The method of accounting your business uses largely determines when you get to take deductions and have to recognize (and pay tax on) income. All larger businesses, and many small ones, use the accrual method of accounting. Under this method you report income in the year it is earned, and deduct expenses in the year they are incurred. Thus, with the accrual method it doesn’t matter when income (money) is actually collected or expenses paid. The right to receive income, not its actual receipt, triggers the requirement to include an item in your taxable income for the year.
Typically, you include an amount as income for the tax year in which (1) all events that fix your right to receive the income have occurred, and (2) you can determine the amount with reasonable accuracy. Under this rule, you report an amount in your gross income on the earliest of the following dates:
- when you receive payment
- when the amount is due to you
- when you earn the income, or
- when title to property has passed to you.
Under the usual accrual rules, if a client or customer pays you in advance for goods or services you will provide later, you treat the payment as income in the year you receive the payment. However, there are some special rules that may allow you to delay reporting advance payments for services or sales or goods. Delaying recognition of income to a future tax year is usually desirable because it can reduce your tax bill for the current year.
Advance Payment for Services
Ordinarily, you must include in your income advance payments for services in the tax year you receive them. However, if you receive an advance payment for services you agree to perform by the end of the next tax year, you can elect to postpone including the advance payment in income until the next tax year. But, you cannot postpone including any payment beyond that tax year.
Example: In December 2016, AAA Contracting, an LLC that uses the accrual method of accounting and the calendar year tax year, receives a $100,000 advance payment from a client to construct a house by the end of 2017. AAA can elect not to include the payment in its income for tax purposes until the 2017 tax year.
What if you’re paid an advance for services you’ll perform during the current year and the following year or later years? The portion of the payment that is for services to be performed in the current tax year must be included in your income for that year. The remainder of the advance payment must be included in income in the subsequent year, even if all the services are not completed during that year.
Example: On October 1, 2016, the Acme Dance Studio receives payment for a one year contract for 48 one hour lessons beginning on that date. It gives eight lessons in 2016. It must include one-sixth (8/48) of the payment in income for 2016, and five-sixths (40/48) of the payment in 2017 even if does not give all the lessons by the end of 2017.
Service Agreements on Property
You can also postpone reporting income from advance payments you receive for entering into service agreements for property you sell, lease, build, or install. This includes a service agreement under which you agree to provide for incidental replacement of parts or materials. However, this rule applies only if you offer the property without a service agreement in the normal course of business.
Example: Acme, Inc. sells and services computers. It received payment in November 2016 for a one year service contract on a computer it sold. Acme can postpone including in income the part of the payment it did not earn in 2016 if, in the normal course of its business, it offers computers for sale without a service contract.
Limitations on Delaying Reporting Payments for Services
There are some significant limitations on accrual taxpayers’ ability to postpone recognizing income.
Time limit: Generally, you can't postpone including an advance payment in income for services if you are to perform any part of the service after the end of the tax year immediately following the year you receive the advance payment.
Example: On October 1, 2016, the Acme Dance Studio receives an advance payment for a two year contract for 96 weekly one hour dance lessons beginning on that date. Acme must include the entire payment in its 2016 income because part of the services won’t be performed until 2018 (the year following the year it received the payment).
This limitation also applies if you are to perform any part of your services at any unspecified future date that might be after the end of the tax year immediately following the year you receive the advance payment
Warranties: Usually you can't postpone reporting income you receive under a guarantee or warranty contract.
Prepaid rent: You also can't postpone reporting income from prepaid rent.
Example: John owns an office building and uses the accrual method of accounting. In December 2016, one of his tenants pays his January rent of $5,000. John must include the payment in his 2016 income.
However, prepaid rent doesn't include payments you receive for space in a hotel, boarding house, tourist home, motor court, motel, or apartment house that furnishes hotel services.
Books and records limitation: Finally, the income you report on your tax return may not be less than the income you list in the financial reports you prepare for the year for purposes other than taxes. These include shareholder and partner reports, consolidated financial statements, and credit applications.
Advance Payments for Sales of Goods
If your business involves the sale of goods to customers, you may be able to postpone including in your income advance payments for such sales until the following tax year. To do so, your method of accounting for the sale must be the same for tax and financial reporting purposes.
Example: Acme, Inc. is a retailer that uses an accrual method of accounting and accounts for the sale of goods when it ships them. It uses this method for both tax and financial reporting purposes. Acme can include advance payments in its income for tax purposes in either: (1) the tax year it receives the payments, or (2) the tax year it ships the goods. In December 2016, Acme receives a $10,000 payment for goods, but doesn’t ship them until January 2017. Acme may elect to report the $10,000 as income in 2017, not 2016. It must treat the $10,000 as income in 2017 on its financial reports.
Questions for Your Attorney
- Can advance income ever be reported in the tax return filed two or more years after receipt?
- Must prepaid lesson fees be included in income by an accrual basis dance studio or can they be included during the period in which the lessons are actually given?
- I am in the repair business and use the accrual method of accounting. If I receive payments for a one year contract where I agree to repair or replace certain parts that fail to function properly, do I include the payments in gross income when I earn them or when I receive them?