Cash Method Now Available to Small Businesses with Inventory

With the release of Rev. Proc. 2000-22, small businesses that would normally be required to use the accrual method of accounting for tax purposes for the purchase and sale of merchandise may now be able to use the cash method.

Generally, a taxpayer may adopt any permissible method of accounting, subject to certain restrictions, such as when a business has inventory. Regs. Sec. 1.471-1 requires a taxpayer to account for inventories when the production, purchase or sale of merchandise is an income-producing factor in the taxpayer's business. Once inventory has been determined to be an income-producing factor, Regs. Sec. 1.446-1 requires the taxpayer to account for the inventory by using the accrual method for purchases and sales of merchandise. In addition, once it has been established that inventory exists, the taxpayer may be required to include an allocable portion of indirect costs in its inventory under Sec. 263A.

In its effort to simplify bookkeeping requirements for small businesses, the IRS will allow the cash method of accounting for certain small taxpayers. This does not mean the taxpayer can expense the inventory on hand at the end of the year. If the taxpayer meets the requirements and does not want to account for inventories, it still "must treat merchandise inventory in the same manner as a material or supply that is not incidental under section 1.162-3." Under this regulation, materials and supplies can only be expensed in the year actually consumed and used in operations. Inventories, therefore, must still be accounted for as materials and supplies and recorded on the taxpayer's balance sheet. The benefits are that Sec. 263A no longer applies and, more importantly, inventory sales are not included in income until received.

To qualify for the automatic consent to change to the cash method under Rev. Proc. 2000-22 (and to continue to use the cash method), a taxpayer must meet the following requirements:

1. The average annual gross receipts for each of the three prior tax years ending after Dec. 16, 1998 must be $1 million or less. The gross receipts test is a three-year rolling average look back, and the taxpayer must meet the requirements each year. Gross receipts are defined by Temp. Regs. Sec. 1.448-1T(f)(2)(iv). Sec. 52(a) and (b), as well as Sec. 414(m) and (o), should be considered to determine if the taxpayer must aggregate gross receipts from two or more related businesses.

2. With limited exceptions, a conformity requirement applies. The taxpayer must use the cash method of accounting to ascertain the income, profit or loss of the trade or business for purposes of its books, records, financial statements and financial reports to stockholders, partners, creditors, etc., for the current and prior three tax years, excluding tax years ending before Dec. 17, 2000.

Taxpayers that wish to obtain the benefits of this procedure must follow the automatic change provisions of Rev. Proc. 99-49, including the Sec. 481 adjustment. However, Rev. Proc. 2000-22 allows taxpayers under examination, before an Appeals officer or before a Federal court, to make accounting method changes. In addition, taxpayers that have already filed, on or before July 14, 2000, their original return for the first tax year ended after Dec. 16, 1999, may file an amended tax return reflecting the accounting method change. The amended tax return must be filed no later than Nov. 13, 2000 and Form 3115, Application for Change in Accounting Method, should be filed with the National Office no later than when the taxpayer's amended tax return is filed.

This procedure is effective for tax years ending after Dec. 16, 1999. It not only applies to taxpayers that want to change from the accrual to the cash method, but also to those who want to change from the cash method without inventories to the cash method with inventories. The Service will not challenge a taxpayer's use of the cash method without inventories in an earlier year, as long as the taxpayer consistently used the cash method and meets the gross receipts and conformity tests for the earlier year in question and the three prior tax years; this same taxpayer would have to make a Sec. 481 adjustment for the cost of supplies on hand on the date of the method change. For taxpayers changing from the accrual to the cash method, the Sec. 481 adjustment would apply to accounts receivable as of the first day of the year of change.

The benefits and advantages of Rev. Proc. 2000-22 vary. A taxpayer presently using the accrual method but changing to the cash method can now ignore the requirements of Sec. 263A and defer income for billings not received before year-end. Taxpayers already using the cash method, but accounting for inventories, can breathe a sigh of relief, because the IRS has now legitimized this method. And finally, amnesty is available for those taxpayers that have inventories, but have historically used the cash method without accounting for them.

From Frank E. Brodnax, CPA, and Bernard K. Fleishman, CPA, Ellin & Tucker, Chartered, Baltimore, MD