Publication 225 (2007), Farmer's Tax Guide

IRS Resources

2. Accounting Methods

Table of Contents

Introduction

You must consistently use an accounting method that clearly shows your income and expenses. You must also figure your taxable income and file an income tax return for an annual accounting period called a tax year. Only accounting methods are discussed in this chapter. For information on accounting periods, see Publication 538, Accounting Periods and Methods, and the instructions for Form 1128, Application To Adopt, Change, or Retain a Tax Year.

Topics - This chapter discusses:

Cash method
Accrual method
Farm inventory
Special methods of accounting
Change in accounting method

Useful Items - You may want to see:

Publication

538 Accounting Periods and Methods
535 Business Expenses

Form (and Instructions)

1128
Application To Adopt, Change, or Retain a Tax Year
3115
Application for Change in Accounting Method

See chapter 17 for information about getting publications and forms.

Accounting Methods

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 receive approval from the IRS. The crop method of accounting is discussed later under Special Methods of Accounting. How to obtain 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 method.
Accrual method.
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 partnership with a corporation as a partner.
A tax shelter.

Note.

Items (1), (2), and (3) do not apply to an S corporation or a business operating a nursery or sod farm, or the raising or harvesting of 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 Internal Revenue Code section 447.

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.

Cash Method

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.

Income

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 (FMV) in income. See chapter 3 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, you will not be considered to have constructively received a payment merely because you had the option to receive it in the year before it is required to be paid.

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 grain contract in December 2007. She was told in December that her payment was available. She requested not to be paid until January 2008. However, she must still include this payment in her 2007 income because it was made available to her in 2007.

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 3.

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 2007 under a bona fide arm's-length contract that calls for payment in 2008. You include the sale proceeds in your 2008 gross income since that is the year payment is received. However, if the contract states 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 2007 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, then you can usually deduct the repayment in the year in which you make it. If the repayment is more than $3,000, a special rule applies. For details, see Repayments in chapter 11 of Publication 535, Business Expenses.

Expenses

Under the cash method, generally you 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 6. See chapter 4 for information on how to deduct farm business expenses on your income tax return.

Prepayment. Generally, you cannot deduct expenses paid 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.

On November 1, 2007, you signed and paid $3,600 for a 3-year (36-month) insurance contract for equipment. In 2007, you are allowed to deduct only $200 (2/36 x $3,600) of the cost of the policy that is attributable to 2007. In 2008, you'll be able to deduct $1,200 (12/36 x $3,600); in 2009, you'll be able to deduct $1,200 (12/36 x $3,600); and in 2010, you'll be able to deduct the remaining balance of $1,000.

Accrual Method

Under an accrual method of accounting, generally you 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.

Income

Generally, you 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.

If you use an accrual method of accounting, complete Part III of Schedule F (Form 1040).

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

Expenses

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

The all-events test has been met. This test is met when:
1. All events have occurred that fix the fact of liability, and
2. The liability can be determined with reasonable accuracy.
Economic performance has occurred.

Economic performance. Generally, you 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, see Economic Performance in Publication 538.

Example.

Jane, who is a farmer, uses a calendar tax year and an accrual method of accounting. She enters into a contract with Waterworks, Inc. in 2007. The contract states that Jane must pay Waterworks, Inc. $200,000 in December 2007. It further stipulates that Waterworks will install a complete irrigation system, including a new well, by January 1, 2008. She pays Waterworks $200,000 in December 2007. Installation begins in May 2008, and they complete the irrigation system in December 2008.

Economic performance for Jane's liability in the contract occurs as the property and services are provided. Jane incurs the $200,000 cost in 2008.

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. For more information, see Internal Revenue Code section 267.

Farm Inventory

Special rules for farming businesses. Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business. However, certain corporations (other than S corporations) and partnerships that have a partner that is a corporation must use an accrual method for their farming business. For this purpose, farming does not include the operation of a nursery or sod farm or the raising or harvesting of trees (other than fruit and nut trees).

If you are required to keep an inventory (see below), 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 applicable.

There is an exception to the requirement to use an accrual method for corporations with gross receipts of $1 million or less for each prior tax year after 1975. For family corporations (defined in section 447(d)(2)(C)) engaged in farming, the exception applies if gross receipts were $25 million or less for each prior tax year after 1985. Tax shelters must keep an inventory of their farm products because they are not allowed to use the cash method of accounting. See section 447 and Revenue Procedure 2002-28 for more information.

After an accounting method is selected, the taxpayer must continue to use that method unless permission to change the method of accounting for farm products is obtained from the IRS.

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. Supplies acquired for sale or that become a physical part of items held for sale must be included in inventory. Deduct the cost of supplies in the year used or consumed in operations. Do not include incidental supplies in inventory as these are deductible 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. Generally, growing crops are not required to be included in inventory. 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 6.

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.

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. However, if you value your livestock inventory using the farm-price method, then you must obtain permission from the IRS 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 method you have chosen. You cannot change your method without obtaining approval from the IRS.

You must include in 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.

Cash Versus Accrual Method

The following examples compare the cash and accrual methods of accounting.

Example 1.

You are a farmer who uses an accrual method of accounting. You keep your books on the calendar tax year basis. You sell grain in December 2007, but you are not paid until January 2008. You must both include the sale proceeds and deduct the costs incurred in producing the grain on your 2007 tax return.

Example 2.

Assume the same facts as in Example 1 except that you use the cash method and there was no constructive receipt of the sale proceeds in 2007. Under this method, you include the sale proceeds in income for 2008, the year you receive payment. Deduct the costs of producing the grain in the year you pay for them.

Special Methods of Accounting

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. See Regulations section 1.162-12 for details on deductible expenses of farmers.

Other special methods. Other special methods of accounting apply to the following items.

Amortization, see chapter 7.
Casualties, see chapter 11.
Condemnations, see chapter 11.
Depletion, see chapter 7.
Depreciation, see chapter 7.
Farm business expenses, see chapter 4.
Farm income, see chapter 3.
Installment sales, see chapter 10.
Soil and water conservation expenses, see chapter 5.
Thefts, see chapter 11.

Combination Method

Generally, you can 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.

If you use the cash method for figuring your income, you must use the cash method for reporting your expenses.
If you use the accrual method for reporting your expenses, you must use the accrual method for figuring your income.

Change in Accounting Method

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

Your overall method, such as from cash to an accrual method, and
Your treatment of any material item, such as a change in your method of valuing inventory (for example, a change from the farm-price method to the unit-livestock-price method).

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

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