Publication 538 - Accounting Periods And Methods (Page 13 of 23) in pdf

year, the shipping costs are more properly matched to in-

generally accepted accounting principles for similar busi-

come in the year of sale than the year the goods are ship-

nesses and must clearly reflect income. Your inventory

ped. Expenses that cannot be practically associated with

practices must be consistent from year to year.

income of a particular period, such as advertising costs,

The rules discussed here apply only if they do not

should be assigned to the period the costs are incurred.

conflict with the uniform capitalization rules of

However, the matching requirement is considered met for

section 263A and the marktomarket rules of sec

certain types of expenses. These expenses include taxes,

CAUTION

tion 475.

payments under insurance, warranty, and service con-

tracts, rebates, refunds, awards, prizes, and jackpots.

Exceptions

Expenses Paid in Advance

The following taxpayers can use the cash method of ac-

counting even if they produce, purchase, or sell merchan-

An expense you pay in advance is deductible only in the

dise. These taxpayers can also account for inventoriable

year to which it applies, unless the expense qualifies for

items as materials and supplies that are not incidental

the 12-month rule. Under the 12-month rule, a taxpayer is

(discussed later).

not required to capitalize amounts paid to create certain

rights or benefits for the taxpayer that do not extend be-

A qualifying taxpayer under Revenue Procedure

yond the earlier of the following.

2001-10 on page 272 of Internal Revenue Bulletin

2001-2, available at

12 months after the right or benefit begins, or

irb01–02.pdf.

The end of the tax year after the tax year in which pay-

A qualifying small business taxpayer under Revenue

ment is made.

Procedure 2002-28, on page 815 of Internal Revenue

Bulletin 2002-18, available at

If you have not been applying the general rule (an ex-

irbs/irb02–18.pdf.

pense paid in advance is deductible only in the year to

which it applies) and/or the 12-month rule to the expenses

In addition to the information provided in this pub

you paid in advance, you must get IRS approval before

lication, you should see the revenue procedures

TIP

using the general rule and/or the 12-month rule. See

referenced in the list, above, and the instructions

Change in Accounting Method, later, for information on

for Form 3115 for information you will need to adopt or

how to get IRS approval. See Expense paid in advance

change to these accounting methods (see Changing

under Cash Method, earlier, for examples illustrating the

methods, later).

application of the general and 12-month rules.

Qualifying taxpayer. You are a qualifying taxpayer un-

Related Persons

der Revenue Procedure 2001-10 only if:

Business expenses and interest owed to a related person

You satisfy the gross receipts test for each prior tax

who uses the cash method of accounting are not deducti-

year ending on or after December 17, 1998 (see

ble until you make the payment and the corresponding

Gross receipts test for qualifying taxpayers, next).

amount is includible in the related person's gross income.

Your average annual gross receipts for each test year

Determine the relationship for this rule as of the end of the

(explained in Step 1, listed next) must be $1 million or

tax year for which the expense or interest would otherwise

less.

be deductible. See section 267 of the Internal Revenue

You are not a tax shelter as defined under section

Code and Pub. 542, Corporations, for the definition of re-

448(d)(3) of the Internal Revenue Code.

lated person.

Gross receipts test for qualifying taxpayers. To

Inventories

determine if you meet the gross receipts test for qualifying

taxpayers, use the following steps:

An inventory is necessary to clearly show income when

1. Step 1. List each of the test years. For qualifying tax-

the production, purchase, or sale of merchandise is an in-

payers under Revenue Procedure 2001-10, the test

come-producing factor. If you must account for an inven-

years are each prior tax year ending on or after De-

tory in your business, you must use an accrual method of

cember 17, 1998.

accounting for your purchases and sales. However, see

2. Step 2. Determine your average annual gross re-

Exceptions, next. See also Accrual Method, earlier.

ceipts for each test year listed in Step 1. Your average

annual gross receipts for a tax year is determined by

To figure taxable income, you must value your inven-

adding the gross receipts for that tax year and the 2

tory at the beginning and end of each tax year. To deter-

preceding tax years and dividing the total by 3.

mine the value, you need a method for identifying the

items in your inventory and a method for valuing these

3. Step 3. You meet the gross receipts test for qualifying

items. See Identifying Cost and Valuing Inventory, later.

taxpayers if your average annual gross receipts for

each test year listed in Step 1 is $1 million or less.

The rules for valuing inventory are not the same for all

businesses. The method you use must conform to

Publication 538 (December 2016)

Page 13

Publication 538 - Accounting Periods And Methods Page 13

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