Under IRC section 446, taxpayers generally can choose any method of accounting to compute taxable income as long as that method clearly reflects income. However, many small business taxpayers who wish to use the cash method are prevented from doing so because of Treasury regulations section 1.446-1(c)(2)(i), which states 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. Regulations section 1.471-1 states that 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. Numerous cases hold the sale of merchandise is an income-producing factor, and therefore, the accrual method of accounting is required even when the taxpayer does not keep inventories in the usual sense. In Thompson Electric (TC Memo 1995-292), for example, an electrical contractor was required to maintain inventories because he regularly kept on hand certain electrical parts used in his work.
Other taxpayers—otherwise eligible to use the cash method—may have elected to use the accrual method in a previous period and may want to change their overall accounting methods to the cash method.
For both types of taxpayers, revenue procedure 2000-22 may help. In it, the IRS outlines circumstances under which it will give certain small business taxpayers automatic consent to change their method of accounting from the accrual basis to cash. To be eligible for this, a taxpayer’s average annual gross receipts for the three years preceding the year of change must be no more than $1 million.
Qualifying taxpayers will file form 3115 according to the automatic-change-in-accounting-method provisions of revenue procedure 99-49. The IRC section 481 adjustment for the accounting method change is recognized over the period specified under revenue procedure 99-49—four years for most taxpayers.
Other important aspects of revenue procedure 2000-22 are as follows:
Even though the benefits of the revenue procedure are available to taxpayers that maintain inventories, they can deduct only the cost of materials and supplies actually consumed or sold during the year. See regulations section 1.162-3.
Related party aggregation rules apply for purposes of determining gross receipts.
A taxpayer that has not been in existence for three years must determine its average annual gross receipts over the number of years it has been in existence. Short years are prorated.
A conformity rule prevents a taxpayer, who regularly uses some other accounting method to determine income to owners and others for purposes of its books and financial statements, from using this revenue procedure to switch to the cash method.. However, a one-time use of another method, to obtain a loan for example, does not violate this rule.
Taxpayers covered under revenue procedure 2000-22 are also exempted from the uniform capitalization rules of IRC section 263A with respect to merchandise inventory.
The revenue procedure is effective for tax years ending after December 17, 1999, and therefore calendar-year taxpayers may be able to take advantage of it for 1999. Eligible taxpayers who filed original 1999 returns on or before July 14, 2000, will need to file an amended return by November 13, 2000.
While the option of using the cash method is certainly welcome news to eligible taxpayers, CPAs must remember that its use under revenue procedure 2000-22 is not a permanent change. An increase in gross receipts for example, could cause a taxpayer to become ineligible under this procedure and therefore may require a change back to the accrual method. The taxpayer’s eligibility must be determined every year.
—Vinay Navani, CPA,
tax manager, Wilkin & Guttenplan, PC,
East Brunswick, New Jersey.