F or many years, the IRS clashed over the cash method of accounting with small business taxpayers who provided services as the mainstay of their business but who were categorized as inventory resellers by the IRS because they provided some type of merchandise in addition to the services.
Treasury regulations section 1.446-1(c)(2)(i) says a taxpayer must use the accrual method for purchases and sales if he or she is required to account for inventories under IRC section 471. Section 1.471-1 says any time the production, purchase or sale of merchandise is an income-producing factor in a taxpayer’s business, the taxpayer must consider the merchandise inventory.
For example, the IRS historically has taken the position that a plumber who provides parts in connection with his or her service of repairs is not eligible for the cash method of accounting because those parts constitute an income-producing factor and, therefore, should be treated as inventory. As a result, the taxpayer must use the accrual method of accounting.
In the past few years, however, both the courts and the IRS have departed somewhat from this strict view. Revenue procedure 2001-10 allowed certain accrual-basis taxpayers to convert to the cash basis as long as their average annual gross receipts for the prior three years was no more than $1 million.
More recently, in notice 2001-76 (as clarified by notice 2002-14), the IRS released one of the most significant pro-taxpayer pronouncements on this topic to date. The proposed revenue procedure allows certain taxpayers with annual average gross receipts (over the three prior taxable years) of not more than $10 million to convert to the cash accounting method. This widens the pool of eligible taxpayers who otherwise have not met the $1 million gross-receipts limitation in revenue procedure 2001-10.
Taxpayers eligible for relief under this notice first must determine that their principal business activity does not fall into the following North American Industry Classification System (NAICS) codes:
Mining activities, as described in NAICS codes 211 and 212
Manufacturing, codes 31–33
Wholesale trade, code 42
Retail trade, codes 44–45
Information industries, codes 5111 and 5122.
Also, taxpayers in the trade or business of farming are excluded from using this notice. (An abbreviated list of NAICS codes can be found online in the IRS instructions for business income tax returns at www.census.gov .
If, within the same business, a taxpayer conducts separate activities that have different NAICS codes, it is necessary to establish which NAICS code describes the principal activity of the taxpayer; this determines whether the business is eligible to use the cash method. Furthermore, if an otherwise qualifying activity is not the taxpayer’s principal activity, taxable income and loss for such activity may qualify for relief if separate books and records are maintained for it.
For example, if a taxpayer’s principal business activity is the retail sale of bathroom fixtures—which falls under one of the ineligible NAICS codes listed above—and a smaller segment is plumbing repairs, he or she cannot use notice 2001-76 to convert the business’s overall method of accounting to cash. However, to the extent that the taxpayer maintains separate books and records for the plumbing repair activity, that activity is eligible for a change in accounting method.
For the year in which they would like to change methods, taxpayers should look to the average annual gross receipts for the three prior taxable years. For example, a proposed change for 2001 for a calendar-year taxpayer will be based on the average annual gross receipts of 1998, 1999 and 2000. Specific rules apply for short tax years and taxpayers that were not in existence the prior three years. In addition, aggregation rules, which focus on whether business entities or parties are related as defined under IRC sections 51(a) and (b) and 414(m) and (o), also apply. These rules determine if gross receipts from multiple entities should be combined for purposes of computing the $10 million limitation.
Taxpayers who are eligible under these new rules and who maintain inventories can deduct only the cost of the inventory actually consumed or sold during the year under the rules that govern materials and supplies not incidental to the service provided. (See regulations section 1.162-3.)
Qualifying taxpayers will file form 3115 in keeping with the automatic-change-in-accounting-method provisions of revenue procedure 2002-9. Note that to the extent that the provisions of regulations section 1.162-3 apply, taxpayers may have to request an automatic change to this method in addition to the request to change to the cash method. The IRC section 481 adjustment for the accounting method change is recognized over the period specified under revenue procedure 2002-9—four years for most taxpayers.
Notice 2001-76 is effective for taxable years ending on or after December 31, 2001. Furthermore, the IRS indicates in the notice it will not challenge a taxpayer’s use of the cash method for earlier years if that taxpayer would have qualified for relief under this notice.
Observation. CPAs should advise their small business clients that, regardless of these new rules, the requirements of IRC section 448 still apply. Most notably, section 448 states that certain C corporations are subject to a $5 million gross receipts ceiling in order to use the cash method of accounting. As mentioned above, this IRS notice is a release of a proposed revenue procedure as well as an invitation to comment. It is possible that the revenue procedure, when final, could modify some of the provisions of this notice—stay tuned.
—Vinay S. Navani, CPA, a tax manager with Wilkin & Guttenplan, PC, East Brunswick, New Jersey.