| Home Online Publications Online Issues TTA Home Table of Contents Use of Cash Method by Small Businesses | |
Use of Cash Method by Small Businesses Notice 2001-76 introduced new rules to simplify use of the cash method for qualifying small businesses with average gross receipts of $10 million or less. This article explains these rules, as amplified by Rev. Proc. 2002-28, in question-and-answer format, and illustrates them via a flowchart.
AICPA
Tax Division's Tax Accounting
For more information about this article, contact George White at gwhite@aicpa.org.
Executive Summary
In a move welcomed by the small business community, the IRS issued Notice 2001-761 in December 2001. In the interest of simplification for both taxpayers and the Service, the notice significantly increases the availability of the cash method of accounting for qualifying small business taxpayers with average gross receipts of $10 million or less. This article explains and illustrates the key provisions of the notice and of Rev. Proc. 2002-28,2 which implemented the notice (see Exhibit 1).
Background Sec. 446 offers taxpayers a choice of tax accounting methods, generally between cash and accrual. However, Sec. 471 significantly inhibits the freedom to choose the cash method; it imposes the accrual method on a taxpayer required to account for inventory. According to Regs. Sec. 1.471-1, the inventory requirement is triggered whenever the production, purchase or sale of merchandise is an income-producing factor in the taxpayer's business. Sec. 448 further limits taxpayers from choosing the cash method: the method cannot be used by a C corporation or by any partnership with a C corporation as a partner, unless average gross receipts are $5 million or less. Further exceptions (independent of the dollar threshold) exist for farming businesses and qualified personal service businesses. The inventory requirement is the principal source of complexity and controversy. Frequently, it is difficult to determine whether the production, purchase or sale of merchandise is an income-producing factor in the taxpayer's business, particularly when the taxpayer sells merchandise as an incidental part of its larger business (e.g., a plumber who also sells plumbing supplies). This difficulty has given rise to considerable litigation. Unfortunately, the court decisions have not resulted in clear lines of authority. The cost of litigation is particularly daunting to small businesses. Litigation has also consumed a considerable portion of government resources better used elsewhere.
Recent Developments In 2000, the Service permitted taxpayers with average gross receipts of $1 million to use the cash method (free of the inventory requirement).3 In 2001, the Joint Committee on Taxation, as part of its simplification study, recommended an increase in the dollar threshold to $5 million.4
Notice 2001-76 Many outside observers thought the IRS believed it lacked the authority to raise the exclusion threshold to as high as $5 million, let alone $10 million. The Joint Committee study did not indicate that its recommendation of a $5 million threshold could be implemented administratively by the Service.
Questions and Answers Q: When was Notice 2001-76 effective? A: The notice set forth the new rules in the form of a proposed revenue procedure finalized as Rev. Proc. 2002-28. Rev. Proc. 2002-28 is generally effective for tax years ending on or after Dec. 31, 2001. Section 9 of the procedure permits eligible calendar-year taxpayers to change to the cash method for the 2001 calendar year.
Q: Are the new rules retroactive? A: Technically, no. The new rules do not permit taxpayers to change their accounting methods for tax years ending before Dec. 31, 2001. How-ever, the new rules can have a significant retroactive effect on taxpayers whose use of the cash method for such prior periods has been challenged by the Service. In an important concession clearly intended to settle pending controversies, Rev. Proc. 2002-28, Section 9, states that the Service will not challenge the taxpayer's treatment for such prior periods if the taxpayer would have qualified for relief under the new rules, had they been in effect.
Q: Does a taxpayer's form of organization affect its eligibility to use the new rules? A: Yes. The new rules are for individuals, S corporations and individually owned partnerships; C corporations are generally not eligible. Sec. 448 generally precludes C corporations from using the cash method, except for farming businesses, qualified personal service corporations and entities with gross receipts of $5 million or less.
Q: Does a taxpayer's principal business activity affect its eligibility to use the new rules? A: Yes. Certain business activities, if they comprise the taxpayer's principal business activity, will preclude the taxpayer from using the new rules. The proscribed business activities are defined by reference to the North American Industry Classification System (NAICS) codes. The following business activities are proscribed:
Q: Is a taxpayer whose business falls within one of the ineligible NAICS codes (e.g., publishing—NAICS codes 5111 and 5122) precluded from using the cash method, even if part of its business consists of providing services (e.g., advertising space in its publications)? A: No. If the service segment comprises a separate and distinct business (evidenced by a complete and separable set of books and records), it can use the cash method (assuming it otherwise qualifies under the $10 million threshold). In addition, if the service segment comprises the overall business's principal business activity, the entire business can use the cash method (assuming it qualifies under the $10 million threshold).
Q: How does a taxpayer determine its principal business activity? A: This is determined by reference to the business's gross receipts. Rev. Proc. 2002-28, Section 6, Example 5, describes a plumbing contractor with two business lines (plumbing installation and retail sales of plumbing supplies). The plumbing contractor may use the cash method for both businesses, if the plumbing installation line gross receipts comprise more than 50% of the combined businesses' total gross receipts. Even if the plumbing installation line gross receipts comprise less than 50% of the combined businesses' total gross receipts, the taxpayer can use the cash method for that line (assuming it constitutes a separate and distinct business that otherwise qualifies under the $10 million threshold).
Q: Can a taxpayer have a principal business activity even if it generates less than 50% of its gross receipts? A: Yes. Rev. Proc. 2002-28, Section 6, Example 8, addresses a taxpayer with four businesses, the largest of which generates 35% of its gross receipts. This business constitutes the taxpayer's principal business activity.
Q: Do the new rules apply to all eligible taxpayers that fall under the $10 million threshold? A: Yes, although taxpayers with average gross receipts of $1 million or less were already exempt under Rev. Proc. 2001-10.5 That exemption applies without regard to the nature of the taxpayer's business; the Rev. Proc. 2002-28 exemption contains limits based on the taxpayer's business.
Q: How is the $10 million threshold determined for 2001 for a calendar-year taxpayer? A: The threshold is met if a taxpayer's average gross receipts for the three tax years preceding 2001 were less than $10 million. Similar look-back rules apply for taxpayers seeking a change for tax years ending after Dec. 31, 2001.
Q: What about taxpayers in existence for fewer than three years? A: These taxpayers determine their eligibility according to the number of years they have actually been in existence (including short periods).
Q: Do the new rules exempt cash-basis taxpayers from the Sec. 471 inventory requirement? A: Yes (but see the next Q&A). The exemption from Sec. 471 should be particularly beneficial for service businesses that also sell related products. As was discussed, the obligation of these service businesses to account for inventories has triggered extensive litigation.
Q: Does the Sec. 471 exemption mean that a cash-basis taxpayer can expense its merchandise in the tax year of purchase? A: No. Rev. Proc. 2002-28 makes clear that the treatment of merchandise purchases must follow the treatment prescribed for purchases of significant (nonincidental) materials and supplies. Taxpayers can deduct the cost of such nonincidental items only as they are consumed during the tax year, under Regs. Sec. 1.162-3. Applying this rule to merchandise purchases means that the cost of such items may be deducted in the year of sale to customers. An exception applies when the taxpayer pays for the merchandise in a tax year later than the year in which it sells the items to customers. In this event, the items are deductible in the later tax year.
Q: How does an accrual-basis taxpayer eligible for the cash method under the new rules change methods? A: The new rules permit an automatic change in method.
Q: How does an accrual-basis taxpayer apply for the automatic change? A: Rev. Proc. 2002-96 sets forth rules for applications for automatic changes. A taxpayer seeking to switch to the cash method should indicate on the top of Form 3115, Application for Change in Accounting Method, that it is filing the form "under Rev. Proc. 2002-28." In addition, taxpayers who do not want to account for inventory under the new rules must also apply for the treatment accorded nonincidental materials and supplies under Regs. Sec. 1.162-3. This application can also be filed subject to the automatic change provisions of Rev. Proc. 2002-9. Both applications for change may be combined in a single Form 3115.
Q: For eligible businesses, is the cash method always the best choice? A: Not necessarily. Under certain facts, the accrual method may actually yield better results (e.g., a taxpayer receiving advance payments). Under the cash method, such amounts are reportable currently, but may be deferrable under the accrual method.7 For taxpayers in this position presently using the cash method, a switch to the accrual method may be particularly advantageous; the method change usually involves a negative adjustment to taxable income reportable in a single tax year.8 |
