Accrual Method Under an accrual method of accounting, income is generally reportedin the year earned and expenses are deducted or capitalized in theyear incurred. The purpose of this method of accounting is to matchincome and expenses in the correct year. Income You generally include an amount as income for the tax year when allevents have occurred that fix your right to receive the income and youcan determine the amount with reasonable accuracy. Example.You are a calendar year, accrual basis taxpayer. You sold acomputer on December 28, 1997. You billed the customer in the firstweek of January 1998, but did not receive payment until February 1998.You must include the amount received for the computer in your 1997income. Estimated income.If you include a reasonably estimated amount in gross income andlater determine the exact amount is different, take the differenceinto account in the tax year you make the determination. Change in payment schedule.If you perform services for a basic rate specified in a contract,you must accrue the income at the basic rate, even if you agree toreceive payments at a lower rate until you complete the services andthen receive the difference. Accounts receivable for services.You may not have to accrue your accounts receivable that, based onyour experience, you will not collect. The nonaccrual-experiencemethod is explained in section 1.448-2T of theregulations. Advance Payment for Services Generally, you report an advance payment for services to beperformed in a later tax year as income in the year you receive thepayment. However, if you receive an advance payment for services youagree to perform by the end of the next tax year, you can elect topostpone including the advance payment in income until the next taxyear. However, you cannot postpone including any payment beyond thattax year. Service agreement.You can postpone reporting income from an advance payment youreceive for a service agreement on property you sell, lease, build,install, or construct. This includes an agreement providing forincidental replacement of parts or materials. However, this appliesonly if you offer the property without a service agreement in thenormal course of business. Postponement not allowed.You generally cannot postpone including an advance payment inincome for services if either of the following applies under theagreement. You are to perform any part of the service after the end ofthe tax year immediately following the year you receive the advancepayment. You are to perform any part of the service at anyunspecified future date that may be after the end of the tax yearimmediately following the year you receive the advance payment. Examples.In each of the following examples, assume you use the calendar yearand an accrual method of accounting. Example 1.You manufacture, sell, and service computers. You received paymentin 1996 for a one-year contingent service contract on a computer yousold. You can postpone including in income the part of the payment youdid not earn in 1996 if, in the normal course of your business, youoffer computers for sale without a contingent service contract. Example 2.You are in the television repair business. You received payments in1996 for one-year contracts under which you agree to repair or replacecertain parts that fail to function properly in television setsmanufactured and sold by unrelated parties. You include the paymentsin gross income as you earn them by performing the services. In Examples 3 and 4, if you do not perform part of theservices by the end of the following tax year (1997), you must includeadvance payments for the unperformed services in gross income for1997. Example 3.You own a dance studio. On November 2, 1996, you received paymentfor a one-year contract for 48 one-hour lessons beginning on thatdate. You gave eight lessons in 1996. Under this method of includingadvance payments, you must include one-sixth (8/48) of the payment inincome for 1996, and five-sixths (40/48) of the payment in 1997, evenif you cannot give all the lessons by the end of 1997. Example 4.Assume the same facts as Example 3, except the paymentis for a two-year contract for 96 lessons. You must include the entirepayment in income in 1996 since part of the services may be performedafter the following year (in 1998). Guarantee or warranty.You generally cannot postpone reporting income you receive for aguarantee or warranty contract. Prepaid rent or interest.You cannot postpone reporting income from prepaid rent or interest.Prepaid rent does not include payment for the use of a room or otherspace when significant service is also provided for the occupant. Youprovide significant service when you supply space in a hotel, boardinghouse, tourist home, motor court, motel, or apartment house thatfurnishes hotel service. Books and records.Any advance payment you include in gross receipts on your taxreturn for the year you receive payment must not be less than thepayment you include in gross receipts for your books and records andall your reports. This includes reports (including consolidatedfinancial statements) to shareholders, partners, other proprietors orbeneficiaries, and for credit purposes. IRS approval.You must get IRS approval, as discussed later under Change inAccounting Method, to change to this method of accounting foradvance payments for services. Advance Payment For Sales Special rules apply to including income from advance payments onagreements for future sales or other dispositions of goods heldprimarily for sale to customers in the ordinary course of your tradeor business. However, the rules do not apply to a payment (or part ofa payment) for services that are not an integral part of the mainactivities covered under the agreement. An agreement includes a giftcertificate that can be redeemed for goods. Amounts due and payableare considered received. How to report payments.You generally include an advance payment in income for the year inwhich you receive it. However, you can use the alternative method,discussed next. Alternative method of reporting.Under the alternative method, you generally include an advancepayment in income in the earlier tax year in which: You include advance payments in gross receipts under themethod of accounting you use for tax purposes, or You include any part of advance payments in income forfinancial reports under the method of accounting used for thosereports. Financial reports include reports to shareholders, partners,beneficiaries, and other proprietors for credit purposes andconsolidated financial statements. Example 1.You are a retailer. You use an accrual method of accounting and youaccount for the sale of goods when you ship the goods. You use thismethod for both tax and financial reporting purposes. You can includeadvance payments in gross receipts for tax purposes either in the taxyear you receive the payments or in the tax year you ship the goods.However, see Exception for inventory goods, later. Example 2.You are a calendar year taxpayer. You manufacture householdfurniture and use an accrual method of accounting. Under this method,you accrue income for your financial reports when you ship thefurniture. For tax purposes, you do not accrue income until thefurniture has been delivered and accepted. In 1996 you received an advance payment of $8,000 for an order offurniture to be manufactured for a total price of $20,000. You shippedthe furniture to the customer in December 1996, but it was notdelivered and accepted until January 1997. For tax purposes, youinclude the $8,000 advance payment in gross income for 1996 and youinclude the remaining $12,000 of the contract price in gross incomefor 1997. Information schedule.If you use the alternative method of reporting advance payments,you must attach a statement with the following information to your taxreturn each year. Total advance payments received in the current taxyear. Total advance payments received in earlier tax years and notincluded in income before the current tax year. Total payments received in earlier tax years included inincome for the current tax year. Exception for inventory goods.If you have an agreement to sell goods properly included ininventory, you can postpone including the advance payment in incomeuntil the end of the second tax year following the year you receivedan advance payment if, on the last day of the tax year: You account for the advance payment under the alternativemethod. You have received a substantial advance payment on theagreement (discussed later). You have enough substantially similar goods on hand, oravailable through your normal source of supply, to satisfy theagreement. These rules also apply to an agreement, such as a giftcertificate, which can be satisfied with goods that cannot beidentified in the tax year you receive an advance payment. If you meet these conditions, all advance payments you receive bythe end of the second tax year, including payments received the prioryear but not reported, must be included in income for that secondyear. You must also deduct in that second year all actual or estimatedcosts for the goods required to satisfy the agreement. If you estimatethe cost, you must take any difference between the estimate and theactual cost into account when the goods are delivered. You must report any advance payments you receive after the secondyear in the year received. No further deferral is allowed. Substantial advance payments.Goteborg accommodationUnder an agreement for a future sale, you have substantial advancepayments if, by the end of the tax year, the total advance paymentsreceived during that year and preceding tax years are equal to or morethan the total costs reasonably estimated to be includible ininventory because of the agreement. Example.You are a calendar year, accrual method taxpayer who accounts foradvance payments under the alternative method. In 1993 you enteredinto a contract for the sale of goods properly includible in yourinventory. The total contract price is $50,000 and you estimate thatyour total inventoriable costs for the goods will be $25,000. Youreceive the following advance payments under the contract: 1993 $17,500 1994 10,000 1995 7,500 1996 5,000 1997 5,000 1998      5,000 Total contract price    $50,000 Your customer asked you to deliver the goods in 1999. In your 1994closing inventory, you had on hand enough of the type of goodsspecified in the contract to satisfy the contract. Since the advancepayments you had received by the end of 1994 were more than the costsyou estimated, the payments are substantial advance payments. Include all payments you receive by the end of 1996, the second taxyear following the tax year in which you received substantial advancepayments, in income for 1996. You must include $40,000 in sales for1996 and you must include in inventory the cost of the goods (orsimilar goods) on hand. If no such goods are on hand, then you mustestimate the cost necessary to satisfy the contract. No further deferral is allowed. You must include in gross incomethe advance payment you receive each remaining year of the contract.You must take into account the difference between any estimated costof goods sold and the actual cost when you deliver the goods in 1999. IRS approval.You must file Form 3115 to get IRS approval to change your methodof accounting for advance payments for sales. Expenses Under an accrual method of accounting, you generally deduct orcapitalize a business expense when the following apply. The all-events test has been met: All events have occurred that fix the fact of liability,and The liability can be determined with reasonableaccuracy. Economic performance has occurred. Economic Performance You generally cannot deduct or capitalize a business expense untileconomic performance occurs. If your expense is for property orservices provided to you, or your use of property, economicperformance occurs as the property or services are provided or theproperty is used. If your expense is for property or services youprovide to others, economic performance occurs as you provide theproperty or services. Example.You are a calendar year taxpayer. You buy office supplies inDecember 1997. You receive the supplies and the bill in December, butyou pay the bill in January 1998. You can deduct the expense in 1997because all events occurred to fix the fact of liability, theliability could be determined, and economic performance occurred in1997. Your office supplies may qualify as a recurring expense, discussedlater. If so, you can deduct them in 1997, even if the supplies arenot delivered until 1998 (when economic performance occurs). Workers' compensation and tort liability.If you are required to make payments under workers' compensationlaws or in satisfaction of any tort, economic performance occurs asyou make the payments. If you are required to make payments to adesignated settlement fund established by court order for a tortliability, economic performance occurs as you make qualified payments. Taxes.Economic performance generally occurs as estimated income tax,property taxes, employment taxes, etc. are paid. However, you canelect to treat taxes as a recurring item, discussed later. You canalso elect to ratably accrue real estate taxes. See chapter 9 ofPublication 535 for information about real estate taxes. Interest.Economic performance occurs with the passage of time (as theborrower uses, and the lender forgoes use of, the lender's money)rather than as payments are made. Generally, interest accruing on debtobligations is figured by using a constant yield method. Compensation for services.Generally, economic performance occurs as an employee rendersservice to the employer. However, an employer's deduction forcompensation or other benefits paid to an employee in a yearsubsequent to economic performance is subject to the rules governingdeferred compensation, deferred benefits, and funded welfare benefitplans. For information on deferred compensation, see UnpaidSalaries in chapter 2 of Publication 535. For information onemployee benefit programs, see chapter 5 of Publication 535. Vacation pay.You can take a current deduction for vacation pay earned by youremployees only if you pay it during the year or, if the amount isvested, within 2 1/2 months after the end of the year. Ifyou pay it later than this, you must deduct it in the year actuallypaid. Exception for recurring items.An exception to the economic performance rule allows certainrecurring items to be treated as incurred during the tax year, eventhough economic performance has not occurred. The exception appliesif: The all-events test is met. The test is met if, by the endof the year, all events that establish the liability have occurred andyou can determine the amount of the liability with reasonableaccuracy. Economic performance occurs by the earlier of: 8 1/2 months after the close of the year,or The date you file a timely return (including extensions) forthe year. The item is recurring in nature and you consistently treatsimilar items as incurred in the tax year in which the all-events testis met. Either: The item is not material, or Accruing the item in the year in which the all-events testis met results in a better match against income than accruing the itemin the year of economic performance. This exception does not apply to workers' compensation or tortliabilities. Amended return.You may be able to file an amended return and treat a liability asincurred under the recurring item exception. You can do so if economicperformance for the liability occurs after you file your tax returnfor the year, but within 8 1/2 months after the close ofthe tax year. Recurrence and consistency.To determine whether an item is recurring and consistentlyreported, consider the frequency with which the item and similar itemsare incurred (or expected to be incurred) and how you report theseitems for tax purposes. A new expense or an expense not incurred everyyear can be treated as recurring if it is reasonable to expect that itwill be incurred regularly in the future. Materiality.Factors to consider in determining the materiality of a recurringitem include the size of the item (both in absolute terms and inrelation to your income and other expenses) and the treatment of theitem on your financial statements. An item considered material for financial statement purposes isalso considered material for tax purposes. However, in certainsituations an immaterial item for financial accounting purposes istreated as material for purposes of economic performance. If an itemis directly related to an activity, the materiality of the item willbe separately determined for that activity. The materiality ofoverhead expenses related to several activities is measured againstthose collective activities. Example.You are a calendar year taxpayer and you enter into a one-yearmaintenance contract on July 1, 1997. You prorate your expensesbetween 1997 and 1998 for financial statement purposes and you do thesame for tax purposes. If you deduct the full amount in 1997 becauseit is immaterial for financial statement purposes under generallyaccepted accounting principles, the expense is not necessarilyimmaterial for purposes of the recurring item exception. Matching.To determine whether the accrual of an expense in a particular yearresults in a better match with the income to which it relates,generally accepted accounting principles are an important factor.Costs directly associated with the revenue of a period are properlyallocable to that period. For example, a sales commission agreement can require certainpayments to be made in a year subsequent to the year sales income isreported. In this situation, economic performance for part of thecommission expense may not occur until the following year.Nevertheless, deducting the expense in the year the sales income isreported will result in a better match of the commission expense withthe sales income. Also, if sales income is recognized in the year ofsale, but the goods are not shipped until the following year, theshipping costs are more properly matched to income in the year of salethan the year the goods are shipped. Expenses such as insurance or rent are generally allocable to aperiod of time. If you are a calendar year taxpayer and enter into a12-month insurance contract on July 1, 1997, allocate half of yourexpense to 1997 and half to 1998. Expenses that cannot be practicallyassociated with income of a particular period, such as advertisingcosts, should be assigned to the period the costs are incurred. Thematching requirement is satisfied if the period to which the expensesare assigned is the same for tax and financial reporting purposes. Amortization of multiyear insurance costs.If you are a manufacturer, wholesaler, or retailer of motorvehicles or other durable consumer goods, you must generally amortizethe costs of intangible assets (including insurance policies) over theperiod of business use. You generally cannot deduct the full amount inthe year you pay it. See Revenue Procedure 98-60, 1998-51I.R.B. 16 (or any successor), for more information. Related Persons You cannot deduct business expenses and interest owed to a relatedperson who uses the cash method of accounting until youmake the payment and the corresponding amount is includible in therelated person's gross income. Determine the relationship, for thisrule, as of the end of the tax year for which the expense or interestwould otherwise be deductible. If a deduction is denied under thisrule, the rule will continue to apply even if your relationship withthe person ends before the expense or interest is includible in thegross income of that person. Related persons.For purposes of this rule, the following persons are related. Members of a family, including only brothers and sisters(either whole or half), husband and wife, ancestors, and linealdescendants. Two corporations that are members of the same controlledgroup as defined in section 267(f). The fiduciaries of two different trusts, and the fiduciaryand beneficiary of two different trusts, if the same person is thegrantor of both trusts. A tax-exempt educational or charitable organization and aperson (if an individual, including the members of the individual'sfamily) who, directly or indirectly, controls such anorganization. An individual and a corporation when the individual owns,directly or indirectly, more than 50% of the value of the outstandingstock of the corporation. A trust fiduciary and a corporation when the trust or thegrantor of the trust owns, directly or indirectly, more than50% in value of the outstanding stock of thecorporation. The grantor and fiduciary, and the fiduciary andbeneficiary, of any trust. Any two S corporations if the same persons own more than 50%in value of the outstanding stock of each corporation. An S corporation and a corporation that is not an Scorporation if the same persons own more than 50% in value of theoutstanding stock of each corporation. A corporation and a partnership if the same persons own morethan 50% in value of the outstanding stock of the corporation and morethan 50% of the capital or profits interest in the partnership. A personal service corporation and any employee-owner,regardless of the amount of stock owned by the employee-owner. Ownership of stock.To determine whether an individual directly or indirectly owns anyof the outstanding stock of a corporation, the following rules apply. Stock owned, directly or indirectly, by or for acorporation, partnership, estate, or trust is treated as being ownedproportionately by or for its shareholders, partners, orbeneficiaries. An individual is treated as owning the stock owned, directlyor indirectly, by or for the individual's family (as defined in item(1) under Related persons). Any individual owning (other than by applying rule (2))any stock in a corporation is treated as owning the stock owneddirectly or indirectly by that individual's partner. To apply rule (1), (2), or (3), stockconstructively owned by a person under rule (1) is treatedas actually owned by that person. But stock constructively owned by anindividual under rule (2) or (3) is not treatedas actually owned by the individual for applying either rule (2)or (3) to make another person the constructive ownerof that stock. Reallocation of income and deductions.Where it is necessary to clearly show income or prevent taxevasion, the IRS can reallocate gross income, deductions, credits, orallowances between two or more organizations, trades, or businessesowned or controlled directly or indirectly by the same interests. Contested Liability You can deduct certain contested liabilities, such as taxes (exceptforeign or U.S. possession income, war profits, and excess profitstaxes), in the tax year in which you pay them, or transfer money orother property to satisfy the obligation, rather than in the tax yearin which the contest is settled. Conditions to be met.You must satisfy each of the following conditions to take thededuction in the year of payment or transfer. Liability must be contested.You do not have to start a suit in a court of law to contest anasserted liability. However, you must deny its validity or accuracy bya positive act. A written protest included with payment of an assertedliability is enough to start a contest. Lodging a protest inaccordance with local law is also enough to contest an assertedliability for taxes. You do not have to deny the validity or accuracyof an asserted liability in writing if you can show by all the factsand circumstances that you have asserted and contested the liability. Contest must exist.The contest for the asserted liability must exist after the time ofthe transfer. If you do not make payment until after the contest issettled, you must accrue the liability in the year in which thecontest is settled. Example.You are a calendar year taxpayer using an accrual method ofaccounting. You had a $500 liability asserted against you in 1995 forrepair work completed that year. You contested the asserted liabilityand settled in 1997 for the full $500. You pay the $500 in January1998. Since you did not make the payment until after the contest wassettled, the liability accrues in 1997 and you can deduct it only in1997. Transfer to creditor.You must transfer to the creditor or other person enough money orother property to cover the payment of the asserted liability. Themoney or other property transferred must be beyond your control. Ifyou transfer it to an escrow agent, you have met this requirement ifyou give up all authority over the money or other property. However,buying a bond to guarantee payment of the asserted liability, makingan entry on your books of account, or transferring funds to an accountwithin your control will not meet this requirement. Liability deductible.The liability must have been deductible in the year of payment, orin an earlier year when it would have accrued, if there had been nocontest. Economic performance rule satisfied.You generally cannot deduct contested liabilities until economicperformance occurs. For workers' compensation or a tort liability,economic performance occurs as payments are made to the person. Thepayment or transfer of money or other property into escrow to contestan asserted liability is not a payment to the claimant that dischargesthe liability. This payment does not satisfy the economic performancetest, discussed earlier. Recovered amounts.An adjustment is usually necessary when you recover any part of acontested liability. This occurs when you deduct the liability in theyear of payment and recover any part of it in a later tax year whenthe contest is settled. You do this by including in gross income inthe year of final settlement the part of the recovered amount that,when deducted, decreased your tax for any tax year. Foreign taxes and taxes of U.S. possessions.The rule allowing the deduction of contested liabilities in the taxyear of payment does not apply to the deduction for income,war profits, and excess profits taxes imposed by any foreigngovernment or U.S. possession. This means that an accrual methodtaxpayer deducts these liabilities in the tax year in which thecontested foreign tax or U.S. possession tax is finally determined. Contested foreign taxes accrued for the foreign tax creditare not covered under this provision but relate back to and arecredited in the tax year in which they would have been accrued if theyhad not been contested.