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The Cash Method for Small Businesses Taxpayers can generally adopt any permissible accounting method, as long as it clearly reflects income. An accounting method will not do this unless taxpayers treat gross receipts and expenses consistently from year to year. Following is a brief summary of major points in a recent revision to the cash-basis rules. An area of contention between the IRS and many small businesses that provide services and also maintain small amounts of inventory, is the mandated use of the accrual method. According to Secs. 461 and 471 and the regulations, taxpayers must use this method to clearly show income when manufacture, purchase or sale of merchandise is an income-producing factor. A taxpayer with inventory may use either the overall accrual method or a hybrid method (using accrual for sales and purchases of inventory and cash for all other transactions).
Cash-Basis Rules The IRS retreated from this stance with Rev. Procs. 2000-22 and 2001-10. Taxpayers with average annual gross receipts of $1 million or less can use the cash method even if they have inventories. However, they must account for the inventories in the same manner as nonincidental materials and supplies under Regs. Sec. 1.162-3, if they deduct the cost of inventory when sold. The advantage of using the cash method under these two revenue procedures is that taxpayers need not recognize accounts receivable income until they collect the receivables. Special rules exist for determining average annual gross receipts for purposes of the gross receipts cap and for changing from the accrual to the cash method. The Service continued to ease restrictions for using the cash method by issuing Notices 2001-76 and 2002-14 and Rev. Proc. 2002-28. These pronouncements allow more small businesses to use the cash method, provided they: 1. Have annual average gross receipts greater than $1 million, but less than $10 million (average of prior three years); 2. Are engaged in an eligible principal business activity; and 3. Do not fall under Sec. 448 restrictions. The definition of "qualifying small businesses" excludes entities with certain activities defined by North American Industry Classification System (NAICS) codes:
The NAICS codes replaced the Standard Industrial Classification codes and are to be used on a taxpayer’s Federal income tax return. Even if the principal business activity is described in one of the ineligible codes, the taxpayer can use the cash method under two additional circumstances:
Even if the principal business activity is described in one of the ineligible codes, the taxpayer could use the cash method for any separate and distinct qualifying trade or business, as long as it maintains a complete and separate set of books and records. All farming activities and tax shelters are precluded from using the cash method, as are (1) C corporations (other than qualified personal service corporations) with average annual gross receipts over $5 million and (2) partnerships with a C partner with average annual gross receipts over $5 million. In calculating gross receipts, a taxpayer must look at sales, receipts from services, interest, dividends and rents. The gross-receipts test is an average of the three tax years immediately preceding the year for which the accounting-method change is implemented. The calculation must be made annually. If at any point after the change, average annual gross receipts exceed $10 million or $5 million for C corporations, the cash method is no longer allowed and the entity must use another reporting method. In spite of Rev. Proc. 2002-28’s favorable provisions, the cash method allowed is really a hybrid method. Inventories are not treated on a cash-method basis; rather, they are accounted for under Sec. 471 or treated as nonincidental materials and supplies under Regs. Sec. 1.162-3. For Rev. Proc. 2002-28 purposes, taxpayers are not required to apply Sec. 263A to inventoriable items treated as nonincidental materials and supplies, which are deductible in the later of the year the taxpayer (1) provides the items to a customer or (2) actually pays for the goods. The allowable deduction for nonincidental materials and supplies can be determined based on a specific identification method (such as FIFO or average cost). The LIFO method cannot be used for nonincidental materials and supplies. The IRS will grant automatic consent to an accounting-method change, as long as the taxpayer files Form 3115, Application for Change in Accounting Method, with its return. The taxpayer must make a Sec. 481(a) adjustment in the change year. If the change created an increase in income, the Service allows the income to be spread over a four-year period; a loss, however, must be taken immediately. Rev. Proc. 2000-22 included a book-tax conformity standard. Rev. Procs. 2001-10 and 2002-28 removed it and allow the overall book-tax accounting method to be different, as long as there are adequate books and records and the book method can be reconciled to the tax method.
Conclusion For small businesses primarily en-gaged in manufacturing, wholesale or retail, the new rules may not be of much benefit, unless the taxpayer maintains separate books and records for any service activities. Rev. Proc. 2002-28 will probably apply to and benefit taxpayers in a service industry, even if they have some manufacturing or retail activities. As long as the service business is the activity that accounts for the largest percentage of gross receipts, the cash method should be available. While the new rules may be somewhat restrictive, they can be very beneficial to eligible small business taxpayers and should not be overlooked. (For more information, see AICPA Tax Division’s Tax Accounting Technical Resource Panel, "Use of Cash Method by Small Businesses," TTA, August 2002, p. 522.) From Bernard F. Fleishman, CPA, and Mark M. Flanigan, J.D., MS, CPA, Ellin & Tucker, Chartered, Baltimore, MD |
