Taxpayer must account for his/her income annually. Here we consider how taxpayer accounts for it. Section 446(a) provides that: “Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” There are some caveats to this facially permissive statement.
Section 446(b) establishes the standard that taxpayer’s method of accounting must “clearly reflect income.” Section 446(c) establishes “permissible methods” of accounting. We will consider only two of them: “cash receipts and disbursements method” and “accrual method.” The regulations define these phrases. Reg. § 1.446-1(c)(1)(i and ii) provide in part
Rule of Thumb (and no more than that)
Cash method: follow the money. Income is not income unless taxpayer has received money, property, or services. When taxpayer has received money, property, or services, it is income – even if taxpayer may not yet have actually “earned” it. The same is true of deductions. Taxpayer is not entitled to a deduction unless he/she has actually paid the deductible expense.
Accrual method: follow the obligation. Taxpayer must recognize income when he/she is entitled to receive it – even if taxpayer has not actually received payment. Similarly, taxpayer is entitled to a deduction when he/she is obligated to pay an expense – even if taxpayer has not actually paid the expense. Section 461(h) also requires that “economic performance” occur before taxpayer may claim a deduction.
(i) Cash receipts and disbursements method. – Generally, under the cash receipts and disbursements method in the computation of taxable income, all items which constitute gross income (whether in the form of cash, property, or services) are to be included for the taxable year in which actually made. ...
(ii) Accrual method. – (A) Generally, under an accrual method, income is to be included for the taxable year when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. Under such a method, a liability is incurred, and generally is taken in to account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. ...
In the next subsections of the text, we consider a few of the principles that these accounting methods incorporate.
Section 446(d) provides that a “taxpayer engaged in more than one trade or business may, in computing taxable income, use a different method of accounting for each trade or business.” However –
- A C corporation or a partnership with a C corporation partner whose average gross receipts for the last 3-taxable year period exceeds $5M may not use the cash receipts and disbursements method of accounting. §§ 448(a)(1 and 2), 448(b)(3), 448(c)(1).
- A tax shelter may not use the cash receipts and disbursements method of accounting. § 448(a)(3).
- A taxpayer who uses an inventory must use the accrual method “with regard to purchases and sales.” Reg. § 1.446-1(c)(2)(ii).