Publication 225: Farmer's Tax Guide; Accounting Periods & Methods

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Table of Contents

Important Reminders for 2003

Automatic approval provisions for change in tax year. There are automatic approval provisions available to certain taxpayers needing to make a change in their tax year. These are discussed in Change in tax year later, and explained in detail in the instructions to Form 1128.

Relief from treatment as constructive receipt of income. If you receive direct or counter-cyclical payments as provided for in the Farm Security and Rural Investment Act of 2002 (Public Law 107-171), you are not considered to constructively receive a payment merely because you have the option to receive it in the year before it is required to be paid. This is discussed later in Direct payments and counter-cyclical payments.

Introduction

You must figure your taxable income and file an income tax return for an annual accounting period called a tax year. You must consistently use an accounting method that clearly shows your income and expenses.

Topics - This chapter discusses:

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When preparing a statement of income and expenses (generally your farm income tax return), you must use books and records kept for a specific interval of time called an accounting period. The annual accounting period for your tax return is called a tax year. You can generally use one of the following tax years.

However, special restrictions apply to partnerships, S corporations, and personal service corporations. If you operate as one of these entities, see Publication 538 for more information.

Calendar year.

A calendar year is 12 consecutive months beginning January 1 and ending December 31.

You must adopt the calendar year if any of the following apply.

You do not keep adequate records.
You have no annual accounting period.
Your present tax year does not qualify as a fiscal year.
You must use the calendar tax year if required under the Internal Revenue Code and the Income Tax Regulations.

If you filed your first income tax return using the calendar year and you later begin business as a farmer, you must continue to use the calendar tax year unless you get IRS approval to change it. See Change in tax year, later.

If you adopt the calendar year you must maintain your books and records and report income and expenses for the period from January 1 through December 31 of each year.

Fiscal tax year.

A fiscal year is 12 consecutive months ending on the last day of any month except December. A 52–53 week tax year is a fiscal year that varies from 52 to 53 weeks but may not end on the last day of a month.

If you adopt a fiscal year you must maintain your books and records and report your income and expenses using the same year.

For more information on a fiscal year, including a 52–53 week tax year, see Publication 538.

Once you have chosen your tax year, you must, with certain exceptions, get IRS approval to change it. To get approval, file Form 1128. The Form 1128 instructions have details on the exceptions (circumstances in which Form 1128 may not be filed) as well as instructions for completing the form where it is required. If you are required to use the form to make a desired change in tax year, you should consult the references to new automatic approval procedures explained in detail in the Form 1128 instructions and Publication 538. If you qualify, you must use the automatic approval procedures. You will not have to pay a user fee. The Form 1128 instructions and Publication 538 also explain new procedures for taxpayers ineligible for automatic approval. These taxpayers must request a ruling and pay a user fee.

An accounting method is a set of rules used to determine when and how income and expenses are reported. Your accounting method includes not only your overall method of accounting, but also the accounting treatment you use for any material item.

You choose an accounting method for your farm business when you file your first income tax return that includes a Schedule F. However, you cannot use the crop method for any tax return, including your first tax return, unless you get IRS approval. The crop method of accounting is discussed later under Special Methods of Accounting. Getting IRS approval to change an accounting method is discussed later under Change in Accounting Method.

Kinds of methods.

Generally, you can use any of the following accounting methods.

Cash.
Accrual.
Special methods of accounting for certain items of income and expenses.
Combination (hybrid) method using elements of two or more of the above.

However, certain farm corporations and partnerships, and all tax shelters, must use an accrual method of accounting. See Accrual method required, later.

Business and personal items.

You can account for business and personal items using different accounting methods. For example, you can figure your business income under an accrual method, even if you use the cash method to figure personal items.

Two or more businesses.

If you operate two or more separate and distinct businesses, you can use a different accounting method for each. No business is separate and distinct, however, unless a complete and separate set of books and records is maintained for each business.

Accrual method required.

The following businesses engaged in farming must use an accrual method of accounting.

A corporation (other than a family corporation) that had gross receipts of more than $1,000,000 for any tax year beginning after 1975.
A family corporation that had gross receipts of more than $25,000,000 for any tax year beginning after 1985.
A farming partnership with a corporation as a partner.
A tax shelter.

For this purpose, an S corporation is not treated as a corporation. Also, items (1), (2), and (3) do not apply to a business engaged in operating a nursery or sod farm or in raising or harvesting trees (other than fruit and nut trees).

Family corporation.

A family corporation is generally a corporation that meets one of the following ownership requirements.

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.
Members of two families have owned, directly or indirectly, since October 4, 1976, at least 65% of the total combined voting power of all classes of voting stock and at least 65% of the total shares of all other classes of the corporation's stock.
Members of three families have owned, directly or indirectly, since October 4, 1976, at least 50% of the total combined voting power of all classes of voting stock and at least 50% of the total shares of all other classes of the corporation's stock.

For more information on family corporations, see section 447 of the Internal Revenue Code.

Tax shelter.

A tax shelter is a partnership, noncorporate enterprise, or S corporation that meets either of the following tests.

Its principal purpose is the avoidance or evasion of federal income tax.
It is a farming syndicate. A farming syndicate is an entity that meets either of the following tests.
1. Interests in the activity have been offered for sale in an offering required to be registered with a federal or state agency with the authority to regulate the offering of securities for sale.
2. More than 35% of the losses during the tax year are allocable to limited partners or limited entrepreneurs.

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. A limited entrepreneur is one who has an interest in an enterprise other than as a limited partner and does not actively participate in the management of the enterprise.

Most farmers use the cash method because they find it easier to keep cash method records. However, certain farm corporations and partnerships and all tax shelters must use an accrual method of accounting. See Accrual method required, earlier.

Under the cash method, include in your gross income all items of income you actually or constructively receive during the tax year. If you receive property or services, you must include their fair market value in income. See chapter 4 for information on how to report farm income on your income tax return.

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. Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations.

Direct payments and counter-cyclical payments.

If you received direct payments or counter-cyclical payments under Subtitle A or C of the Farm Security and Rural Investment Act of 2002 (Public Law 107-171), you will not be considered to constructively receive a payment merely because you had the option to receive it in the year before it is required to be paid. You disregard that option in determining when to include the payment in your income.

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.

Example.

Frances Jones, a farmer, was entitled to receive a $10,000 payment on a contract in December 2003. She was told in December that her payment was available. At her request, she was not paid until January 2004. She must still include this payment in her 2003 income because it was made available to her in 2003.

Debts paid by another person or canceled.

If your debts are paid by another person or are canceled by your creditors, you may have to report part or all of this debt relief as income. If you receive income in this way, you constructively receive the income when the debt is canceled or paid. See Cancellation of Debt in chapter 4.

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 tax year. You sell grain in December 2003 under a bona fide arm's-length contract that calls for payment in 2004. You include the sale proceeds in your 2004 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 2003 income, regardless of when you actually receive payment.

Repayment of income.

If you include an amount in income and in a later year you have to repay all or part of it, you can usually deduct the repayment in the year in which you make it. If the amount you repay is over $3,000, a special rule applies. For details about the special rule, see Repayments in chapter 13 of Publication 535, Business Expenses.

Under the cash method, you 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 under Uniform Capitalization Rules in chapter 7. See chapter 5 for information on how to deduct farm business expenses on your income tax return.

Prepayment.

You cannot deduct expenses in advance, even if you pay them in advance. This rule applies to any expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year.

Example.

In 2003, you signed a 3-year insurance contract. Even though you paid the premiums for 2003, 2004, and 2005 when you signed the contract, you can only deduct the premium for 2003 on your 2003 tax return. Deduct in 2004 and 2005 the premium allocable to those years.

Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to correctly match income and expenses.

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

Inventory.

If you keep an inventory, you generally must use an accrual method of accounting to determine your gross income. See Farm Inventory, later, for more information.

Under an accrual method of accounting, you generally deduct or capitalize a business expense when both of the following apply.

Economic performance.

You generally cannot deduct or capitalize a business expense 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 as the property is used.

If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.

An exception to the economic performance rule allows certain recurring items to be treated as incurred during a tax year even though economic performance has not occurred. For more information on economic performance, see Economic Performance in Publication 538.

Example.

Jane is a farmer who uses a calendar tax year and an accrual method of accounting. She enters into a contract with Waterworks in 2003. The contract states that Jane must pay Waterworks $200,000 in December 2003 and they will install a complete irrigation system, including a new well, by the close of 2005. She pays Waterworks $200,000 in December 2003, they start the installation in May 2005, and they complete the irrigation system in December 2005.

Economic performance for Jane's liability in the contract occurs as the property and services are provided. Jane incurs the $200,000 cost in 2005.

Special rule for related persons.

Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible until you make the payment and the corresponding amount is includible in the related person's gross income. Determine the relationship, for this rule, as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is denied, the rule will continue to apply even if your relationship with the person ends before the expense or interest is includible in the gross income of that person.

Related persons include members of your immediate family, including brothers and sisters (either whole or half), your spouse, ancestors, and lineal descendants. For a list of other related persons, see Related Persons in Publication 538. For example, in the following examples, Corporation B is a legal person. A is related to Corporation B because of his majority stock ownership.

Example 1.

As of December 31, 2003, A, a calendar year individual taxpayer, owns 60% of the stock in Corporation B, which is engaged in farming. A owes Corporation B $1,000 interest due in December of 2003, but does not pay until January of 2004. Corporation B, also a calendar year taxpayer, uses cash basis accounting (its receipts are less than $1,000,000). A may not deduct the $1,000 payment when filing his 2003 tax year return in 2004 because the expense is not considered incurred until January of 2004.

Example 2.

The facts are the same, but A sells all his stock in the corporation in November of 2003. A still may not make the deduction in his 2003 tax year.

Contested liability.

If you use an accrual method of accounting and contest an asserted liability for a farm business expense, you can deduct the liability either in the year you pay it (or transfer money or other property in satisfaction of it) or in the year you finally settle the contest. However, 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.

If you keep an inventory, you generally must use an accrual method of accounting to determine your gross income. 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 for use as feed, seed, etc., whether raised or purchased, that are unsold at the end of the year.

Accounting for inventory.

Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, if you are a qualifying taxpayer or a qualifying small business taxpayer that has an eligible business, you can use the cash method of accounting, even if you produce, purchase, or sell merchandise. If you qualify, you also can choose not to keep an inventory, even if you do not change to the cash method.

You are a qualifying taxpayer only if you meet the gross receipts test for each prior tax year ending after December 16, 1998. To meet the test for a prior tax year, your average annual gross receipts must be $1,000,000 or less for the 3 tax years ending with the prior tax year. A tax shelter cannot be a qualifying taxpayer. See Publication 538 for more information.

You are a qualifying small business taxpayer for your eligible business only if you meet the gross receipts test for each prior tax year ending on or after December 31, 2000, and are not prohibited from using the cash method under section 448 of the Internal Revenue Code. To meet the test for a prior tax year, your average annual gross receipts must be $10,000,000 or less for the 3 tax years ending with the prior tax year. Certain other requirements must be met. See Publication 538 for more information.

The qualifying small business taxpayer exception does not apply to a farming business. However, if you are a qualifying small business taxpayer engaged in a farming business, this exception may apply to your nonfarming businesses, if any.

Hatchery business.

If you are in the hatchery business, and use the accrual method of accounting, you must include in inventory eggs in the process of incubation.

Products 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 in inventory.

Supplies.

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

Livestock.

Livestock held primarily for sale must be included in inventory. Livestock held for draft, breeding, or dairy purposes can either be depreciated or included in inventory. See also Unit-livestock-price method, later. If you are in the business of breeding and raising chinchillas, mink, foxes, or other fur-bearing animals, these animals are livestock for inventory purposes.

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. See Uniform Capitalization Rules in chapter 7.

Required to use accrual method.

The following applies if you are required to use an accrual method of accounting.

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.
The costs of animals are subject to the uniform capitalization rules.

Inventory valuation methods.

The following methods, described below, are those generally available for valuing inventory.

Cost.
Lower of cost or market.
Farm-price method.
Unit-livestock-price method.

Cost and lower of cost or market methods.

See Publication 538 for information on these valuation methods.

If you value your livestock inventory at cost or the lower of cost or market, you do not need IRS approval to change to the unit-livestock-price method.

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 broker's commissions, 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 under 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 must annually reevaluate your unit livestock prices and adjust the prices upward or downward to reflect increases or decreases in the costs of raising livestock. IRS approval is not required for these adjustments. Any other changes in unit prices or classifications do require IRS approval.

If you use this method, include all raised livestock in inventory, regardless of whether they are held for sale or for draft, breeding, sport, or dairy 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 those most recently acquired.

You must include in inventory all livestock purchased primarily for sale. You can choose either to include in inventory or depreciate livestock purchased for draft, breeding, sport or dairy purposes. However, you must be consistent from year to year, regardless of the practice you have chosen. You cannot change your practice without 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 6 months of the year. This no increase rule does not apply to tax shelters which must make an adjustment for any animal purchased during the year. It also does not apply to taxpayers that must make an adjustment to reasonably reflect the particular period in the year in which animals are purchased, if necessary to avoid significant distortions in income.

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.

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 that 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.

Other special methods of accounting apply to the following items.

Amortization, see chapter 8.
Casualties, see chapter 13.
Condemnations, see chapter 13.
Depletion, see chapter 8.
Depreciation, see chapter 8.
Farm business expenses, see chapter 5.
Farm income, see chapter 4.
Installment sales, see chapter 12.
Soil and water conservation expenses, see chapter 6.
Thefts, see chapter 13.

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

Once you have set up your accounting method, you must generally get IRS approval before you can change to another method. A change in your accounting method includes a change in:

To get approval, you must file Form 3115. You may have to pay a fee. For more information, see the Form 3115 instructions.