When is Income Taxable, When are Expenses Deductible?

As we head into the end of the year, it’s important to consider when income and expenses are recognized for tax purposes.

Most individual taxpayers are on the cash method of accounting, so any income that you have in your hands before the end of the year will be taxable in 2010.  This is true even if the income is in the form of a check and you don’t deposit the check until the first part of January.  The same logic applies to expenses.  If you write the check and send it before the end of the year, you can deduct it this year, even if the recipient doesn’t cash the check until January.

It gets a little trickier for accrual basis taxpayers.  Many businesses use the accrual method.  Under the accrual method, income is recognized and expenses are deducted when the “all-events” tests have been met.  For income, this means (from IRS Publication 334):

Under an accrual method, you generally include an amount in your gross 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.

For expenses, the all-events test is met in much the same way, except that “economic performance” must have occurred as well, which means the goods or services must have been received or performed, as well.  (NOTE:  this is a very, very general overview of economic performance.)

Special rules apply when related taxpayers are involved and they use different methods of accounting.