Under an accrual method of accounting, generally you report income in the year it is earned. The right to receive, not actual receipt, triggers the inclusion of an item in income under accrual-basis accounting.
Typically, you include an amount as gross 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. Under this rule, you report an amount in your gross income on the earliest of the following dates:
- When you receive payment
- When the income amount is due to you
- When you earn the income
- When title has passed
Advance Payment for Services
Generally you report an advance payment for services that are to be performed in a later tax year, as income in the year you receive the payment. 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. You can't postpone including any payment beyond that tax year.
Advance Payment for Service Agreements on Property
You can postpone reporting income from an advance payment you receive for a service agreement on property you sell, lease, build, install or construct. This includes an agreement providing for incidental replacement of parts or materials. However, this applies only if you offer the property without a service agreement in the normal course of business.
Generally, you can't postpone including an advance payment in income for services if either of the following applies:
- 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
- You are to perform any part of the service at any unspecified future date that may be after the end of the tax year immediately following the year you receive the advance payment
Usually you can't postpone reporting income you receive under a guarantee or warranty contract.
You can't postpone reporting income from prepaid rent. Prepaid rent doesn't include payment for the use of a room or other space when significant service is also provided for the occupant. You provide significant service when you supply space in a hotel, boarding house, tourist home, motor court, motel or apartment house that furnishes hotel services.
Any advance payment you include in gross receipts on your tax return for the year you receive payment must not be less than the payment you include in income for financial reports under the method of accounting used for those reports. Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements.
Advance Payment for Sales
Special rules apply to including income from advance payments on agreements for future sales or other goods held primarily for sale to customers in the ordinary course of your trade or business. However, the rules don't apply to a payment (or part of a payment) for services that are not an integral part of the main activities covered under the agreement. An agreement includes a gift certificate that can be redeemed for goods. Amounts due and payable are considered received.
Generally, include an advance payment in income in the year in which you receive it. However, you can use the alternative method of reporting. Under the alternative method, you include an advance payment in income in the earlier of the following:
- The taxable year the payments are accruable in income under your method of tax accounting
- The year the payments are includible in gross receipts on your financial reports
For example, if you are a retailer who uses an accrual method of accounting and account for the sale of goods when you ship the goods. You use this method for both tax and financial reporting purposes. You can include advance payments in gross receipts for tax purposes in either the tax year in which you receive the payments or the tax year in which you ship the goods.
If you have an agreement to sell goods properly included in inventory, you can postpone including the advance payment in income until the end of the second tax year following the year you receive an advance payment if, on the last day of the tax year, you meet all of the following requirements:
- You account for the advance payment under the alternative method
- You have received a substantial advance payment on the agreement
- You have enough substantially similar goods on hand, or available through your normal source of supply, to satisfy the agreement
These rules also apply to an agreement, such as a gift certificate, that can be satisfied with goods that can't be identified in the tax year you receive an advance payment.
If you meet these conditions, all advance payments you receive by the end of the second tax year, including payments received in prior years but not reported, must be included in income by the second tax year following the tax year of receipt of substantial advance payments. You must also deduct in that second year all actual or estimated costs for the goods required to satisfy the agreement. If you estimated the cost, you must take into account any difference between the estimate and the actual cost when the goods are delivered.
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?