Cash Method of Accounting

Most individuals and many small businesses use the cash method of accounting. Generally, if the taxpayer produces, purchases, or sells merchandise, he or she must keep an inventory and use an accrual method for sales and purchases of merchandise. Under the cash method, the taxpayer in his or her gross income all items of income he or she actually or constructively receives during the tax year. If the taxpayer receives property and services, he or she must include their fair market value (FMV) in income.
Under the cash method, generally, a taxpayer deducts expenses in the tax year in which he or she actually pays them. This includes business expenses for which he or she contests liability. However, the taxpayer may not be able to deduct an expense paid in advance. Instead, he or she may be required to capitalize certain costs.
An expense a taxpayer pays in advance is deductible only in the year to which it applies, unless the expense qualifies for the 12-month rule. Under the 12-month rule, a taxpayer is not required to capitalize amounts paid to create certain rights or benefits for the taxpayer that do not extend beyond the earlier of the following:

• 12 months after the right or benefit begins;
• the end of the tax year after the tax year in which payment is made.

If the taxpayer has not been applying the general rule (an expense paid in advance is deductible only in the year to which it applies) and/or the 12 month rule to the expenses he or she paid in advance, the taxpayer must obtain approval from the IRS before using the general rule and/or the 12-month rule.

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

• A corporation (other than an S corporation) with average annual gross receipts exceeding $5 million;
• A partnership with a corporation (other than an S corporation) as a partner, and with the partnership having average annual gross receipts exceeding $5 million;
• A tax shelter.

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 or nut trees)

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 engaged in farming, the exception applies if gross receipts were $25 million or less for each prior tax year after 1985.