IRS Eases Cash Accounting Rules

Through consultations with small to medium business owners we have encountered frustration with the need to use accrual basis accounting for tax purposes. This has been especially troublesome to businesses which provide services as their main income producing activity, but who were categorized as inventory resellers by the Internal Revenue Service because they also provided some kind of merchandise in addition to the services. This article covers some of the new IRS notices and regulations that provide relief to these types of businesses by allowing them to use cash basis accounting for tax purposes.

I would like to file my business tax returns on the cash basis. What options do I have to do this?

In the past, the IRS generally prohibited the use of the cash method by a C Corporation (other than a farming business and a qualified personal service corporation) and a partnership with a C Corporation partner (again, other than a farming business and a qualified personal service corporation). These stipulations did not apply if the business had average gross receipts of not more than five million for the prior 3 years. However, the IRS also held that the method used must be the method that most clearly reflects the business' income. For this reason, the rules became as complicated as the different business scenarios that evolved. For instance, a contracting business, whose main business is providing services was told it had to keep track of any parts or materials it used that produced income for them and use the accrual method of accounting.

Relief came to some of these small businesses last year when the IRS stated that the cash method could be used if their annual average gross receipts were under one million for each of the last three years. Now the Internal Revenue Service has expanded the scope of this exception with Notice 2001-76. It now allows any business that has annual average gross receipts of not more than ten million over the three prior taxable years to convert to the cash accounting method. The IRS is taking this action in an effort to reduce the administrative and tax compliance burden on the business owner and minimize the number of disputes caused by the requirement to use the accrual method of accounting because of the requirement to account for inventories. It is expected to benefit around five-hundred thousand businesses.

I own a retail shop that does around two million in average annual gross receipts. Does this mean I can convert to the cash method?

No. The Internal Revenue Service has prohibited certain businesses with specified principal business activities from being allowed to change their accounting method to cash. The following five North American Industry Classification System codes are prohibited: Mining activities, as described in NAICS codes 211 and 212; Manufacturing, codes 31-33; Wholesale trade, code 42; Retail trade, codes 44-45; and Information industries, codes 5111 and 5122.

In situations where you have a mix of retail sales and provision of services, if the majority of your gross receipts are from retail sales you would be prohibited from using the cash method of accounting. If your receipts indicate a 60:40 relationship of service to retail sales, you have a clear majority to safely take this stance. Suppose you provide a service, say tailoring clothing, but also sell some clothing in your shop. If the gross receipts are clearly greater from the tailoring part of the business, you can convert to the cash accounting method for income tax reporting purposes for the entire business. If the gross receipts for the clothing sales are larger, you can use the cash method for the tailoring services if you keep complete and separate books and records for the tailoring portion. You would still have to use accrual for the retail sales portion of the business.

I run a plumbing business and often I have to provide parts in order to perform the services. Do I have to use the accrual method?

Probably not. As long as parts are incidental to the repair service and not your main source of gross receipts you are allowed to use the cash method if you meet the gross receipts test.

Gross receipts are defined as equal to all receipts derived from all of a taxpayer's trades or businesses that must be recognized under the method of accounting actually used by the taxpayer for that taxable year for income tax purposes. As long as the average annual gross receipts were $10 million or less for each prior taxable year ending on or after December 31, 2000, you are allowed to use the cash method for reporting for tax purposes.

How do I go about making this change in accounting method?

You must secure the consent from the Commissioner by filing Form 3115, Application for Change in Accounting Method. This must be done during the taxable year for which you want to make the proposed change or within the time specified for the filing of a tax return for the year of change when following the procedures of Revenue Procedure 99-49. The Commissioner will then prescribe the limitations, terms and conditions deemed necessary for you to meet in order to get the consent to make the change. These include the year of change, whether the change is to be made with special adjustments under section 481(a) of the Internal Revenue Code or on a cut-off basis, and the period that must be used for the section 481(a) adjustment.

If you are under examination before an appeals office, or before a federal court with respect to income taxes, special rules apply. You must provide a copy of Form 3115 to the examining agent(s), appeals officer, or counsel for the government when you file the copy of Form 3115 with the national office. The forms must have the name(s) and telephone numbers of the examining agent(s), appeals officers or counsel for the government , as appropriate, All applicable parts of the form must be completed. Specifically, Part II, line 17 (regarding information on gross receipts in previous years) and Part III (regarding the Section 481(a) adjustment) must be completed. "Filed under Rev. Proc. 2001-76" should be written at the top of the Form 3115.

Give us a call to get professional assistance to determine if you qualify to switch to the cash method and in completing Form 3115. Our CPA's have the tax knowledge and the background to help get the correct information compiled for the filing.

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