J.K. Lasser's Small Business Taxes 2018. Barbara Weltman

to obtain a mortgage on your office building, these points are considered to be prepaid interest. You must deduct the points ratably over the term of the loan.

      Example

      If the mortgage on the office building runs for 30 years (or 360 months) and you pay the points on July 1, you can deduct 6/360 of the points in the first year. In each succeeding year you would deduct 12/360 of the points. In the final year, you would again deduct 6/360.

      Deposits may be called advances. If they are refundable, then they cannot be deducted when paid. If they are nonrefundable, they can be deducted when made.

      If you pay off the mortgage before the end of the term (you sell the property or refinance the loan), you can then write off any points you still have not deducted.

      RESTRICTIONS ON THE USE OF THE CASH METHOD

      You cannot use the cash method of accounting if you maintain inventory unless you qualify for a small business exception. If you are barred from using the cash method, you must use the accrual method or another method of accounting.

      Corporate Exceptions

      While farming corporations and farming partnerships in which a corporation is a partner usually must use the accrual method, the business is exempt from this rule if it is an S corporation, a family farming corporation with annual gross receipts not exceeding $25 million, and any corporation (other than a family farming corporation) with gross receipts not exceeding $1 million. A farming business includes any business that operates a nursery or sod farm or that raises or harvests trees bearing fruit, nuts, or other crops and ornamental trees.

      Gross receipts All the income taken in by the business without offsets for expenses. For example, if a consultant receives fees of $25,000 for the year and has expenses of $10,000, gross receipts are $25,000.

      PSC Exception

      A qualified personal service corporation (PSC) can use the cash method of accounting.

      Qualified personal service corporation A corporation (other than an S corporation) with a substantial number of activities involving the performance of personal services in the fields of medicine, law, accounting, architecture, actuarial sciences, performing arts, or consulting by someone who owns stock in the corporation (or who is retired or the executor of the estate of a deceased former employee).

      Small Business Exception

      Corporations other than S corporations and partnerships that have a corporation (other than an S corporation) as a partner can use the cash method of accounting if they are considered to be small businesses even if they do not qualify for the inventory-based exception below. A small business for this purpose is one that has average annual gross receipts of $5 million or less in at least one of 3 prior taxable years. In view of the gross receipt rule, you can see that a business may be able to use the cash method for one year but be precluded from using it in the following year. As a practical matter, if a business gets big enough to approach $5 million in gross receipts, it may have outgrown the cash method and may prefer to change permanently to the accrual method to avoid changes dependent upon gross receipts.

      NOTE

      If you use the small business exception or small inventory-based business exception, you can account for inventoriable items as non-incidental materials and supplies (see Chapter 4).

      Small Inventory-Based Business Exception

      Even though you maintain inventory, you are permitted to use the cash method if your average annual gross receipts for the 3 prior years do not exceed $10 million and you are not otherwise prohibited from using the cash method (see the Small Business Exception above). More specifically, you can use the cash method if your average annual gross receipts for the 3 tax years (or the years in which you are in business if less than 3 years) do not exceed $10 million. In effect, in order to qualify for the cash method under this exception in 2017, your average annual gross receipts must not exceed $10 million in each 3-year period starting in 1998 (or when the corporation was formed, if later).

      You can use the cash method of accounting even though you use the accrual method for financial accounting purposes (for example, on profit and loss statements). However, you do not qualify for this exception if your principal business activity is retailing, wholesaling, manufacturing (other than custom manufacturing), mining, publishing, or sound recording. (Principal business activity is based on the largest percentage of your gross receipts using the North American Industry Classification System [NAICS], published by the U.S. Department of Commerce and which can be found in instructions to Schedule C of Form 1040.) NAICS codes are also used for government contracting purposes, so be sure that you use the correct code if you want to work with the government. You can get help determining which NAICS code is most appropriate for your business by using an online tool at www.naics.com/search.htm. Alternatively, you can contact the U.S. Census Bureau for help by calling 888-75NAICS.

      In addition to the inventory limitation, certain types of business organizations generally cannot use the cash method of accounting. These include:

      ● Corporations other than S corporations

      ● Partnerships that have a corporation (other than an S corporation) as a partner

      ● Tax shelters

      However, there are exceptions under which some of these businesses can still use the cash method of accounting.

      If you are a small inventory-based business that has been using the accrual method but is qualified to change to the cash method, you can make the change under an automatic change of accounting rule. For more information about qualifying for the cash method and changing to it, see Revenue Procedure 2002-28 and revenue procedures that update this one.

Accrual Method of Accounting

      Under the accrual method, you report income when it is earned rather than when it is received, and you deduct expenses when they are incurred rather than when they are paid. There are 2 tests to determine whether there is a fixed right to receive income so that it must be accrued and whether an expense is treated as having been incurred for tax purposes.

      ALL EVENTS TEST

      All events that fix the income and set the liability must have occurred. Also, you must be able to determine the amount of the income or expense with reasonable accuracy.

      ECONOMIC PERFORMANCE TEST

      In order to report income or deduct an expense, economic performance must occur. In most cases, this is rather obvious. If you provide goods and services, economic performance occurs when you provide the goods or services. By the same token, if goods or services are provided to you, economic performance occurs when the goods or services are provided to you. Thus, for example, if you buy office supplies, economic performance occurs when the purchase is made and the bill is tendered. You can accrue the expense at that date even though you do not pay the bill until a later date.

      If you sell gift cards to customers, do not report the income until the cards are redeemed. For example, if you sell a gift card to a customer in December 2017, and the customer gives the card to a friend who redeems it in January 2018, under the all-events test, the income from the sale of the gift card is not fixed until 2018. If you give gift cards to customers in exchange for returns of merchandise, you can now treat the card as a payment of a cash refund and a sale of a gift card, allowing you to defer the income to be received through the gift cards. This is treated as a change in accounting method for which automatic consent is provided, but you must file for a change in accounting method as explained later in this chapter.

      There is an exception to the economic performance test for certain recurring items (items that are repeated on a regular basis). A deduction for these items can be accrued even though economic performance has not occurred.

      There is a special rule for real estate taxes. An election can be made to ratably accrue real property taxes that are related to a definite period of time over that period of time.

      Example

      You