Accrual Method of Accounting
With the accrual method, include amounts in gross income when they are earned, even though payment may be received in another year. Income is earned when:
• All events have occurred that fix the right to receive the income, and
• The amount to be received can be determined with reasonable accuracy.
Generally, a taxpayer’s right to income accrues when title to property passes to the buyer or services are performed for customers. If there is potential for refund, the income is reported in the year of sale and a deduction is allowed in subsequent years when actual claims accrue.
When a taxpayer’s right to income is contested, the year of income inclusion depends on whether payment has been received. If payment hasn’t been received, no income is recognized until the claim is settled. However, if the payment is received prior to settlement of the dispute, the claim-of-right doctrine requires the taxpayer to recognize the income in the year of receipt.
Measurement of the Income on Accrual Basis
The amount of income to report is the amount the taxpayer has a right to receive (contrast this with the cash method above).
Expenses
Expenses are claimed when a taxpayer becomes liable for them, whether or not they are actually paid in the same year.
Accrual Method Must Be Used
For businesses maintaining inventory, except as noted below. The following must use the accrual method:
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Corporations (not S corps).
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Partnerships with a corporate partner.
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Tax Shelters.
The Accrual Requirement Has These Exceptions
(a) Family farming corporations; (b) Qualified personal service corporations and partnerships with a qualified personal service corporation as a partner; (c) C corps and partnerships (not tax shelters) with average annual gross receipts for the most recent 3-year period of $5 million or less. Note: See above for rules added by Revenue Procedures 2001-10 and 2002-28 for small businesses prior to 2018 and TCJA of 2017 for years after 2017. Situations where accrual method isn’t applied even with an accrual basis taxpayer:
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Prepaid income: When it comes to financial reporting, advance payments are reflected as prepaid income and liabilities of the seller., For tax purposes, though, prepaid income is often taxed in the year of receipt., When the income should be reported often becomes a sore point between the IRS and taxpayers.
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Advance payments for goods: Generally, a taxpayer can elect to defer income recognition for advances paid for goods if the method of accounting for the sale is the same for both tax and financial reporting purposes.
Example - Advance Payment for Goods: Vance & Co. ships goods only after payment for them is received. In December 2022, Vance got $8,000 for goods not shipped until January 2023. Vance can elect to report the income for tax purposes in 2022, assuming they report the income the same way on their 2022 books.
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Advance payment for services: Rev. Proc. 71-21 allows accrual basis taxpayers to defer recognition of income for services to be performed by the end of the tax year following the year of receipt. No deferral is allowed, however, if the taxpayer might be required to perform any services, under the agreement, after the tax year following the year of receipt of the advance payment.
Rev Proc 71-21 doesn’t apply to prepaid rent, or prepaid interest.
TCJA Change Re Advance Payments for Accrual Method Taxpayers
For tax years beginning after 2017, an advance payment or other prepaid income received during the tax year must either be included in gross income for the tax year of receipt or the taxpayer must make an election to defer the inclusion of the payment in gross income with respect to the category of advance payments to which it belongs. (Code Sec. 451(c)). When the deferral election is made, the part of the advance payment that must be included in gross income in the year payment is actually or constructively received is the portion of the advance payment required to be included as gross income in the taxpayer’s AFS. The remainder is included in gross income in the following year. See IRS Notice 2018-35 for further information.