By George G. Jones and Mark A. Luscombe
In what may be the final chapter in an ongoing battle over the availability of the cash method of accounting to small business owners, the Internal Revenue Service has now released Rev. Proc. 2002-28.
As with the proposed guidance issued last December in Notice 2001-76, the final guidance provides the automatic consent procedures for a qualifying small business with gross receipts of $10 million or less to utilized the cash method of accounting. The proposed guidance had authorized reliance on the procedures in Notice 2001-76 for tax years ending on or after Dec. 31, 2001. Tax practitioners may have already had a chance to work with the proposed guidance in preparing 2001 tax returns. We will focus on the clarifications made in the final guidance in response to comments submitted pursuant to Notice 2001-76 - and the opportunity they present.
Background
The IRS has long viewed that the presence of business inventories have created a need for the use of the accrual method of accounting under the statutory authority of Code Sec. 446, the clear reflection of income standard, and Code Sec. 471, the requirement to use inventories to clearly reflect income. The battleground typically focused on service businesses that, in conjunction with providing a service, also provided related goods or merchandise.
Faced with a number of setbacks in court, the IRS promulgated Rev. Proc. 2000-22 in 2000. It provided a safe harbor for small businesses with average annual gross receipts of $1 million or less to use the cash method of accounting. The safe harbor included a conformity test, basically providing that the business could not be regularly preparing its books on the accrual basis for accounting purposes while reporting on the cash basis for tax purposes.
At the time, many practitioners, while welcoming the guidance, felt that the $1 million limit was too low to help the majority of small businesses that needed assistance. The IRS, at the time, indicated that it was uncomfortable going any higher than $1 million given the statutory provisions Ð and therefore the congressional mandate Ð with which it was working.
At the end of 2001, the IRS apparently got more comfortable with a higher limit as it sought to divert valuable resources from pursuing cases where the taxpayers had gross receipts in excess of $1 million.
In December, 2001, the IRS issued Notice 2001-76, allowing specified taxpayers with up to $10,000,000 of annual gross receipts to use the cash method. Although obviously solving some personnel resource issues, the IRS put a positive spin on the change and billed the new $10,000,000 gross receipts limit as being good for small business.
In fact, they were right. Taxpayers were authorized to rely on Notice 2001-76 for calendar year 2001 returns and for the automatic consent procedures for changing from the accrual method to the cash method.
Rev. Proc. 2002-28
The final IRS guidance issued in newly released Rev. Proc. 2002-28 tracks the guidance in Notice 2001-76 fairly closely, except to provide clarifications and expanded relief in response to comments received in response to Notice 2001-76.
A qualifying small business taxpayer may use the cash method of accounting for all of its trades or businesses if it satisfies one of three tests and did not previously change or was not required to have changed to the accrual method as a result of becoming ineligible for the cash method under Rev. Proc. 2002-28. The three tests are:
1. The taxpayer-s principal business activity is classified in a North American Industry Classification System code other than mining activity (NAICS Code 211 and 212), manufacturing activity (NAICS Code 31 to 33), wholesale trade (NAICS Code 42), retail trade (NAICS Code 44 and 45) and information industries (NAICS Code 5111 and 5122).
2. The taxpayer-s principal business activity is not classified under one of the eligible NAICS codes above, but the taxpayer reasonably determines that its principal business activity is the provision of services, including property incidental to the provision of those services.
3. The taxpayer-s principal business activity is not classified under one of the eligible NAICS codes above, but the taxpayer reasonably determines that its principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications (once again, bringing in the service-to-customers element). The property must be significantly modified according to the customer specifications and must not be made in significant quantities.
The final guidance clarifies that, even if a taxpayer-s principal business activity does not qualify for the cash method, other separate and distinct trade or businesses of the taxpayer may qualify for the cash method if those separate and distinct businesses each meet the above criteria.
If a taxpayer qualifies under the above criteria to use the cash method of accounting and chooses not to use an overall accrual method with inventories accounted for under Code Sec. 471, in response to comments received, the final guidance provides the taxpayer with three options.
1. The taxpayer can use the overall cash method and account for inventories under Code Sec. 471.
2. The taxpayer can use an overall accrual method and account for items that can be inventoried as non-incidental materials and supplies under Reg. 1.162-3.
3. The taxpayer can use the overall cash method and account for items that can be inventoried as non-incidental materials and supplies under Reg. 1.162-3.
Rev. Proc 2002-28 also clarifies that, in line with Rev. Proc. 2002-10, the uniform capitalization rules of Code Sec. 263A do not apply to inventory-able items treated as non-incidental materials and supplies under Reg. 1.162-3.
The conformity requirement that had been a part of Rev. Proc. 2000-22 was not a part of either Notice 2001-76 or Rev. Proc. 2002-28. There is now no requirement, therefore, that books and records not be maintained on the accrual basis in order to take advantage of the cash method for tax purposes.
The effective date for the Rev. Proc. 2002-28 continues to be tax years ending on or after Dec. 31, 2001, as had been the case under Notice 2001-76. Taxpayers, therefore, are entitled to rely on this guidance for calendar year 2001 returns and all subsequent returns.
A qualifying small business taxpayer is a taxpayer with average annual gross receipts of $10 million or less. The final guidance clarifies that, to qualify, the taxpayer also must not be prohibited from using the cash method under Code Sec. 448. A three-year period prior to the current year is generally used to measure average gross receipts.
If the taxpayer has not been in existence for three years, it may use the periods during which it has been in existence. A three-year test was also added in the final guidance for purposes of determining which trade or business is the taxpayer-s principal business activity. Therefore, a taxpayer may choose to use either the gross receipts for its prior tax year or the average annual gross receipts for its three most recent prior tax years.
The final guidance clarifies that if a taxpayer is in its first year, it may use the gross receipts from that year to determine its principal business activity.
The final guidance provides 26 examples explaining the application of the provisions and the procedures for the automatic change in accounting method. Examples added in the final guidance clarify that the cost of raw materials under the cash method may not be deducted until the product is delivered to the customer and also clarify the open accounts receivable rule. The final guidance further clarifies that, in determining the deduction for inventory-able items treated as non-incidental material and supplies, the taxpayer may use only the specific identification; first-in, first-out; and average cost methods.
Additional guidance is added with regard to when taxpayers may retain specific methods of accounting for particular items on their returns. Finally, a new flow chart helps in understanding the interaction of Rev. Proc. 2002-28 with other authority and guidance.
Planning
Even tax practitioners who have already undertaken a review of Notice 2001-76 with their clients for 2001 tax returns will want to update that review with the clarifications made in Rev. Proc. 2002-28, which has allowed new-found flexibility for many small businesses with multiple sources of revenue. It is estimated that this guidance will have a potential impact on over 500,000 small business taxpayers.
Practitioners should not automatically assume, however, that the cash method would necessarily be the preferred method for any particular qualifying small business client. Small business clients that customarily receive cash advances from clients before undertaking work may well find that remaining on the accrual basis is more advantageous.
Also, keep in mind that taxpayers may still request permission from the IRS to change to the cash method of accounting even if the taxpayer does not fall within the requirements of Rev. Proc. 2002-28.
