash method and there was no constructive receipt of the sale proceeds in 1999. Under this method, you include the sale proceeds in income for 2000, the year you receive payment. You deduct the cost of producing the grain in the year you pay it.

Special Methods of Accounting

There are special methods of accounting for certain items of income and expense.

Crop method. If you do not harvest and dispose of your crop in the same tax year you plant it, you can, with IRS approval, use the crop method of accounting. Under this method, you deduct the entire cost of producing the crop, including the expense of seed or young plants, in the year you realize income from the crop.

You cannot use this method for timber or any commodity subject to the uniform capitalization rules.

Other special methods. Methods of accounting for depreciation, depletion, and amortization are explained in chapter 8. Accounting for an installment sale is explained in chapter 12.

Combination (Hybrid) Method

You can generally use any combination of cash, accrual, and special methods of accounting if it clearly shows your income and expenses and you use it consistently. However, the following restrictions apply.

1. If an inventory is necessary to account for income, you must use an accrual method for purchases and sales. You can use the cash method for all other items of income and expense. See Farm Inventory, earlier.
2. If you use the cash method for figuring your income, you must use the cash method for reporting your expenses.
3. Halmstad hotel roomsIf you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.

Any combination that uses the cash method is treated as the cash method.

Change in Accounting Method

When you file your first return you can choose any permitted accounting method except the crop method, discussed earlier, without IRS approval. The method must clearly show your income and be used consistently from year to year. If you want to change your accounting method after that, you must get IRS approval unless you qualify under one of the exceptions described next under Approval not required.

A change in your accounting method includes a change in:

1. Your overall method, such as from cash to an accrual method or vice versa, and
2. Your treatment of any material item, such as a change in your method of valuing inventory (for example, a change from the "farm-price method" to the "unit-livestock-price method").

Approval not required. You do not need IRS approval to change your accounting method in the following situations.

1. You value livestock inventory at cost or the lower of cost or market and you change to the unit-livestock-price method.
2. You are a family farm corporation, described earlier under Accrual Method Not Required, and you must change to an accrual method because your annual gross receipts are more than $25 million. However, for tax years ending before June 9, 1997, you must establish a suspense account to reduce the section 481(a) adjustments you must include in income. In addition, you must ratably phaseout any existing suspense account over a 20-year period beginning with the first tax year after June 8, 1997. For tax years ending after June 8, 1997, you can no longer establish a suspense account to defer reporting the income that results from the change in method of accounting. Rather, you must spread the income adjustment caused by the change in accounting method over a period of 10 years beginning with the year of change. See sections 447(i)(5) and 447(f)(3) of the Internal Revenue Code for more information.
3. You have certain deferred payment sales (DPS) contracts (relating to property used or produced in your trade or business of farming) and you change your method of accounting to the installment method for alternative minimum tax (ATM) purposes. See Revenue Procedure 98-59 in Internal Revenue Bulletin No. 1998-49 for more information.

Approval required. You need IRS approval to change your accounting method before you can do the following.

1. Change from cash to an accrual method or vice versa.
2. Change the method or basis used to value inventory.
3. Adopt any specialized method of computing net income, such as the crop method, or change the use of a specialized method.
4. Transfer draft, dairy, or breeding animals from inventory to a fixed asset account.
5. Change from reporting loan proceeds from the Commodity Credit Corporation (CCC) as income in the year received to reporting the proceeds as income in the year the crop securing the loan is forfeited or sold.

Form 3115. Generally, you must file a current Form 3115 to get IRS approval to change your accounting method. You must file the form as early as possible during the tax year for which you request the change and you must furnish the applicable information requested on the form. You are required to send a user fee with the form. However, no user fee is required for an automatic change (IRS approval not required). See the form instructions, Revenue Procedure 97-27 in Cumulative Bulletin 1997-1, Revenue Procedure 98-60 in Internal Revenue Bulletin No. 1998-51, and Publication 538 for more information.

If you want to change your method of reporting CCC loans, you must request IRS approval during the first 180 days of the tax year. See Revenue Procedure 83-77 in Cumulative Bulletin 1983-2. See Commodity Credit Corporation (CCC) Loans in chapter 4 for information on CCC loans.

Extension of time to file Form 3115. The IRS will grant you an extension only in unusual and compelling circumstances. See Revenue Procedure 97-27 in Cumulative Bulletin 1997-1, Revenue Procedure 99-1 in Internal Revenue Bulletin No. 1999-1, and section 301.9100-3(c)(2) of the regulations for more information. A separate user fee is required for requesting extensions.