Farmer View:

Determining an Accounting Method for Income and Expenses

Every farmer needs to have an accounting period, a tax year, which can be either a calendar year or a fiscal year. Calendar year ends in December and Fiscal year ends in any month of the year except December. Individuals or partnerships that use calendar year don’t have an accounting period and don’t qualify for a fiscal year. You choose your accounting period when you first file your income tax return. To change your tax year after that file form 1128.

There are four types of accounting methods that you can use:

  • Cash Method – This method is preferred by many farmers but it’s not possible for all of them to use it. Cash method of accounting is where you include all income that you have generated in one tax year and you have constructive receipts of that income. A good example of a constructive receipt is when you have no restrictions over when to withdraw the money from an account meaning if a certain amount of funds were made available to you for withdrawal but you decided to withdraw it in two years, the day the amount becomes available to you should be reported in the tax year that day happens to be in, not when you withdraw it. Checks are the same way, if you receive a check in one tax year but don’t cash it till the next year, the check should be included in your income for the tax year that you received it in. Expenses under the cash method are incurred when you pay for them. On a different note, if you are a recipient of production flexibility payment under Federal Agriculture Improvement and Reform act of 1996, you don’t have to include the payments in the year that you have the option to receive them, you include them in the year that you actually get them.

  • Accrual Method – Accrual method of accounting is where you include the income you earned and the expenses you incurred in a tax year. Accrual method is about accurately pinpointing all income to its source and to have not just constructive receipts for the amounts but also to have the amounts in your possession. This method employs inventory (include all items that are not sold by the end of the year that you sell, bought, raised, or use to feed your animals) to determine the gross income of the business. All expenses incurred are determined to occur in a particular tax year if all the "events have occurred that fix the fact of liability and the liability can be determined with reasonable accuracy," according to the IRS. It means if you bought a tractor in December 1998 and then received it in the same month but you got the bill for it in January 1999, that expense of buying the tractor would be included in your 1998 tax return. If you hadn’t received the tractor in the same month and had received it in January 1999, then you would have included the expense of buying the tractor in your 1999 tax return under the accrual method of accounting. Contested liability for any expenses should be included in your tax return for the tax year in which the liability is either settled or paid off.

  • Crop Method– If you are unable to harvest and sell your crop in the year that you sowed it into the ground, then using this method you can deduct the entire cost of planting the crop into the ground the year you do make money from harvesting and selling the crop. This accounting method is only used for crops.

  • Combination Method – You combine the various methods available to make it easier and more profitable for you to run your business except with a few exceptions that IRS has set:
    • You have to use the Cash method for your expenses if you use the Cash method for figuring your income.
    • You have to use the Accrual method for figuring out your income if you use it for your expenses.

File form 3115, if you decide to make a change in your accounting methods.