Accounting Periods, Methods & Inventory (2025)

Tax Years

§444 Election

Partnerships, S-corps, and PSCs can elect a fiscal year other than required year by filing Form 8716. Must make "required payment" (pre-paying tax on deferred income value). Conditions: not a member of a tiered structure, no prior §444 election, deferral period ≤3 months. Election remains in effect until terminated (entity changes to required year, liquidates, joins tiered structure, or S election terminates). If terminated, cannot re-elect for same tax year.

Short Tax Year

Occurs when entity: begins operations mid-year, changes tax year, or terminates. Filing and payment requirements are the same as for a full 12-month tax year. Dissolved entities must file a short-year return based on the final dissolution date.

Accounting Methods

Cash Method

Income recognized when actually or constructively received. Expenses deducted when paid. Available to most small businesses (gross receipts ≤$31M averaged over 3 prior years, 2025). S-corps and partnerships generally can use cash method regardless of gross receipts (exception: partnerships with C-corp partners exceeding threshold). Tax shelters must always use accrual. C-corps with average gross receipts >$31M (2025) must use accrual.

Constructive receipt: Income is constructively received when credited to taxpayer's account or made available without substantial restriction. Substantial limitations include: funds in escrow (legal disputes), contract conditions (performance milestones), escrow accounts pending conditions.

12-month rule (prepaid expenses): Cash-basis taxpayers need not capitalize prepaid amounts if the benefit period does not extend beyond the earlier of: (1) 12 months after benefit begins, or (2) the tax year following the payment year.

Accrual Method

Income recognized when earned (all events test met, amount determinable). Expenses deducted when liability fixed and determinable and economic performance has occurred. Required for businesses with inventory (unless small business exception). Taxpayers with applicable financial statements must not recognize income later than on their AFS. Recurring item exception: Certain recurring items deductible even if economic performance hasn't occurred (within 8.5 months of year-end, if immaterial or better income matching) — does not apply to workers' compensation or tort liability.

Hybrid Method

Combination: accrual for inventory, cash for other items. Must clearly reflect income. If inventory is material and taxpayer is not a "small business," must use accrual for purchases and sales. Cash may be used for other income/expense items. Must use same method for income and expenses within a category.

Change in Accounting Method

Generally requires IRS consent (Form 3115). Changes requiring prior approval: cash↔accrual, inventory valuation method changes, depreciation/amortization method changes. Changes NOT requiring approval: adjusting useful lives (but not MACRS recovery periods), correcting calculation errors, tax-law-mandated changes. §481 adjustment spreads the income adjustment to prevent double counting/omission. Mandatory cash→accrual change (when exceeding $31M threshold) is an automatic change. OBBBA allows immediate deduction of domestic R&E expenses (instead of amortization) for tax years beginning after Dec 31, 2024.

Inventory Accounting

Who Must Account for Inventory

Businesses that produce, purchase, or sell merchandise. Small taxpayer exception (gross receipts ≤$31M, 2025): can treat inventory as non-incidental materials/supplies OR use method conforming to financial statements. Even with this exception, cash-basis taxpayers generally cannot deduct inventory purchases until the later of sale or payment.

Inventory Valuation Methods

• Cost: Invoice cost + freight + handling. Includes direct and indirect costs per UNICAP. Trade discounts reduce cost. Damaged/obsolete goods must be valued at actual selling price less direct disposal costs.
• Lower of Cost or Market (LCM): Compare market value to cost for each item, use lower. Market = normal selling price. Cannot be used with LIFO. Applies to purchased goods held, basic cost elements of goods being manufactured, and finished goods on hand.
• FIFO (First-In, First-Out): Oldest costs assigned to COGS. In inflation, higher ending inventory, lower COGS, higher taxable income.
• LIFO (Last-In, First-Out): Newest costs assigned to COGS. In inflation, lower ending inventory, higher COGS, lower taxable income. IRS approval (Form 3115) required to change FROM LIFO. Must use LIFO for financial reports if used for tax.
• Specific Identification: Each item tracked individually (serial numbers). Best for limited quantities of high-value, unique items (art, gems, custom goods, vehicles).
• Average Cost: Total cost of units ÷ total units = average unit cost. Used for large quantities of interchangeable, inexpensive items.
• Retail Method: Estimate ending inventory using cost-to-retail ratio (cost ÷ retail price). Assumes uniform markup. Requires periodic physical inventory. Useful for multi-store retailers.

Shipping Terms (Ownership Transfer)

• FOB Destination: Title transfers at buyer's location (when goods arrive). Seller includes in inventory until delivery.
• FOB Shipping Point (Origin): Title transfers when goods leave seller's premises. Buyer includes in inventory from ship date.

Uniform Capitalization (UNICAP) — §263A

Certain direct and indirect costs must be capitalized into inventory (not expensed): direct materials, direct labor, indirect production costs. Applies to producers of tangible/intangible personal property, real property producers, and businesses acquiring wholesale inventory for resale.

Exemptions (regardless of size): R&E/software development costs, intangible drilling costs, timber growing, qualified creative expenses of self-employed writers/musicians/artists, loan origination, warranty/product liability costs, property provided incidentally with services.

Small business exemption (≤$31M gross receipts, 2025): Exempt from UNICAP. Does NOT apply to real property producers (e.g., real estate developers building homes for resale).

Inventory Casualty/Theft Loss

Inventory "shrinkage" (theft, damage, loss) reduces ending inventory, increasing COGS. Two options: (1) adjust COGS, or (2) deduct separately as casualty/theft loss (must then remove affected items from COGS to avoid double-counting). Theft losses generally deducted in year discovered. If insurance recovery is expected, do not claim loss to the extent of reasonable recovery prospect.

Key Entity Due Dates