Payment Methods

Most business transactions are in cash. For tax purposes the term cash includes checks, credit card charges, PayPal, and smart cards. However, in some cases, payments may take a different form.

1099 Income

If you are an independent contractor, your clients or customers who are in business are required to report income paid to you on Form 1099-MISC, Miscellaneous Income. This informs the IRS of income you have received. Income is required to be reported on Form 1099 if annual payments are at least $600, but you are required to report on your tax return all income you receive (even if no Form 1099 has been issued). Form 1099-MISC must also be given by businesses to incorporated attorneys and law firms for payments of $600 or more.

Advances and Prepayments

If you receive income for services to be performed in the future, you usually report the income if you have free and unrestricted use of the money.

However, if you use the accrual method and receive an advance payment for services to be performed by the end of the next year, you can elect to postpone, including the advance payment in income, until the next year. Postponement cannot extend beyond that next year.

You can postpone reporting income from an advance payment for a service agreement on property you sell, lease, build, install, or contract, provided that you offer the property without a service agreement in the normal course of business. You cannot postpone income if you are to perform any part of the service after the end of the tax year immediately following the year you receive the advance payment or you are to perform any part of the service at an unspecified future date that may be after the end of the year immediately following the year you receive advance payment. You usually cannot postpone reporting income received under a guarantee or warranty contract.

Cost of Goods Sold

Cost of goods sold (COGS) is determined each year by adjusting beginning inventory for changes made during the year. For Forms 1065, 1120, and 1120S, the cost of goods sold is figured on Form 1025-A (rather than on a schedule on the return).

Start with your opening inventory, which is usually the closing inventory from the previous year. For merchants, this is the cost of merchandise on hand at the beginning of the year that is for sale to customers. For manufacturers, opening inventory includes the total cost of raw materials, work in process, finished goods, and materials and supplies used in manufacturing the goods.

Increase opening inventory for purchases during the year (less any items withdrawn for your personal use). For manufacturers, purchases include the cost of all raw materials or parts purchased for manufacture into a finished product. Use the prices you pay after any trade discounts you receive.

Subtract all returns and allowances you make during the year. Also, if you are a manufacturer, subtract labor costs properly allocable to the cost of goods sold, which includes both the direct and indirect labor used in fabricating the raw material into a finished, saleable product. Also, if you are a manufacturer, subtract materials and supplies, such as hardware and chemicals, used in manufacturing goods charged to cost of goods sold, as well as other costs (e.g., containers; freight-in, overhead expenses allocable to the cost of goods sold).

After increasing your opening inventory and then making certain subtractions, find your cost of goods sold (COGS). Again, by reducing your gross receipts for the year by COGS, you determine your gross profit (explained in detail next).

To know what your opening inventory and closing inventory is, you need to take a physical inventory. A physical inventory must be taken at reasonable intervals, and the actual count must be used to adjust the inventory figures you have been maintaining all along. Generally, a physical inventory is taken at year-end. You are permitted to estimate year-end inventory by factoring in a reasonable allowance for shrinkage (for example, loss due to theft that you failed to detect). If you make such an estimate, then you must take a physical count on a consistent basis and adjust—upward or downward—the actual inventory count.

There are 4 methods for reporting inventory. They are:

1. Cost

2. Lower of cost or market method

3. Write-down of subnormal goods

4. Other inventory methods

Retailers can use a retail inventory method (see Revenue Procedure 2014-48 for instructions on how to change to this method if the business is currently using a different method).

Resellers—those who buy items for sale to others—use certain rules and methods to assign the cost of these items to those sold during the year:

• First-in, First-out (FIFO). An item sold is deemed to be the first item booked into inventory. For example, if you bought 10 widgets on 3 occasions at a cost of 10¢ each, 15¢ each, and 20¢ each and you sell 15, under FIFO you have sold 10 at 10¢ each and 5 at 15¢ each.

• Last-in, First-out (LIFO). An item sold is deemed to be the last item booked into inventory. In the widge example, you have sold 10 at 20¢ each and 5 at 15¢ each.

  Note: There have been proposals to repeal LIFO, but at the time of publication, there has been no legislation to do this; check the Supplement.

• Specific identification method. The actual cost of the items is used. This method generally is used when a business owns large or unique items (for example, an antique store would use this method for its objects since items are not identical and cannot be commingled).

Small businesses are allowed to use a simplified value LIFO method that makes it easier to determine the value of inventory. If you elect FIFO, you must use the lower of cost or market method to report inventory. If you elect LIFO, you must use cost to report inventory.

Note: If you use the small business exception or the small inventory-based business exception to the requirement that you use the accrual method of accounting and instead use the cash method, then instead of treating purchases as part of COGS you can treat inventoriable items as non-incidental materials and supplies. This means the costs are deductible when purchased or used (i.e., items are sold), whichever is later. Non-incidental materials and supplies are items for which a record of consumption or physical inventory is kept.

Gross Profits

Gross profits from the sale of goods is the difference between the gross receipts (sales revenues) and the cost of goods sold (as well as other allowances). If you remove items from inventory for your personal use, be sure to adjust your figures accordingly.

You generally cannot use the installment method of accounting to report the sale of inventory items—even if you receive payment on an installment plan. You report the sale according to your usual method of accounting so that on the accrual basis you pick up the income in full in the year of sale even though the full payment will not be received at that time.

Other Income for Direct Sellers

In addition to income from sales of products to customers, direct sellers may receive income in other ways:

• Commissions, bonuses, or percentages you receive for sales and the sales of others who work under you.

• Prizes, awards, and gifts resulting from your sales activities.

Commodity Credit Corporation loans

Loan proceeds generally are not income. However, farmers who pledge part or all of their production to secure a Commodity Credit Corporation (CCC) loan can make a special election to treat the loan proceeds as income in the year received and obtain a basis in the commodity for the amount reported as income. The election is made by including the loan proceeds as income on Schedule F and attaching a statement to the return showing the details of the loan. Then the amount you report as income becomes your basis in the commodity, so that when you later repay the loan, redeem the pledged commodity, and sell it, you report as income the sale proceeds minus the basis in the commodity. A forfeiture of pledged crops is treated as a sale for this purpose. Farmers who do not make this election must report market gain as income.

The repayment amount generally is based on the lower of the loan rate or the prevailing world market price of the commodity on the date of repayment. If the world price is lower when the loan is repaid, the difference between the repayment amount and the original loan amount is market gain. Whether cash or CCC certificates are used to repay the loan, Form 1099-CCC is issued to show the market gain. Market gain is included in income in the year of repayment if the CCC loan was not included in income in the year received.

Not all income received by farmers and ranchers is includable in gross income. Income from federal or state cost-sharing conservation, reclamation, and restoration programs can be excluded in whole or in part (depending on the program and other factors). Qualifying programs include, but are not limited to, small watershed programs as well as the water bank program under the Water Bank Act, emergency conservation measures program under Title IV of the Agricultural Credit Act of 1978, and the Great Plains conservation program authorized by the Soil Conservation and Domestic Policy Act.

Farm Income Averaging

You can choose to figure the tax on your farming income (elected farm income) by averaging it over the past 3 years. If you make this election, it will lower the tax on this year's income if income was substantially lower in the 3 prior years. However, it does not always save taxes to average your farming income—it is a good idea to figure your tax in both ways (the usual way and averaging) to determine which method is more favorable to you.

Income Averaging from Fishing

The income averaging rules applicable to farmers, explained earlier, apply to commercial fishermen.

Interest Income

Interest received on business bank accounts and on accounts or notes receivable in the ordinary course of business is a common type of ordinary business income. If the business lends money, interest received on business loans is business income. Deductions for business loans that go sour are explained in Chapter 22.

Businesses that make below-market or interest-free loans may be deemed to receive interest, called imputed interest. Below-market loan rules from the deduction perspective are discussed in Chapter 13.

Dividends

Businesses that own stock in a corporation may receive dividends. C corporations report the dividends as ordinary income. Pass-through entities report the dividends as separately stated items to enable owners to apply favorable tax rates on their personal returns. For example, if the dividends are “qualified,” owners may pay tax at no more than 15% on their share of the dividends (those in the 39.6% tax bracket would pay no more than 20% on their share of dividends).

Rents

Rents can be generated from leasing personal property items such as equipment, formal wear, or vehicles. Rents can also be generated from leasing out real property.

Cancellation of Debt

If you owe money and some or all of your debt is forgiven by the lender, you generally must include this debt forgiveness in income. However, you do not have to include debt forgiveness in income if any of the following conditions apply:

• You file for bankruptcy under Title 11 of the U.S. Code.

• You are insolvent at the time of the cancellation. Your exclusion is limited to the extent of your insolvency.

• The canceled debt is a qualified farm debt. This is a debt incurred by a business that received at least 50% of its gross receipts in the prior 3 years from farming activities. This debt must be owed to one who is regularly engaged in lending money, including the U.S. Department of Agriculture.

• The canceled debt is qualified real property business debt—secured by the property and incurred before January 1, 1993, or after December 31, 1992, if incurred or assumed to acquire, construct, or substantially improve real property used in the business. You must elect this exclusion for the year in which the cancellation occurs. The exclusion cannot exceed certain amounts.

Instead of recognizing income from the cancellation of indebtedness (referred to as COD income), you can choose to reduce certain tax attributes. This has the effect of limiting your future write-offs with respect to these tax attributes. Generally the amount excluded from income reduces the tax attributes (in a certain order) on a dollar-for-dollar or 33⅓ cents basis. As follows:

• Net operating loss (NOL) for the year of the COD (dollar-for-dollar)

• General business credit carryover to or from the year of COD (33⅓¢ per dollar)

• Minimum tax credit as of the beginning of the tax year immediately after the year of COD (33⅓¢ per dollar)

• Net capital loss for the year of COD (dollar-for-dollar)

• Basis of property (dollar-for-dollar)

• Passive activity loss (dollar-for-dollar) and credit (33⅓¢ per dollar) carryovers from the year of COD

• Foreign tax credit carryover to or from the year of COD

However, a corporation can elect to adjust the basis of property in a manner that is different from the general rule described in Reg. §1.1082-3(b).

The election to reduce tax attributes instead of recognizing COD income is made on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.

Note: C corporations that had COD income from the reacquisition of debt after December 31, 2008, and before January 1, 2011, could have elected to defer recognition for 5 years (e.g., until 2014 for 2009 COD income) and then report the income ratably over 5 years. Thus, there will be COD income reported on 2016 returns for C corporations that made this election.

Cancellation of debt income for S corporations. When corporate debt is forgiven and the S corporation opts not to report the cancellation of debt income but rather to reduce tax attributes, special rules apply. Any disallowed losses or deductions, including those of a shareholder who transferred all stock during the year, are included in an S corporation's deemed NOL (it is “deemed” because technically NOLs are reported only at the shareholder level, but adjustments to the NOL are made at the corporate level). If the deemed NOL exceeds the discharged cancellation of debt income, the excess deemed NOL is allowed to the shareholders as disallowed losses and deductions that shareholders can later take into account.

The character of the excess deemed NOL that is allocated to shareholders will consist of a proportionate amount of each item of the shareholder's loss or deduction that is disallowed for the year of the debt discharge. The corporations are required to provide information to shareholders regarding these suspended losses.

Damages and Other Recoveries

If you receive damages for patent, copyright or trademark infringement, breach of contract, or other business-related injuries, you report the damages as business income.

Special Income Items for S Corporations

If a corporation operated as a C corporation and then converted to S status, certain unique income items may result. These items are taxed to the S corporation; they are not pass-through items taxed to the shareholders:

• Last-in, first-out inventory recapture on the conversion from C status to S status. It can also result from the transfer of LIFO inventory by a C corporation to the S corporation in a transaction in which no income was recognized. Recapture results in an income adjustment payable in 4 equal installments, one reported on the final return of the C corporation (or the year of the transfer), and one-fourth each in the first, second, and third years of the S corporation's life (or the year of the transfer and the 2 successive years).

• Excess net passive income. If there were accumulated earnings and profits (E&P) from the time when the corporation was a C corporation and it has passive income for the year in excess of 25% of gross receipts, then tax is due at the rate of 35%. The S corporation must have taxable income for the year to be subject to this special tax.

• Built-in capital gains. If the corporation has appreciated property when it converts, the appreciation to the date of conversion is reported as built-in gains if the property is sold or otherwise disposed of within 5 years of conversion (7 years in 2009 and 2010; 10 years before 2009). The tax on the net recognized built-in gains is 35%.

If a corporation elects S status for its first year of existence it need not be concerned with any of these income items; they will never arise.

Special Income Items for C Corporations

If a C corporation converts to S status and reports inventory using LIFO, it must recapture one-fourth of the resulting income adjustment, reporting it as income on its final return (the year of conversion).

If the corporation receives a tax refund of taxes deducted in a prior year, the refund must be reported as income to the extent that it produced a tax benefit for the corporation.

Calculating NOLs

After you have completed your tax return for the year, you may find that you have an NOL. If you are an individual, you may have an NOL if your adjusted gross income, reduced by itemized deductions or the standard deduction (but before personal exemptions), is a negative figure. C corporations may have an NOL if taxable income is a negative figure. This negative figure merely indicates a possibility of an NOL; then you must determine whether, in fact, there actually is one. This is due to the fact that certain adjustments must be made to that negative figure in arriving at an NOL. Individuals and corporations calculate NOLs in a slightly different manner.

Carrybacks and Carryovers

Net operating losses may be carried back and, if not used up, carried forward for a certain number of years. The carryback and carryforward periods depend on the year in which the NOL arose. Keep careful track of your NOLs so you can take full advantage of them.

Generally, there is a 2-year carryback and a 20-year carryforward period. However, for small businesses (those with average annual gross receipts of $5 million or less during a 3-year period), a 3-year carryback applies to NOLs arising from government-declared disasters, and for farmers and ranchers and certain specified disaster victims, there is a 5-year carryback for all NOLs. There is a 10-year carryback for NOLs arising from product liability.

Note: For partnerships, limited liability companies, and S corporations, the election of the longer carryback period was made at the entity level even though the carryback was claimed by owners on their personal returns.

If you have an NOL in 2016, the basic 2-year carryback period again applies. You first carry the loss back to a year that is 2 years before the year in which the NOL arose (the NOL year), which is 2014. If it is not used up in that year, carry it to the year before the NOL year, which is 2015. If the NOL is still not used up, you can begin to carry it forward (with modifications explained below). However, if it is not used up after carrying it forward for 20 years, it is lost forever.

Personal service corporations (PSCs) are not allowed to carry back an NOL to any year in which there is a Section 444 election in effect to use a tax year other than a required tax year.

If your marital status in the carryback or carryover years differs from your status in the NOL year, only the spouse who has the NOL can claim it. If you file a joint return, the NOL deduction is limited to the income of the spouse who had the NOL. Special rules apply for carrybacks to a year involving a different marital status from the status in the year the NOL arises.

If your NOL is greater than the taxable income for the year to which you carried it, you must make certain modifications to taxable income to see how much of the NOL is used up in that carryback/carryover year and how much is still available as a carryover. The carryover is the excess of the NOL deduction over modified taxable income for the carryback/carryforward year. Modified taxable income is taxable income without regard to the NOL and with no deduction for net capital losses or personal exemptions. Also, you must recalculate items affected by a change in adjusted gross income. Your modified taxable income cannot be less than zero. You can determine your modified taxable income using Schedule B of Form 1045 for any carryback years and for carryovers from those years. If you have carryovers from more than one year, you use the carryovers in the order in which they were incurred. Thus, if you have a carryforward from 2014 and 2015, first use the amounts from 2014; if income is not fully offset, then use the 2015 carryforward.

While the NOL carryforward reduces income in the carryforward years for income tax purposes, it does not affect income for self-employment tax purposes in the carryforward years.

Basis

If you own a pass-through entity, business losses claimed on your personal return cannot exceed your tax basis in the company. Losses in excess of basis can be carried forward and used in future years to the extent of basis at that time. There is no time limit on these carryforwards.

At-Risk Rules

In the past it was not uncommon for someone to invest in a business by contributing a small sum of cash and a large note on which there was no personal liability. The note increased the investor's basis against which tax write-offs could be claimed. If the business prospered, all was well and good. If the business failed, the individual lost only the small amount of cash invested. Congress felt this arrangement was unreasonably beneficial to investors and created at-risk rules. At-risk rules operate to limit your losses to the extent of your at-risk amounts in the activity. Your at-risk amounts are, in effect, your economic investment in the activity. This is the cash you put into a business. It also includes the adjusted basis of other property you contribute and any debts secured by your property or for which you are personally liable for repayment.

You are not considered at risk if you have an agreement or arrangement that limits your risk. As a practical matter, if you set up and conduct an active business operation, you probably do not have to be concerned with the at-risk rules. First, you may qualify for an exception to the at-risk rules for closely held C corporations (discussed later). Also, in all probability your investment is what has started and sustained the business. But, if you are an investor, your contribution may be limited, and your losses may be limited as well.

If you are subject to the at-risk rules, you do not lose your deductions to the extent they exceed your at-risk amounts; you simply cannot claim them currently. The losses can be carried forward and used in subsequent years if your at-risk amount increases. There is no limit on the carryover period. If the activity is sold, your gain from the disposition of property is treated as income from the activity, and you can then offset the gain by the amount of your carried-over losses.

At-risk rules do not apply to investments in closely held C corporations that meet active business tests and that do not engage in equipment leasing or any business involving master sound recording, films, videotapes, or other artistic, literary, or musical property.

Passive Activity Loss Rules

If you work for your business full-time, you need not be concerned with the passive activity loss (PAL) rules. These rules apply only to a business in which you have an ownership interest but do not work in the day-to-day operations or management (i.e., materially participate) as well as rental real estate activities. If an owner is subject to the PAL rules, then deductions from the activity for the year are limits (see under How the Passive Activity Loss Rules Limit Deductions for Expenses). If the owner falls under the PAL rules, he or she may also be subject to the 3.8% additional Medicare tax on net investment income (NII).

Limited partners can never materially participate because they are barred by their status from making day-to-day operating decisions in their business. However, some courts have decided that LLC members are not treated the same as limited partners because they can participate in daily activities; their material participation determines whether they are subject to the PAL rules. The IRS has acquiesced in these cases.

The 7 tests for proving material participation include:

1. You participate in the activity for more than 500 hours during the year. You need only participate for a mere 10 hours a week for 50 weeks in the year to satisfy this test.

2. Your participation is substantially all of the participation in the activity of all individuals for the year, including the participation of individuals who did not own any interest in the activity. This means that if you are a sole proprietor and do not hire someone else to run the business, you meet this participation test, even if you work only 5 hours each week.

3. You participate in the activity for more than 100 hours during the tax year, and you participate at least as much as any other individual (including individuals who do not own any interest in the activity) for the year.

4. The activity is a significant participation activity, and you participate in all significant participation activities for more than 500 hours. A significant participation activity is any business in which you participate for more than 100 hours during the year and in which you did not materially participate under any of the other material participation tests.

5. You materially participated in the activity for any 5 (whether or not consecutive) of the 10 preceding tax years. This rule can be useful to someone who retires from the business while continuing to own an interest but who materially participated prior to retirement.

6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years.

7. Based on all the facts and circumstances, you participate in the activity on a regular, continuous, and substantial basis. At a minimum, you must have participated during more than 100 hours. Managing the activity is not treated as participation if any person other than you received compensation for managing it or any individual spent more hours during the year managing the activity than you (regardless of whether such individual was compensated).

Limited partners are automatically treated as subject to the passive activity loss rules because they are prohibited from participating in the business activities. Under regulations proposed, limited liability company (LLC) members would be treated like limited partners only if:

• The LLC is treated like a partnership, and
• The member does not have rights to manage the LLC at all times during the LLC's tax year under the law of the jurisdiction in which the LLC was organized and under the LLC governing agreement. Rights to manage include the power to bind the entity to a contract.

Limits on Farm Losses

Farming losses cannot be used as a tax shelter. Farming losses by those receiving certain subsidies are limited in how much can be used to offset nonfarm income on Schedule F. The limit is the greater of $300,000 ($150,000 for married persons filing separately) or the net farm income received over the past 5 years.

Losses limited by this rule are not lost forever; they can be carried forward and used in future years to the extent allowed by this rule. The limit applies to farmers (other than those operating as C corporations) who receive any direct or countercyclical payments under Title I of the Food, Conservation, and Energy Act of 2008, or Commodity Credit loans. For partnerships and S corporations, the limit applies at the partner or shareholder level, based on the year in which the entity's tax year ends.