rev. proc 2000-22 allows certain taxpayers to use cash method

Accounting Methods & Periods

Rev. Proc. 2000-22 Allows Certain Taxpayers to Use Cash Methods

Generally, taxpayers with inventory are required to use the accrual method of accounting. However, a new revenue procedure allows taxpayers meeting certain requirements to use the cash method. This article explains why the procedure may cause more problems than it solves.

Christopher W. Hesse, CPA
Director of Taxation
LeMaster & Daniels PLLC
Moses Lake, WA

Editor's note: Mr. Hesse is a member of the AICPA Tax Division's Tax Accounting Technical Resource Panel. Author's note: The author thanks Diane Herndon, Charles Napier and James Connor, members of the AICPA Tax Division's Cash Method of Accounting Task Force, for providing comments in the preparation of this article. For more information about this article, contact Mr. Hesse at (509) 750-1849 or chesse@lemaster-daniels.com .

Executive Summary

If inventory exists, the regulations require use of the accrual method.

Rev. Proc. 2000-22 now provides an administrative exception to use of the accrual method for certain small taxpayers.

The procedure is no panacea; there are a number of problems.

An accrual-method taxpayer generally must recognize income when all events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. An accrual-method taxpayer may deduct the amount of any receivable previously included in income that becomes worthless during the year. Such taxpayers are not required to include in income amounts to be received for the performance of services that, on the basis of experience, will not be collected (the nonaccrual experience method). The availability of this method is conditioned on the taxpayer not charging interest or a penalty for failure to timely pay the amount charged. An expense is deductible when incurred; however, there are exceptions, which include complying with the rules for economic performance and accruals to related-party, cash-method taxpayers under Sec. 267.

A cash-method taxpayer is not required to include an amount in income until it is actually or constructively received. An expense, if deductible, is allowed when paid. The prepayment of an expense is generally not deductible until the expense is incurred. (There are various exceptions for cash-method farm taxpayers.) Hybrid methods of accounting, combining various aspects of the cash and accrual methods, have been allowed if consistently applied.

Restrictions on Cash-Method Use

Treasury Tax Legislative Counsel Joseph Mikrut summarized the restrictions on the use of the cash method in testimony¹ before the House Committee on Small Business, as reproduced in Exhibit 1.

Exhibit 1: Mikrut testimony

Long-standing Treasury regulations provide that, in order to clearly reflect income, taxpayers (other than farmers) that are required to use inventories for a particular trade or business generally must use an accrual method of accounting for their purchases and sales. Treasury Reg. Section 1.446-1(c)(2). A taxpayer is required to use inventories in any case in which the production, purchase, or sale of merchandise is an income-producing factor. Treasury Reg. Section 1.471-1. Any other permissible method (including the cash method) may be used to account for items of income and deduction other than purchases and sales in that trade or business or for other trades or businesses of the taxpayer. A farmer generally may use the cash method of accounting even though the farmer is engaged in the production and sale of merchandise.

In addition to the general requirement that a taxpayer's accounting method clearly reflect income, the Code places several specific restrictions on the use of the cash method for income tax purposes. Under section 448, certain entities have been specifically barred from using the cash method since 1986. Those entities generally include a C corporation (other than a farming business and a qualified personal service corporation) with average annual gross receipts over $5 million; a partnership (other than a farming business) with a C corporation (other than a qualified personal service corporation) partner and average annual gross receipts over $5 million; or a tax shelter. Taxpayers not specifically prohibited from using the cash method under section 448 are not automatically eligible to use the cash method. On the contrary, these taxpayers remain subject to the other requirements that a method of accounting must clearly reflect income and that an accrual method must be used for purchases and sales of inventories. As explained in legislative history underlying section 448:

Present law requires the use of the accrual method in certain situations. First, if the production, purchase or sale of merchandise is an income-producing factor to the taxpayer, the taxpayer is required to use the accrual method of accounting and to keep inventories...The Committee bill does not change the rules of present law relating to what accounting methods clearly reflect income or the authority of the Secretary of the Treasury to require the use of an accounting method that clearly reflects income.ⁱ ...Consistent with the legislative history underlying section 448, Temporary Treasury Reg. section 1.448-1T(c) provides that "nothing in section 448 affects the...requirement of section 1.446-1(c)(2) that an accrual method be used with respect to the purchases and sales of inventory." Thus, for example, if the purchase, production or sale of merchandise is an income-producing factor in a taxpayer's business, the taxpayer generally must use an accrual method for its purchases and sales, regardless of whether the taxpayer has average annual gross receipts of $5 million or less.

In order to clearly reflect income, Treasury regulations since 1918 have required the use of inventories and an accrual method to properly match gross receipts from merchandise sales with the related cost of goods sold when the purchase, production or sale of merchandise is an income-producing factor. The rationale for these regulations has been recognized by Congress and the courts. For example, as explained by the court in Knight-Ridder Newspapers ⁱⁱ...:

The reasoning behind this regulatory scheme is straightforward, according to accounting wisdom, the income realized from the sale of merchandise is most clearly measured by matching the costs of that merchandise with the revenue derived from its sale. In order to achieve such a matching of revenue and cost, it is necessary to keep an inventory account reflecting the costs of merchandise, raw materials and manufacturing expenses. The costs are not deducted immediately when paid but are deferred until the year when the resulting merchandise is sold. To make the matching complete, the taxpayer must report income on the accrual method. That method helps to ensure that income from the sale (like the inventory costs) is reflected in the year of the sale.

Not only does the cash method fail to reflect economic income, the cash method is subject to manipulation that distorts taxable income. For example, cash method taxpayers may attempt to postpone the collection of income that they are otherwise entitled to receive or to prepay certain expenditures in order to yield a targeted taxable income. Because of this concern, Congress denied the use of the cash method to tax shelters in section 448.ⁱⁱⁱ

Despite these defects...the relative simplicity of the cash method justifies its use for tax purposes by smaller, less sophisticated businesses for which accrual accounting may be burdensome. In addition, the cash method is ingrained with certainty as to the actual realization of items of income and deduction. Finally, the cash method addresses liquidity concerns in that it provides for payment of tax at the time the taxpayer is most likely to have the ability to pay the tax.

ⁱ H. Rep't No. 99-426, 99th Cong., 1st Sess. (1985), pp. 604, 606; see also Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (5/4/87) (hereinafter, "Bluebook"), p. 474 et seq.

ⁱⁱKnight-Ridder Newspapers, Inc., 743 F2d 781 (11th Cir. 1984).

ⁱⁱⁱ See Bluebook, note i supra, p. 479.

Treasury has long held that taxpayers with inventory must use the accrual method. But, when does a taxpayer have inventory such that the accrual method must be used? This issue has been exacerbated by the repeal of the installment method for accrual-method taxpayers.² Now, taxpayers desiring a tax deferral on the sale of qualifying assets will seek to use the cash method. Constituents and lobbyists have contacted Congress to overturn the installment-method repeal or ease the restrictions on use of the cash method. Rev. Proc. 2000-22³ now provides an administrative exception for small taxpayers.

What Is "Inventory"?

Sec. 471(a) provides:

Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.

Congress provided that Treasury determines when "inventory" must be recorded as such to clearly reflect income, but never defined "inventory." The ongoing dispute is whether a particular item is inventory. If inventory exists, the regulations require use of the accrual method (absent Rev. Proc. 2000-22).

Merchandise bought for resale is not inventoriable unless the sale is intended for profit.⁴ However, in Thompson Electric, Inc.,⁵ a taxpayer could not avoid recording inventory of electrical supplies on hand consumed in its provision of contracting services. In Osteopathic Medical Oncology and Hematology P.C.,⁶ the court focused on what the customer (patient) was buying. The supplies or materials on hand were provided as part of the taxpayer's provision of medical services. The supplies were not otherwise "sold" to the patients, but were administered by the medical professionals.

Even when a taxpayer has no materials on hand at the end of the day, the courts have ruled that the accrual method must be used. Acquiring ownership of sand and gravel (even if only for a few hours) was sufficient to force a taxpayer to the accrual method in Von Euw & L. J. Nunes Trucking, Inc.⁷ However, use of wet concrete, sand, drain rock, wire mesh, rebar and other materials was not inventory in RACMP Enterprises, Inc.⁸

In various cases, the courts have focused on different aspects of the inventory issue:

Whether merchandise was "marked up" (and, thus, generated a profit).
The ratio of merchandise purchased to the taxpayer's gross receipts.
What a customer/patient was buying.
Whether materials were held for sale or consumed in performing a service.

There may be other aspects to this issue; the cited cases are relatively recent. The issue is not being narrowed; it is becoming more confused.

Clear Reflection of Income

Sec. 446(b) provides an exception to the general accounting method rules. Absent Sec. 446(b), taxpayers compute taxable income under their regular accounting method used in keeping books. Sec. 446(b) provides:

If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.

Treasury initially determines the method of accounting that clearly reflects income. The ultimate authority in such matters is in a court's hands, if it determines that the IRS exceeded its authority. As long as an accounting method clearly reflects income, it may be used, even if, in the IRS's opinion, another method may more clearly reflect income.⁹

Rev. Proc. 2000-22

According to Rev. Proc. 2000-22, Section 4, pursuant to discretion under Secs. 446(b) and 471, and to simplify bookkeeping requirements for small taxpayers, the IRS, as a matter of administrative convenience, will except certain taxpayers from any requirement to account for inventories under Sec. 471 or to use an accrual method under Sec. 446. The procedure applies to a taxpayer with "average annual gross receipts" of $1 million or less who meets a conformity requirement.

Under the conformity requirement in Section 5.07, a taxpayer cannot "regularly" use any method other than the cash method to ascertain the trade's or business's income, profit or loss for purposes of its books and records and reports (including financial statements) to owners or beneficiaries or for credit purposes. The conformity requirement must be met for the current and prior three tax years (excluding tax years ending before Dec. 17, 2000). An isolated preparation of a financial statement on the accrual method will not violate the conformity requirement (e.g., a one-time issuance to obtain a bank loan).

A qualifying taxpayer that does not want to account for inventories must treat merchandise inventory in the same manner as a material or supply not incidental under Regs. Sec. 1.162-3; Sec. 263A will not apply to such merchandise inventory. Regs. Sec. 1.162-3 provides that taxpayers carrying materials and supplies on hand should include in expenses the charges for them only in the amount that they are actually consumed and used in operation during the tax year for which the return is made, provided that their costs have not been deducted in determining the net income or loss or taxable income for any previous year. If a taxpayer carries incidental materials or supplies on hand for which no record of consumption is kept or for which physical inventories at the beginning and end of the year are not taken, the taxpayer can include in his expenses and deduct from gross income the total cost of such supplies and materials as were purchased during the tax year for which the return is made (provided taxable income is clearly reflected by this method).

Practitioner Comments

Rev. Proc. 2000-22 has been criticized for a number of reasons:

1. While purporting to relieve small taxpayers from the burden of the accrual method, the procedure requires them to continue to account for merchandise inventory as materials and supplies on hand that are not incidental. Deductions are not allowed for such items until actually consumed or used in operations.

2. By imposing a conformity requirement, taxpayers are discouraged from maintaining records and reporting to certain management (owners) and advisers (banks and other lending institutions) information necessary for the proper operation of their business.

3. The procedure adds a level of complexity to the administration of the tax laws by carving out an exception for taxpayers with gross receipts of $1 million or less, separate from the requirements for taxpayers with gross receipts of $5 million or less.

The study that culminated in the issuance of Rev. Proc. 2000-22 was initiated prior to the installment-method repeal for accrual-basis taxpayers.

Taxpayer Sophistication

Rev. Proc. 2000-22 is intended to alleviate the complexity of the accrual method's bookkeeping requirements. To the extent a taxpayer demonstrates an ability to handle such requirements after Dec. 17, 2000, it does not need relief. Taxpayers that must report to their banks or owners using the accrual method do not need a reprieve from those rules.

The relief is not having to account and record in the books accounts receivable (and payable). For nontax reasons, inventories may need to be accounted for at year-end (e.g., state and local property tax reporting).

Rev. Proc. 2000-22 is a relief procedure from the requirement to maintain full accrual-basis records; it does not impose the accrual method on taxpayers not already subject to it.

Gross Receipts

Taxpayers that lack the sophistication (and need) for reporting on the accrual method may use the cash method. In comments to the AICPA Tax Division's Tax Accounting Technical Resource Panel, IRS representatives stated that the $1 million gross receipts level was the limit of the Treasury's discretionary authority under Sec. 471. By providing a threshold, Treasury removed significant numbers of taxpayers from the accrual-method issue. Treasury reviewed the legislative history regarding the accrual and cash methods and determined that the $5 million gross receipts level allows certain taxpayers to use the cash method.

Sec. 448 contains the general rule that C corporations and other taxpayers may not use the cash method. Under Sec. 448(b)(3), such taxpayers may use the cash method if their gross receipts have been $5 million or less. These rules do not, according to the legislative history, change the Treasury's authority under Sec. 446. The corporations affected (and excepted) by Sec. 448(b)(3), therefore, are those with gross receipts of $5 million or less and without inventory, or for which materials and supplies are not integral to producing income. Rev. Proc. 2000-22 grants certain taxpayers for which materials and supplies are integral to producing income an exception from the requirement that they use the accrual method.

Conclusion

The IRS issued Rev. Proc. 2000-22 to reduce the full accrual-method recordkeeping requirement for small taxpayers. "Small taxpayers" are defined as those with average annual gross receipts of $1 million or less that otherwise meet the procedure's conformity rules. Such taxpayers may use the procedure to change to the cash method; they will be relieved of the need to record and recognize income from accounts receivable, and will not deduct expenses associated with accounts payable. Taxpayers using the cash method continue to use the installment method to report qualifying sales of property.

The IRS intended Rev. Proc. 2000-22 to be a relief provision for unsophisticated taxpayers unfamiliar with the accounting requirements for accounts receivable and payable. However, such taxpayers may not have the sophistication to understand the cash-method requirements; guidance is not provided in the procedure and must be found elsewhere. Additional complexity stems from the exception for taxpayers with gross receipts of $1 million or less, separate from the statutory requirements for taxpayers with gross receipts of $5 million or less.