- Methods of Accounting.
- In General.
- An S corporation is generally not restricted to a particular method of accounting unless inventory is a material income producing factor. Section 448 which mandates the use of the accrual method for certain entities does not apply to an S corporation.
- Small Taxpayer Exception to Accrual Method.
- Under Rev. Proc. 2001-10 which modifies Rev. Proc. 2000-22, taxpayers with average annual gross receipts of $1 million or less will no longer have to account for inventories or use the accrual method of accounting for purchases and sales or merchandise. Taxpayers are not required to use the cash method for book purposes. Qualifying taxpayers may get automatic consent to change to the cash method.
- Accrual-Method Requirement - Taxpayers generally must keep inventories when the production, purchase, or sale of merchandise is an income-producing factor in the taxpayer's business (§ 471; Reg. § 1.471-1). Those who are required to account for inventories must use an accrual method of accounting for merchandise purchases and sales, unless otherwise authorized by IRS (Reg. § 1.446-1(c)(2)).
- New Small-Taxpayer Exception - In Rev. Proc. 2001-10, IRS excepts taxpayers with average annual gross receipts of $1 million or less from both the accrual method and from the uniform capitalization rules of § 263A. A taxpayer may use a non-cash method for books, records, and reports (including financial reporting) or use an accrual method of accounting.
- Rev. Proc. 2001-10 says that taxpayers that qualify for the exception and do not want to use inventories must treat merchandise inventory in the same way that cash method taxpayers are required to treat material or supplies that are not incidental under Reg. § 1.162-3. Under Reg. § 1.162-3, materials and supplies that are not incidental are deductible only in the year in which they are actually consumed and used in the taxpayer's business. For purposes of Rev. Proc. 2001-10, inventoriable items that are treated as materials and supplies that are not incidental are consumed and used in the year in which the taxpayer sells the merchandise or finished goods. Thus, under the cash method, the cost of such inventoriable items are deductible only in that year, or in the year in which the taxpayer actually pays for the inventoriable items, whichever is later. Producers may use any reasonable method of estimating the amount of raw materials in their year-end work-in-process and finished goods inventory to determine the amount of raw materials that were used to produce finished goods that are sold during the tax year, provided that method is used consistently.
- Thus taxpayers using the cash method under Rev. Proc. 2001-10 may not deduct merchandise costs until the year in which the merchandise is consumed, used, or sold. The new procedure does not say whether this deduction must be taken on a FIFO basis, or whether methods such as LIFO may be used.
- Apart from somewhat simplified bookkeeping, the main advantage of IRS's liberalized allowance of the cash method is deferral of income until payment is received instead of taking income into account when billed.
- A taxpayer has average annual gross receipts of $1 million or less if, for each prior tax year ending after December 16, 1998, the taxpayer's (or predecessor's) average annual gross receipts for the 3-tax-year period ending with the applicable prior tax year does not exceed $1 million. Gross receipts for this purpose are defined in Reg. § 1.448-1T(f)(2)(iv), and include all receipts derived from all of the taxpayer's trades or businesses that must be recognized under the method of accounting that the taxpayer actually used for that tax year for federal income tax purposes. For example, gross receipts include total sales (net of returns and allowances), all amounts received from services, interest, dividends, and rents. However, gross receipts do not include sales tax or other similar state and local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority.
- Gross receipts is defined in the same way for this purpose as it is for the $5 million gross receipts exception to the limitation on the use of the cash method that applies under § 448 to C corporations, partnerships with a C corporation shareholder, and tax shelters, even if they are not required to keep inventories.
Example 12: A calendar year manufacturer sells widgets and uses an overall accrual method of accounting for tax purposes. Taxpayer uses inventory accounts and capitalizes direct and indirect costs. Taxpayer has gross receipts of $200,000 in 1996, $800,000 in 1997 and $1,100,000 in 1998.
Taxpayer computes its average annual gross receipts for each prior tax year ending on or after December 17, 1998, that is, its 1998 tax year. Taxpayer's average annual gross receipts for 1998 is $700,000 ($2,100,000/3). Since taxpayer's average annual gross receipts for each prior tax year ending after December 17, 1998, does not exceed $1 million, Taxpayer qualifies for the small taxpayer exception for its 1999 tax year, and may change to the cash method for the tax year ending December 31, 1999.
To qualify for the exception for its 2000 tax year, Taxpayer's average annual gross receipts for 1999 (that is, the average of its gross receipts for 1999, 1998, and 1997) also must be $1 million or less, and it must meet the conformity requirement, i.e. not use a non-cash method for book purposes.
- A taxpayer in existence for less than three tax years determines average annual gross receipts for the number of years (including short tax years) of its existence. Gross income for short tax years must be annualized.
- Gross receipts must be aggregated for all taxpayers treated as a single employer under § 52(a) (aggregation of controlled group employees), § 52(b) (aggregation of employees of partnerships and proprietorships under common control), and for employee benefit purposes under § 414(m) or § 414(o).
- Changing Accounting Method - A taxpayer that qualifies under Rev. Proc. 2001-10 and wants to change to the cash method must follow the automatic change in accounting method provisions of Rev. Proc. 2002-9 (or its successor) with some modifications, including the fact that taxpayers in audit, appeals, or before a court are not restricted in their use of the automatic change procedure.
- There is no user fee for automatic consent accounting method change requests under Rev. Proc. 2002-9.
- A qualifying taxpayer that wants to change to the cash method also must make any necessary change from its inventory method, and, if applicable, its method of capitalizing costs under § 263A to treat merchandise in the manner that non-incidental supplies must be treated under Reg. § 1.l62-3. Taxpayers may file a single Form 3115 to change both from the accrual method and from accounting for inventories.
- The § 481(a) adjustment period to prevent amounts from being duplicated or omitted as a result of an accounting method change under Rev. Proc. 99-49 generally is four tax years beginning with the year of change. However, a taxpayer may elect to take the adjustment into account in one year if it is less than $25,000 (either positive or negative).
- Taxpayers using LIFO inventory valuation methods may have to make § 481(a) adjustments to prevent income omissions as a result of a change to the cash method.
- Future Changes - Taxpayers who change to the cash method under the new procedure and later exceed the $1 million gross-receipts test must change to an inventory method and an accrual method using either the automatic change method of Rev. Proc. 2002-9, if applicable, or the advance consent provisions of Rev. Proc. 97-27 (or its successor).
- Growing businesses that qualify currently but are likely to exceed the gross-receipts threshold in the near future may want to remain on the accrual method to avoid having to change accounting methods twice.
- Retroactive Relief - Although the new procedure is effective for tax years ending after December 16, 1999, IRS will not challenge a taxpayer's use of the cash method (and failure to account for inventories) in an earlier year if the taxpayer consistently used the cash method (and consistently did not account for inventories) and would satisfy the three-tax-year-period gross receipts test (applied by testing the three-tax-year period ending immediately before that earlier year), and the requirement not to use a non-cash method regularly for book and reporting purposes (applied by testing the earlier year and the three tax years immediately before that year).
- Contractor Exception to Accrual Method.
- The IRS has issued Rev. Proc. 2002-28 that allows qualifying small business taxpayers (mostly contractors) with average annual gross receipts of more than $1 million but less than or equal to $10 million to use the cash method of accounting for eligible trades or businesses. The rules will benefit service businesses that also sell related products, such as a plumber who sells plumbing supplies, but will be of little help to others, such as manufacturers, wholesalers, and retailers, who are excluded from the new rules unless they are principally a service business or perform certain kinds of custom manufacturing. Rev. Proc. 2002-28 is effective for tax years ending on or after December 31, 2001.
- Rev. Proc. 2002-28 applies to any qualifying small business taxpayer. A qualifying small business taxpayer is any eligible taxpayer with average annual gross receipts of more than $1 million but less than or equal to $10 million who is not otherwise prohibited from using the cash method. Average annual gross receipts is a function of the average of the three years prior to the applicable taxable year, including any annualized short taxable years and the taxable years of any predecessor to the taxpayer. The proposed revenue procedure does not apply to a farming business. However, if a qualifying small business taxpayer is engaged in the trade or business of farming the revenue procedure may apply to the taxpayer's non-farming trades or businesses. Taxpayers engaged in the trade or business of farming generally are allowed to use the cash method for any farming business, unless the taxpayer is required to use an accrual method under § 447 (i.e., the taxpayer is a corporation or a partnership with a corporate partner) or is prohibited from using the cash method under § 448 (e.g., because it is a tax shelter).
- Taxpayers with average annual gross receipts of less than $1 million are generally allowed to use the cash method of accounting under Rev. Proc. 2001-10.
- The new rules apply to a qualifying small business taxpayer that reasonably determines that its principal business activity (i.e., the activity from which the taxpayer derived the largest percentage of its gross receipts) for its prior taxable year is described in North American Industry Classification System (NAICS) code other than an ineligible code. The ineligible NAICS codes are: (a) mining activities within the meaning of NAICS codes 211 and 212; (2) manufacturing within the meaning of NAICS codes 31-33; (3) wholesale trade within the meaning of NAICS code 42; (4) retail trade within the meaning of NAICS codes 44-45; and, (5) information industries within the meaning of NAICS codes 5111 and 5122.
- Information regarding the NAICS codes, can be found at www.census.gov. Select "Subjects A to Z," followed by "N," and then select "NAICS (North America)." Taxpayers also may find a partial list of NAICS codes, described as "Principal Business Activity Codes," in the instructions to their tax return forms.
- Rev. Proc. 2002-28 also applies to a qualifying taxpayer where the principal business of the taxpayer is the provision of services. This includes providing property incident to those services. Thus, for example, a publisher whose principal business activity is the sale of advertising space in its publications is eligible to use the cash method as described in Rev. Proc. 2002-28, notwithstanding that the taxpayer's principal business activity is described in an ineligible NAICS code.
- A qualifying small business taxpayer must use the cash method as described in Rev. Proc. 2002-28 for all of its trades or businesses if its principal business activity is the fabrication or modification of tangible personal property on demand in accordance with customer design or specifications.
- Notwithstanding the taxpayer's principal business activity, a qualifying small business taxpayer may use the cash method with respect to any separate and distinct trade or business whose principal business activity is not described in an ineligible NAICS code.
- Rev. Proc. 2002-28 provides that, notwithstanding § 1001, qualifying taxpayers that want to use the cash method for an eligible trade or business must include amounts in income attributable to open accounts receivable (i.e., receivables due in 120 days or less) as amounts are actually or constructively received. Qualifying small business taxpayers who are permitted to use the cash method for an eligible trade or business under Rev. Proc. 2002-28 and who do not want to account for inventories under § 471 must treat all inventoriable items (e.g., items purchased for resale to customers and raw materials purchased for use in producing finished goods) in their trade or business in the same manner as materials and supplies that are not incidental under Reg. § 1.162-3. Under Reg. § 1.162-3, materials and supplies that are not incidental are deductible only in the year in which they are actually consumed and used in the taxpayer's business.
- For purposes of Rev. Proc. 2002-28, inventoriable items that are treated as materials and supplies that are not incidental are consumed and used in the year the qualifying small business taxpayer sells the items to a customer. Thus, the cost of such inventoriable items are deductible only in that year, or in the year in which the taxpayer actually pays for the goods, whichever is later. Items that would be accounted for as incidental materials and supplies for purposes of Reg. § 1.162-3 may still be accounted for in that manner. Whether an item is purchased for resale (and thus, must be accounted for as a non-incidental material and supply) or is purchased to provide to customers incident to services (and thus, may be accounted for as either an incidental or a nonincidental material and supply depending on the facts and circumstances) must be determined under general tax principles.
Example 13: John is a roofing contractor and a qualifying small business taxpayer eligible to use the cash method under Rev. Proc. 2002-28. John, a calendar year taxpayer, chooses to use the cash method described in Rev. Proc. 2002-28 and to not account for inventories. John enters into a contract with a homeowner in December 2001 to replace the homeowner's roof. John purchases roofing shingles from a local supplier and has them delivered to the homeowner's residence. He pays the supplier $5,000 for the shingles on their delivery later that month. John replaces the homeowner's roof in December 2001, and gives the homeowner a bill for $15,000 at that time. He receives a check from the homeowner in January 2002. John deducts the $5,000 cost of the shingles on his 2001 federal income tax return and includes the $15,000 in income in 2002 when he receives the check from the homeowner.
Example 14: The same facts as Example 13, except that John does not replace the roof until January 2002 and is not paid until March 2002. Because the shingles are not used until 2002 their cost can only be deducted on John's 2002 federal income tax return notwithstanding that John paid for the shingles in 2001. Thus, on his 2002 return, John must report $15,000 of income and $5,000 of deductions.
- Automatic Permission to Change to Cash Method.
- As set forth above, Rev. Proc. 2002-28 allows certain small businesses with average annual gross receipts of $10 million or less to use the cash method of accounting and to treat inventoriable items as non-incidental materials and supplies with respect to eligible trades or businesses.
- Pursuant to the IRS's discretion under § 446(e), Rev. Proc. 2002-28 provides that any qualifying small business taxpayer may change to these methods of accounting with respect to its eligible trades or businesses for any taxable year ending on or after December 31, 2001.