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Personal service corporations that make a Section 444 election need not make a required payment. Instead, these corporations must make required distributions. They must distribute certain amounts of compensation to employee-owners by December 31 of each year for which an election is in effect. The reason for the required elections is to ensure that amounts will be taxed to owner-employees as soon as possible and will not be deferred simply because the corporation uses a fiscal year. Required distributions are figured on Part I of Schedule H of Form 1120, Section 280H Limitations for a Personal Service Corporation.
Owners in pass-through entities who are on a calendar year report their share of the business's income, deductions, gains, losses, and credits from the entity's tax year that ends in the owners’ tax year.
Example
You are in a partnership that uses a fiscal year ending October 31. The partnership's items for its 2017 fiscal year ending October 31, 2017, are reported on your 2017 return. The portion of the partnership's income and deductions from the period November 1, 2017, through December 31, 2017, are part of its 2018 fiscal year, which will be reported on your 2018 return.
You may have a year that is less than a full tax year. This results most commonly in the year you start or end a business.
Example
You start an LLC on August 1, 2017, and use a calendar year to report your income and expenses. The LLC's first tax year is a short tax year, running from August 1, 2017, through December 31, 2017.
A short tax year can also result when a C corporation that had been reporting on a fiscal year elects S status and adopts a calendar year. The tax year of the C corporation ends on the date the S election becomes effective.
Alternatively, if an S election is terminated within the year or there is a substantial change in ownership (50 % or more), then the corporation can have 2 short tax years in this case.
Example
A C corporation with a fiscal year ending on June 30 elects to become an S corporation and adopts a calendar year. The election is effective on January 1, 2018. The C corporation has a short tax year starting on July 1, 2017, and ending on December 31, 2017.
Example
An S corporation reporting on a calendar year has its election involuntarily terminated on July 31, 2017, when another corporation becomes a shareholder. The corporation has 2 short tax years: the S tax year running from January 1, 2017, through July 31, 2017, and the C tax year running from August 1, 2017, through December 31, 2017.
The IRS says that an unincorporated entity converting to a corporation under a state law formless conversion statute or check-the-box rules and which is eligible for S corporation status as of the first day of its first year does not have any short tax year for the momentary period it was a C corporation.
If your business has been using a particular tax year and you want to change to a different one, you must obtain IRS approval to do so. Depending on the reason for the change, approval may be automatic or discretionary. You can request a change in your tax year by filing Form 1128, Application to Adopt, Change, or Retain a Tax Year. There is a user fee (an amount set by the IRS) for this request.
Accounting Methods
An accounting method is a set of rules used to determine when and how to record income and expenses on your books and for tax-reporting purposes. In some cases, how items are treated may differ for tax reporting purposes and financial accounting purposes. What is included in this chapter are the accounting method rules for tax reporting purposes.
There are 2 principal methods of accounting: cash basis and accrual basis. Use of a particular method determines when a deduction can be claimed. However, restrictions apply for both methods of accounting. Also, the form of business organization may preclude the use of the cash method of accounting even though it may be the method of choice.
Cash method is the simpler accounting method. Income is reported when it is actually or constructively received, and a deduction can be claimed when and to the extent the expense is paid.
Example
You are a consultant. You perform services and send a bill. You report the income when you receive payment. Similarly, you buy business cards and stationery. You can deduct this expense when you pay for the supplies.
Actual receipt is the time when income is in your hands. Constructive receipt occurs when you have control over the income and can reduce it to an actual receipt.
Example
You earn a fee for services rendered but ask your customer not to pay you immediately. Since the customer was ready and able to pay immediately, you are in constructive receipt of the fee at that time.
Payments received by check are income when the check is received even though you may deposit it some time later. However, if the check bounces, then no income results at the time the check was received. You report income only when the check is later honored.
Sole proprietors and independent contractors on the cash method (and reporting on a calendar year basis) can run into a problem with respect to Form 1099-MISC for year-end payments. A company may send a payment late in December 2017 and include it on Form 1099-MISC for 2017; the contractor may receive the payment in January 2018. While this income is not taxable to the contractor until 2018, he or she must report the income on the return as it is reported by the company (because of IRS computer matching of information returns with income reported by recipients on their returns) and then make a subtraction to eliminate this amount from income. The payment is included in income in 2018 even though it is not reflected on a Form 1099-MISC for 2018.
Expenses are usually fully deductible when paid. Payments by a general credit card, such as MasterCard or Visa, are deductible in the year they are charged, even if you pay the credit card bill in the following year. Payments using ``pay by phone'' with your bank are deductible when the bank sends the payment (check your bank account statement). There has been no IRS guidance on deductibility when using PayPal, Amazon Payments, or other electronic payment methods, but it appears that payments are deductible when you instruct PayPal or other provider to make them because that is when the funds are taken from your account. Bitcoin and other digital currencies are not treated by the IRS as currency (they're treated as property), so this complicates the deduction process.
You may not be able to deduct all expenses when they are paid because there are some limitations that come into play. Generally, you cannot deduct advance payments (so-called prepaid expenses) that relate to periods beyond the current tax year.
Example
You take out a 3-year subscription to a business journal and pay the 3-year subscription price this year. You can deduct only of the payment – the amount that relates to the current year. You can deduct another next year, and the final ⅓ the following year.
Prepayments may occur for a number of expenses. You may prepay rent, insurance premiums, or subscriptions. Generally, prepayments that do not extend beyond 12 months are currently deductible.
In the case of interest, no deduction is allowed for prepayments by businesses. For example, if you are required to pay