Tax Accounting Methods & Periods
Income Recognition, Deferrals, and Methods
Valuation professionals that provide either consulting or tax reporting services will encounter taxpayers with unique questions regarding what income to report. This article provides CPAs and consulting professionals with an overview of what to report and why.
In the last quarter 2015, a client I will call “Michael” came to my firm with an interesting set of facts and a question: his employer (who hired Michael as an independent contractor) offered to pay Michael’s entire compensation for 2016—in 2015. Michael wanted to know if he would be taxed for all of this double income (what his employer had paid for 2015, plus the proposed services he would perform in 2016 but be paid for in 2015) in 2015. The accountant for his colleague (who had been offered the same deal) had advised the colleague that he would be taxed for the entire amount in 2015. This independent contractor wanted to get to the bottom of the foregoing.
The truth, or answer, depends on the accounting method that is elected and used to figure and report taxes. “Cash method” and “accrual method” are the two most commonly used ones. Taxpayers are mandated to report income in the tax-year received (and deduct expenses accordingly), that is, if the taxpayer is using the cash method. Under this method, taxpayers recognize income when the cash (or its equivalent) is received, and taxpayers deduct expenses when they are actually paid—regardless of the period to which they pertain.
On the other hand, under the accrual method, taxpayers measure financial performance by recognizing the underlying economic events; regardless of when cash comes into, or leaves their hands.
These methods, and others, are commonly used for financial statement reporting. Fortunately, the IRS also recognizes them for tax computation. One key condition that the IRS requires is consistency—taxpayers may not switch back and forth as events suit their needs or whims. Once a taxpayer declares a method of accounting as one or the other to the IRS, the taxpayer may not switch without good reason.
To start, taxpayers must elect a “tax-year” (a yearly period for tracking records, and realizing revenues and expenses) to figure their taxable income. The two basic choices are: calendar year or fiscal year. As the name implies, a calendar year starts on January 1, and runs until December 31 of any given year.
A fiscal year, on the other hand, is defined as: any 12 consecutive months ending on the last day of any month except December 31 (which would then automatically make it a calendar year). Like with methods, taxpayers may not change tax-years on a whim, but need the blessing of the IRS. (Generally, a taxpayer seeking a change must file Form 1128 to request IRS approval to the tax-year change.)
Here is an example: A taxpayer uses a cash method and a calendar-year end. On 1 July 2015, the taxpayer paid $5,000 for an annual insurance policy (through 30 June 2016) so the taxpayer will need to deduct the entire $5,000 on their 2015 return. Using the same facts, but assuming the accrual method, the taxpayer will then only realize one-half of that expense ($2,500) in 2015, and the other half in 2016.
One important distinction regarding the accrual method is that taxpayers may not postpone income recognition from an advance payment for services (if the taxpayer agrees to perform any part of the service after the end of the tax-year immediately following the year the taxpayer received the payment, or at any unspecified future date) which may be after the end of the tax-year immediately following the year the taxpayer received the payment.
For instance (assuming a calendar year and accrual method), that the taxpayer operates a karate studio. On 1 November 2015, the taxpayer pays for a one-year contract for 24 two-hour lessons—in other words, two lessons per month—beginning on the same date. The taxpayer will teach four sessions in 2015. The taxpayer here must include one-sixth (4/24) of the payment in recognized income for 2015, and the remainder in 2016, even if the taxpayer does not fully perform the contract by the end of 2016.
Assuming the same facts, except that the terms of the contract specified a two-year period in which to perform (i.e., 1 November 2015–31 October 2017). This time the taxpayer will need to recognize the entire payment in 2015, because part of the services may be performed after the end of 2016.
Keep in mind that cash and accrual methods are the most commonly used, but not the only games in town! There are also the “special” and “hybrid” methods. As far as the “tax-years” are concerned, a taxpayer may also adopt a “52-53 week tax-year”, or a “short tax-year”. There are also detailed procedures to correct an “improper tax-year”, or to make a “change in tax-year”.
A taxpayer may adopt a tax-year by filing with the first income tax return—using taxpayer’s desired tax-year (unless you have a required tax-year, according to taxpayer’s circumstances/profession).
The above discussion generally applies to businesses (including sole proprietorships); individuals generally must adopt the calendar year. However, an individual taxpayer may adopt a fiscal year if he/she maintains books and records on the basis of the fiscal year adopted. Furthermore, restrictions apply to partnerships, S corporations, and personal service corporations, as follows:
Partnerships. Need to follow their partners’ tax-years, unless the partnership elects under IRC 444 (generally referred to as “Section 444”) to have a tax-year other than the required one. The partnership needs to file Form 8716 if it wants to go this route. The other exception is if the partnership chooses one of the specialty tax-years (e.g., 52-53 week). However, such election must culminate with reference to either partnership’s “required” tax-year (what normally would be for partnerships in that industry, or as defined by law for their particular situation);or a tax-year elected under the aforementioned IRC 444; or, if the partnership is able to show why/how a different tax-year better suits its purpose.
What exactly is a “required” tax-year for a partnership? Well…it depends! If the “majority” (over fifty percent) interest in a partnership’s profits and capital is held by partner(s) having a particular tax-year, the partnership must necessarily elect the same year. However, if there are no majority partners as such, then the partnership needs to use the tax-year of its “principal” (five percent or more interest in profits or capital) partners.
What if there is no majority interest, and the principal partners do not share the same tax-year? Then the partnership is required to use a tax-year which results in the “least overall deferral of income” to partners. One bright side: the partnership can get automatic approval for switching to a required tax-year (due to these rules). It still needs to file Form 1128, however, to receive the automatic approval.
This is how the IRS wants partnerships to determine their “least aggregate deferral of income”. Using one partner’s tax-year, determine how many months of deferral for each partner by counting the months from the end of that one partner’s tax-year forward to the end of every other partner’s tax-year. Then, multiply each partner’s months of deferral by that partner’s share of interest in the partnership profits for that same year.
Next, add the amounts thus far obtained to get the total deferral for the original tax-year.
Repeat the above for each partner’s tax-year that is different from the other partners.
The tax-year of the partner yielding the lowest aggregate number is the tax-year that needs to be used by the partnership. The partnership can pick and choose the foregoing results in more than one qualifying tax-year. If one of the qualifying tax-years turns out to be the partnership’s existing year, then the partnership must retain that same year.
For instance: Jack and Jill each have a fifty percent interest in J&J Partnership, with a June 30 ending fiscal year. Jack has adopted the calendar year, while Jill has elected a November 30 ending fiscal year. As seen from the table below, J&J needs to switch its tax-year to a November 30 ending fiscal year since this results (the second half of the table) in the lesser of the two aggregate income deferred to Jack and Jill.
Year End Year Profits Months Interest ×
12/31: End Interest Deferred Deferral
Jack 12/31 0.5 -0- -0-
Jill 11/30 0.5 11 5.5
Total Deferral 5.5
Year End Year Profits Months Interest ×
12/31: End Interest Deferred Deferral
Jack 12/31 0.5 1 0.5
Jill 11/30 0.5 -0- -0-
Total Deferral 0.5
Unless special circumstances apply (as determined by the IRS), at the beginning of the current partnership’s tax-year is when the foregoing determination (under the least aggregate deferral rules) should be made.
S Corporations. Regardless of the commencement of S corporation status, all have to use one of the following:
- The calendar year.
- A tax-year elected under IRC 444.
- A 52-53 week tax-year (ending with reference to the calendar year, or a tax-year elected under IRC 444).
- Any other year—so long as the corporation can show a valid business purpose.
Form 2553 (and not Form 1128 [for partnerships]) has to be used by the S corp to use a tax-year other than calendar. (However, relevant information is found in Instructions for Form 1128.)
Personal Service Corporation (PSC). If the taxpayer is a PSC, then they must adopt a calendar year, unless:
- Taxpayer makes an election under IRC 444.
- Taxpayer adopts a 52-53 week tax-year ending with reference to the calendar year, or a tax-year elected under IRC 444.
- The S corp shows valid cause for a fiscal tax-year.
So, what is imbedded in IRC 444? Except as otherwise provided in the text of this section, a partnership, S corporation, or personal service corporation may elect to have a taxable year other than the required taxable year. Perhaps most importantly, a business entity using this election needs to ensure all required payments (distributions in case of PSC’s) are made on a timely basis (so that the change in tax-year does not create any ambiguity in payments). Additionally, any of the aforementioned business entities that can show a just business purpose for a period other than its required tax-year need not worry about IRC 444.
Generally, a business entity in one of the aforementioned categories can make a section 444 election if: it is not a “tiered structure” member; is applying IRC 444 for the first time; and it adopts a year which meets the deferral period requirements.
Finally, an elaboration regarding “52-53 week tax-year”: a taxpayer may choose a 52-53 week tax-year if the taxpayer can show that he or she will maintain the bookkeeping and reporting on that basis. If a taxpayer makes this election, then the taxpayers’ 52-53 week tax-year must always end on the same day of the week. In other words, your 52-53 week tax-year must always end on whichever date this same day of the week last occurs in a calendar month, or on whichever date this same day of the week falls that is closest to the final day of the calendar month.
For instance, if a taxpayer that uses a 52-53 week tax-year always ends on the last Friday in May, for 2015 your tax-year ending will be on May 31, 2016 (which happens to be a Monday).
Why all the alternatives? To ensure taxpayers can fairly represent their true income and deductions which reasonably fit their particular circumstances. Since businesses are defined by seasons, locations, and various economic, geopolitical, financial, and other variables, they can select from the available choices which they feel best showcases their income (and therefore taxation) reality.
A skilled accountant can assess the reality of a business concern: independently, and also in light of its industry; local, national, and global economy; and cluster of entities sharing the same business structure. On that basis, the professional may provide alternatives and recommendations (to the client’s management) regarding which of the tax methods and periods available can best be tailor-made for that particular client-entity—as very effective tax planning and tax avoidance tools.
Remember if you have any questions always speak to your accountant or visit the IRS website www.irs.gov