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Aarp tax help 1. Aarp tax help   Investment Income Table of Contents Topics - This chapter discusses: Useful Items - You may want to see: General InformationSSN for joint account. Aarp tax help Custodian account for your child. Aarp tax help Penalty for failure to supply SSN. Aarp tax help Certification. Aarp tax help Underreported interest and dividends. Aarp tax help How to stop backup withholding due to underreporting. Aarp tax help How to stop backup withholding due to an incorrect identification number. Aarp tax help Reporting backup withholding. Aarp tax help Nonresident aliens. Aarp tax help Penalties. Aarp tax help Savings account with parent as trustee. Aarp tax help Interest IncomeInterest not reported on Form 1099-INT. Aarp tax help Nominees. Aarp tax help Incorrect amount. Aarp tax help Information reporting requirement. Aarp tax help Taxable Interest — General Below-Market Loans U. Aarp tax help S. Aarp tax help Savings Bonds U. Aarp tax help S. Aarp tax help Treasury Bills, Notes, and Bonds Bonds Sold Between Interest Dates Insurance State or Local Government Obligations Discount on Debt InstrumentsOriginal Issue Discount (OID) Market Discount Bonds Discount on Short-Term Obligations Election To Report All Interest as OID When To Report Interest IncomeConstructive receipt. Aarp tax help How To Report Interest IncomeSchedule B (Form 1040A or 1040). Aarp tax help Worksheet for savings bonds distributed from a retirement or profit-sharing plan. Aarp tax help File Form 1099-INT with the IRS. Aarp tax help Dividends and Other DistributionsDividends not reported on Form 1099-DIV. Aarp tax help Nominees. Aarp tax help Ordinary Dividends Capital Gain Distributions Nondividend Distributions Liquidating Distributions Distributions of Stock and Stock Rights Other Distributions How To Report Dividend IncomeElection. Aarp tax help Independent contractor. Aarp tax help Investment interest deducted. Aarp tax help Exception 1. Aarp tax help Exception 2. Aarp tax help Undistributed capital gains. Aarp tax help File Form 1099-DIV with the IRS. Aarp tax help Stripped Preferred Stock REMICs, FASITs, and Other CDOsREMICs Collateralized Debt Obligations (CDOs) FASITs S CorporationsLimit on losses and deductions. Aarp tax help Passive activity losses. Aarp tax help Form 8582. Aarp tax help Investment ClubsInvestments in name of member. Aarp tax help Tax Treatment of the Club Topics - This chapter discusses: Interest Income , Discount on Debt Instruments , When To Report Interest Income , How To Report Interest Income , Dividends and Other Distributions , How To Report Dividend Income , Stripped Preferred Stock , Real estate mortgage investment conduits (REMICs), financial asset securitization investment trusts (FASITs), and other collateralized debt obligations (CDOs) , S Corporations , and Investment Clubs . Aarp tax help Useful Items - You may want to see: Publication 525 Taxable and Nontaxable Income 537 Installment Sales 590 Individual Retirement Arrangements (IRAs) 925 Passive Activity and At-Risk Rules 1212 Guide to Original Issue Discount (OID) Instruments Form (and Instructions) Schedule B (Form 1040A or 1040) Interest and Ordinary Dividends Schedule D (Form 1040) Capital Gains and Losses 1040 U. Aarp tax help S. Aarp tax help Individual Income Tax Return 1040A U. Aarp tax help S. Aarp tax help Individual Income Tax Return 1040EZ Income Tax Return for Single and Joint Filers With No Dependents 1099 General Instructions for Certain Information Returns 2439 Notice to Shareholder of Undistributed Long-Term Capital Gains 3115 Application for Change in Accounting Method 6251 Alternative Minimum Tax — Individuals 8582 Passive Activity Loss Limitations 8615 Tax for Certain Children Who Have Unearned Income 8814 Parents' Election To Report Child's Interest and Dividends 8815 Exclusion of Interest From Series EE and I U. Aarp tax help S. Aarp tax help Savings Bonds Issued After 1989 8818 Optional Form To Record Redemption of Series EE and I U. Aarp tax help S. Aarp tax help Savings Bonds Issued After 1989 8824 Like-Kind Exchanges 8949 Sales and Other Dispositions of Capital Assets 8960 Net Investment Income Tax—Individuals, Estates, and Trusts See chapter 5, How To Get Tax Help , for information about getting these publications and forms. Aarp tax help General Information A few items of general interest are covered here. Aarp tax help Recordkeeping. Aarp tax help You should keep a list showing sources and investment income amounts you receive during the year. Aarp tax help Also keep the forms you receive showing your investment income (Forms 1099-INT, Interest Income, and 1099-DIV, Dividends and Distributions, for example) as an important part of your records. Aarp tax help Net investment income tax (NIIT). Aarp tax help   Beginning in 2013, you may be subject to the NIIT. Aarp tax help The NIIT is a 3. Aarp tax help 8% tax on the lesser of your net investment income or the amount of your modified adjusted gross income (MAGI) that is over a threshold amount based on your filing status. Aarp tax help    Filing Status Threshold Amount Married filing jointly $250,000 Married filing separately $125,000 Single $200,000 Head of household (with qualifying person) $200,000 Qualifying Widow(er) with dependent child $250,000    For more information, see Form 8960 and Instructions for Form 8960. Aarp tax help Tax on unearned income of certain children. Aarp tax help   Part of a child's 2013 unearned income may be taxed at the parent's tax rate. Aarp tax help This may happen if all of the following are true. Aarp tax help The child had more than $2,000 of unearned income. Aarp tax help The child is required to file a tax return. Aarp tax help The child was: Under age 18 at the end of 2013, Age 18 at the end of 2013 and did not have earned income that was more than half of the child's support, or A full-time student over age 18 and under age 24 at the end of 2013 and did not have earned income that was more than half of the child's support. Aarp tax help At least one of the child's parents was alive at the end of 2013. Aarp tax help The child does not file a joint return for 2013. Aarp tax help A child born on January 1, 1996, is considered to be age 18 at the end of 2013; a child born on January 1, 1995, is considered to be age 19 at the end of 2013; a child born on January 1, 1990, is considered to be age 24 at the end of 2013. Aarp tax help   If all of these statements are true, Form 8615 must be completed and attached to the child's tax return. Aarp tax help If any of these statements is not true, Form 8615 is not required and the child's income is taxed at his or her own tax rate. Aarp tax help    However, the parent can choose to include the child's interest and dividends on the parent's return if certain requirements are met. Aarp tax help Use Form 8814 for this purpose. Aarp tax help   For more information about the tax on unearned income of children and the parents' election, see Publication 929, Tax Rules for Children and Dependents. Aarp tax help Beneficiary of an estate or trust. Aarp tax help   Interest, dividends, and other investment income you receive as a beneficiary of an estate or trust is generally taxable income. Aarp tax help You should receive a Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, Credits, etc. Aarp tax help , from the fiduciary. Aarp tax help Your copy of Schedule K-1 (Form 1041) and its instructions will tell you where to report the income on your Form 1040. Aarp tax help Social security number (SSN). Aarp tax help   You must give your name and SSN or individual tax identification number (ITIN) to any person required by federal tax law to make a return, statement, or other document that relates to you. Aarp tax help This includes payers of interest and dividends. Aarp tax help If you do not give your SSN or ITIN to the payer of interest, you may have to pay a penalty. Aarp tax help SSN for joint account. Aarp tax help   If the funds in a joint account belong to one person, list that person's name first on the account and give that person's SSN to the payer. Aarp tax help (For information on who owns the funds in a joint account, see Joint accounts , later. Aarp tax help ) If the joint account contains combined funds, give the SSN of the person whose name is listed first on the account. Aarp tax help This is because only one name and SSN can be shown on Form 1099. Aarp tax help   These rules apply both to joint ownership by a married couple and to joint ownership by other individuals. Aarp tax help For example, if you open a joint savings account with your child using funds belonging to the child, list the child's name first on the account and give the child's SSN. Aarp tax help Custodian account for your child. Aarp tax help   If your child is the actual owner of an account that is recorded in your name as custodian for the child, give the child's SSN to the payer. Aarp tax help For example, you must give your child's SSN to the payer of dividends on stock owned by your child, even though the dividends are paid to you as custodian. Aarp tax help Penalty for failure to supply SSN. Aarp tax help   You will be subject to a penalty if, when required, you fail to: Include your SSN on any return, statement, or other document, Give your SSN to another person who must include it on any return, statement, or other document, or Include the SSN of another person on any return, statement, or other document. Aarp tax help The penalty is $50 for each failure up to a maximum penalty of $100,000 for any calendar year. Aarp tax help   You will not be subject to this penalty if you can show that your failure to provide the SSN was due to reasonable cause and not to willful neglect. Aarp tax help   If you fail to supply an SSN, you may also be subject to backup withholding. Aarp tax help Backup withholding. Aarp tax help   Your investment income is generally not subject to regular withholding. Aarp tax help However, it may be subject to backup withholding to ensure that income tax is collected on the income. Aarp tax help Under backup withholding, the bank, broker, or other payer of interest, original issue discount (OID), dividends, cash patronage dividends, or royalties must withhold, as income tax, on the amount you are paid, applying the appropriate withholding rate. Aarp tax help   Backup withholding applies if: You do not give the payer your identification number (either a social security number or an employer identification number) in the required manner, The IRS notifies the payer that you gave an incorrect identification number, The IRS notifies the payer that you are subject to backup withholding on interest or dividends because you have underreported interest or dividends on your income tax return, or You are required, but fail, to certify that you are not subject to backup withholding for the reason described in (3). Aarp tax help Certification. Aarp tax help   For new accounts paying interest or dividends, you must certify under penalties of perjury that your SSN is correct and that you are not subject to backup withholding. Aarp tax help Your payer will give you a Form W-9, Request for Taxpayer Identification Number and Certification, or similar form, to make this certification. Aarp tax help If you fail to make this certification, backup withholding may begin immediately on your new account or investment. Aarp tax help Underreported interest and dividends. Aarp tax help   You will be considered to have underreported your interest and dividends if the IRS has determined for a tax year that: You failed to include any part of a reportable interest or dividend payment required to be shown on your return, or You were required to file a return and to include a reportable interest or dividend payment on that return, but you failed to file the return. Aarp tax help How to stop backup withholding due to underreporting. Aarp tax help   If you have been notified that you underreported interest or dividends, you can request a determination from the IRS to prevent backup withholding from starting or to stop backup withholding once it has begun. Aarp tax help You must show that at least one of the following situations applies. Aarp tax help No underreporting occurred. Aarp tax help You have a bona fide dispute with the IRS about whether underreporting occurred. Aarp tax help Backup withholding will cause or is causing an undue hardship, and it is unlikely that you will underreport interest and dividends in the future. Aarp tax help You have corrected the underreporting by filing a return if you did not previously file one and by paying all taxes, penalties, and interest due for any underreported interest or dividend payments. Aarp tax help   If the IRS determines that backup withholding should stop, it will provide you with a certification and will notify the payers who were sent notices earlier. Aarp tax help How to stop backup withholding due to an incorrect identification number. Aarp tax help   If you have been notified by a payer that you are subject to backup withholding because you have provided an incorrect SSN or employer identification number, you can stop it by following the instructions the payer gives you. Aarp tax help Reporting backup withholding. Aarp tax help   If backup withholding is deducted from your interest or dividend income or other reportable payment, the bank or other business must give you an information return for the year (for example, a Form 1099-INT) indicating the amount withheld. Aarp tax help The information return will show any backup withholding as “Federal income tax withheld. Aarp tax help ” Nonresident aliens. Aarp tax help    Generally, payments made to nonresident aliens are not subject to backup withholding. Aarp tax help You can use Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding, to certify exempt status. Aarp tax help However, this does not exempt you from the 30% (or lower treaty) withholding rate that may apply to your investment income. Aarp tax help For information on the 30% rate, see Publication 519, U. Aarp tax help S. Aarp tax help Tax Guide for Aliens. Aarp tax help Penalties. Aarp tax help   There are civil and criminal penalties for giving false information to avoid backup withholding. Aarp tax help The civil penalty is $500. Aarp tax help The criminal penalty, upon conviction, is a fine of up to $1,000, or imprisonment of up to 1 year, or both. Aarp tax help Where to report investment income. Aarp tax help   Table 1-1 gives an overview of the forms and schedules to use to report some common types of investment income. Aarp tax help But see the rest of this publication for detailed information about reporting investment income. Aarp tax help Joint accounts. Aarp tax help   If two or more persons hold property (such as a savings account, bond, or stock) as joint tenants, tenants by the entirety, or tenants in common, each person's share of any interest or dividends from the property is determined by local law. Aarp tax help Community property states. Aarp tax help   If you are married and receive a distribution that is community income, one-half of the distribution is generally considered to be received by each spouse. Aarp tax help If you file separate returns, you must each report one-half of any taxable distribution. Aarp tax help See Publication 555, Community Property, for more information on community income. Aarp tax help   If the distribution is not considered community property and you and your spouse file separate returns, each of you must report your separate taxable distributions. Aarp tax help Example. Aarp tax help You and your spouse have a joint money market account. Aarp tax help Under state law, half the income from the account belongs to you, and half belongs to your spouse. Aarp tax help If you file separate returns, you each report half the income. Aarp tax help Income from property given to a child. Aarp tax help   Property you give as a parent to your child under the Model Gifts of Securities to Minors Act, the Uniform Gifts to Minors Act, or any similar law becomes the child's property. Aarp tax help   Income from the property is taxable to the child, except that any part used to satisfy a legal obligation to support the child is taxable to the parent or guardian having that legal obligation. Aarp tax help Savings account with parent as trustee. Aarp tax help   Interest income from a savings account opened for a minor child, but placed in the name and subject to the order of the parents as trustees, is taxable to the child if, under the law of the state in which the child resides, both of the following are true. Aarp tax help The savings account legally belongs to the child. Aarp tax help The parents are not legally permitted to use any of the funds to support the child. Aarp tax help Table 1-1. Aarp tax help Where To Report Common Types of Investment Income (For detailed information about reporting investment income, see the rest of this publication, especially How To Report Interest Income and How To Report Dividend Income in chapter 1. Aarp tax help ) Type of Income If you file Form 1040, report on . Aarp tax help . Aarp tax help . Aarp tax help If you can file Form 1040A, report on . Aarp tax help . Aarp tax help . Aarp tax help If you can file Form 1040EZ, report on . Aarp tax help . Aarp tax help . Aarp tax help Tax-exempt interest (Form 1099-INT, box 8) Line 8b Line 8b Space to the left of line 2 (enter “TEI” and the amount) Taxable interest that totals $1,500 or less Line 8a (You may need to file Schedule B as well. Aarp tax help ) Line 8a (You may need to file Schedule B as well. Aarp tax help ) Line 2 Taxable interest that totals more than $1,500 Line 8a; also use Schedule B, line 1 Line 8a; also use Schedule B, line 1   Savings bond interest you will exclude because of higher education expenses Schedule B; also use Form 8815 Schedule B; also use Form 8815   Ordinary dividends that total $1,500 or less Line 9a (You may need to file Schedule B as well. Aarp tax help ) Line 9a (You may need to file Schedule B as well. Aarp tax help )   Ordinary dividends that total more than $1,500 Line 9a; also use Schedule B, line 5 Line 9a; also use Schedule B, line 5   Qualified dividends (if you do not have to file Schedule D) Line 9b; also use the Qualified Dividends and Capital Gain Tax Worksheet, line 2 Line 9b; also use the Qualified Dividends and Capital Gain Tax Worksheet, line 2   Qualified dividends (if you have to file Schedule D) Line 9b; also use the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet, line 2 You cannot use Form 1040A    You cannot use Form 1040EZ Capital gain distributions (if you do not have to file Schedule D) Line 13; also use the Qualified Dividends and Capital Gain Tax Worksheet, line 3 Line 10; also use the Qualified Dividends and Capital Gain Tax Worksheet, line 3   Capital gain distributions (if you have to file Schedule D) Schedule D, line 13; also use the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet     Section 1250, 1202, or collectibles gain (Form 1099-DIV, box 2b, 2c, or 2d) Form 8949 and Schedule D     Nondividend distributions (Form 1099-DIV, box 3) Generally not reported*     Undistributed capital gains (Form 2439, boxes 1a - 1d) Schedule D     Gain or loss from sales of stocks or bonds Line 13; also use Form 8949, Schedule D, and the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet You cannot use Form 1040A   Gain or loss from exchanges of like-kind investment property Line 13; also use Schedule D, Form 8824, and the Qualified Dividends and Capital Gain Tax Worksheet or the Schedule D Tax Worksheet     *Report any amounts in excess of your basis in your mutual fund shares on Form 8949. Aarp tax help Use Part II if you held the shares more than 1 year. Aarp tax help Use Part I if you held your mutual fund shares 1 year or less. Aarp tax help For details on Form 8949, see Reporting Capital Gains and Losses in chapter 4, and the Instructions for Form 8949. Aarp tax help Accuracy-related penalty. Aarp tax help   An accuracy-related penalty of 20% can be charged for underpayments of tax due to negligence or disregard of rules or regulations or substantial understatement of tax. Aarp tax help For information on the penalty and any interest that applies, see Penalties in chapter 2. Aarp tax help Interest Income This section discusses the tax treatment of different types of interest income. Aarp tax help In general, any interest that you receive or that is credited to your account and can be withdrawn is taxable income. Aarp tax help (It does not have to be entered in your passbook. Aarp tax help ) Exceptions to this rule are discussed later. Aarp tax help Form 1099-INT. Aarp tax help   Interest income is generally reported to you on Form 1099-INT, or a similar statement, by banks, savings and loans, and other payers of interest. Aarp tax help This form shows you the interest you received during the year. Aarp tax help Keep this form for your records. Aarp tax help You do not have to attach it to your tax return. Aarp tax help   Report on your tax return the total interest income you receive for the tax year. Aarp tax help Interest not reported on Form 1099-INT. Aarp tax help   Even if you do not receive Form 1099-INT, you must still report all of your interest income. Aarp tax help For example, you may receive distributive shares of interest from partnerships or S corporations. Aarp tax help This interest is reported to you on Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc. Aarp tax help , and Schedule K-1 (Form 1120S), Shareholder's Share of Income, Deductions, Credits, etc. Aarp tax help Nominees. Aarp tax help   Generally, if someone receives interest as a nominee for you, that person must give you a Form 1099-INT showing the interest received on your behalf. Aarp tax help   If you receive a Form 1099-INT that includes amounts belonging to another person, see the discussion on Nominee distributions , later, under How To Report Interest Income. Aarp tax help Incorrect amount. Aarp tax help   If you receive a Form 1099-INT that shows an incorrect amount (or other incorrect information), you should ask the issuer for a corrected form. Aarp tax help The new Form 1099-INT you receive will be marked “Corrected. Aarp tax help ” Form 1099-OID. Aarp tax help   Reportable interest income also may be shown on Form 1099-OID, Original Issue Discount. Aarp tax help For more information about amounts shown on this form, see Original Issue Discount (OID) , later in this chapter. Aarp tax help Exempt-interest dividends. Aarp tax help   Exempt-interest dividends you receive from a mutual fund or other regulated investment company, including those received from a qualified fund of funds in any tax year beginning after December 22, 2010, are not included in your taxable income. Aarp tax help (However, see Information reporting requirement , next. Aarp tax help ) Exempt-interest dividends should be shown in box 10 of Form 1099-DIV. Aarp tax help You do not reduce your basis for distributions that are exempt-interest dividends. Aarp tax help Information reporting requirement. Aarp tax help   Although exempt-interest dividends are not taxable, you must show them on your tax return if you have to file. Aarp tax help This is an information reporting requirement and does not change the exempt-interest dividends into taxable income. Aarp tax help See How To Report Interest Income , later. Aarp tax help Note. Aarp tax help Exempt-interest dividends paid from specified private activity bonds may be subject to the alternative minimum tax. Aarp tax help The exempt-interest dividends subject to the alternative minimum tax are shown in box 11 of Form 1099-DIV. Aarp tax help See Form 6251 and its instructions for more information about this tax. Aarp tax help Private activity bonds are discussed later under State or Local Government Obligations. Aarp tax help Interest on VA dividends. Aarp tax help   Interest on insurance dividends left on deposit with the Department of Veterans Affairs (VA) is not taxable. Aarp tax help This includes interest paid on dividends on converted United States Government Life Insurance policies and on National Service Life Insurance policies. Aarp tax help Individual retirement arrangements (IRAs). Aarp tax help   Interest on a Roth IRA generally is not taxable. Aarp tax help Interest on a traditional IRA is tax deferred. Aarp tax help You generally do not include it in your income until you make withdrawals from the IRA. Aarp tax help See Publication 590 for more information. Aarp tax help Taxable Interest — General Taxable interest includes interest you receive from bank accounts, loans you make to others, and other sources. Aarp tax help The following are some sources of taxable interest. Aarp tax help Dividends that are actually interest. Aarp tax help   Certain distributions commonly called dividends are actually interest. Aarp tax help You must report as interest so-called “dividends” on deposits or on share accounts in: Cooperative banks, Credit unions, Domestic building and loan associations, Domestic savings and loan associations, Federal savings and loan associations, and Mutual savings banks. Aarp tax help  The “dividends” will be shown as interest income on Form 1099-INT. Aarp tax help Money market funds. Aarp tax help   Money market funds are offered by nonbank financial institutions such as mutual funds and stock brokerage houses, and pay dividends. Aarp tax help Generally, amounts you receive from money market funds should be reported as dividends, not as interest. Aarp tax help Certificates of deposit and other deferred interest accounts. Aarp tax help   If you open any of these accounts, interest may be paid at fixed intervals of 1 year or less during the term of the account. Aarp tax help You generally must include this interest in your income when you actually receive it or are entitled to receive it without paying a substantial penalty. Aarp tax help The same is true for accounts that mature in 1 year or less and pay interest in a single payment at maturity. Aarp tax help If interest is deferred for more than 1 year, see Original Issue Discount (OID) , later. Aarp tax help Interest subject to penalty for early withdrawal. Aarp tax help   If you withdraw funds from a deferred interest account before maturity, you may have to pay a penalty. Aarp tax help You must report the total amount of interest paid or credited to your account during the year, without subtracting the penalty. Aarp tax help See Penalty on early withdrawal of savings under How To Report Interest Income, later, for more information on how to report the interest and deduct the penalty. Aarp tax help Money borrowed to invest in certificate of deposit. Aarp tax help   The interest you pay on money borrowed from a bank or savings institution to meet the minimum deposit required for a certificate of deposit from the institution and the interest you earn on the certificate are two separate items. Aarp tax help You must report the total interest you earn on the certificate in your income. Aarp tax help If you itemize deductions, you can deduct the interest you pay as investment interest, up to the amount of your net investment income. Aarp tax help See Interest Expenses in chapter 3. Aarp tax help Example. Aarp tax help You deposited $5,000 with a bank and borrowed $5,000 from the bank to make up the $10,000 minimum deposit required to buy a 6-month certificate of deposit. Aarp tax help The certificate earned $575 at maturity in 2013, but you received only $265, which represented the $575 you earned minus $310 interest charged on your $5,000 loan. Aarp tax help The bank gives you a Form 1099-INT for 2013 showing the $575 interest you earned. Aarp tax help The bank also gives you a statement showing that you paid $310 interest for 2013. Aarp tax help You must include the $575 in your income. Aarp tax help If you itemize your deductions on Schedule A (Form 1040), Itemized Deductions, you can deduct $310, subject to the net investment income limit. Aarp tax help Gift for opening account. Aarp tax help   If you receive noncash gifts or services for making deposits or for opening an account in a savings institution, you may have to report the value as interest. Aarp tax help   For deposits of less than $5,000, gifts or services valued at more than $10 must be reported as interest. Aarp tax help For deposits of $5,000 or more, gifts or services valued at more than $20 must be reported as interest. Aarp tax help The value is determined by the cost to the financial institution. Aarp tax help Example. Aarp tax help You open a savings account at your local bank and deposit $800. Aarp tax help The account earns $20 interest. Aarp tax help You also receive a $15 calculator. Aarp tax help If no other interest is credited to your account during the year, the Form 1099-INT you receive will show $35 interest for the year. Aarp tax help You must report $35 interest income on your tax return. Aarp tax help Interest on insurance dividends. Aarp tax help   Interest on insurance dividends left on deposit with an insurance company that can be withdrawn annually is taxable to you in the year it is credited to your account. Aarp tax help However, if you can withdraw it only on the anniversary date of the policy (or other specified date), the interest is taxable in the year that date occurs. Aarp tax help Prepaid insurance premiums. Aarp tax help   Any increase in the value of prepaid insurance premiums, advance premiums, or premium deposit funds is interest if it is applied to the payment of premiums due on insurance policies or made available for you to withdraw. Aarp tax help U. Aarp tax help S. Aarp tax help obligations. Aarp tax help   Interest on U. Aarp tax help S. Aarp tax help obligations, such as U. Aarp tax help S. Aarp tax help Treasury bills, notes, and bonds, issued by any agency or instrumentality of the United States is taxable for federal income tax purposes. Aarp tax help Interest on tax refunds. Aarp tax help   Interest you receive on tax refunds is taxable income. Aarp tax help Interest on condemnation award. Aarp tax help   If the condemning authority pays you interest to compensate you for a delay in payment of an award, the interest is taxable. Aarp tax help Installment sale payments. Aarp tax help   If a contract for the sale or exchange of property provides for deferred payments, it also usually provides for interest payable with the deferred payments. Aarp tax help That interest is taxable when you receive it. Aarp tax help If little or no interest is provided for in a deferred payment contract, part of each payment may be treated as interest. Aarp tax help See Unstated Interest and Original Issue Discount (OID) in Publication 537. Aarp tax help Interest on annuity contract. Aarp tax help   Accumulated interest on an annuity contract you sell before its maturity date is taxable. Aarp tax help Usurious interest. Aarp tax help   Usurious interest is interest charged at an illegal rate. Aarp tax help This is taxable as interest unless state law automatically changes it to a payment on the principal. Aarp tax help Interest income on frozen deposits. Aarp tax help   Exclude from your gross income interest on frozen deposits. Aarp tax help A deposit is frozen if, at the end of the year, you cannot withdraw any part of the deposit because: The financial institution is bankrupt or insolvent, or The state in which the institution is located has placed limits on withdrawals because other financial institutions in the state are bankrupt or insolvent. Aarp tax help   The amount of interest you must exclude is the interest that was credited on the frozen deposits minus the sum of: The net amount you withdrew from these deposits during the year, and The amount you could have withdrawn as of the end of the year (not reduced by any penalty for premature withdrawals of a time deposit). Aarp tax help If you receive a Form 1099-INT for interest income on deposits that were frozen at the end of 2013, see Frozen deposits under How To Report Interest Income for information about reporting this interest income exclusion on your tax return. Aarp tax help   The interest you exclude is treated as credited to your account in the following year. Aarp tax help You must include it in income in the year you can withdraw it. Aarp tax help Example. Aarp tax help $100 of interest was credited on your frozen deposit during the year. Aarp tax help You withdrew $80 but could not withdraw any more as of the end of the year. Aarp tax help You must include $80 in your income and exclude $20 from your income for the year. Aarp tax help You must include the $20 in your income for the year you can withdraw it. Aarp tax help Bonds traded flat. Aarp tax help    If you buy a bond at a discount when interest has been defaulted or when the interest has accrued but has not been paid, the transaction is described as trading a bond flat. Aarp tax help The defaulted or unpaid interest is not income and is not taxable as interest if paid later. Aarp tax help When you receive a payment of that interest, it is a return of capital that reduces the remaining cost basis of your bond. Aarp tax help Interest that accrues after the date of purchase, however, is taxable interest income for the year received or accrued. Aarp tax help See Bonds Sold Between Interest Dates , later in this chapter. Aarp tax help Below-Market Loans If you make a below-market gift or demand loan, you must report as interest income any forgone interest (defined later) from that loan. Aarp tax help The below-market loan rules and exceptions are described in this section. Aarp tax help For more information, see section 7872 of the Internal Revenue Code and its regulations. Aarp tax help If you receive a below-market loan, you may be able to deduct the forgone interest as well as any interest you actually paid, but not if it is personal interest. Aarp tax help Loans subject to the rules. Aarp tax help   The rules for below-market loans apply to: Gift loans, Pay-related loans, Corporation-shareholder loans, Tax avoidance loans, and Certain loans made to qualified continuing care facilities under a continuing care contract. Aarp tax help A pay-related loan is any below-market loan between an employer and an employee or between an independent contractor and a person for whom the contractor provides services. Aarp tax help A tax avoidance loan is any below-market loan where the avoidance of federal tax is one of the main purposes of the interest arrangement. Aarp tax help Forgone interest. Aarp tax help   For any period, forgone interest is: The amount of interest that would be payable for that period if interest accrued on the loan at the applicable federal rate and was payable annually on December 31, minus Any interest actually payable on the loan for the period. Aarp tax help Applicable federal rate. Aarp tax help   Applicable federal rates are published by the IRS each month in the Internal Revenue Bulletin. Aarp tax help Some IRS offices have these bulletins available for research. Aarp tax help See chapter 5, How To Get Tax Help , for other ways to get this information. Aarp tax help Rules for below-market loans. Aarp tax help   The rules that apply to a below-market loan depend on whether the loan is a gift loan, demand loan, or term loan. Aarp tax help Gift and demand loans. Aarp tax help   A gift loan is any below-market loan where the forgone interest is in the nature of a gift. Aarp tax help   A demand loan is a loan payable in full at any time upon demand by the lender. Aarp tax help A demand loan is a below-market loan if no interest is charged or if interest is charged at a rate below the applicable federal rate. Aarp tax help   A demand loan or gift loan that is a below-market loan is generally treated as an arm's-length transaction in which the lender is treated as having made: A loan to the borrower in exchange for a note that requires the payment of interest at the applicable federal rate, and An additional payment to the borrower in an amount equal to the forgone interest. Aarp tax help The borrower is generally treated as transferring the additional payment back to the lender as interest. Aarp tax help The lender must report that amount as interest income. Aarp tax help   The lender's additional payment to the borrower is treated as a gift, dividend, contribution to capital, pay for services, or other payment, depending on the substance of the transaction. Aarp tax help The borrower may have to report this payment as taxable income, depending on its classification. Aarp tax help These transfers are considered to occur annually, generally on December 31. Aarp tax help Term loans. Aarp tax help   A term loan is any loan that is not a demand loan. Aarp tax help A term loan is a below-market loan if the amount of the loan is more than the present value of all payments due under the loan. Aarp tax help   A lender who makes a below-market term loan other than a gift loan is treated as transferring an additional lump-sum cash payment to the borrower (as a dividend, contribution to capital, etc. Aarp tax help ) on the date the loan is made. Aarp tax help The amount of this payment is the amount of the loan minus the present value, at the applicable federal rate, of all payments due under the loan. Aarp tax help An equal amount is treated as original issue discount (OID). Aarp tax help The lender must report the annual part of the OID as interest income. Aarp tax help The borrower may be able to deduct the OID as interest expense. Aarp tax help See Original Issue Discount (OID) , later. Aarp tax help Exceptions to the below-market loan rules. Aarp tax help   Exceptions to the below-market loan rules are discussed here. Aarp tax help Exception for loans of $10,000 or less. Aarp tax help   The rules for below-market loans do not apply to any day on which the total outstanding amount of loans between the borrower and lender is $10,000 or less. Aarp tax help This exception applies only to: Gift loans between individuals if the gift loan is not directly used to buy or carry income-producing assets, and Pay-related loans or corporation-shareholder loans if the avoidance of federal tax is not a principal purpose of the interest arrangement. Aarp tax help This exception does not apply to a term loan described in (2) earlier that previously has been subject to the below-market loan rules. Aarp tax help Those rules will continue to apply even if the outstanding balance is reduced to $10,000 or less. Aarp tax help Exception for loans to continuing care facilities. Aarp tax help   Loans to qualified continuing care facilities under continuing care contracts are not subject to the rules for below-market loans for the calendar year if the lender or the lender's spouse is age 62 or older at the end of the year. Aarp tax help For the definitions of qualified continuing care facility and continuing care contract, see Internal Revenue Code section 7872(h). Aarp tax help Exception for loans without significant tax effect. Aarp tax help   Loans are excluded from the below-market loan rules if their interest arrangements do not have a significant effect on the federal tax liability of the borrower or the lender. Aarp tax help These loans include: Loans made available by the lender to the general public on the same terms and conditions that are consistent with the lender's customary business practice; Loans subsidized by a federal, state, or municipal government that are made available under a program of general application to the public; Certain employee-relocation loans; Certain loans from a foreign person, unless the interest income would be effectively connected with the conduct of a U. Aarp tax help S. Aarp tax help trade or business and would not be exempt from U. Aarp tax help S. Aarp tax help tax under an income tax treaty; Gift loans to a charitable organization, contributions to which are deductible, if the total outstanding amount of loans between the organization and lender is $250,000 or less at all times during the tax year; and Other loans on which the interest arrangement can be shown to have no significant effect on the federal tax liability of the lender or the borrower. Aarp tax help For a loan described in (6) above, all the facts and circumstances are used to determine if the interest arrangement has a significant effect on the federal tax liability of the lender or borrower. Aarp tax help Some factors to be considered are: Whether items of income and deduction generated by the loan offset each other; The amount of these items; The cost to you of complying with the below-market loan rules, if they were to apply; and Any reasons other than taxes for structuring the transaction as a below-market loan. Aarp tax help If you structure a transaction to meet this exception and one of the principal purposes of that structure is the avoidance of federal tax, the loan will be considered a tax-avoidance loan, and this exception will not apply. Aarp tax help Limit on forgone interest for gift loans of $100,000 or less. Aarp tax help   For gift loans between individuals, if the outstanding loans between the lender and borrower total $100,000 or less, the forgone interest to be included in income by the lender and deducted by the borrower is limited to the amount of the borrower's net investment income for the year. Aarp tax help If the borrower's net investment income is $1,000 or less, it is treated as zero. Aarp tax help This limit does not apply to a loan if the avoidance of federal tax is one of the main purposes of the interest arrangement. Aarp tax help Effective dates. Aarp tax help    These rules apply to term loans made after June 6, 1984, and to demand loans outstanding after that date. Aarp tax help U. Aarp tax help S. Aarp tax help Savings Bonds This section provides tax information on U. Aarp tax help S. Aarp tax help savings bonds. Aarp tax help It explains how to report the interest income on these bonds and how to treat transfers of these bonds. Aarp tax help U. Aarp tax help S. Aarp tax help savings bonds currently offered to individuals include Series EE bonds and Series I bonds. Aarp tax help For other information on U. Aarp tax help S. Aarp tax help savings bonds, write to:  For Series HH/H: Bureau of the Fiscal Service Division of Customer Assistance P. Aarp tax help O. Aarp tax help Box 2186 Parkersburg, WV 26106-2186  For Series EE and I paper savings bonds: Bureau of the Fiscal Service Division of Customer Assistance P. Aarp tax help O. Aarp tax help Box 7012 Parkersburg, WV 26106-7012  For Series EE and I electronic bonds: Bureau of the Fiscal Service  Division of Customer Assistance P. Aarp tax help O. Aarp tax help Box 7015 Parkersburg, WV 26106-7015 Or, on the Internet, visit: www. Aarp tax help treasurydirect. Aarp tax help gov/indiv/indiv. Aarp tax help htm. Aarp tax help Accrual method taxpayers. Aarp tax help   If you use an accrual method of accounting, you must report interest on U. Aarp tax help S. Aarp tax help savings bonds each year as it accrues. Aarp tax help You cannot postpone reporting interest until you receive it or until the bonds mature. Aarp tax help Cash method taxpayers. Aarp tax help   If you use the cash method of accounting, as most individual taxpayers do, you generally report the interest on U. Aarp tax help S. Aarp tax help savings bonds when you receive it. Aarp tax help But see Reporting options for cash method taxpayers , later. Aarp tax help Series HH bonds. Aarp tax help   These bonds were issued at face value. Aarp tax help Interest is paid twice a year by direct deposit to your bank account. Aarp tax help If you are a cash method taxpayer, you must report interest on these bonds as income in the year you receive it. Aarp tax help   Series HH bonds were first offered in 1980 and last offered in August 2004. Aarp tax help Before 1980, series H bonds were issued. Aarp tax help Series H bonds are treated the same as series HH bonds. Aarp tax help If you are a cash method taxpayer, you must report the interest when you receive it. Aarp tax help   Series H bonds have a maturity period of 30 years. Aarp tax help Series HH bonds mature in 20 years. Aarp tax help The last series H bonds matured in 2009. Aarp tax help The last series HH bonds will mature in 2024. Aarp tax help Series EE and series I bonds. Aarp tax help   Interest on these bonds is payable when you redeem the bonds. Aarp tax help The difference between the purchase price and the redemption value is taxable interest. Aarp tax help Series EE bonds. Aarp tax help   Series EE bonds were first offered in January 1980 and have a maturity period of 30 years. Aarp tax help Before July 1980, series E bonds were issued. Aarp tax help The original 10-year maturity period of series E bonds has been extended to 40 years for bonds issued before December 1965 and 30 years for bonds issued after November 1965. Aarp tax help Paper series EE and series E bonds are issued at a discount. Aarp tax help The face value is payable to you at maturity. Aarp tax help Electronic series EE bonds are issued at their face value. Aarp tax help The face value plus accrued interest is payable to you at maturity. Aarp tax help As of January 1, 2012, paper savings bonds were no longer sold at financial institutions. Aarp tax help    Owners of paper series EE bonds can convert them to electronic bonds. Aarp tax help These converted bonds do not retain the denomination listed on the paper certificate but are posted at their purchase price (with accrued interest). Aarp tax help Series I bonds. Aarp tax help   Series I bonds were first offered in 1998. Aarp tax help These are inflation-indexed bonds issued at their face amount with a maturity period of 30 years. Aarp tax help The face value plus all accrued interest is payable to you at maturity. Aarp tax help Reporting options for cash method taxpayers. Aarp tax help   If you use the cash method of reporting income, you can report the interest on series EE, series E, and series I bonds in either of the following ways. Aarp tax help Method 1. Aarp tax help Postpone reporting the interest until the earlier of the year you cash or dispose of the bonds or the year in which they mature. Aarp tax help (However, see Savings bonds traded , later. Aarp tax help )  Note. Aarp tax help Series EE bonds issued in 1983 matured in 2013. Aarp tax help If you have used method 1, you generally must report the interest on these bonds on your 2013 return. Aarp tax help The last series E bonds were issued in 1980 and matured in 2010. Aarp tax help If you used method 1, you generally should have reported the interest on these bonds on your 2010 return. Aarp tax help Method 2. Aarp tax help Choose to report the increase in redemption value as interest each year. Aarp tax help  You must use the same method for all series EE, series E, and series I bonds you own. Aarp tax help If you do not choose method 2 by reporting the increase in redemption value as interest each year, you must use method 1. Aarp tax help If you plan to cash your bonds in the same year you will pay for higher educational expenses, you may want to use method 1 because you may be able to exclude the interest from your income. Aarp tax help To learn how, see Education Savings Bond Program, later. Aarp tax help Change from method 1. Aarp tax help   If you want to change your method of reporting the interest from method 1 to method 2, you can do so without permission from the IRS. Aarp tax help In the year of change, you must report all interest accrued to date and not previously reported for all your bonds. Aarp tax help   Once you choose to report the interest each year, you must continue to do so for all series EE, series E, and series I bonds you own and for any you get later, unless you request permission to change, as explained next. Aarp tax help Change from method 2. Aarp tax help   To change from method 2 to method 1, you must request permission from the IRS. Aarp tax help Permission for the change is automatically granted if you send the IRS a statement that meets all the following requirements. Aarp tax help You have typed or printed the following number at the top: “131. Aarp tax help ” It includes your name and social security number under “131. Aarp tax help ” It includes the year of change (both the beginning and ending dates). Aarp tax help It identifies the savings bonds for which you are requesting this change. Aarp tax help It includes your agreement to: Report all interest on any bonds acquired during or after the year of change when the interest is realized upon disposition, redemption, or final maturity, whichever is earliest; and Report all interest on the bonds acquired before the year of change when the interest is realized upon disposition, redemption, or final maturity, whichever is earliest, with the exception of the interest reported in prior tax years. Aarp tax help   You must attach this statement to your tax return for the year of change, which you must file by the due date (including extensions). Aarp tax help   You can have an automatic extension of 6 months from the due date of your return for the year of change (excluding extensions) to file the statement with an amended return. Aarp tax help On the statement, type or print “Filed pursuant to section 301. Aarp tax help 9100-2. Aarp tax help ” To get this extension, you must have filed your original return for the year of the change by the due date (including extensions). Aarp tax help    By the date you file the original statement with your return, you must also send a signed copy to the address below. Aarp tax help    Internal Revenue Service Attention: CC:IT&A (Automatic Rulings Branch) P. Aarp tax help O. Aarp tax help Box 7604 Benjamin Franklin Station Washington, DC 20044   If you use a private delivery service, send the signed copy to the address below. Aarp tax help Internal Revenue Service Attention: CC:IT&A  (Automatic Rulings Branch) Room 5336 1111 Constitution Avenue, NW Washington, DC 20224    Instead of filing this statement, you can request permission to change from method 2 to method 1 by filing Form 3115. Aarp tax help In that case, follow the form instructions for an automatic change. Aarp tax help No user fee is required. Aarp tax help Co-owners. Aarp tax help   If a U. Aarp tax help S. Aarp tax help savings bond is issued in the names of co-owners, such as you and your child or you and your spouse, interest on the bond is generally taxable to the co-owner who bought the bond. Aarp tax help One co-owner's funds used. Aarp tax help   If you used your funds to buy the bond, you must pay the tax on the interest. Aarp tax help This is true even if you let the other co-owner redeem the bond and keep all the proceeds. Aarp tax help Under these circumstances, the co-owner who redeemed the bond will receive a Form 1099-INT at the time of redemption and must provide you with another Form 1099-INT showing the amount of interest from the bond taxable to you. Aarp tax help The co-owner who redeemed the bond is a “nominee. Aarp tax help ” See Nominee distributions under How To Report Interest Income, later, for more information about how a person who is a nominee reports interest income belonging to another person. Aarp tax help Both co-owners' funds used. Aarp tax help   If you and the other co-owner each contribute part of the bond's purchase price, the interest is generally taxable to each of you, in proportion to the amount each of you paid. Aarp tax help Community property. Aarp tax help   If you and your spouse live in a community property state and hold bonds as community property, one-half of the interest is considered received by each of you. Aarp tax help If you file separate returns, each of you generally must report one-half of the bond interest. Aarp tax help For more information about community property, see Publication 555. Aarp tax help Table 1-2. Aarp tax help   These rules are also shown in Table 1-2. Aarp tax help Child as only owner. Aarp tax help   Interest on U. Aarp tax help S. Aarp tax help savings bonds bought for and registered only in the name of your child is income to your child, even if you paid for the bonds and are named as beneficiary. Aarp tax help If the bonds are series EE, series E, or series I bonds, the interest on the bonds is income to your child in the earlier of the year the bonds are cashed or disposed of or the year the bonds mature, unless your child chooses to report the interest income each year. Aarp tax help Choice to report interest each year. Aarp tax help   The choice to report the accrued interest each year can be made either by your child or by you for your child. Aarp tax help This choice is made by filing an income tax return that shows all the interest earned to date, and by stating on the return that your child chooses to report the interest each year. Aarp tax help Either you or your child should keep a copy of this return. Aarp tax help   Unless your child is otherwise required to file a tax return for any year after making this choice, your child does not have to file a return only to report the annual accrual of U. Aarp tax help S. Aarp tax help savings bond interest under this choice. Aarp tax help However, see Tax on unearned income of certain children , earlier, under General Information. Aarp tax help Neither you nor your child can change the way you report the interest unless you request permission from the IRS, as discussed earlier under Change from method 2 . Aarp tax help Ownership transferred. Aarp tax help   If you bought series E, series EE, or series I bonds entirely with your own funds and had them reissued in your co-owner's name or beneficiary's name alone, you must include in your gross income for the year of reissue all interest that you earned on these bonds and have not previously reported. Aarp tax help But, if the bonds were reissued in your name alone, you do not have to report the interest accrued at that time. Aarp tax help   This same rule applies when bonds (other than bonds held as community property) are transferred between spouses or incident to divorce. Aarp tax help Example. Aarp tax help You bought series EE bonds entirely with your own funds. Aarp tax help You did not choose to report the accrued interest each year. Aarp tax help Later, you transfer the bonds to your former spouse under a divorce agreement. Aarp tax help You must include the deferred accrued interest, from the date of the original issue of the bonds to the date of transfer, in your income in the year of transfer. Aarp tax help Your former spouse includes in income the interest on the bonds from the date of transfer to the date of redemption. Aarp tax help Table 1-2. Aarp tax help Who Pays the Tax on U. Aarp tax help S. Aarp tax help Savings Bond Interest IF . Aarp tax help . Aarp tax help . Aarp tax help THEN the interest must be reported by . Aarp tax help . Aarp tax help . Aarp tax help you buy a bond in your name and the name of another person as co-owners, using only your own funds you. Aarp tax help you buy a bond in the name of another person, who is the sole owner of the bond the person for whom you bought the bond. Aarp tax help you and another person buy a bond as co-owners, each contributing part of the purchase price both you and the other co-owner, in proportion to the amount each paid for the bond. Aarp tax help you and your spouse, who live in a community property state, buy a bond that is community property you and your spouse. Aarp tax help If you file separate returns, both you and your spouse generally report one-half of the interest. Aarp tax help Purchased jointly. Aarp tax help   If you and a co-owner each contributed funds to buy series E, series EE, or series I bonds jointly and later have the bonds reissued in the co-owner's name alone, you must include in your gross income for the year of reissue your share of all the interest earned on the bonds that you have not previously reported. Aarp tax help The former co-owner does not have to include in gross income at the time of reissue his or her share of the interest earned that was not reported before the transfer. Aarp tax help This interest, however, as well as all interest earned after the reissue, is income to the former co-owner. Aarp tax help   This income-reporting rule also applies when the bonds are reissued in the name of your former co-owner and a new co-owner. Aarp tax help But the new co-owner will report only his or her share of the interest earned after the transfer. Aarp tax help   If bonds that you and a co-owner bought jointly are reissued to each of you separately in the same proportion as your contribution to the purchase price, neither you nor your co-owner has to report at that time the interest earned before the bonds were reissued. Aarp tax help Example 1. Aarp tax help You and your spouse each spent an equal amount to buy a $1,000 series EE savings bond. Aarp tax help The bond was issued to you and your spouse as co-owners. Aarp tax help You both postpone reporting interest on the bond. Aarp tax help You later have the bond reissued as two $500 bonds, one in your name and one in your spouse's name. Aarp tax help At that time neither you nor your spouse has to report the interest earned to the date of reissue. Aarp tax help Example 2. Aarp tax help You bought a $1,000 series EE savings bond entirely with your own funds. Aarp tax help The bond was issued to you and your spouse as co-owners. Aarp tax help You both postponed reporting interest on the bond. Aarp tax help You later have the bond reissued as two $500 bonds, one in your name and one in your spouse's name. Aarp tax help You must report half the interest earned to the date of reissue. Aarp tax help Transfer to a trust. Aarp tax help   If you own series E, series EE, or series I bonds and transfer them to a trust, giving up all rights of ownership, you must include in your income for that year the interest earned to the date of transfer if you have not already reported it. Aarp tax help However, if you are considered the owner of the trust and if the increase in value both before and after the transfer continues to be taxable to you, you can continue to defer reporting the interest earned each year. Aarp tax help You must include the total interest in your income in the year you cash or dispose of the bonds or the year the bonds finally mature, whichever is earlier. Aarp tax help   The same rules apply to previously unreported interest on series EE or series E bonds if the transfer to a trust consisted of series HH or series H bonds you acquired in a trade for the series EE or series E bonds. Aarp tax help See Savings bonds traded , later. Aarp tax help Decedents. Aarp tax help   The manner of reporting interest income on series E, series EE, or series I bonds, after the death of the owner (decedent), depends on the accounting and income-reporting methods previously used by the decedent. Aarp tax help Decedent who reported interest each year. Aarp tax help   If the bonds transferred because of death were owned by a person who used an accrual method, or who used the cash method and had chosen to report the interest each year, the interest earned in the year of death up to the date of death must be reported on that person's final return. Aarp tax help The person who acquires the bonds includes in income only interest earned after the date of death. Aarp tax help Decedent who postponed reporting interest. Aarp tax help   If the transferred bonds were owned by a decedent who had used the cash method and had not chosen to report the interest each year, and who had bought the bonds entirely with his or her own funds, all interest earned before death must be reported in one of the following ways. Aarp tax help The surviving spouse or personal representative (executor, administrator, etc. Aarp tax help ) who files the final income tax return of the decedent can choose to include on that return all interest earned on the bonds before the decedent's death. Aarp tax help The person who acquires the bonds then includes in income only interest earned after the date of death. Aarp tax help If the choice in (1) is not made, the interest earned up to the date of death is income in respect of the decedent and should not be included in the decedent's final return. Aarp tax help All interest earned both before and after the decedent's death (except any part reported by the estate on its income tax return) is income to the person who acquires the bonds. Aarp tax help If that person uses the cash method and does not choose to report the interest each year, he or she can postpone reporting it until the year the bonds are cashed or disposed of or the year they mature, whichever is earlier. Aarp tax help In the year that person reports the interest, he or she can claim a deduction for any federal estate tax paid on the part of the interest included in the decedent's estate. Aarp tax help For more information on income in respect of a decedent, see Publication 559, Survivors, Executors, and Administrators. Aarp tax help Example 1. Aarp tax help Your uncle, a cash method taxpayer, died and left you a $1,000 series EE bond. Aarp tax help He had bought the bond for $500 and had not chosen to report the interest each year. Aarp tax help At the date of death, interest of $200 had accrued on the bond, and its value of $700 was included in your uncle's estate. Aarp tax help Your uncle's executor chose not to include the $200 accrued interest in your uncle's final income tax return. Aarp tax help The $200 is income in respect of the decedent. Aarp tax help You are a cash method taxpayer and do not choose to report the interest each year as it is earned. Aarp tax help If you cash the bond when it reaches maturity value of $1,000, you report $500 interest income—the difference between maturity value of $1,000 and the original cost of $500. Aarp tax help For that year, you can deduct (as a miscellaneous itemized deduction not subject to the 2%-of-adjusted-gross-income limit) any federal estate tax paid because the $200 interest was included in your uncle's estate. Aarp tax help Example 2. Aarp tax help If, in Example 1 , the executor had chosen to include the $200 accrued interest in your uncle's final return, you would report only $300 as interest when you cashed the bond at maturity. Aarp tax help $300 is the interest earned after your uncle's death. Aarp tax help Example 3. Aarp tax help If, in Example 1 , you make or have made the choice to report the increase in redemption value as interest each year, you include in gross income for the year you acquire the bond all of the unreported increase in value of all series E, series EE, and series I bonds you hold, including the $200 on the bond you inherited from your uncle. Aarp tax help Example 4. Aarp tax help When your aunt died, she owned series HH bonds that she had acquired in a trade for series EE bonds. Aarp tax help You were the beneficiary of these bonds. Aarp tax help Your aunt used the cash method and did not choose to report the interest on the series EE bonds each year as it accrued. Aarp tax help Your aunt's executor chose not to include any interest earned before your aunt's death on her final return. Aarp tax help The income in respect of the decedent is the sum of the unreported interest on the series EE bonds and the interest, if any, payable on the series HH bonds but not received as of the date of your aunt's death. Aarp tax help You must report any interest received during the year as income on your return. Aarp tax help The part of the interest payable but not received before your aunt's death is income in respect of the decedent and may qualify for the estate tax deduction. Aarp tax help For information on when to report the interest on the series EE bonds traded, see Savings bonds traded , later. Aarp tax help Savings bonds distributed from a retirement or profit-sharing plan. Aarp tax help   If you acquire a U. Aarp tax help S. Aarp tax help savings bond in a taxable distribution from a retirement or profit-sharing plan, your income for the year of distribution includes the bond's redemption value (its cost plus the interest accrued before the distribution). Aarp tax help When you redeem the bond (whether in the year of distribution or later), your interest income includes only the interest accrued after the bond was distributed. Aarp tax help To figure the interest reported as a taxable distribution and your interest income when you redeem the bond, see Worksheet for savings bonds distributed from a retirement or profit-sharing plan under How To Report Interest Income, later. Aarp tax help Savings bonds traded. Aarp tax help   If you postponed reporting the interest on your series EE or series E bonds, you did not recognize taxable income when you traded the bonds for series HH or series H bonds, unless you received cash in the trade. Aarp tax help (You cannot trade series I bonds for series HH bonds. Aarp tax help After August 31, 2004, you cannot trade any other series of bonds for series HH bonds. Aarp tax help ) Any cash you received is income up to the amount of the interest earned on the bonds traded. Aarp tax help When your series HH or series H bonds mature, or if you dispose of them before maturity, you report as interest the difference between their redemption value and your cost. Aarp tax help Your cost is the sum of the amount you paid for the traded series EE or series E bonds plus any amount you had to pay at the time of the trade. Aarp tax help Example. Aarp tax help You traded series EE bonds (on which you postponed reporting the interest) for $2,500 in series HH bonds and $223 in cash. Aarp tax help You reported the $223 as taxable income on your tax return. Aarp tax help At the time of the trade, the series EE bonds had accrued interest of $523 and a redemption value of $2,723. Aarp tax help You hold the series HH bonds until maturity, when you receive $2,500. Aarp tax help You must report $300 as interest income in the year of maturity. Aarp tax help This is the difference between their redemption value, $2,500, and your cost, $2,200 (the amount you paid for the series EE bonds). Aarp tax help (It is also the difference between the accrued interest of $523 on the series EE bonds and the $223 cash received on the trade. Aarp tax help ) Choice to report interest in year of trade. Aarp tax help   You could have chosen to treat all of the previously unreported accrued interest on series EE or series E bonds traded for series HH bonds as income in the year of the trade. Aarp tax help If you made this choice, it is treated as a change from method 1. Aarp tax help See Change from method 1 under Series EE and series I bonds, earlier. Aarp tax help Form 1099-INT for U. Aarp tax help S. Aarp tax help savings bond interest. Aarp tax help   When you cash a bond, the bank or other payer that redeems it must give you a Form 1099-INT if the interest part of the payment you receive is $10 or more. Aarp tax help Box 3 of your Form 1099-INT should show the interest as the difference between the amount you received and the amount paid for the bond. Aarp tax help However, your Form 1099-INT may show more interest than you have to include on your income tax return. Aarp tax help For example, this may happen if any of the following are true. Aarp tax help You chose to report the increase in the redemption value of the bond each year. Aarp tax help The interest shown on your Form 1099-INT will not be reduced by amounts previously included in income. Aarp tax help You received the bond from a decedent. Aarp tax help The interest shown on your Form 1099-INT will not be reduced by any interest reported by the decedent before death, or on the decedent's final return, or by the estate on the estate's income tax return. Aarp tax help Ownership of the bond was transferred. Aarp tax help The interest shown on your Form 1099-INT will not be reduced by interest that accrued before the transfer. Aarp tax help You were named as a co-owner, and the other co-owner contributed funds to buy the bond. Aarp tax help The interest shown on your Form 1099-INT will not be reduced by the amount you received as nominee for the other co-owner. Aarp tax help (See Co-owners , earlier in this section, for more information about the reporting requirements. Aarp tax help ) You received the bond in a taxable distribution from a retirement or profit-sharing plan. Aarp tax help The interest shown on your Form 1099-INT will not be reduced by the interest portion of the amount taxable as a distribution from the plan and not taxable as interest. Aarp tax help (This amount is generally shown on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Aarp tax help , for the year of distribution. Aarp tax help )   For more information on including the correct amount of interest on your return, see U. Aarp tax help S. Aarp tax help savings bond interest previously reported or Nominee distributions under How To Report Interest Income, later. Aarp tax help    Interest on U. Aarp tax help S. Aarp tax help savings bonds is exempt from state and local taxes. Aarp tax help The Form 1099-INT you receive will indicate the amount that is for U. Aarp tax help S. Aarp tax help savings bonds interest in box 3. Aarp tax help Do not include this income on your state or local income tax return. Aarp tax help Education Savings Bond Program You may be able to exclude from income all or part of the interest you receive on the redemption of qualified U. Aarp tax help S. Aarp tax help savings bonds during the year if you pay qualified higher educational expenses during the same year. Aarp tax help This exclusion is known as the Education Savings Bond Program. Aarp tax help You do not qualify for this exclusion if your filing status is married filing separately. Aarp tax help Form 8815. Aarp tax help   Use Form 8815 to figure your exclusion. Aarp tax help Attach the form to your Form 1040 or Form 1040A. Aarp tax help Qualified U. Aarp tax help S. Aarp tax help savings bonds. Aarp tax help   A qualified U. Aarp tax help S. Aarp tax help savings bond is a series EE bond issued after 1989 or a series I bond. Aarp tax help The bond must be issued either in your name (sole owner) or in your and your spouse's names (co-owners). Aarp tax help You must be at least 24 years old before the bond's issue date. Aarp tax help For example, a bond bought by a parent and issued in the name of his or her child under age 24 does not qualify for the exclusion by the parent or child. Aarp tax help    The issue date of a bond may be earlier than the date the bond is purchased because the issue date assigned to a bond is the first day of the month in which it is purchased. Aarp tax help Beneficiary. Aarp tax help   You can designate any individual (including a child) as a beneficiary of the bond. Aarp tax help Verification by IRS. Aarp tax help   If you claim the exclusion, the IRS will check it by using bond redemption information from the Department of Treasury. Aarp tax help Qualified expenses. Aarp tax help   Qualified higher educational expenses are tuition and fees required for you, your spouse, or your dependent (for whom you claim an exemption) to attend an eligible educational institution. Aarp tax help   Qualified expenses include any contribution you make to a qualified tuition program or to a Coverdell education savings account. Aarp tax help For information about these programs, see Publication 970, Tax Benefits for Education. Aarp tax help   Qualified expenses do not include expenses for room and board or for courses involving sports, games, or hobbies that are not part of a degree or certificate granting program. Aarp tax help Eligible educational institutions. Aarp tax help   These institutions include most public, private, and nonprofit universities, colleges, and vocational schools that are accredited and eligible to participate in student aid programs run by the Department of Education. Aarp tax help Reduction for certain benefits. Aarp tax help   You must reduce your qualified higher educational expenses by all of the following tax-free benefits. Aarp tax help Tax-free part of scholarships and fellowships. Aarp tax help Expenses used to figure the tax-free portion of distributions from a Coverdell ESA. Aarp tax help Expenses used to figure the tax-free portion of distributions from a qualified tuition program. Aarp tax help Any tax-free payments (other than gifts or inheritances) received as educational assistance, such as: Veterans' educational assistance benefits, Qualified tuition reductions, or Employer-provided educational assistance. Aarp tax help Any expense used in figuring the American Opportunity and lifetime learning credits. Aarp tax help For information about these benefits, see Publication 970. Aarp tax help Amount excludable. Aarp tax help   If the total proceeds (interest and principal) from the qualified U. Aarp tax help S. Aarp tax help savings bonds you redeem during the year are not more than your adjusted qualified higher educational expenses for the year, you may be able to exclude all of the interest. Aarp tax help If the proceeds are more than the expenses, you may be able to exclude only part of the interest. Aarp tax help   To determine the excludable amount, multiply the interest part of the proceeds by a fraction. Aarp tax help The numer
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The Aarp Tax Help

Aarp tax help Publication 538 - Main Content Table of Contents Accounting PeriodsCalendar Year Fiscal Year Short Tax Year Improper Tax Year Change in Tax Year Individuals Partnerships, S Corporations, and Personal Service Corporations (PSCs) Corporations (Other Than S Corporations and PSCs) Accounting MethodsSpecial methods. Aarp tax help Hybrid method. Aarp tax help Cash Method Accrual Method Inventories Change in Accounting Method How To Get Tax HelpLow Income Taxpayer Clinics (LITCs). Aarp tax help Accounting Periods You must use a tax year to figure your taxable income. Aarp tax help A tax year is an annual accounting period for keeping records and reporting income and expenses. Aarp tax help An annual accounting period does not include a short tax year (discussed later). Aarp tax help You can use the following tax years: A calendar year; or A fiscal year (including a 52-53-week tax year). Aarp tax help Unless you have a required tax year, you adopt a tax year by filing your first income tax return using that tax year. Aarp tax help A required tax year is a tax year required under the Internal Revenue Code or the Income Tax Regulations. Aarp tax help You cannot adopt a tax year by merely: Filing an application for an extension of time to file an income tax return; Filing an application for an employer identification number (Form SS-4); or Paying estimated taxes. Aarp tax help This section discusses: A calendar year. Aarp tax help A fiscal year (including a period of 52 or 53 weeks). Aarp tax help A short tax year. Aarp tax help An improper tax year. Aarp tax help A change in tax year. Aarp tax help Special situations that apply to individuals. Aarp tax help Restrictions that apply to the accounting period of a partnership, S corporation, or personal service corporation. Aarp tax help Special situations that apply to corporations. Aarp tax help Calendar Year A calendar year is 12 consecutive months beginning on January 1st and ending on December 31st. Aarp tax help If you adopt the calendar year, you must maintain your books and records and report your income and expenses from January 1st through December 31st of each year. Aarp tax help If you file your first tax return using the calendar tax year and you later begin business as a sole proprietor, become a partner in a partnership, or become a shareholder in an S corporation, you must continue to use the calendar year unless you obtain approval from the IRS to change it, or are otherwise allowed to change it without IRS approval. Aarp tax help See Change in Tax Year, later. Aarp tax help Generally, anyone can adopt the calendar year. Aarp tax help However, you must adopt the calendar year if: You keep no books or records; You have no annual accounting period; Your present tax year does not qualify as a fiscal year; or You are required to use a calendar year by a provision in the Internal Revenue Code or the Income Tax Regulations. Aarp tax help Fiscal Year A fiscal year is 12 consecutive months ending on the last day of any month except December 31st. Aarp tax help If you are allowed to adopt a fiscal year, you must consistently maintain your books and records and report your income and expenses using the time period adopted. Aarp tax help 52-53-Week Tax Year You can elect to use a 52-53-week tax year if you keep your books and records and report your income and expenses on that basis. Aarp tax help If you make this election, your 52-53-week tax year must always end on the same day of the week. Aarp tax help Your 52-53-week tax year must always end on: Whatever date this same day of the week last occurs in a calendar month, or Whatever date this same day of the week falls that is nearest to the last day of the calendar month. Aarp tax help For example, if you elect a tax year that always ends on the last Monday in March, your 2012 tax year will end on March 25, 2013. Aarp tax help Election. Aarp tax help   To make the election for the 52-53-week tax year, attach a statement with the following information to your tax return. Aarp tax help The month in which the new 52-53-week tax year ends. Aarp tax help The day of the week on which the tax year always ends. Aarp tax help The date the tax year ends. Aarp tax help It can be either of the following dates on which the chosen day: Last occurs in the month in (1), above, or Occurs nearest to the last day of the month in (1), above. Aarp tax help   When you figure depreciation or amortization, a 52-53-week tax year is generally considered a year of 12 calendar months. Aarp tax help   To determine an effective date (or apply provisions of any law) expressed in terms of tax years beginning, including, or ending on the first or last day of a specified calendar month, a 52-53-week tax year is considered to: Begin on the first day of the calendar month beginning nearest to the first day of the 52-53-week tax year, and End on the last day of the calendar month ending nearest to the last day of the 52-53-week tax year. Aarp tax help Example. Aarp tax help Assume a tax provision applies to tax years beginning on or after July 1, 2012, which happens to be a Sunday. Aarp tax help For this purpose, a 52-53-week tax year that begins on the last Tuesday of June, which falls on June 26, 2012, is treated as beginning on July 1, 2012. Aarp tax help Short Tax Year A short tax year is a tax year of less than 12 months. Aarp tax help A short period tax return may be required when you (as a taxable entity): Are not in existence for an entire tax year, or Change your accounting period. Aarp tax help Tax on a short period tax return is figured differently for each situation. Aarp tax help Not in Existence Entire Year Even if a taxable entity was not in existence for the entire year, a tax return is required for the time it was in existence. Aarp tax help Requirements for filing the return and figuring the tax are generally the same as the requirements for a return for a full tax year (12 months) ending on the last day of the short tax year. Aarp tax help Example 1. Aarp tax help XYZ Corporation was organized on July 1, 2012. Aarp tax help It elected the calendar year as its tax year. Aarp tax help Therefore, its first tax return was due March 15, 2013. Aarp tax help This short period return will cover the period from July 1, 2012, through December 31, 2012. Aarp tax help Example 2. Aarp tax help A calendar year corporation dissolved on July 23, 2012. Aarp tax help Its final return is due by October 15, 2012. Aarp tax help It will cover the short period from January 1, 2012, through July 23, 2012. Aarp tax help Death of individual. Aarp tax help   When an individual dies, a tax return must be filed for the decedent by the 15th day of the 4th month after the close of the individual's regular tax year. Aarp tax help The decedent's final return will be a short period tax return that begins on January 1st, and ends on the date of death. Aarp tax help In the case of a decedent who dies on December 31st, the last day of the regular tax year, a full calendar-year tax return is required. Aarp tax help Example. Aarp tax help   Agnes Green was a single, calendar year taxpayer. Aarp tax help She died on March 6, 2012. Aarp tax help Her final income tax return must be filed by April 15, 2013. Aarp tax help It will cover the short period from January 1, 2012, to March 6, 2012. Aarp tax help Figuring Tax for Short Year If the IRS approves a change in your tax year or you are required to change your tax year, you must figure the tax and file your return for the short tax period. Aarp tax help The short tax period begins on the first day after the close of your old tax year and ends on the day before the first day of your new tax year. Aarp tax help Figure tax for a short year under the general rule, explained below. Aarp tax help You may then be able to use a relief procedure, explained later, and claim a refund of part of the tax you paid. Aarp tax help General rule. Aarp tax help   Income tax for a short tax year must be annualized. Aarp tax help However, self-employment tax is figured on the actual self-employment income for the short period. Aarp tax help Individuals. Aarp tax help   An individual must figure income tax for the short tax year as follows. Aarp tax help Determine your adjusted gross income (AGI) for the short tax year and then subtract your actual itemized deductions for the short tax year. Aarp tax help You must itemize deductions when you file a short period tax return. Aarp tax help Multiply the dollar amount of your exemptions by the number of months in the short tax year and divide the result by 12. Aarp tax help Subtract the amount in (2) from the amount in (1). Aarp tax help The result is your modified taxable income. Aarp tax help Multiply the modified taxable income in (3) by 12, then divide the result by the number of months in the short tax year. Aarp tax help The result is your annualized income. Aarp tax help Figure the total tax on your annualized income using the appropriate tax rate schedule. Aarp tax help Multiply the total tax by the number of months in the short tax year and divide the result by 12. Aarp tax help The result is your tax for the short tax year. Aarp tax help Relief procedure. Aarp tax help   Individuals and corporations can use a relief procedure to figure the tax for the short tax year. Aarp tax help It may result in less tax. Aarp tax help Under this procedure, the tax is figured by two separate methods. Aarp tax help If the tax figured under both methods is less than the tax figured under the general rule, you can file a claim for a refund of part of the tax you paid. Aarp tax help For more information, see section 443(b)(2) of the Internal Revenue Code. Aarp tax help Alternative minimum tax. Aarp tax help   To figure the alternative minimum tax (AMT) due for a short tax year: Figure the annualized alternative minimum taxable income (AMTI) for the short tax period by completing the following steps. Aarp tax help Multiply the AMTI by 12. Aarp tax help Divide the result by the number of months in the short tax year. Aarp tax help Multiply the annualized AMTI by the appropriate rate of tax under section 55(b)(1) of the Internal Revenue Code. Aarp tax help The result is the annualized AMT. Aarp tax help Multiply the annualized AMT by the number of months in the short tax year and divide the result by 12. Aarp tax help   For information on the AMT for individuals, see the Instructions for Form 6251, Alternative Minimum Tax–Individuals. Aarp tax help For information on the AMT for corporations, see the Instructions to Form 4626, Alternative Minimum Tax–Corporations. Aarp tax help Tax withheld from wages. Aarp tax help   You can claim a credit against your income tax liability for federal income tax withheld from your wages. Aarp tax help Federal income tax is withheld on a calendar year basis. Aarp tax help The amount withheld in any calendar year is allowed as a credit for the tax year beginning in the calendar year. Aarp tax help Improper Tax Year Taxpayers that have adopted an improper tax year must change to a proper tax year. Aarp tax help For example, if a taxpayer began business on March 15 and adopted a tax year ending on March 14 (a period of exactly 12 months), this would be an improper tax year. Aarp tax help See Accounting Periods, earlier, for a description of permissible tax years. Aarp tax help To change to a proper tax year, you must do one of the following. Aarp tax help If you are requesting a change to a calendar tax year, file an amended income tax return based on a calendar tax year that corrects the most recently filed tax return that was filed on the basis of an improper tax year. Aarp tax help Attach a completed Form 1128 to the amended tax return. Aarp tax help Write “FILED UNDER REV. Aarp tax help PROC. Aarp tax help 85-15” at the top of Form 1128 and file the forms with the Internal Revenue Service Center where you filed your original return. Aarp tax help If you are requesting a change to a fiscal tax year, file Form 1128 in accordance with the form instructions to request IRS approval for the change. Aarp tax help Change in Tax Year Generally, you must file Form 1128 to request IRS approval to change your tax year. Aarp tax help See the Instructions for Form 1128 for exceptions. Aarp tax help If you qualify for an automatic approval request, a user fee is not required. Aarp tax help Individuals Generally, individuals must adopt the calendar year as their tax year. Aarp tax help An individual can adopt a fiscal year provided that the individual maintains his or her books and records on the basis of the adopted fiscal year. Aarp tax help Partnerships, S Corporations, and Personal Service Corporations (PSCs) Generally, partnerships, S corporations (including electing S corporations), and PSCs must use a required tax year. Aarp tax help A required tax year is a tax year that is required under the Internal Revenue Code and Income Tax Regulations. Aarp tax help The entity does not have to use the required tax year if it receives IRS approval to use another permitted tax year or makes an election under section 444 of the Internal Revenue Code (discussed later). Aarp tax help The following discussions provide the rules for partnerships, S corporations, and PSCs. Aarp tax help Partnership A partnership must conform its tax year to its partners' tax years unless any of the following apply. Aarp tax help The partnership makes an election under section 444 of the Internal Revenue Code to have a tax year other than a required tax year by filing Form 8716. Aarp tax help The partnership elects to use a 52-53-week tax year that ends with reference to either its required tax year or a tax year elected under section 444. Aarp tax help The partnership can establish a business purpose for a different tax year. Aarp tax help The rules for the required tax year for partnerships are as follows. Aarp tax help If one or more partners having the same tax year own a majority interest (more than 50%) in partnership profits and capital, the partnership must use the tax year of those partners. Aarp tax help If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. Aarp tax help A principal partner is one who has a 5% or more interest in the profits or capital of the partnership. Aarp tax help If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use a tax year that results in the least aggregate deferral of income to the partners. Aarp tax help If a partnership changes to a required tax year because of these rules, it can get automatic approval by filing Form 1128. Aarp tax help Least aggregate deferral of income. Aarp tax help   The tax year that results in the least aggregate deferral of income is determined as follows. Aarp tax help Figure the number of months of deferral for each partner using one partner's tax year. Aarp tax help Find the months of deferral by counting the months from the end of that tax year forward to the end of each other partner's tax year. Aarp tax help Multiply each partner's months of deferral figured in step (1) by that partner's share of interest in the partnership profits for the year used in step (1). Aarp tax help Add the amounts in step (2) to get the aggregate (total) deferral for the tax year used in step (1). Aarp tax help Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years. Aarp tax help   The partner's tax year that results in the lowest aggregate (total) number is the tax year that must be used by the partnership. Aarp tax help If the calculation results in more than one tax year qualifying as the tax year with the least aggregate deferral, the partnership can choose any one of those tax years as its tax year. Aarp tax help However, if one of the tax years that qualifies is the partnership's existing tax year, the partnership must retain that tax year. Aarp tax help Example. Aarp tax help A and B each have a 50% interest in partnership P, which uses a fiscal year ending June 30. Aarp tax help A uses the calendar year and B uses a fiscal year ending November 30. Aarp tax help P must change its tax year to a fiscal year ending November 30 because this results in the least aggregate deferral of income to the partners, as shown in the following table. Aarp tax help Year End 12/31: Year End Profits Interest Months of Deferral Interest × Deferral A 12/31 0. Aarp tax help 5 -0- -0- B 11/30 0. Aarp tax help 5 11 5. Aarp tax help 5 Total Deferral 5. Aarp tax help 5 Year End 11/30: Year End Profits Interest Months of Deferral Interest × Deferral A 12/31 0. Aarp tax help 5 1 0. Aarp tax help 5 B 11/30 0. Aarp tax help 5 -0- -0- Total Deferral 0. Aarp tax help 5 When determination is made. Aarp tax help   The determination of the tax year under the least aggregate deferral rules must generally be made at the beginning of the partnership's current tax year. Aarp tax help However, the IRS can require the partnership to use another day or period that will more accurately reflect the ownership of the partnership. Aarp tax help This could occur, for example, if a partnership interest was transferred for the purpose of qualifying for a particular tax year. Aarp tax help Short period return. Aarp tax help   When a partnership changes its tax year, a short period return must be filed. Aarp tax help The short period return covers the months between the end of the partnership's prior tax year and the beginning of its new tax year. Aarp tax help   If a partnership changes to the tax year resulting in the least aggregate deferral, it must file a Form 1128 with the short period return showing the computations used to determine that tax year. Aarp tax help The short period return must indicate at the top of page 1, “FILED UNDER SECTION 1. Aarp tax help 706-1. Aarp tax help ” More information. Aarp tax help   For more information about changing a partnership's tax year, and information about ruling requests, see the Instructions for Form 1128. Aarp tax help S Corporation All S corporations, regardless of when they became an S corporation, must use a permitted tax year. Aarp tax help A permitted tax year is any of the following. Aarp tax help The calendar year. Aarp tax help A tax year elected under section 444 of the Internal Revenue Code. Aarp tax help See Section 444 Election, below for details. Aarp tax help A 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444. Aarp tax help Any other tax year for which the corporation establishes a business purpose. Aarp tax help If an electing S corporation wishes to adopt a tax year other than a calendar year, it must request IRS approval using Form 2553, instead of filing Form 1128. Aarp tax help For information about changing an S corporation's tax year and information about ruling requests, see the Instructions for Form 1128. Aarp tax help Personal Service Corporation (PSC) A PSC must use a calendar tax year unless any of the following apply. Aarp tax help The corporation makes an election under section 444 of the Internal Revenue Code. Aarp tax help See Section 444 Election, below for details. Aarp tax help The corporation elects to use a 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444. Aarp tax help The corporation establishes a business purpose for a fiscal year. Aarp tax help See the Instructions for Form 1120 for general information about PSCs. Aarp tax help For information on adopting or changing tax years for PSCs and information about ruling requests, see the Instructions for Form 1128. Aarp tax help Section 444 Election A partnership, S corporation, electing S corporation, or PSC can elect under section 444 of the Internal Revenue Code to use a tax year other than its required tax year. Aarp tax help Certain restrictions apply to the election. Aarp tax help A partnership or an S corporation that makes a section 444 election must make certain required payments and a PSC must make certain distributions (discussed later). Aarp tax help The section 444 election does not apply to any partnership, S corporation, or PSC that establishes a business purpose for a different period, explained later. Aarp tax help A partnership, S corporation, or PSC can make a section 444 election if it meets all the following requirements. Aarp tax help It is not a member of a tiered structure (defined in section 1. Aarp tax help 444-2T of the regulations). Aarp tax help It has not previously had a section 444 election in effect. Aarp tax help It elects a year that meets the deferral period requirement. Aarp tax help Deferral period. Aarp tax help   The determination of the deferral period depends on whether the partnership, S corporation, or PSC is retaining its tax year or adopting or changing its tax year with a section 444 election. Aarp tax help Retaining tax year. Aarp tax help   Generally, a partnership, S corporation, or PSC can make a section 444 election to retain its tax year only if the deferral period of the new tax year is 3 months or less. Aarp tax help This deferral period is the number of months between the beginning of the retained year and the close of the first required tax year. Aarp tax help Adopting or changing tax year. Aarp tax help   If the partnership, S corporation, or PSC is adopting or changing to a tax year other than its required year, the deferral period is the number of months from the end of the new tax year to the end of the required tax year. Aarp tax help The IRS will allow a section 444 election only if the deferral period of the new tax year is less than the shorter of: Three months, or The deferral period of the tax year being changed. Aarp tax help This is the tax year immediately preceding the year for which the partnership, S corporation, or PSC wishes to make the section 444 election. Aarp tax help If the partnership, S corporation, or PSC's tax year is the same as its required tax year, the deferral period is zero. Aarp tax help Example 1. Aarp tax help BD Partnership uses a calendar year, which is also its required tax year. Aarp tax help BD cannot make a section 444 election because the deferral period is zero. Aarp tax help Example 2. Aarp tax help E, a newly formed partnership, began operations on December 1. Aarp tax help E is owned by calendar year partners. Aarp tax help E wants to make a section 444 election to adopt a September 30 tax year. Aarp tax help E's deferral period for the tax year beginning December 1 is 3 months, the number of months between September 30 and December 31. Aarp tax help Making the election. Aarp tax help   Make a section 444 election by filing Form 8716 with the Internal Revenue Service Center where the entity will file its tax return. Aarp tax help Form 8716 must be filed by the earlier of: The due date (not including extensions) of the income tax return for the tax year resulting from the section 444 election, or The 15th day of the 6th month of the tax year for which the election will be effective. Aarp tax help For this purpose, count the month in which the tax year begins, even if it begins after the first day of that month. Aarp tax help Note. Aarp tax help If the due date falls on a Saturday, Sunday, or legal holiday, file on the next business day. Aarp tax help   Attach a copy of Form 8716 to Form 1065, Form 1120S, or Form 1120 for the first tax year for which the election is made. Aarp tax help Example 1. Aarp tax help AB, a partnership, begins operations on September 13, 2012, and is qualified to make a section 444 election to use a September 30 tax year for its tax year beginning September 13, 2012. Aarp tax help AB must file Form 8716 by January 15, 2013, which is the due date of the partnership's tax return for the period from September 13, 2012, to September 30, 2012. Aarp tax help Example 2. Aarp tax help The facts are the same as in Example 1 except that AB begins operations on October 21, 2012. Aarp tax help AB must file Form 8716 by March 17, 2013. Aarp tax help Example 3. Aarp tax help B is a corporation that first becomes a PSC for its tax year beginning September 1, 2012. Aarp tax help B qualifies to make a section 444 election to use a September 30 tax year for its tax year beginning September 1, 2012. Aarp tax help B must file Form 8716 by December 17, 2012, the due date of the income tax return for the short period from September 1, 2012, to September 30, 2012. Aarp tax help Note. Aarp tax help The due dates in Examples 2 and 3 are adjusted because the dates fall on a Saturday, Sunday or legal holiday. Aarp tax help Extension of time for filing. Aarp tax help   There is an automatic extension of 12 months to make this election. Aarp tax help See the Form 8716 instructions for more information. Aarp tax help Terminating the election. Aarp tax help   The section 444 election remains in effect until it is terminated. Aarp tax help If the election is terminated, another section 444 election cannot be made for any tax year. Aarp tax help   The election ends when any of the following applies to the partnership, S corporation, or PSC. Aarp tax help The entity changes to its required tax year. Aarp tax help The entity liquidates. Aarp tax help The entity becomes a member of a tiered structure. Aarp tax help The IRS determines that the entity willfully failed to comply with the required payments or distributions. Aarp tax help   The election will also end if either of the following events occur. Aarp tax help An S corporation's S election is terminated. Aarp tax help However, if the S corporation immediately becomes a PSC, the PSC can continue the section 444 election of the S corporation. Aarp tax help A PSC ceases to be a PSC. Aarp tax help If the PSC elects to be an S corporation, the S corporation can continue the election of the PSC. Aarp tax help Required payment for partnership or S corporation. Aarp tax help   A partnership or an S corporation must make a required payment for any tax year: The section 444 election is in effect. Aarp tax help The required payment for that year (or any preceding tax year) is more than $500. Aarp tax help    This payment represents the value of the tax deferral the owners receive by using a tax year different from the required tax year. Aarp tax help   Form 8752, Required Payment or Refund Under Section 7519, must be filed each year the section 444 election is in effect, even if no payment is due. Aarp tax help If the required payment is more than $500 (or the required payment for any prior year was more than $500), the payment must be made when Form 8752 is filed. Aarp tax help If the required payment is $500 or less and no payment was required in a prior year, Form 8752 must be filed showing a zero amount. Aarp tax help Applicable election year. Aarp tax help   Any tax year a section 444 election is in effect, including the first year, is called an applicable election year. Aarp tax help Form 8752 must be filed and the required payment made (or zero amount reported) by May 15th of the calendar year following the calendar year in which the applicable election year begins. Aarp tax help Required distribution for PSC. Aarp tax help   A PSC with a section 444 election in effect must distribute certain amounts to employee-owners by December 31 of each applicable year. Aarp tax help If it fails to make these distributions, it may be required to defer certain deductions for amounts paid to owner-employees. Aarp tax help The amount deferred is treated as paid or incurred in the following tax year. Aarp tax help   For information on the minimum distribution, see the instructions for Part I of Schedule H (Form 1120), Section 280H Limitations for a Personal Service Corporation (PSC). Aarp tax help Back-up election. Aarp tax help   A partnership, S corporation, or PSC can file a back-up section 444 election if it requests (or plans to request) permission to use a business purpose tax year, discussed later. Aarp tax help If the request is denied, the back-up section 444 election must be activated (if the partnership, S corporation, or PSC otherwise qualifies). Aarp tax help Making back-up election. Aarp tax help   The general rules for making a section 444 election, as discussed earlier, apply. Aarp tax help When filing Form 8716, type or print “BACK-UP ELECTION” at the top of the form. Aarp tax help However, if Form 8716 is filed on or after the date Form 1128 (or Form 2553) is filed, type or print “FORM 1128 (or FORM 2553) BACK-UP ELECTION” at the top of Form 8716. Aarp tax help Activating election. Aarp tax help   A partnership or S corporation activates its back-up election by filing the return required and making the required payment with Form 8752. Aarp tax help The due date for filing Form 8752 and making the payment is the later of the following dates. Aarp tax help May 15 of the calendar year following the calendar year in which the applicable election year begins. Aarp tax help 60 days after the partnership or S corporation has been notified by the IRS that the business year request has been denied. Aarp tax help   A PSC activates its back-up election by filing Form 8716 with its original or amended income tax return for the tax year in which the election is first effective and printing on the top of the income tax return, “ACTIVATING BACK-UP ELECTION. Aarp tax help ” 52-53-Week Tax Year A partnership, S corporation, or PSC can use a tax year other than its required tax year if it elects a 52-53-week tax year (discussed earlier) that ends with reference to either its required tax year or a tax year elected under section 444 (discussed earlier). Aarp tax help A newly formed partnership, S corporation, or PSC can adopt a 52-53-week tax year ending with reference to either its required tax year or a tax year elected under section 444 without IRS approval. Aarp tax help However, if the entity wishes to change to a 52-53-week tax year or change from a 52-53-week tax year that references a particular month to a non-52-53-week tax year that ends on the last day of that month, it must request IRS approval by filing Form 1128. Aarp tax help Business Purpose Tax Year A partnership, S corporation, or PSC establishes the business purpose for a tax year by filing Form 1128. Aarp tax help See the Instructions for Form 1128 for details. Aarp tax help Corporations (Other Than S Corporations and PSCs) A new corporation establishes its tax year when it files its first tax return. Aarp tax help A newly reactivated corporation that has been inactive for a number of years is treated as a new taxpayer for the purpose of adopting a tax year. Aarp tax help An S corporation or a PSC must use the required tax year rules, discussed earlier, to establish a tax year. Aarp tax help Generally, a corporation that wants to change its tax year must obtain approval from the IRS under either the: (a) automatic approval procedures; or (b) ruling request procedures. Aarp tax help See the Instructions for Form 1128 for details. Aarp tax help Accounting Methods An accounting method is a set of rules used to determine when income and expenses are reported on your tax return. Aarp tax help Your accounting method includes not only your overall method of accounting, but also the accounting treatment you use for any material item. Aarp tax help You choose an accounting method when you file your first tax return. Aarp tax help If you later want to change your accounting method, you must get IRS approval. Aarp tax help See Change in Accounting Method, later. Aarp tax help No single accounting method is required of all taxpayers. Aarp tax help You must use a system that clearly reflects your income and expenses and you must maintain records that will enable you to file a correct return. Aarp tax help In addition to your permanent accounting books, you must keep any other records necessary to support the entries on your books and tax returns. Aarp tax help You must use the same accounting method from year to year. Aarp tax help An accounting method clearly reflects income only if all items of gross income and expenses are treated the same from year to year. Aarp tax help If you do not regularly use an accounting method that clearly reflects your income, your income will be refigured under the method that, in the opinion of the IRS, does clearly reflect income. Aarp tax help Methods you can use. Aarp tax help   In general, you can compute your taxable income under any of the following accounting methods. Aarp tax help Cash method. Aarp tax help Accrual method. Aarp tax help Special methods of accounting for certain items of income and expenses. Aarp tax help A hybrid method which combines elements of two or more of the above accounting methods. Aarp tax help The cash and accrual methods of accounting are explained later. Aarp tax help Special methods. Aarp tax help   This publication does not discuss special methods of accounting for certain items of income or expenses. Aarp tax help For information on reporting income using one of the long-term contract methods, see section 460 of the Internal Revenue Code and the related regulations. Aarp tax help The following publications also discuss special methods of reporting income or expenses. Aarp tax help Publication 225, Farmer's Tax Guide. Aarp tax help Publication 535, Business Expenses. Aarp tax help Publication 537, Installment Sales. Aarp tax help Publication 946, How To Depreciate Property. Aarp tax help Hybrid method. Aarp tax help   Generally, you can use any combination of cash, accrual, and special methods of accounting if the combination clearly reflects your income and you use it consistently. Aarp tax help However, the following restrictions apply. Aarp tax help If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales. Aarp tax help See Exceptions under Inventories, later. Aarp tax help Generally, you can use the cash method for all other items of income and expenses. Aarp tax help See Inventories, later. Aarp tax help If you use the cash method for reporting your income, you must use the cash method for reporting your expenses. Aarp tax help If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income. Aarp tax help Any combination that includes the cash method is treated as the cash method for purposes of section 448 of the Internal Revenue Code. Aarp tax help Business and personal items. Aarp tax help   You can account for business and personal items using different accounting methods. Aarp tax help For example, you can determine your business income and expenses under an accrual method, even if you use the cash method to figure personal items. Aarp tax help Two or more businesses. Aarp tax help   If you operate two or more separate and distinct businesses, you can use a different accounting method for each business. Aarp tax help No business is separate and distinct, unless a complete and separate set of books and records is maintained for each business. Aarp tax help Note. Aarp tax help If you use different accounting methods to create or shift profits or losses between businesses (for example, through inventory adjustments, sales, purchases, or expenses) so that income is not clearly reflected, the businesses will not be considered separate and distinct. Aarp tax help Cash Method Most individuals and many small businesses use the cash method of accounting. Aarp tax help Generally, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise. Aarp tax help See Inventories, later, for exceptions to this rule. Aarp tax help Income Under the cash method, you include in your gross income all items of income you actually or constructively receive during the tax year. Aarp tax help If you receive property and services, you must include their fair market value (FMV) in income. Aarp tax help Constructive receipt. Aarp tax help   Income is constructively received when an amount is credited to your account or made available to you without restriction. Aarp tax help You need not have possession of it. Aarp tax help If you authorize someone to be your agent and receive income for you, you are considered to have received it when your agent receives it. Aarp tax help Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations. Aarp tax help Example. Aarp tax help You are a calendar year taxpayer. Aarp tax help Your bank credited, and made available, interest to your bank account in December 2012. Aarp tax help You did not withdraw it or enter it into your books until 2013. Aarp tax help You must include the amount in gross income for 2012, the year you constructively received it. Aarp tax help You cannot hold checks or postpone taking possession of similar property from one tax year to another to postpone paying tax on the income. Aarp tax help You must report the income in the year the property is received or made available to you without restriction. Aarp tax help Expenses Under the cash method, generally, you deduct expenses in the tax year in which you actually pay them. Aarp tax help This includes business expenses for which you contest liability. Aarp tax help However, you may not be able to deduct an expense paid in advance. Aarp tax help Instead, you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules. Aarp tax help Expense paid in advance. Aarp tax help   An expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for the 12-month rule. Aarp tax help   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. Aarp tax help 12 months after the right or benefit begins, or The end of the tax year after the tax year in which payment is made. Aarp tax help   If you have 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 you paid in advance, you must obtain approval from the IRS before using the general rule and/or the 12-month rule. Aarp tax help See Change in Accounting Method, later. Aarp tax help Example 1. Aarp tax help You are a calendar year taxpayer and pay $3,000 in 2012 for a business insurance policy that is effective for three years (36 months), beginning on July 1, 2012. Aarp tax help The general rule that an expense paid in advance is deductible only in the year to which it applies is applicable to this payment because the payment does not qualify for the 12-month rule. Aarp tax help Therefore, only $500 (6/36 x $3,000) is deductible in 2012, $1,000 (12/36 x $3,000) is deductible in 2013, $1,000 (12/36 x $3,000) is deductible in 2014, and the remaining $500 is deductible in 2015. Aarp tax help Example 2. Aarp tax help You are a calendar year taxpayer and pay $10,000 on July 1, 2012, for a business insurance policy that is effective for only one year beginning on July 1, 2012. Aarp tax help The 12-month rule applies. Aarp tax help Therefore, the full $10,000 is deductible in 2012. Aarp tax help Excluded Entities The following entities cannot use the cash method, including any combination of methods that includes the cash method. Aarp tax help (See Special rules for farming businesses, later. Aarp tax help ) A corporation (other than an S corporation) with average annual gross receipts exceeding $5 million. Aarp tax help See Gross receipts test, below. Aarp tax help 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. Aarp tax help See Gross receipts test, below. Aarp tax help A tax shelter. Aarp tax help Exceptions The following entities are not prohibited from using the cash method of accounting. Aarp tax help Any corporation or partnership, other than a tax shelter, that meets the gross receipts test for all tax years after 1985. Aarp tax help A qualified personal service corporation (PSC). Aarp tax help Gross receipts test. Aarp tax help   A corporation or partnership, other than a tax shelter, that meets the gross receipts test can generally use the cash method. Aarp tax help A corporation or a partnership meets the test if, for each prior tax year beginning after 1985, its average annual gross receipts are $5 million or less. Aarp tax help    An entity's average annual gross receipts for a prior tax year is determined by: Adding the gross receipts for that tax year and the 2 preceding tax years; and Dividing the total by 3. Aarp tax help See Gross receipts test for qualifying taxpayers, for more information. Aarp tax help Generally, a partnership applies the test at the partnership level. Aarp tax help Gross receipts for a short tax year are annualized. Aarp tax help Aggregation rules. Aarp tax help   Organizations that are members of an affiliated service group or a controlled group of corporations treated as a single employer for tax purposes are required to aggregate their gross receipts to determine whether the gross receipts test is met. Aarp tax help Change to accrual method. Aarp tax help   A corporation or partnership that fails to meet the gross receipts test for any tax year is prohibited from using the cash method and must change to an accrual method of accounting, effective for the tax year in which the entity fails to meet this test. Aarp tax help Special rules for farming businesses. Aarp tax help   Generally, a taxpayer engaged in the trade or business of farming is allowed to use the cash method for its farming business. Aarp tax help 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. Aarp tax help 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 and nut trees). Aarp tax help   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. Aarp tax help For family corporations engaged in farming, the exception applies if gross receipts were $25 million or less for each prior tax year after 1985. Aarp tax help See chapter 2 of Publication 225, Farmer's Tax Guide, for more information. Aarp tax help Qualified PSC. Aarp tax help   A PSC that meets the following function and ownership tests can use the cash method. Aarp tax help Function test. Aarp tax help   A corporation meets the function test if at least 95% of its activities are in the performance of services in the fields of health, veterinary services, law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts, or consulting. Aarp tax help Ownership test. Aarp tax help   A corporation meets the ownership test if at least 95% of its stock is owned, directly or indirectly, at all times during the year by one or more of the following. Aarp tax help Employees performing services for the corporation in a field qualifying under the function test. Aarp tax help Retired employees who had performed services in those fields. Aarp tax help The estate of an employee described in (1) or (2). Aarp tax help Any other person who acquired the stock by reason of the death of an employee referred to in (1) or (2), but only for the 2-year period beginning on the date of death. Aarp tax help   Indirect ownership is generally taken into account if the stock is owned indirectly through one or more partnerships, S corporations, or qualified PSCs. Aarp tax help Stock owned by one of these entities is considered owned by the entity's owners in proportion to their ownership interest in that entity. Aarp tax help Other forms of indirect stock ownership, such as stock owned by family members, are generally not considered when determining if the ownership test is met. Aarp tax help   For purposes of the ownership test, a person is not considered an employee of a corporation unless that person performs more than minimal services for the corporation. Aarp tax help Change to accrual method. Aarp tax help   A corporation that fails to meet the function test for any tax year; or fails to meet the ownership test at any time during any tax year must change to an accrual method of accounting, effective for the year in which the corporation fails to meet either test. Aarp tax help A corporation that fails to meet the function test or the ownership test is not treated as a qualified PSC for any part of that tax year. Aarp tax help Accrual Method Under the accrual method of accounting, generally you report income in the year it is earned and deduct or capitalize expenses in the year incurred. Aarp tax help The purpose of an accrual method of accounting is to match income and expenses in the correct year. Aarp tax help Income Generally, you include an amount in 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. Aarp tax help Under this rule, you report an amount in your gross income on the earliest of the following dates. Aarp tax help When you receive payment. Aarp tax help When the income amount is due to you. Aarp tax help When you earn the income. Aarp tax help When title has passed. Aarp tax help Estimated income. Aarp tax help   If you include a reasonably estimated amount in gross income and later determine the exact amount is different, take the difference into account in the tax year you make that determination. Aarp tax help Change in payment schedule. Aarp tax help   If you perform services for a basic rate specified in a contract, you must accrue the income at the basic rate, even if you agree to receive payments at a reduced rate. Aarp tax help Continue this procedure until you complete the services, then account for the difference. Aarp tax help Advance Payment for Services Generally, you report an advance payment for services to be performed in a later tax year as income in the year you receive the payment. Aarp tax help 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. Aarp tax help However, you cannot postpone including any payment beyond that tax year. Aarp tax help Service agreement. Aarp tax help   You can postpone reporting income from an advance payment you receive for a service agreement on property you sell, lease, build, install, or construct. Aarp tax help This includes an agreement providing for incidental replacement of parts or materials. Aarp tax help However, this applies only if you offer the property without a service agreement in the normal course of business. Aarp tax help Postponement not allowed. Aarp tax help   Generally, one cannot postpone including an advance payment in income for services if either of the following applies. Aarp tax help 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. Aarp tax help 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. Aarp tax help Examples. Aarp tax help   In each of the following examples, assume the tax year is a calendar year and that the accrual method of accounting is used. Aarp tax help Example 1. Aarp tax help You manufacture, sell, and service computers. Aarp tax help You received payment in 2012 for a one-year contingent service contract on a computer you sold. Aarp tax help You can postpone including in income the part of the payment you did not earn in 2012 if, in the normal course of your business, you offer computers for sale without a contingent service contract. Aarp tax help Example 2. Aarp tax help You are in the television repair business. Aarp tax help You received payments in 2012 for one-year contracts under which you agree to repair or replace certain parts that fail to function properly in television sets manufactured and sold by unrelated parties. Aarp tax help You include the payments in gross income as you earn them. Aarp tax help Example 3. Aarp tax help You own a dance studio. Aarp tax help On October 1, 2012, you receive payment for a one-year contract for 48 one-hour lessons beginning on that date. Aarp tax help You give eight lessons in 2012. Aarp tax help Under this method of including advance payments, you must include one-sixth (8/48) of the payment in income for 2012, and five-sixths (40/48) of the payment in 2013, even if you do not give all the lessons by the end of 2013. Aarp tax help Example 4. Aarp tax help Assume the same facts as in Example 3, except the payment is for a two-year contract for 96 lessons. Aarp tax help You must include the entire payment in income in 2012 since part of the services may be performed after the following year. Aarp tax help Guarantee or warranty. Aarp tax help   Generally, you cannot postpone reporting income you receive under a guarantee or warranty contract. Aarp tax help Prepaid rent. Aarp tax help   You cannot postpone reporting income from prepaid rent. Aarp tax help Prepaid rent does not include payment for the use of a room or other space when significant service is also provided for the occupant. Aarp tax help 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. Aarp tax help Books and records. Aarp tax help   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. Aarp tax help Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements. Aarp tax help IRS approval. Aarp tax help   You must file Form 3115 to obtain IRS approval to change your method of accounting for advance payment for services. Aarp tax help Advance Payment for Sales Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods held primarily for sale to customers in the ordinary course of your trade or business. Aarp tax help However, the rules do not 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. Aarp tax help An agreement includes a gift certificate that can be redeemed for goods. Aarp tax help Amounts due and payable are considered received. Aarp tax help How to report payments. Aarp tax help   Generally, include an advance payment in income in the year in which you receive it. Aarp tax help However, you can use the alternative method, discussed next. Aarp tax help Alternative method of reporting. Aarp tax help   Under the alternative method, generally include an advance payment in income in the earlier tax year in which you: Include advance payments in gross receipts under the method of accounting you use for tax purposes, or Include any part of advance payments in income for financial reports under the method of accounting used for those reports. Aarp tax help Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements. Aarp tax help Example 1. Aarp tax help You are a retailer. Aarp tax help You use an accrual method of accounting and account for the sale of goods when you ship the goods. Aarp tax help You use this method for both tax and financial reporting purposes. Aarp tax help You can include advance payments in gross receipts for tax purposes in either: (a) the tax year in which you receive the payments; or (b) the tax year in which you ship the goods. Aarp tax help However, see Exception for inventory goods, later. Aarp tax help Example 2. Aarp tax help You are a calendar year taxpayer. Aarp tax help You manufacture household furniture and use an accrual method of accounting. Aarp tax help Under this method, you accrue income for your financial reports when you ship the furniture. Aarp tax help For tax purposes, you do not accrue income until the furniture has been delivered and accepted. Aarp tax help In 2012, you received an advance payment of $8,000 for an order of furniture to be manufactured for a total price of $20,000. Aarp tax help You shipped the furniture to the customer in December 2012, but it was not delivered and accepted until January 2013. Aarp tax help For tax purposes, you include the $8,000 advance payment in gross income for 2012; and include the remaining $12,000 of the contract price in gross income for 2013. Aarp tax help Information schedule. Aarp tax help   If you use the alternative method of reporting advance payments, you must attach a statement with the following information to your tax return each year. Aarp tax help Total advance payments received in the current tax year. Aarp tax help Total advance payments received in earlier tax years and not included in income before the current tax year. Aarp tax help Total payments received in earlier tax years included in income for the current tax year. Aarp tax help Exception for inventory goods. Aarp tax help   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 the following requirements. Aarp tax help You account for the advance payment under the alternative method (discussed earlier). Aarp tax help You have received a substantial advance payment on the agreement (discussed next). Aarp tax help You have enough substantially similar goods on hand, or available through your normal source of supply, to satisfy the agreement. Aarp tax help These rules also apply to an agreement, such as a gift certificate, that can be satisfied with goods that cannot be identified in the tax year you receive an advance payment. Aarp tax help   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. Aarp tax help You must also deduct in that second year all actual or estimated costs for the goods required to satisfy the agreement. Aarp tax help If you estimated the cost, you must take into account any difference between the estimate and the actual cost when the goods are delivered. Aarp tax help Note. Aarp tax help You must report any advance payments you receive after the second year in the year received. Aarp tax help No further deferral is allowed. Aarp tax help Substantial advance payments. Aarp tax help   Under an agreement for a future sale, you have substantial advance payments if, by the end of the tax year, the total advance payments received during that year and preceding tax years are equal to or more than the total costs reasonably estimated to be includible in inventory because of the agreement. Aarp tax help Example. Aarp tax help You are a calendar year, accrual method taxpayer who accounts for advance payments under the alternative method. Aarp tax help In 2008, you entered into a contract for the sale of goods properly includible in your inventory. Aarp tax help The total contract price is $50,000 and you estimate that your total inventoriable costs for the goods will be $25,000. Aarp tax help You receive the following advance payments under the contract. Aarp tax help 2009 $17,500 2010 10,000 2011 7,500 2012 5,000 2013 5,000 2014 5,000 Total contract price $50,000   Your customer asked you to deliver the goods in 2015. Aarp tax help In your 2010 closing inventory, you had on hand enough of the type of goods specified in the contract to satisfy the contract. Aarp tax help Since the advance payments you had received by the end of 2010 were more than the costs you estimated, the payments are substantial advance payments. Aarp tax help   For 2012, include in income all payments you received by the end of 2012, the second tax year following the tax year in which you received substantial advance payments. Aarp tax help You must include $40,000 in sales for 2012 (the total amounts received from 2009 through 2012) and include in inventory the cost of the goods (or similar goods) on hand. Aarp tax help If no such goods are on hand, then estimate the cost necessary to satisfy the contract. Aarp tax help   No further deferral is allowed. Aarp tax help You must include in gross income the advance payment you receive each remaining year of the contract. Aarp tax help Take into account the difference between any estimated cost of goods sold and the actual cost when you deliver the goods in 2015. Aarp tax help IRS approval. Aarp tax help   You must file Form 3115 to obtain IRS approval to change your method of accounting for advance payments for sales. Aarp tax help Expenses Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply. Aarp tax help The all-events test has been met. Aarp tax help The test is met when: All events have occurred that fix the fact of liability, and The liability can be determined with reasonable accuracy. Aarp tax help Economic performance has occurred. Aarp tax help Economic Performance Generally, you cannot deduct or capitalize a business expense until economic performance occurs. Aarp tax help If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided or the property is used. Aarp tax help If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. Aarp tax help Example. Aarp tax help You are a calendar year taxpayer. Aarp tax help You buy office supplies in December 2012. Aarp tax help You receive the supplies and the bill in December, but you pay the bill in January 2013. Aarp tax help You can deduct the expense in 2012 because all events have occurred to fix the liability, the amount of the liability can be determined, and economic performance occurred in 2012. Aarp tax help Your office supplies may qualify as a recurring item, discussed later. Aarp tax help If so, you can deduct them in 2012, even if the supplies are not delivered until 2013 (when economic performance occurs). Aarp tax help Workers' compensation and tort liability. Aarp tax help   If you are required to make payments under workers' compensation laws or in satisfaction of any tort liability, economic performance occurs as you make the payments. Aarp tax help If you are required to make payments to a special designated settlement fund established by court order for a tort liability, economic performance occurs as you make the payments. Aarp tax help Taxes. Aarp tax help   Economic performance generally occurs as estimated income tax, property taxes, employment taxes, etc. Aarp tax help are paid. Aarp tax help However, you can elect to treat taxes as a recurring item, discussed later. Aarp tax help You can also elect to ratably accrue real estate taxes. Aarp tax help See chapter 5 of Publication 535 for information about real estate taxes. Aarp tax help Other liabilities. Aarp tax help   Other liabilities for which economic performance occurs as you make payments include liabilities for breach of contract (to the extent of incidental, consequential, and liquidated damages), violation of law, rebates and refunds, awards, prizes, jackpots, insurance, and warranty and service contracts. Aarp tax help Interest. Aarp tax help   Economic performance occurs with the passage of time (as the borrower uses, and the lender forgoes use of, the lender's money) rather than as payments are made. Aarp tax help Compensation for services. Aarp tax help   Generally, economic performance occurs as an employee renders service to the employer. Aarp tax help However, deductions for compensation or other benefits paid to an employee in a year subsequent to economic performance are subject to the rules governing deferred compensation, deferred benefits, and funded welfare benefit plans. Aarp tax help For information on employee benefit programs, see Publication 15-B, Employer's Tax Guide to Fringe Benefits. Aarp tax help Vacation pay. Aarp tax help   You can take a current deduction for vacation pay earned by your employees if you pay it during the year or, if the amount is vested, within 2½ months after the end of the year. Aarp tax help If you pay it later than this, you must deduct it in the year actually paid. Aarp tax help An amount is vested if your right to it cannot be nullified or cancelled. Aarp tax help Exception for recurring items. Aarp tax help   An exception to the economic performance rule allows certain recurring items to be treated as incurred during the tax year even though economic performance has not occurred. Aarp tax help The exception applies if all the following requirements are met. Aarp tax help The all-events test, discussed earlier, is met. Aarp tax help Economic performance occurs by the earlier of the following dates. Aarp tax help 8½ months after the close of the year. Aarp tax help The date you file a timely return (including extensions) for the year. Aarp tax help The item is recurring in nature and you consistently treat similar items as incurred in the tax year in which the all-events test is met. Aarp tax help Either: The item is not material, or Accruing the item in the year in which the all-events test is met results in a better match against income than accruing the item in the year of economic performance. Aarp tax help This exception does not apply to workers' compensation or tort liabilities. Aarp tax help Amended return. Aarp tax help   You may be able to file an amended return and treat a liability as incurred under the recurring item exception. Aarp tax help You can do so if economic performance for the liability occurs after you file your tax return for the year, but within 8½ months after the close of the tax year. Aarp tax help Recurrence and consistency. Aarp tax help   To determine whether an item is recurring and consistently reported, consider the frequency with which the item and similar items are incurred (or expected to be incurred) and how you report these items for tax purposes. Aarp tax help A new expense or an expense not incurred every year can be treated as recurring if it is reasonable to expect that it will be incurred regularly in the future. Aarp tax help Materiality. Aarp tax help   Factors to consider in determining the materiality of a recurring item include the size of the item (both in absolute terms and in relation to your income and other expenses) and the treatment of the item on your financial statements. Aarp tax help   An item considered material for financial statement purposes is also considered material for tax purposes. Aarp tax help However, in certain situations an immaterial item for financial accounting purposes is treated as material for purposes of economic performance. Aarp tax help Matching expenses with income. Aarp tax help   Costs directly associated with the revenue of a period are properly allocable to that period. Aarp tax help To determine whether the accrual of an expense in a particular year results in a better match with the income to which it relates, generally accepted accounting principles (GAAP; visit www. Aarp tax help fasab. Aarp tax help gov/accepted. Aarp tax help html) are an important factor. Aarp tax help   For example, if you report sales income in the year of sale, but you do not ship the goods until the following year, the shipping costs are more properly matched to income in the year of sale than the year the goods are shipped. Aarp tax help Expenses that cannot be practically associated with income of a particular period, such as advertising costs, should be assigned to the period the costs are incurred. Aarp tax help However, the matching requirement is considered met for certain types of expenses. Aarp tax help These expenses include taxes, payments under insurance, warranty, and service contracts, rebates, refunds, awards, prizes, and jackpots. Aarp tax help Expenses Paid in Advance An expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for the 12-month rule. Aarp tax help 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. Aarp tax help 12 months after the right or benefit begins, or The end of the tax year after the tax year in which payment is made. Aarp tax help If you have 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 you paid in advance, you must get IRS approval before using the general rule and/or the 12-month rule. Aarp tax help See Change in Accounting Method, later, for information on how to get IRS approval. Aarp tax help See Expense paid in advance under Cash Method, earlier, for examples illustrating the application of the general and 12-month rules. Aarp tax help Related Persons Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible until you make the payment and the corresponding amount is includible in the related person's gross income. Aarp tax help Determine the relationship for this rule as of the end of the tax year for which the expense or interest would otherwise be deductible. Aarp tax help See section 267 of the Internal Revenue Code and Publication 542, Corporations, for the definition of related person. Aarp tax help Inventories An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. Aarp tax help If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales. Aarp tax help However, see Exceptions, next. Aarp tax help See also Accrual Method, earlier. Aarp tax help To figure taxable income, you must value your inventory at the beginning and end of each tax year. Aarp tax help To determine the value, you need a method for identifying the items in your inventory and a method for valuing these items. Aarp tax help See Identifying Cost and Valuing Inventory, later. Aarp tax help The rules for valuing inventory are not the same for all businesses. Aarp tax help The method you use must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Aarp tax help Your inventory practices must be consistent from year to year. Aarp tax help The rules discussed here apply only if they do not conflict with the uniform capitalization rules of section 263A and the mark-to-market rules of section 475. Aarp tax help Exceptions The following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. Aarp tax help These taxpayers can also account for inventoriable items as materials and supplies that are not incidental (discussed later). Aarp tax help A qualifying taxpayer under Revenue Procedure 2001-10 on page 272 of Internal Revenue Bulletin 2001-2, available at www. Aarp tax help irs. Aarp tax help gov/pub/irs-irbs/irb01–02. Aarp tax help pdf. Aarp tax help A qualifying small business taxpayer under Revenue Procedure 2002-28, on page 815 of Internal Revenue Bulletin 2002-18, available at www. Aarp tax help irs. Aarp tax help gov/pub/irs-irbs/irb02–18. Aarp tax help pdf. Aarp tax help In addition to the information provided in this publication, you should see the revenue procedures referenced in the list, above, and the instructions for Form 3115 for information you will need to adopt or change to these accounting methods (see Changing methods, later). Aarp tax help Qualifying taxpayer. Aarp tax help   You are a qualifying taxpayer under Revenue Procedure 2001-10 only if: You satisfy the gross receipts test for each prior tax year ending on or after December 17, 1998 (see Gross receipts test for qualifying taxpayers, next). Aarp tax help Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $1 million or less. Aarp tax help You are not a tax shelter as defined under section 448(d)(3) of the Internal Revenue Code. Aarp tax help Gross receipts test for qualifying taxpayers. Aarp tax help   To determine if you meet the gross receipts test for qualifying taxpayers, use the following steps: Step 1. Aarp tax help List each of the test years. Aarp tax help For qualifying taxpayers under Revenue Procedure 2001-10, the test years are each prior tax year ending on or after December 17, 1998. Aarp tax help Step 2. Aarp tax help Determine your average annual gross receipts for each test year listed in Step 1. Aarp tax help Your average annual gross receipts for a tax year is determined by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3. Aarp tax help Step 3. Aarp tax help You meet the gross receipts test for qualifying taxpayers if your average annual gross receipts for each test year listed in Step 1 is $1 million or less. Aarp tax help Qualifying small business taxpayer. Aarp tax help   You are a qualifying small business taxpayer under Revenue Procedure 2002-28 only if: You satisfy the gross receipts test for each prior tax year ending on or after December 31, 2000 (see Gross receipts test for qualifying small business taxpayers, next). Aarp tax help Your average annual gross receipts for each test year (explained in Step 1, listed next) must be $10 million or less. Aarp tax help You are not prohibited from using the cash method under section 448 of the Internal Revenue Code. Aarp tax help Your principle business activity is an eligible business. Aarp tax help See Eligible business, later. Aarp tax help You have not changed (or have not been required to change) from the cash method because you became ineligible to use the cash method under Revenue Procedure 2002-28. Aarp tax help Note. Aarp tax help Revenue Procedure 2002-28 does not apply to a farming business of a qualifying small business taxpayer. Aarp tax help A taxpayer engaged in the trade or business of farming generally is allowed to use the cash method for any farming business. Aarp tax help See Special rules for farming businesses under Cash Method, earlier. Aarp tax help Gross receipts test for qualifying small business taxpayers. Aarp tax help   To determine if you meet the gross receipts test for qualifying small business taxpayers, use the following steps: Step 1. Aarp tax help List each of the test years. Aarp tax help For qualifying small business taxpayers under Revenue Procedure 2002-28, the test years are each prior tax year ending on or after December 31, 2000. Aarp tax help Step 2. Aarp tax help Determine your average annual gross receipts for each test year listed in Step 1. Aarp tax help Your average annual gross receipts for a tax year is determined by adding the gross receipts for that tax year and the 2 preceding tax years and dividing the total by 3. Aarp tax help Step 3. Aarp tax help You meet the gross receipts test for qualifying small business taxpayers if your average annual gross receipts for each test year listed in Step 1 is $10 million or less. Aarp tax help Eligible business. Aarp tax help   An eligible business is any business for which a qualified small business taxpayer can use the cash method and choose to not keep an inventory. Aarp tax help You have an eligible business if you meet any of the following requirements. Aarp tax help Your principal business activity is described in a North American Industry Classification System (NAICS) code other than any of the following NAICS subsector codes: NAICS codes 211 and 212 (mining activities). Aarp tax help NAICS codes 31-33 (manufacturing). Aarp tax help NAICS code 42 (wholesale trade). Aarp tax help NAICS codes 44-45 (retail trade). Aarp tax help NAICS codes 5111 and 5122 (information industries). Aarp tax help Your principal business activity is the provision of services, including the provision of property incident to those services. Aarp tax help Your principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications. Aarp tax help   Information about the NAICS codes can be found at http://www. Aarp tax help census. Aarp tax help gov/naics or in the instructions for your federal income tax return. Aarp tax help Gross receipts. Aarp tax help   In general, gross receipts must include all receipts from all your trades or businesses that must be recognized under the method of accounting you used for that tax year for federal income tax purposes. Aarp tax help See the definit