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W2 ez Publication 597 - Main Content Table of Contents Application of Treaty Personal Services Pensions, Annuities, Social Security, and AlimonyRoth IRAs. W2 ez Tax-deferred plans. W2 ez Investment Income From Canadian Sources Other Income Charitable ContributionsQualified charities. W2 ez Income Tax Credits Competent Authority Assistance How To Get Tax HelpText of Treaty U. W2 ez S. W2 ez Taxation Canadian Taxation Application of Treaty The benefits of the income tax treaty are generally provided on the basis of residence for income tax purposes. W2 ez That is, a person who is recognized as a resident of the United States who has income from Canada, will often pay less income tax to Canada on that income than if no treaty was in effect. W2 ez Article IV provides definitions of residents of Canada and the United States, and provides specific criteria for applying the treaty in cases where a taxpayer is considered by both countries to be a resident. W2 ez Saving clause. W2 ez In most instances, a treaty does not affect the right of a country to tax its own residents (including those who are U. W2 ez S. W2 ez citizens) or of the United States to tax its residents or citizens (including U. W2 ez S. W2 ez citizens who are residents of the foreign country). W2 ez This provision is known as the “saving clause. W2 ez ” For example, an individual who is a U. W2 ez S. W2 ez citizen and a resident of Canada may have dividend income from a U. W2 ez S. W2 ez corporation. W2 ez The treaty provides a maximum rate of 15% on dividends received by a resident of Canada from sources in the United States. W2 ez Even though a resident of Canada, the individual is a U. W2 ez S. W2 ez citizen and the saving clause overrides the treaty article that limits the U. W2 ez S. W2 ez tax to 15%. W2 ez Exceptions to the saving clause can be found in Article XXIX, paragraph 3. W2 ez Treaty-based position. W2 ez If you take the position that any U. W2 ez S. W2 ez tax is overruled or otherwise reduced by a U. W2 ez S. W2 ez treaty (a treaty-based position), you generally must disclose that position on Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), and attach it to your return. W2 ez Personal Services A U. W2 ez S. W2 ez citizen or resident who is temporarily present in Canada during the tax year is exempt from Canadian income taxes on pay for services performed, or remittances received from the United States, if the citizen or resident qualifies under one of the treaty exemption provisions set out below. W2 ez Income from employment (Article XV). W2 ez Income U. W2 ez S. W2 ez residents receive for the performance of dependent personal services in Canada (except as public entertainers) is exempt from Canadian tax if it is not more than $10,000 in Canadian currency for the year. W2 ez If it is more than $10,000 for the year, it is exempt only if: The residents are present in Canada for no more than 183 days in any 12-month period beginning or ending in the year concerned, and The income is not paid by, or on behalf of, a Canadian resident and is not borne by a permanent establishment in Canada. W2 ez Whether there is a permanent establishment in Canada is determined by the rules set forth in Article V. W2 ez Example. W2 ez You are a U. W2 ez S. W2 ez resident employed under an 8-month contract with a Canadian firm to install equipment in their Montreal plant. W2 ez During the calendar year you were physically present in Canada for 179 days and were paid $16,500 (Canadian) for your services. W2 ez Although you were in Canada for not more than 183 days during the year, your income is not exempt from Canadian income tax because it was paid by a Canadian resident and was more than $10,000 (Canadian) for the year. W2 ez Pay received by a U. W2 ez S. W2 ez resident for work regularly done in more than one country as an employee on a ship, aircraft, motor vehicle, or train operated by a U. W2 ez S. W2 ez resident is exempt from Canadian tax. W2 ez Income from self-employment (Article VII). W2 ez Income from services performed (other than those performed as an employee) are taxed in Canada if they are attributable to a permanent establishment in Canada. W2 ez This income is treated as business profits, and deductions similar to those allowed under U. W2 ez S. W2 ez law are allowable. W2 ez If you carry on (or have carried on) business in both Canada and the United States, the business profits are attributable to each country based on the profits that the permanent establishment might be expected to make if it were a distinct and separate person engaged in the same or similar activities. W2 ez The business profits attributable to the permanent establishment include only those profits derived from assets used, risks assumed, and activities performed by the permanent establishment. W2 ez You may be considered to have a permanent establishment if you meet certain conditions. W2 ez For more information, see Article V (Permanent Establishment) and Article VII (Business Profits). W2 ez Public entertainers (Article XVI). W2 ez The provisions under income from employment or income from self-employment do not apply to public entertainers (such as theater, motion picture, radio, or television artistes, musicians, or athletes) from the United States who receive more than $15,000 in gross receipts in Canadian currency, including reimbursed expenses, from their entertainment activities in Canada during the calendar year. W2 ez However, this provision for public entertainers does not apply (and the other provisions will apply) to athletes participating in team sports in leagues with regularly scheduled games in both the United States and Canada. W2 ez Compensation paid by the U. W2 ez S. W2 ez Government (Article XIX). W2 ez Wages, salaries, and similar income (other than pensions) paid to a U. W2 ez S. W2 ez citizen by the United States or any of its agencies, instrumentalities, or political subdivisions for discharging governmental functions are exempt from Canadian income tax. W2 ez The exemption does not apply to pay for services performed in connection with any trade or business carried on for profit by the United States, or any of its agencies, instrumentalities, or political subdivisions. W2 ez Students and apprentices (Article XX). W2 ez A full-time student, apprentice, or business trainee who is in Canada to study or acquire business experience is exempt from Canadian income tax on remittances received from any source outside Canada for maintenance, education, or training. W2 ez The recipient must be or must have been a U. W2 ez S. W2 ez resident immediately before visiting Canada. W2 ez An apprentice or business trainee can claim this exemption only for a period of one year from the date the individual first arrived in Canada for the purpose of training. W2 ez Pensions, Annuities, Social Security, and Alimony Under Article XVIII, pensions and annuities from Canadian sources paid to U. W2 ez S. W2 ez residents are subject to tax by Canada, but the tax is limited to 15% of the gross amount (if a periodic pension payment) or of the taxable amount (if an annuity). W2 ez Canadian pensions and annuities paid to U. W2 ez S. W2 ez residents may be taxed by the United States, but the amount of any pension included in income for U. W2 ez S. W2 ez tax purposes may not be more than the amount that would be included in income in Canada if the recipient were a Canadian resident. W2 ez Pensions. W2 ez A pension includes any payment under a pension or other retirement arrangement, Armed Forces retirement pay, war veterans pensions and allowances, and payments under a sickness, accident, or disability plan. W2 ez It includes pensions paid by private employers and the government for services rendered. W2 ez Pensions also include payments from individual retirement arrangements (IRAs) in the United States, registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs) in Canada. W2 ez Pensions do not include social security benefits. W2 ez Roth IRAs. W2 ez A distribution from a Roth IRA is exempt from Canadian tax to the extent it would be exempt from U. W2 ez S. W2 ez tax if paid to a U. W2 ez S. W2 ez resident. W2 ez In addition, you may elect to defer any tax in Canada on income accrued within the Roth IRA but not distributed by the Roth IRA. W2 ez However, you cannot defer tax on any accruals due to contributions made after you become a Canadian resident. W2 ez Tax-deferred plans. W2 ez Generally, income that accrues in a Canadian RRSP or RRIF is subject to U. W2 ez S. W2 ez tax, even if it is not distributed. W2 ez However, a U. W2 ez S. W2 ez citizen or resident can elect to defer U. W2 ez S. W2 ez tax on income from the plan until the income is distributed. W2 ez Form 8891 is used to make the election. W2 ez Annuities. W2 ez An annuity is a stated sum payable periodically at stated times, during life, or during a specified number of years, under an obligation to make the payments in return for adequate and full consideration (other than services rendered). W2 ez Annuities do not include: Non-periodic payments, or An annuity the cost of which was deductible for tax purposes. W2 ez Special rules. W2 ez Special rules apply to pensions and annuities with respect to: Short-term assignments, Cross-border commuters, and Individuals who participate in a Canadian qualifying plan. W2 ez Generally, distributions in such cases are deemed to be earned in the country in which the plan is established, without regard to where the services were rendered. W2 ez Social security benefits. W2 ez U. W2 ez S. W2 ez social security benefits paid to a resident of Canada are taxed in Canada as if they were benefits under the Canada Pension Plan, except that 15% of the amount of the benefit is exempt from Canadian tax. W2 ez Alimony. W2 ez Alimony and similar amounts (including child support payments) from Canadian sources paid to U. W2 ez S. W2 ez residents are exempt from Canadian tax. W2 ez For purposes of U. W2 ez S. W2 ez tax, these amounts are excluded from income to the same extent they would be excluded from income in Canada if the recipient was a Canadian resident. W2 ez Investment Income From Canadian Sources The treaty provides beneficial treatment for certain items of Canadian source income that result from an investment of capital. W2 ez Dividends (Article X). W2 ez For Canadian source dividends received by U. W2 ez S. W2 ez residents, the Canadian income tax generally may not be more than 15%. W2 ez A 5% rate applies to intercorporate dividends paid from a subsidiary to a parent corporation owning at least 10% of the subsidiary's voting stock. W2 ez However, a 10% rate applies if the payer of the dividend is a nonresident-owned Canadian investment corporation. W2 ez These rates do not apply if the owner of the dividends carries on, or has carried on, a business in Canada through a permanent establishment and the holding on which the income is paid is effectively connected with that permanent establishment. W2 ez Interest (Article XI). W2 ez Generally, Canadian source interest received by U. W2 ez S. W2 ez residents is exempt from Canadian income tax. W2 ez The exemption does not apply if the owner of the interest carries on, or has carried on, a business in Canada through a permanent establishment and the debt on which the income is paid is effectively connected with that permanent establishment. W2 ez Gains from the sale of property (Article XIII). W2 ez Generally, gains from the sale of personal property by a U. W2 ez S. W2 ez resident having no permanent establishment in Canada are exempt from Canadian income tax. W2 ez However, the exemption from Canadian tax does not apply to gains realized by U. W2 ez S. W2 ez residents on Canadian real property, and on personal property belonging to a permanent establishment in Canada. W2 ez If the property subject to Canadian tax is a capital asset and was owned by the U. W2 ez S. W2 ez resident on September 26, 1980, not as part of the business property of a permanent establishment in Canada, generally the taxable gain is limited to the appreciation after 1984. W2 ez Royalties (Article XII). W2 ez The following are exempt from Canadian tax: Copyright royalties and other like payments for the production or reproduction of any literary, dramatic, musical, or artistic work (other than payments for motion pictures and works on film, videotape, or other means of reproduction for use in connection with television, which may be taxed at 10%), Payments for the use of, or the right to use, computer software, Payments for the use of, or the right to use, any patent or any information concerning industrial, commercial, or scientific experience (but not within a rental or franchise agreement), and Payments for broadcasting as agreed to in an exchange of notes between the countries. W2 ez This rate or exemption does not apply if the owner of the royalties carries on, or has carried on, a business in Canada through a permanent establishment and the right or property on which the income is paid is effectively connected with that permanent establishment. W2 ez This exemption (or lower rate) does not apply to royalties to explore for or to exploit mineral deposits, timber, and other natural resources. W2 ez Other Income Generally, Canadian source income that is not specifically mentioned in the treaty, may be taxed by Canada. W2 ez Gambling losses. W2 ez Canadian residents may deduct gambling losses in the U. W2 ez S. W2 ez against gambling winnings in the U. W2 ez S. W2 ez in the same manner as a U. W2 ez S. W2 ez resident. W2 ez Charitable Contributions United States income tax return. W2 ez Under Article XXI, you may deduct contributions to certain qualified Canadian charitable organizations on your United States income tax return. W2 ez Besides being subject to the overall limits applicable to all your charitable contributions under U. W2 ez S. W2 ez tax law, your charitable contributions to Canadian organizations (other than contributions to a college or university at which you or a member of your family is or was enrolled) are subject to the U. W2 ez S. W2 ez percentage limits on charitable contributions, applied to your Canadian source income. W2 ez If your return does not include gross income from Canadian sources, charitable contributions to Canadian organizations are generally not deductible. W2 ez Example. W2 ez You are a U. W2 ez S. W2 ez citizen living in Canada. W2 ez You have both U. W2 ez S. W2 ez and Canadian source income. W2 ez During your tax year, you contribute to Canadian organizations that would qualify as charitable organizations under U. W2 ez S. W2 ez tax law if they were U. W2 ez S. W2 ez organizations. W2 ez To figure the maximum amount of the contribution to Canadian organizations that you can deduct on your U. W2 ez S. W2 ez income tax return, multiply your adjusted gross income from Canadian sources by the percentage limit that applies to contributions under U. W2 ez S. W2 ez income tax law. W2 ez Then include this amount on your return along with all your domestic charitable contributions, subject to the appropriate percentage limit required for contributions under U. W2 ez S. W2 ez income tax law. W2 ez The appropriate percentage limit for U. W2 ez S. W2 ez tax purposes is applied to your total adjusted gross income from all sources. W2 ez Qualified charities. W2 ez These Canadian organizations must meet the qualifications that a U. W2 ez S. W2 ez charitable organization must meet under U. W2 ez S. W2 ez tax law. W2 ez Usually an organization will notify you if it qualifies. W2 ez For further information on charitable contributions and the U. W2 ez S. W2 ez percentage limits, see Publication 526, Charitable Contributions. W2 ez Canadian income tax return. W2 ez Under certain conditions, contributions to qualified U. W2 ez S. W2 ez charitable organizations may also be claimed on your Canadian income tax return if you are a Canadian resident. W2 ez Income Tax Credits The treaty contains a credit provision (Article XXIV) for the elimination of double taxation. W2 ez In general, the United States and Canada both allow a credit against their income tax for the income tax paid to the other country on income from sources in that other country. W2 ez For detailed discussions of the U. W2 ez S. W2 ez income tax treatment of tax paid to foreign countries, see Publication 514, Foreign Tax Credit for Individuals. W2 ez See paragraphs (4) and (5) of Article XXIV for certain provisions that affect the computation of the credit allowed by the United States for Canadian income taxes paid by U. W2 ez S. W2 ez citizens residing in Canada. W2 ez Competent Authority Assistance Under Article XXVI, a U. W2 ez S. W2 ez citizen or resident may request assistance from the U. W2 ez S. W2 ez competent authority when the actions of Canada, the United States, or both, potentially result in double taxation or taxation contrary to the treaty. W2 ez The U. W2 ez S. W2 ez competent authority may then consult with the Canadian competent authority to determine if the double taxation or denial of treaty benefits in question can be avoided. W2 ez If the competent authorities are not able to reach agreement in a case, binding arbitration proceedings may apply. W2 ez It is important that your request for competent authority assistance be made as soon as you have been notified by either Canada or the United States of proposed adjustments that would result in denial of treaty benefits or in double taxation. W2 ez This is so that implementation of any agreement reached by the competent authorities is not barred by administrative, legal, or procedural barriers. W2 ez For information that you should include with your request for competent authority assistance, see Revenue Procedure 2006-54, 2006-49 IRB 1035, available at www. W2 ez irs. W2 ez gov/irb/2006-49_IRB/ar13. W2 ez html. W2 ez The request should be addressed to: Deputy Commissioner (International) Large Business and International Division Attn: Office of Tax Treaty Internal Revenue Service 1111 Constitution Ave. W2 ez , NW Routing: MA3-322A Washington, D. W2 ez C. W2 ez 20024 In addition to a timely request for assistance, you should take the following measures: File a timely protective claim for credit or refund of U. W2 ez S. W2 ez taxes on Form 1040X, Form 1120X, or amended Form 1041, whichever is appropriate. W2 ez This will, among other things, give you the benefit of a foreign tax credit in case you do not qualify for the treaty benefit in question. W2 ez For figuring this credit, attach either Form 1116, Foreign Tax Credit (Individual, Estate, or Trust), or Form 1118, Foreign Tax Credit — Corporations, as appropriate. W2 ez Attach your protective claim to your request for competent authority assistance. W2 ez Take appropriate action under Canadian procedures to avoid the lapse or termination of your right of appeal under Canadian income tax law. W2 ez How To Get Tax Help You can get help with unresolved tax issues, order free publications and forms, ask tax questions, and get information from the IRS and the Canada Revenue Agency in several ways. W2 ez Text of Treaty You can get the text of the U. W2 ez S. W2 ez —Canada income tax treaty from: Superintendent of Documents U. W2 ez S. W2 ez Government Printing Office P. W2 ez O. W2 ez Box 371954 Pittsburgh, PA 15250-7954 The treaty can also be found on the Internet at IRS. W2 ez gov. W2 ez U. W2 ez S. W2 ez Taxation During the filing season, the IRS conducts a taxpayer assistance program in Canada. W2 ez To find out if IRS personnel will be in your area, you should contact the consular office at the nearest U. W2 ez S. W2 ez Embassy or consulate. W2 ez Mail. W2 ez For answers to technical or account questions, you can write to: Internal Revenue Service International Section Philadelphia, PA 19255-0525 Phone. W2 ez You can call the IRS for help at (267) 941-1000 (not a toll-free call). W2 ez Canadian Taxation You can get information on Canadian taxation from the Canada Revenue Agency. W2 ez The International Tax Services Office can be contacted on 1-800-267-5177 (from anywhere in Canada and the U. W2 ez S. W2 ez ) or on the Internet at www. W2 ez cra-arc. W2 ez gc. W2 ez ca. W2 ez Prev Up Next Home More Online Publications
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W2 ez 2. W2 ez Accounting Methods Table of Contents Introduction Topics - This chapter discusses: Useful Items - You may want to see: Accounting MethodsCash Method Accrual Method Farm Inventory Cash Versus Accrual Method Special Methods of Accounting Combination Method Changes in Methods of Accounting Introduction You must use an accounting method that clearly shows your income and expenses. W2 ez You must also figure your taxable income and file an income tax return for an annual accounting period called a tax year. W2 ez This chapter discusses accounting methods. W2 ez For information on accounting periods, see Publication 538, Accounting Periods and Methods, and the Instructions for Form 1128, Application To Adopt, Change, or Retain a Tax Year. W2 ez Topics - This chapter discusses: Cash method Accrual method Farm inventory Special methods of accounting Changes in methods of accounting Useful Items - You may want to see: Publication 538 Accounting Periods and Methods 535 Business Expenses Form (and Instructions) 1128 Application To Adopt, Change, or Retain a Tax Year 3115 Application for Change in Accounting Method See chapter 16 for information about getting publications and forms. W2 ez Accounting Methods An accounting method is a set of rules used to determine when and how your income and expenses are reported on your tax return. W2 ez Your accounting method includes not only your overall method of accounting, but also the accounting treatment you use for any material item. W2 ez A material item is one that affects the proper time for inclusion of income or allowance of a deduction. W2 ez An item considered material for financial statement purposes is generally also considered material for income tax purposes. W2 ez See Publication 538 for more information. W2 ez You generally choose an accounting method for your farm business when you file your first income tax return that includes a Schedule F (Form 1040), Profit or Loss From Farming. W2 ez If you later want to change your accounting method, you generally must get IRS approval. W2 ez How to obtain IRS approval is discussed later under Changes in Methods of Accounting . W2 ez Types of accounting methods. W2 ez Generally, you can use any of the following accounting methods. W2 ez Each method is discussed in detail below. W2 ez Cash method. W2 ez Accrual method. W2 ez Special methods of accounting for certain items of income and expenses. W2 ez Combination (hybrid) method using elements of two or more of the above. W2 ez Business and other items. W2 ez You can account for business and personal items using different accounting methods. W2 ez For example, you can figure your business income under an accrual method, even if you use the cash method to figure personal items. W2 ez Two or more businesses. W2 ez If you operate two or more separate and distinct businesses, you can use a different accounting method for each business. W2 ez Generally, no business is separate and distinct unless a complete and separate set of books and records is maintained for each business. W2 ez Cash Method Most farmers use the cash method because they find it easier to keep records using the cash method. W2 ez However, certain farm corporations and partnerships and all tax shelters must use an accrual method of accounting. W2 ez See Accrual Method Required , later. W2 ez Income Under the cash method, include in your gross income all items of income you actually or constructively received during the tax year. W2 ez Items of income include money received as well as property or services received. W2 ez If you receive property or services, you must include the fair market value (FMV) of the property or services in income. W2 ez See chapter 3 for information on how to report farm income on your income tax return. W2 ez Constructive receipt. W2 ez Income is constructively received when an amount is credited to your account or made available to you without restriction. W2 ez You do not need to have possession of the income for it to be treated as income for the tax year. W2 ez If you authorize someone to be your agent and receive income for you, you are considered to have received the income when your agent receives it. W2 ez Income is not constructively received if your receipt of the income is subject to substantial restrictions or limitations. W2 ez Direct payments and counter-cyclical payments. W2 ez If you received direct payments or counter-cyclical payments under Subtitle A or C of the Farm Security and Rural Investment Act of 2002, you will not be considered to have constructively received a payment merely because you had the option to receive it in the year before it is required to be paid. W2 ez Delaying receipt of income. W2 ez You cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. W2 ez You must report the income in the year the money or property is received or made available to you without restriction. W2 ez Example. W2 ez Frances Jones, a farmer, was entitled to receive a $10,000 payment on a grain contract in December 2013. W2 ez She was told in December that her payment was available. W2 ez She requested not to be paid until January 2014. W2 ez However, she must still include this payment in her 2013 income because it was made available to her in 2013. W2 ez Debts paid by another person or canceled. W2 ez If your debts are paid by another person or are canceled by your creditors, you may have to report part or all of this debt relief as income. W2 ez If you receive income in this way, you constructively receive the income when the debt is canceled or paid. W2 ez See Cancellation of Debt in chapter 3. W2 ez Deferred payment contract. W2 ez If you sell an item under a deferred payment contract that calls for payment in a future year, there is no constructive receipt in the year of sale. W2 ez However, if the sales contract states that you have the right to the proceeds of the sale from the buyer at any time after delivery of the item, then you must include the sales price in income in the year of the sale, regardless of when you actually receive payment. W2 ez Example. W2 ez You are a farmer who uses the cash method and a calendar tax year. W2 ez You sell grain in December 2013 under a bona fide arm's-length contract that calls for payment in 2014. W2 ez You include the proceeds from the sale in your 2014 gross income since that is the year payment is received. W2 ez However, if the contract states that you have the right to the proceeds from the buyer at any time after the grain is delivered, you must include the sales price in your 2013 income, regardless of when you actually receive payment. W2 ez Repayment of income. W2 ez If you include an amount in income and in a later year you have to repay all or part of it, then you can usually deduct the repayment in the year repaid. W2 ez If the repayment is more than $3,000, a special rule applies. W2 ez For details, see Repayments in chapter 11 of Publication 535, Business Expenses. W2 ez Expenses Under the cash method, generally you deduct expenses in the tax year you pay them. W2 ez This includes business expenses for which you contest liability. W2 ez However, you may not be able to deduct an expense paid in advance or you may be required to capitalize certain costs, as explained under Uniform Capitalization Rules in chapter 6. W2 ez See chapter 4 for information on how to deduct farm business expenses on your income tax return. W2 ez Prepayment. W2 ez Generally, you cannot deduct expenses paid in advance. W2 ez This rule applies to any expense paid far enough in advance to, in effect, create an asset with a useful life extending substantially beyond the end of the current tax year. W2 ez Example. W2 ez On November 1, 2013, you signed and paid $3,600 for a 3-year (36-month) insurance contract for equipment. W2 ez In 2013, you are allowed to deduct only $200 (2/36 x $3,600) of the cost of the policy that is attributable to 2013. W2 ez In 2014, you'll be able to deduct $1,200 (12/36 x $3,600); in 2015, you'll be able to deduct $1,200 (12/36 x $3,600); and in 2016 you'll be able to deduct the remaining balance of $1,000. W2 ez An exception applies if the expense qualifies for the 12-month rule. W2 ez See Publication 538 for more information and examples. W2 ez See chapter 4 for special rules for prepaid farm supplies and prepaid livestock feed. W2 ez Accrual Method Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. W2 ez The purpose of an accrual method of accounting is to correctly match income and expenses. W2 ez Certain businesses engaged in farming must use an accrual method of accounting for its farm business and for sales and purchases of inventory items. W2 ez See Accrual Method Required and Farm Inventory , later. W2 ez Income Generally, you include an amount in 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. W2 ez Under this rule, include an amount in income on the earliest of the following dates. W2 ez When you receive payment. W2 ez When the income amount is due to you. W2 ez When you earn the income. W2 ez When title passes. W2 ez If you use an accrual method of accounting, complete Part III of Schedule F (Form 1040) to report your income. W2 ez Inventory. W2 ez If you keep an inventory, generally you must use an accrual method of accounting to determine your gross income. W2 ez An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. W2 ez See Publication 538 for more information. W2 ez Also see Farm Inventory , later, for more information on items that must be included in inventory by farmers and inventory valuation methods for farmers. W2 ez Expenses Under an accrual method of accounting, you generally deduct or capitalize a business expense when both of the following apply. W2 ez The all-events test has been met. W2 ez This test is met when: All events have occurred that fix the fact that you have a liability, and The amount of the liability can be determined with reasonable accuracy. W2 ez Economic performance has occurred. W2 ez Economic performance. W2 ez Generally, you cannot deduct or capitalize a business expense until economic performance occurs. W2 ez 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 as the property is used. W2 ez If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. W2 ez Example. W2 ez Jane, who is a farmer, uses a calendar tax year and an accrual method of accounting. W2 ez She entered into a contract with ABC Farm Consulting in 2012. W2 ez The contract stated that Jane pay ABC Farm Consulting $2,000 in December 2012. W2 ez It further stipulates that ABC Farm Consulting will develop a plan for integrating her farm with a larger farm operation based in a neighboring state by March 1, 2013. W2 ez Jane paid ABC Farm Consulting $2,000 in December 2012. W2 ez Integration of operations according to the plan began in May 2013 and they completed the integration in December 2013. W2 ez Economic performance for Jane's liability in the contract occurs as the services are provided. W2 ez Jane incurs the $2,000 cost in 2013. W2 ez An exception to the economic performance rule allows certain recurring items to be treated as incurred during a tax year even though economic performance has not occurred. W2 ez For more information, see Economic Performance in Publication 538. W2 ez Special rule for related persons. W2 ez 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. W2 ez Determine the relationship for this rule as of the end of the tax year for which the expense or interest would otherwise be deductible. W2 ez For more information, see Internal Revenue Code section 267. W2 ez Accrual Method Required Generally, the following businesses, if engaged in farming, must use an accrual method of accounting. W2 ez A corporation (other than a family corporation) that had gross receipts of more than $1,000,000 for any tax year beginning after 1975. W2 ez A family corporation that had gross receipts of more than $25,000,000 for any tax year beginning after 1985. W2 ez A partnership with a corporation as a partner, if that corporation meets the requirements of (1) or (2) above. W2 ez A tax shelter. W2 ez Note. W2 ez Items (1), (2), and (3) above do not apply to an S corporation or a business operating a nursery or sod farm, or the raising or harvesting of trees (other than fruit and nut trees). W2 ez Family corporation. W2 ez A family corporation is generally a corporation that meets one of the following ownership requirements. W2 ez Members of the same family own at least 50% of the total combined voting power of all classes of stock entitled to vote and at least 50% of the total shares of all other classes of stock of the corporation. W2 ez Members of two families have owned, directly or indirectly, since October 4, 1976, at least 65% of the total combined voting power of all classes of voting stock and at least 65% of the total shares of all other classes of the corporation's stock. W2 ez Members of three families have owned, directly or indirectly, since October 4, 1976, at least 50% of the total combined voting power of all classes of voting stock and at least 50% of the total shares of all other classes of the corporation's stock. W2 ez For more information on family corporations, see Internal Revenue Code section 447. W2 ez Tax shelter. W2 ez A tax shelter is a partnership, noncorporate enterprise, or S corporation that meets either of the following tests. W2 ez Its principal purpose is the avoidance or evasion of federal income tax. W2 ez It is a farming syndicate. W2 ez A farming syndicate is an entity that meets either of the following tests. W2 ez Interests in the activity have been offered for sale in an offering required to be registered with a federal or state agency with the authority to regulate the offering of securities for sale. W2 ez More than 35% of the losses during the tax year are allocable to limited partners or limited entrepreneurs. W2 ez A “limited partner” is one whose personal liability for partnership debts is limited to the money or other property the partner contributed or is required to contribute to the partnership. W2 ez A “limited entrepreneur” is one who has an interest in an enterprise other than as a limited partner and does not actively participate in the management of the enterprise. W2 ez Farm Inventory If you are required to keep an inventory, you should keep a complete record of your inventory as part of your farm records. W2 ez This record should show the actual count or measurement of the inventory. W2 ez It should also show all factors that enter into its valuation, including quality and weight, if applicable. W2 ez Hatchery business. W2 ez If you are in the hatchery business, and use an accrual method of accounting, you must include in inventory eggs in the process of incubation. W2 ez Products held for sale. W2 ez All harvested and purchased farm products held for sale or for feed or seed, such as grain, hay, silage, concentrates, cotton, tobacco, etc. W2 ez , must be included in inventory. W2 ez Supplies. W2 ez Supplies acquired for sale or that become a physical part of items held for sale must be included in inventory. W2 ez Deduct the cost of supplies in the year used or consumed in operations. W2 ez Do not include incidental supplies in inventory as these are deductible in the year of purchase. W2 ez Livestock. W2 ez Livestock held primarily for sale must be included in inventory. W2 ez Livestock held for draft, breeding, or dairy purposes can either be depreciated or included in inventory. W2 ez See also Unit-livestock-price method , later. W2 ez If you are in the business of breeding and raising chinchillas, mink, foxes, or other fur-bearing animals, these animals are livestock for inventory purposes. W2 ez Growing crops. W2 ez Generally, growing crops are not required to be included in inventory. W2 ez However, if the crop has a preproductive period of more than 2 years, you may have to capitalize (or include in inventory) costs associated with the crop. W2 ez See Uniform capitalization rules below. W2 ez Also see Uniform Capitalization Rules in chapter 6. W2 ez Items to include in inventory. W2 ez Your inventory should include all items held for sale, or for use as feed, seed, etc. W2 ez , whether raised or purchased, that are unsold at the end of the year. W2 ez Uniform capitalization rules. W2 ez The following applies if you are required to use an accrual method of accounting. W2 ez The uniform capitalization rules apply to all costs of raising a plant, even if the preproductive period of raising a plant is 2 years or less. W2 ez The costs of animals are subject to the uniform capitalization rules. W2 ez Inventory valuation methods. W2 ez The following methods, described below, are those generally available for valuing inventory. W2 ez The method you use must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. W2 ez Cost. W2 ez Lower of cost or market. W2 ez Farm-price method. W2 ez Unit-livestock-price method. W2 ez Cost and lower of cost or market methods. W2 ez See Publication 538 for information on these valuation methods. W2 ez If you value your livestock inventory at cost or the lower of cost or market, you do not need IRS approval to change to the unit-livestock-price method. W2 ez However, if you value your livestock inventory using the farm-price method, then you must obtain permission from the IRS to change to the unit-livestock-price method. W2 ez Farm-price method. W2 ez Under this method, each item, whether raised or purchased, is valued at its market price less the direct cost of disposition. W2 ez Market price is the current price at the nearest market in the quantities you usually sell. W2 ez Cost of disposition includes broker's commissions, freight, hauling to market, and other marketing costs. W2 ez If you use this method, you must use it for your entire inventory, except that livestock can be inventoried under the unit-livestock-price method. W2 ez Unit-livestock-price method. W2 ez This method recognizes the difficulty of establishing the exact costs of producing and raising each animal. W2 ez You group or classify livestock according to type and age and use a standard unit price for each animal within a class or group. W2 ez The unit price you assign should reasonably approximate the normal costs incurred in producing the animals in such classes. W2 ez Unit prices and classifications are subject to approval by the IRS on examination of your return. W2 ez You must annually reevaluate your unit livestock prices and adjust the prices upward or downward to reflect increases or decreases in the costs of raising livestock. W2 ez IRS approval is not required for these adjustments. W2 ez Any other changes in unit prices or classifications do require IRS approval. W2 ez If you use this method, include all raised livestock in inventory, regardless of whether they are held for sale or for draft, breeding, sport, or dairy purposes. W2 ez This method accounts only for the increase in cost of raising an animal to maturity. W2 ez It does not provide for any decrease in the animal's market value after it reaches maturity. W2 ez Also, if you raise cattle, you are not required to inventory hay you grow to feed your herd. W2 ez Do not include sold or lost animals in the year-end inventory. W2 ez If your records do not show which animals were sold or lost, treat the first animals acquired as sold or lost. W2 ez The animals on hand at the end of the year are considered those most recently acquired. W2 ez You must include in inventory all livestock purchased primarily for sale. W2 ez You can choose either to include in inventory or depreciate livestock purchased for draft, breeding, sport or dairy purposes. W2 ez However, you must be consistent from year to year, regardless of the method you have chosen. W2 ez You cannot change your method without obtaining approval from the IRS. W2 ez You must include in inventory animals purchased after maturity or capitalize them at their purchase price. W2 ez If the animals are not mature at purchase, increase the cost at the end of each tax year according to the established unit price. W2 ez However, in the year of purchase, do not increase the cost of any animal purchased during the last 6 months of the year. W2 ez This “no increase” rule does not apply to tax shelters which must make an adjustment for any animal purchased during the year. W2 ez It also does not apply to taxpayers that must make an adjustment to reasonably reflect the particular period in the year in which animals are purchased, if necessary to avoid significant distortions in income. W2 ez Uniform capitalization rules. W2 ez A farmer can determine costs required to be allocated under the uniform capitalization rules by using the farm-price or unit-livestock-price inventory method. W2 ez This applies to any plant or animal, even if the farmer does not hold or treat the plant or animal as inventory property. W2 ez Cash Versus Accrual Method The following examples compare the cash and accrual methods of accounting. W2 ez Example 1. W2 ez You are a farmer who uses an accrual method of accounting. W2 ez You keep your books on the calendar year basis. W2 ez You sell grain in December 2013 but you are not paid until January 2014. W2 ez Because the accrual method was used and 2013 was the tax year in which the grain was sold, you must both include the sales proceeds and deduct the costs incurred in producing the grain on your 2013 tax return. W2 ez Example 2. W2 ez Assume the same facts as in Example 1 except that you use the cash method and there was no constructive receipt of the sales proceeds in 2013. W2 ez Under this method, you include the sales proceeds in income for 2014, the year you receive payment. W2 ez Deduct the costs of producing the grain in the year you pay for them. W2 ez Special Methods of Accounting There are special methods of accounting for certain items of income and expense. W2 ez Crop method. W2 ez If you do not harvest and dispose of your crop in the same tax year that you plant it, you can, with IRS approval, use the crop method of accounting. W2 ez You cannot use the crop method for any tax return, including your first tax return, unless you receive approval from the IRS. W2 ez Under this method, you deduct the entire cost of producing the crop, including the expense of seed or young plants, in the year you realize income from the crop. W2 ez See chapter 4 for details on deducting the costs of operating a farm. W2 ez Also see Regulations section 1. W2 ez 162-12. W2 ez Other special methods. W2 ez Other special methods of accounting apply to the following items. W2 ez Amortization, see chapter 7. W2 ez Casualties, see chapter 11. W2 ez Condemnations, see chapter 11. W2 ez Depletion, see chapter 7. W2 ez Depreciation, see chapter 7. W2 ez Farm business expenses, see chapter 4. W2 ez Farm income, see chapter 3. W2 ez Installment sales, see chapter 10. W2 ez Soil and water conservation expenses, see chapter 5. W2 ez Thefts, see chapter 11. W2 ez Combination Method Generally, you can use any combination of cash, accrual, and special methods of accounting if the combination clearly shows your income and expenses and you use it consistently. W2 ez However, the following restrictions apply. W2 ez If you use the cash method for figuring your income, you must use the cash method for reporting your expenses. W2 ez If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income. W2 ez Changes in Methods of Accounting A change in your method of accounting includes a change in: Your overall method, such as from the cash method to an accrual method, and Your treatment of any material item, such as a change in your method of valuing inventory (for example, a change from the farm-price method to the unit-livestock-price method, discussed earlier). W2 ez Generally, once you have set up your accounting method, you must receive approval from the IRS before you can change to another method of accounting. W2 ez You may also have to pay a fee. W2 ez To obtain approval, you must generally file Form 3115. W2 ez There are instances when you can obtain automatic consent to change certain methods of accounting. W2 ez See the List of Automatic Accounting Method Changes located in the Instructions for Form 3115. W2 ez For more information on changes in methods of accounting, see Form 3115 and the Instructions for Form 3115. W2 ez Also see Publication 538. W2 ez Prev Up Next Home More Online Publications