Most individuals and many small businesses with no inventory use the cash method of accounting. However, if an inventory is necessary to account for your income, you must use an accrual method of accounting for sales and purchases.

Income

Under the cash method, you include all items of income actually or constructively received during the year in gross income for that year. If you receive property and 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. If you authorize someone to be your agent and receive income for you, you are considered to have received it when your agent receives it.

Example 1. Interest is credited to your bank account in December 1997, but you do not withdraw it or enter it into your passbook until 1998. You must include the amount in gross income for 1997, not 1998.

Example 2. You have interest coupons that mature and become payable in 1997, but you do not cash them until 1998. You must include the interest in gross income for 1997, the year of constructive receipt. You must include the interest in your 1997 income, even if you later exchange the coupons for other property, instead of cashing them.

Delaying receipt of income. You cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. You must report the income in the year the property is received or made available to you without restriction.

Expenses

Under the cash method of accounting, you must generally deduct expenses in the tax year in which you actually pay them. This includes business expenses for which you contest liability. However, you may not be able to deduct an expense paid in advance or you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules.

Expense paid in advance. An expense you pay in advance can be deducted only in the year to which it applies.

Example. You are a calendar year taxpayer and you pay $1,000 in 1997 for a business insurance policy that is effective for one year, beginning July 1st. You can deduct $500 in 1997 and $500 in 1998.

Excluded Entities

The following entities cannot use the cash method, including any combination of methods that includes the cash method.

1. A corporation (other than an S corporation).
2. A partnership with a corporation (other than an S corporation) as a partner.
3. A tax shelter.

Exceptions

The following entities can use the cash method of accounting:

1. A family farming corporation with gross receipts of $25 million or less for each prior tax year beginning after 1985. See chapter 3 of Publication 225 for information on this exception.
2. An entity with average annual gross receipts of $5 million or less.
3. A qualified personal service corporation.

Gross receipts test. Any corporation or partnership, other than a tax shelter, that meets the gross receipts test for all tax years after 1985 can use the cash method. A corporation or a partnership meets the test if its average annual gross receipts are $5 million or less for the 3 tax years ending with the prior tax year or the period of existence, if shorter. Generally, a partnership applies the test at the partnership level. For these rules, gross receipts for a short tax year are annualized.

Aggregation rules. Organizations that are members of an affiliated service group or a controlled group of corporations treated as a single employer for tax purposes are required to aggregate their gross receipts with those of the other members of the group to determine whether the gross receipts test is met.

Qualified personal service corporation. A personal service corporation that meets the function and ownership tests can use the cash method.

Function test. A corporation meets the function test if at least 95% of its activities are the performance of service in the fields of health, veterinary services, law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts, or consulting.

Ownership test. A corporation meets the ownership test if at least 95% of its stock is owned, directly or indirectly, by the following.

1. Employees performing services for the corporation in a field qualifying under the function test.
2. Retired employees who had performed services in those fields.
3. The estate of an employee described in (1) or (2).
4. Any other person who acquired the stock by reason of the death of an employee referred to in (1) or (2), but only for the 2-year period beginning on the date of death.

Indirect ownership is generally taken into account if the stock is owned indirectly through one or more partnerships, S corporations, or qualified personal service corporations. Stock owned by one of these entities is considered owned by the entity's owners in proportion to their ownership interest in that entity. Other forms of indirect stock ownership, such as stock owned by family members, are generally not considered when determining if the ownership test is met.

For purposes of the ownership test, a person is not considered an employee of a corporation unless that person performs more than minimal services for the corporation.

Change to accrual method. A corporation that fails to meet the function test for any tax year or fails to meet the ownership test at any time during any tax year must change to an accrual method of accounting, effective for the year in which the corporation fails to meet either test. A corporation that fails to meet the function test or the ownership test is not treated as a qualified personal service corporation for any part of that tax year.

Failure to meet exceptions. An entity that fails to meet any of these exceptions in any tax year must change to an accrual method of accounting. See Change in Accounting Method, later.

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