Publication 538 - Accounting Periods And Methods (Page 10 of 19) in pdf

Advance Payment for Services

2-year period beginning on the date of

entire payment in income in 2002 since part of

death.

the services may be performed after the follow-

Generally, you report an advance payment for

ing year.

Indirect ownership is generally taken into ac-

services to be performed in a later tax year as

count if the stock is owned indirectly through one

Guarantee or warranty. You generally can-

income in the year you receive the payment.

not postpone reporting income you receive

or more partnerships, S corporations, or quali-

However, if you receive an advance payment for

under a guarantee or warranty contract.

fied personal service corporations. Stock owned

services you agree to perform by the end of the

by one of these entities is considered owned by

next tax year, you can elect to postpone includ-

Prepaid rent or interest. You cannot post-

the entity’s owners in proportion to their owner-

ing the advance payment in income until the

pone reporting income from prepaid rent or in-

ship interest in that entity. Other forms of indirect

next tax year. However, you cannot postpone

terest. Prepaid rent does not include payment

stock ownership, such as stock owned by family

including any payment beyond that tax year.

for the use of a room or other space when

members, are generally not considered when

significant service is also provided for the occu-

determining if the ownership test is met.

Service agreement. You can postpone re-

pant. You provide significant service when you

For purposes of the ownership test, a person

porting income from an advance payment you

supply space in a hotel, boarding house, tourist

is not considered an employee of a corporation

receive for a service agreement on property you

home, motor court, motel, or apartment house

unless that person performs more than minimal

sell, lease, build, install, or construct. This in-

that furnishes hotel services.

services for the corporation.

cludes an agreement providing for incidental

Books and records. Any advance payment

replacement of parts or materials. However, this

Change to accrual method. A corporation

you include in gross receipts on your tax return

applies only if you offer the property without a

that fails to meet the function test for any tax

for the year you receive payment must not be

service agreement in the normal course of busi-

year or fails to meet the ownership test at any

less than the payment you include in gross re-

ness.

time during any tax year must change to an

ceipts for your books and records and all your

accrual method of accounting, effective for the

Postponement not allowed You generally

reports. This includes reports (including consoli-

year in which the corporation fails to meet either

cannot postpone including an advance payment

dated financial statements) to shareholders,

test. A corporation that fails to meet the function

in income for services if either of the following

partners, other proprietors or beneficiaries, and

test or the ownership test is not treated as a

applies.

for credit purposes.

qualified personal service corporation for any

•

You are to perform any part of the service

part of that tax year.

IRS approval. You must get IRS approval, as

after the end of the tax year immediately

discussed later under Change in Accounting

following the year you receive the advance

Method, to change your method of accounting

payment.

for advance payments for services.

Accrual Method

•

You are to perform any part of the service

at any unspecified future date that may be

Advance Payment for Sales

Under an accrual method of accounting, you

after the end of the tax year immediately

generally report income in the year earned and

following the year you receive the advance

Special rules apply to including income from

deduct or capitalize expenses in the year in-

payment.

advance payments on agreements for future

curred. The purpose of an accrual method of

sales or other dispositions of goods held prima-

accounting is to match income and expenses in

Examples. In each of the following examples,

rily for sale to customers in the ordinary course

the correct year.

assume you use the calendar year and an ac-

of your trade or business. However, the rules do

crual method of accounting.

not apply to a payment (or part of a payment) for

Income

services that are not an integral part of the main

Example 1. You manufacture, sell, and

activities covered under the agreement. An

You generally include an amount as gross in-

service computers. You received payment in

agreement includes a gift certificate that can be

come for the tax year in which all events that fix

2002 for a one-year contingent service contract

redeemed for goods. Amounts due and payable

your right to receive the income have occurred

on a computer you sold. You can postpone in-

are considered received.

and you can determine the amount with reason-

cluding in income the part of the payment you

able accuracy.

How to report payments. You generally in-

did not earn in 2002 if, in the normal course of

clude an advance payment in income in the year

your business, you offer computers for sale with-

Example. You are a calendar year, accrual

in which you receive it. However, you can use

out a contingent service contract.

basis taxpayer. You sold a computer on Decem-

the alternative method, discussed next.

ber 28, 2001. You billed the customer in the first

Example 2. You are in the television repair

Alternative method of reporting. Under the

week of January 2002, but did not receive pay-

business. You received payments in 2002 for

alternative method, you generally include an ad-

ment until February 2002. You include the

one-year contracts under which you agree to

vance payment in income in the earlier tax year

amount received in February for the computer in

repair or replace certain parts that fail to function

in which:

your 2001 income.

properly in television sets manufactured and

•

sold by unrelated parties. You include the pay-

You include advance payments in gross

Estimated income. If you include a reasona-

ments in gross income as you earn them.

receipts under the method of accounting

bly estimated amount in gross income and later

you use for tax purposes, or

In Examples 3 and 4, if you do not perform

determine the exact amount is different, take the

part of the services by the end of the following

•

You include any part of advance payments

difference into account in the tax year you make

tax year (2003), you must still include advance

in income for financial reports under the

that determination.

payments for the unperformed services in gross

method of accounting used for those re-

income for 2003.

ports. Financial reports include reports to

Change in payment schedule. If you perform

shareholders, partners, beneficiaries, and

services for a basic rate specified in a contract,

Example 3. You own a dance studio. On

other proprietors for credit purposes and

you must accrue the income at the basic rate,

November 1, 2002, you receive payment for a

consolidated financial statements.

even if you agree to receive payments at a

one-year contract for 48 one-hour lessons be-

reduced rate. Continue this procedure until you

ginning on that date. You give eight lessons in

complete the services, then account for the dif-

Example 1. You are a retailer. You use an

2002. Under this method of including advance

ference.

accrual method of accounting and you account

payments, you must include one-sixth (8/48) of

for the sale of goods when you ship the goods.

the payment in income for 2002, and five-sixths

Accounts receivable for services. You may

You use this method for both tax and financial

(40/48) of the payment in 2003, even if you

not have to accrue your accounts receivable

reporting purposes. You can include advance

cannot give all the lessons by the end of 2003.

that, based on your experience, you will not

payments in gross receipts for tax purposes

collect. The nonaccrual-experience method is

Example 4. Assume the same facts as in

either in the tax year you receive the payments

explained in section 1.448 – 2T of the regula-

Example 3, except the payment is for a two-year

or in the tax year you ship the goods. However,

tions.

contract for 96 lessons. You must include the

see Exception for inventory goods, later.

Page 10

Publication 538 - Accounting Periods And Methods Page 10

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