A sole proprietor keeps no books and has no established annual accounting period. Which tax year must the proprietor adopt?
Based on: IRS Publication 334 (2025), Tax Guide for Small Business
Enrolled Agent Exam (SEE) · Business returns
Business Tax Preparation: Accounting Methods, Income and Cost of Goods Sold
Business Tax Preparation is the single heaviest topic on the whole exam: 37 of the 85 scored questions on Part 2, more than 43 percent of that part. It rewards mechanical accuracy about when income is recognised, when an expense is deductible, and how cost of goods sold is built up.
Practice
Free practice questions
Which of the following is a requirement for property to be depreciable?
Based on: IRS Publication 946 (2025), How To Depreciate Property
Which condition must be met to aggregate two trades or businesses for section 199A?
Based on: Treasury Regulation section 1.199A-4(b)(1)
May a specified service trade or business be aggregated with a non-service business?
Based on: Treasury Regulation section 1.199A-4(b)(1)(iii)
Which form does a taxpayer with taxable income at or below the threshold amount, who is not a patron of an agricultural or horticultural cooperative, use to figure the section 199A deduction?
Based on: IRS Form 8995 instructions (2025)
A taxpayer's qualified businesses produce an overall net qualified business loss for the year. What happens to that loss?
Based on: IRC section 199A(c)(2); IRS Form 8995 instructions (2025)
For digital asset sales on or after January 1, 2025, what were brokers REQUIRED to report on Form 1099-DA?
Based on: IRS Form 1099-DA instructions; Treasury Regulation section 1.6045-1
Under Revenue Procedure 2024-28, how must digital asset basis be tracked from January 1, 2025?
Based on: Revenue Procedure 2024-28
Which amount is generally NOT part of a taxpayer's amount at risk in an activity?
Based on: IRC section 465(b)(6); IRS Form 6198 instructions (2025)
What happens to a loss disallowed by the at-risk rules?
Based on: IRC section 465(a)(2); IRS Form 6198 instructions (2025)
Tax years and accounting methods
You must adopt the calendar tax year if you keep no books, have no annual accounting period, or your present tax year does not qualify as a fiscal year. Changing a tax year afterwards generally needs IRS approval, requested on Form 1128. The accounting method is chosen when you file the first income tax return that includes a Schedule C for the business, and once set it cannot simply be changed: you generally need IRS approval, requested on Form 3115. A pairing rule catches people out here. If you use the cash method for figuring income, you must use the cash method for reporting expenses too.
When income is received: constructive receipt
Under the cash method, income is taxed when it is made available to you without restriction, not when you choose to take it. A payment left available to you at the end of December is income for that year even if you collect it in January, because you cannot postpone income simply by declining to take it. Receipt of a valid check by the end of the tax year is constructive receipt in that year even if the check cannot be cashed or deposited until the following year. Property and services received under the cash method go into income at their fair market value, and the same applies to what you receive in a barter transaction.
When expenses are deductible
Under the cash method a prepaid expense is deductible only in the year to which it applies, so half of a one-year policy bought mid-year falls into each of two years. Under an accrual method income is reported when all the events fixing the right to receive it have occurred and the amount can be determined, and an expense is deducted or capitalised when the all-events test is met and economic performance has occurred. There is a related-party brake on all of this: you cannot deduct an expense or interest owed to a related cash-method person until you actually pay it and the amount becomes includible in that person's gross income.
- A small business taxpayer has average annual gross receipts of $31 million or less for the three prior tax years and is not a tax shelter, with the figure indexed for inflation
- If you produce, purchase or sell merchandise you must generally keep an inventory and use an accrual method for purchases and sales
- Uniform capitalisation costs are recovered through depreciation, amortisation or cost of goods sold when the property is used, sold or disposed of, never as a current deduction
- A sole proprietor cannot deduct their own salary or personal withdrawals, because a sole proprietor is not an employee of the business
- Property placed in service and disposed of in the same tax year cannot be depreciated at all
What is and is not gross receipts
Several items look like income and are not. Sales taxes imposed on the buyer that you collect and pay over to the government are not your income. Trade discounts are never entered on the books at all: you record only the net amount as the cost of the merchandise purchased. A post-purchase reduction in what you owe a seller is treated, unless you are bankrupt or insolvent, as a purchase price adjustment that reduces basis rather than as income. Consignments are not sales, so title stays with the consignor, the goods remain in the consignor's inventory, and no profit arises until they are sold. On the other side of the line, punitive damages must be included in income, and a recovery of a previously deducted amount is income except to the extent the earlier deduction produced no tax benefit.
Cost of goods sold
Cost of goods sold is built as goods available for sale less ending inventory. On Schedule C that is line 42 equals line 40 minus line 41, and the exam does ask it in that line-number form. Freight-in, on raw materials and on merchandise bought for resale alike, is part of cost of goods sold rather than a separate deductible expense. Getting the classification right matters twice over: an item put in the wrong place changes both gross profit and the expense deduction.
| Question | Cash method | Accrual method |
|---|---|---|
| When is income reported? | When actually or constructively received, including a valid check received by year end | When all events fixing the right to receive it occur and the amount is determinable |
| When is an expense deducted? | When paid, and a prepaid expense only in the year to which it applies | When the all-events test is met and economic performance has occurred |
| Owed to a related cash-method person? | Deduct when paid | Still cannot deduct until paid and includible in that person's income |
| Required where merchandise is produced, purchased or sold? | Not permitted for purchases and sales | Generally required, together with an inventory |
FAQ
Frequently asked questions
Which form changes a business accounting method?
Form 3115, Application for Change in Accounting Method. Changing the tax year is a different application, made on Form 1128.
What is the gross receipts test for a small business taxpayer?
Average annual gross receipts of $31 million or less for the three prior tax years, provided the business is not a tax shelter. The threshold is indexed for inflation, so the figure moves between exam windows.
If a customer's check arrives on 31 December but the bank is closed, which year is it income?
The year the check was received. Receipt of a valid check by the end of the tax year is constructive receipt in that year, even if it cannot be cashed or deposited until the following year.
Can a sole proprietor deduct their own salary?
No. A sole proprietor is not an employee of the business, so neither a salary to themselves nor personal withdrawals is deductible.
How is cost of goods sold calculated on Schedule C?
Goods available for sale minus ending inventory. In Schedule C line terms, line 42 equals line 40 minus line 41. Freight-in on raw materials and on merchandise bought for resale is included in cost of goods sold.
Are sales taxes collected from customers business income?
No. Sales taxes imposed on the buyer that you collect and pay over to the government are not income to you. Sales taxes imposed on the seller are a different matter and are treated as an expense.
Practice questions