Ability to Use Cash Method Expanded

Generally, a taxpayer can choose its accounting method, as long as the method clearly reflects income. However, the IRS often prohibits taxpayers from using the cash method of accounting under Regs. Sec. 1.446-1(c)(2)(i), which requires taxpayers with inventories to use the accrual method of accounting (absent the Service’s approval).

Sec. 471 mandates the use of inventories whenever necessary to clearly determine a taxpayer’s income. Regs. Sec. 1.471-1 requires that taxpayers must use inventories whenever the production, purchase or sale of merchandise is an income-producing factor. Under these rules, the IRS requires most taxpayers that engage in the sale of tangible property to use the accrual method.

In recent months, the Service has expanded a taxpayer’s ability to use the cash method. Sec. 471 has been challenged in a string of Tax Court cases dealing with service providers that sell tangible property as part of their services; see Galeridge Construction, Inc., TC Memo 1997-240, Osteopathic Medical Oncology and Hematology, PC, 113 TC 376 (1999), and RACMP Enterprises, Inc., 114 TC No. 16. In addition, the IRS issued Rev. Proc. 2000-22, which allows small taxpayers to use the cash method.

The Service issued Rev. Proc. 2000-22 under the discretion given under Secs. 446(b) and 471 to except small taxpayers from using inventories and to allow them to use the cash method. The procedure provides numerous benefits to taxpayers whose average gross receipts fall under $1 million. The use of the cash method allows taxpayers to control the recognition of taxable income, through management of the timing of receipts and disbursements. It also allows relief from the prohibition against using the installment sale rules for accrual-basis taxpayers. Further, exempting taxpayers from keeping inventories under Sec. 471 allows taxpayers that would otherwise capitalize certain expenses into inventory under Sec. 263A to avoid this requirement.

While Rev. Proc. 2000-22 expressly exempts taxpayers from keeping inventories under Sec. 471, they must still track inventory purchases. A qualified 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. Therefore, taxpayers can only expense purchases in the year consumed (i.e., the year the taxpayer either sells or uses the inventory).

To qualify under the procedure, taxpayers must have average annual gross receipts of less than $1 million for the preceding three tax years. Special rules exist for short years, and for companies in existence for less than three years. The aggregation rules of Sec. 52(a) and (b) and Sec. 414(m) and (o) apply, requiring related taxpayers to combine their receipts in most cases for purposes of determining the gross-receipts limit. Rev. Proc. 2000-22 also requires taxpayers to conform to the cash method for financial accounting purposes, if they intend to use the method for tax purposes. (The Service may except certain special-use reports from this requirement.)

A taxpayer that falls within these parameters may change its method of accounting to the cash method by following the automatic change procedures set forth in Rev. Proc. 99-49, with certain modifications. For example, contrary to most automatic changes the IRS allows, under Rev. Proc. 99-49, a taxpayer can make an automatic change under Rev. Proc. 2000-22 if it is under audit, in appeals or in court, as long as the taxpayer meets certain disclosure requirements. In addition, taxpayers can still make the change for their first tax year ending after Dec. 16, 1999, if they filed original returns before July 15, 2000, as long as they complete Form 3115, Application for Change in Accounting Method, in duplicate and attach the original to an amended return filed before Nov. 14, 2000. The taxpayer must send the duplicate Form 3115 to the IRS National Office no later than the return’s due date.

If taxpayers choose not to account for inventories under Sec. 471, they must include the changes relating to it (along with related changes for Sec. 263A) on the same Form 3115 as the accrual-to-cash change. Rev. Proc. 99-49 requires taxpayers to account for a Sec. 481(a) adjustment (which results from the changes) generally over four years. If the adjustment is less than $25,000, the taxpayer can account for it in one year.

Rev. Proc. 2000-22 is effective for tax years ending after Dec, 16, 1999. However, the Service will not challenge taxpayers who used the cash method in earlier years, as long as they met the criteria in Rev. Proc. 2000-22 for the years in question.

Many professional organizations and members of Congress have protested that the $1 million gross-receipts limit is too low to provide meaningful relief, asking instead for a $5 million limit. This, along with the arguments that continue on the availability of installment treatment to accrual-basis taxpayers and the definition of merchandise inventory, will continue to be fought for medium and large taxpayers in the coming months. However, Rev. Proc. 2000-22 provides welcome relief to small businesses that have been hurt by these controversies.

From Louis J. Miller, CPA, South Bend, IN