TAX BRIEF

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.

TAX BRIEF

President Bush signed HR 2884, Victims of Terrorism Tax Relief Act of 2001, into law on January 23, 2002. The act provides tax relief for victims of the September 11 terrorist attacks, the Oklahoma City bombing and the anthrax letters by excluding from taxable income certain death benefits, payments from charitable organizations, forgiveness of debt and qualified disaster relief payments these victims receive.

The act defines “specified terrorist victim” as “any decedent…who dies as a result of wounds or injury as a result of terrorist attacks against the United States on April 19, 1995, or September 11, 2001, or…who dies as a result of illness incurred as a result of an attack involving anthrax occurring on or after September 11, 2001, and before January 1, 2002.” The act notes that no individual the U.S. attorney general identifies as having been either a participant or conspirator in terrorist attacks or a representative of such a person would be considered a terrorist victim.

Section 101 of the act exempts such victims from income tax for the year of death and for the prior year. The minimum benefit for each eligible individual is $10,000. The exclusion, however, does not apply to deferred compensation that would have been payable after death had the taxpayer not been a terrorist victim or to amounts payable in the taxable year that would not have been payable but for an action taken after September 11, 2001. For purposes of this exemption, victims or their families are permitted to file amended returns for a minimum of one year after the president signs the bill. This provision will allow survivors of Oklahoma City bombing victims to file for tax relief even though the normal statutory period for amended returns has passed.

The receipt of employer-provided death benefits normally is a taxable event; however, section 102 of the act excludes certain death benefits from income. It says gross income will not include amounts an employer pays by reason of the death of an employee who is specified as a terrorist victim.

Section 103 sets special lower estate tax rates both for victims of included terrorist acts and for combat-zone-related deaths of members of the armed forces. The rates range from 1% on the first $50,000 by which the taxable estate exceeds $100,000 to a marginal rate of 20% of the excess of the estate over $10,100,000. This is a substantial reduction in the unified transfer tax rates applicable for 2001 which range from 18% on the first $10,000 by which a taxable estate exceeds $10,000 to a marginal rate of 55% on estates over $3,000,000.

Under section 104, payments a 501(c)(3) charitable organization makes due to the injury, death, wounding or illness of September 11 attack victims will also be tax-exempt. This applies to payments made on or after September 11, 2001. The exemption extends to victims of anthrax attacks occurring on or after September 11, 2001, and before January 1, 2002. To qualify, payments must be made in good faith using a reasonable and objective formula that is consistently applied. Payments by a private foundation are also excludable.

Normally, the forgiveness of debt by a creditor would be a taxable transaction. However, section 105 of the act excludes from gross income debt forgiveness by reason of the death of an individual as a result of the September 11 terrorist attacks or as a result of illness due to the anthrax attacks. Only debt discharges on or after September 11, 2001, and before January 1, 2002, qualify for the exemption.

Observation. This legislation provides substantial tax relief for terrorist victims. CPAs should be aware of these provisions to ensure that any client who qualifies for this relief receives the full benefit of the act. Although tax years 1994 and 1995 are closed, this legislation reopens those years for survivors of Oklahoma City bombing victims.

—Rebecca Carr, CPA, instructor in accounting, and Tina Quinn, CPA, PhD, associate professor of accounting, Arkansas State University.

TAX BRIEF

M ost accountants today can’t overlook state tax issues. Clients who once did business in only one state now often have business connections in many. This can make keeping up with state tax law changes difficult. But thanks to the Internet, it’s easier for CPAs to stay current. Many states now offer tax newsletters that can be e-mailed when available, and others post the newsletters on their Web sites.

A listing of all 50 states and the District of Columbia tells where to find each newsletter. (See below.)

—Jay A. Scheidlinger CPA, JD, an associate with M.R. Weiser & Co., LLP, Lake Success, New York.

TAX CASE

As a general rule, taxpayers are required to follow—and the courts will enforce—published announcements, including revenue rulings, by the Treasury Department and the IRS. Recently, the Court of Federal Claims addressed the question of when revenue rulings are not enforceable.

Computer Sciences Corp. (CSC) maintained a 401(k) plan for its employees. Based on the generally accepted interpretation of revenue ruling 76-28, the company deducted contributions it made after yearend on its extended tax returns.

On June 11, 1990, CSC requested and received an extension until December 17, 1989, to file its 1989 tax return. On December 7 the IRS issued revenue ruling 90-105, which changed the deductibility of 401(k) contributions made after yearend. In addition, the ruling required taxpayers that had followed the now incorrect interpretation of revenue ruling 76-28 to change their accounting method to follow revenue ruling 90-10. By its terms, this ruling did not apply to taxpayers that had filed returns and deducted contributions before December 7, 1990.

CSC filed its tax return on December 17 and complied with the new revenue ruling. It then decided the ruling should not apply to its 1989 tax return and filed a refund claim. The IRS dismissed the claim and CSC sued for a refund, requesting partial summary judgment.

Result. For the taxpayer. The Court of Federal Claims said the taxpayer conceded revenue ruling 90-105 was a correct interpretation of the law. CSC’s challenge was to how the government chose to implement that ruling (lack of retroactivity and mandatory accounting- method change.)

IRC section 7805 authorizes the IRS to issue all necessary rules to enforce the code. The IRS also has the right to change its position. The fact that CSC relied on the prior interpretation to its detriment is irrelevant. The IRS has the power to make a change retroactive. (The Taxpayers Bill of Rights limits the IRS’s right to modify regulations retroactively for provisions enacted after July 30, 1996. However, the legislation does not apply to this case nor does it apply to revenue rulings.)

The right to change rules retroactively is not unlimited. The modification must be rational and not an abuse of discretion. A change may be an abuse of discretion if it results in similar taxpayers being taxed differently. Alternatively, failure to make a change retroactive could be an abuse if the result of that failure is different tax treatments for similarly situated taxpayers.

The court concluded that applying revenue ruling 90-105 only to taxpayers who had not filed by December 7 resulted in similar taxpayers’ being treated differently. The decision not to make the ruling retroactive was an abuse of discretion because the IRS presented no rational basis for the different treatment received by similar taxpayers (those who filed before and after December 7). The fact the taxpayers are in different industries does not make them dissimilar. Similarity is based on eligibility for the challenged deduction.

The court also ruled that CSC’s filing of its original return based on the new rule did not prevent it from successfully arguing the IRS had abused its discretion. Likewise, the court ignored the company’s change in accounting methods since the new revenue ruling had mandated it. CSC was entitled to follow the old rule for one more year.

When clients are confronted with new rules or with changes in existing rules, CPAs should help them determine whether applying these rules will result in similar taxpayers’ having different tax outcomes and whether that difference is an abuse of discretion.

Computer Sciences Corp. v. United States, 2001-2 USTC 50,635.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.