ith the release of revenue procedure 2000-22, the IRS provided small businesses with much needed guidance on choosing or changing their accounting methods for tax purposes. This article summarizes the rules that apply when businesses must pick an accounting method and examines some of the other factors that influence their decision.
THE SALES TEST
Revenue procedure 2000-22 allows any company that meets a sales test to use the cash method of accounting for tax purposes. This includes sole proprietors, partnerships, S corporations and regular corporations. If a taxpayer meets the sales test, it no longer matters whether it is selling merchandise that is a “material income-producing factor” (discussed below).
To compute the sales test, a company averages revenue from the last three years. If the average is less than the $1 million threshold, the cash method is always allowed (but not required). For purposes of this test gross receipts include most normal items, such as sales revenue, services, interest, dividends, rents, royalties and the like, but not sales tax the taxpayer collects.
Companies that are part of controlled groups must combine receipts for all entities included in the group to determine if they meet the $1 million test. Short years require an annualization adjustment. For taxpayers in business less than three years, the average is computed using revenue from only the years in existence.
The revenue procedure originally had included one other requirement: the conformity rule. Except in isolated circumstances, such as on a one-time basis to obtain a bank loan, the taxpayer was required to use the cash method of accounting for financial statements prepared for any party—management, investors or creditors—and for any year ending after December 16, 2000. This requirement would have undoubtedly caused problems when an accountant prepared accrual-basis financial statements for a small business client. The IRS remedied the problem early this year in revenue procedure 2001-10, which removed the conformity requirement but reemphasized the need for adequate books and records—as required by IRC section 446—and reminded companies to maintain a reconciliation between book and tax income.
Revenue procedure 2000-22 does not apply to companies that fail the $1 million average revenue test. For these entities, determining whether to use the cash or the accrual method is based on two issues: the material income-producing factor test and the type of entity. Generally companies that sell merchandise must use the accrual method for purchases and sales. This rule is more properly known, under Treasury regulations section 1.446-1, as the material income-producing factor rule.
In the past, the IRS used this rule to force taxpayers to change to the accrual method, arguing the cash method did not clearly reflect income. In early 2000, the IRS lost a key court case ( Osteopathic Medical Oncology and Hematology, 113 TC No. 16). The courts held that the material income-producing factor test would not apply when
Material was inseparable from the services.
Sale or use of the material was subordinate to providing the services.
Although the IRS acquiesced in result only, this case forms the basis for arguments that entities such as medical specialists, architects or contractors may present to support their use of the cash method in similar situations when they have more than $1 million in annual sales.
Additional court cases and informal IRS statements seem to indicate that, when the cost of purchases is 8% or less of total receipts, the cash method would be allowed in certain entities. For purposes of this article, an entity that meets either the requirements in Osteopathic Medical or the 8% test will be called a service business and will be considered to meet the requirements to use the cash method, except as discussed below.
The second issue companies must consider is their type of entity. C corporations (other than farms) must use the accrual method if they have average annual gross receipts for the previous three tax years of more than $5 million [IRC section 448(b)(3)]. The accrual method is also required for tax shelters [IRC section 448(a)(3)], and for general partnerships failing the $5 million test that have a C corporation as a partner (section 448(a)(2)).
Other than for farmers and the unusual tax shelter and corporate partner exceptions discussed above, the rules in revenue procedure 2000-22 can be summarized as follows:
For sole proprietors, S corporations, limited liability companies and partnerships:
The cash method is always allowed if the entity meets the $1 million average revenue test.
The entity test does not apply.
The cash method is allowed if the company has more than $1 million in sales and meets the service business test.
The accrual method is required if the entity fails both the $1 million average revenue and the material income-producing factor tests.
For C corporations:
The cash method is allowed if the company is a qualified personal service corporation.
The cash method is always allowed if the corporation meets the $1 million average revenue test.
The cash method is allowed if average sales are over $1 million but less than $5 million and the company meets the service business test.
The accrual method is required if the entity fails both the $1 million and the material income-producing factor tests.
The accrual method is required if the company has more than $5 million in average sales.
The exhibit below includes a flow chart to help small businesses select the proper accounting method.
A GOOD BEGINNING
Revenue procedure 2000-22 and the subsequent revenue procedure 2001-10 will not solve the cash or accrual questions that have plagued CPAs for the last 25 years. They are, however, a needed first effort at easing the recordkeeping and compliance burdens of small businesses. Small business groups, as well as many members of Congress, continue to push for a further relaxation of the sales test so that it will affect only companies with sales between $2.5 million and $5 million annually. With the election of a Republican administration bent on tax changes, the likelihood of future increases in the sales threshold seems greater.