December 2001
IRS Exempts Small Taxpayers from Inventory Accounting
By Timothy R. Koski
The IRS announced in Revenue Procedure 2000-22 that qualifying taxpayers with $1 million or less in average annual gross receipts will no longer be required to use the accrual method of accounting for inventories. Designed to simplify bookkeeping for small taxpayers, this decision will allow qualifying taxpayers to defer recognition of income until payment is received, rather than when services are performed. Revenue Procedure 2000-22 was recently modified and superseded by Revenue Procedure 2001-10, which eliminates the book-tax conformity requirement contained in Revenue Procedure 2000-22 and makes the small taxpayer exception even more attractive.
Methods of Tax Accounting
The three primary methods of accounting for tax purposes are as follows:
Cash method. Under the cash method, income is recognized when actually or constructively received by the taxpayer, regardless of whether services have been performed. Income recognition is deferred until accounts receivables are collected. Expenses are generally deductible only when actually paid. Many small businesses prefer the cash method because it is easy to use and defers recognition of income until cash is collected.
Accrual method. Under the accrual method, income is recognized when earned. Regulation section 1.446-1(c)(ii) sets forth an all-events test to determine when income is earned. Under this test, income is considered earned when all events that fix the right to receive the income have occurred and the amount can be determined with reasonable accuracy. Generally, expenses are deductible when all events establishing the liability have occurred, when the amount can be determined with reasonable accuracy, and when economic performance has occurred with respect to the liability.
Hybrid method. The hybrid method is often used by small taxpayers who are required to use the accrual method to account for inventories but prefer to use the cash method for all other income and expense items.
Certain taxpayers are not allowed to use the cash method. IRC section 448(a) provides that corporations other than S corporations, partnerships with a corporate partner, and tax shelters must use the accrual method. Section 448(a)'s restriction on use of the cash method does not apply to farming businesses, qualified personal service corporations (e.g., an accounting firm), or non-tax shelter taxpayers with average annual gross receipts for the three most recent years of less than $5 million.
Accounting for Inventory
Another exception to use of the cash method applies to taxpayers that maintain inventory. Under IRC section 471 and Treasury Regulations section 1.471-1, taxpayers are required to use the accrual method with regard to the purchase and sale of merchandise whenever the production, purchase, or sale of merchandise is a material income-producing factor in their business. Thus, such taxpayers are required to use the accrual method to account for inventories even if they are otherwise eligible for the cash method (e.g., a non-tax shelter taxpayer with average annual gross receipts less than $5 million). Consequently, many small businesses use a hybrid method: the accrual method for inventory, the cash method for all other items.
Revenue Procedures 2000-22 and 2001-10 changed accounting for inventory effective for tax years ending after December 16, 1999. Qualifying taxpayers can now use the cash method for all items, including inventory, and defer recognition of income until payment is received, rather than when services are performed.
Gross Receipts and Conformity Requirements
To qualify for exemption from inventory accounting under Revenue Procedure 2000-22, taxpayers had to meet both a gross receipts requirement and a conformity requirement. Under this conformity requirement, qualifying taxpayers were not allowed to use the cash method for tax purposes if they used the accrual method for financial accounting purposes. Because the conformity requirement was inappropriate for a provision designed to simplify accounting for small taxpayers, the IRS responded to criticism and eliminated it in Revenue Procedure 2001-10. Therefore, taxpayers can use the accrual method for financial accounting and still qualify for using the cash method for tax purposes. Taxpayers must still comply with the requirements of section 446(a) and maintain adequate books and records, including a reconciliation of any differences between financial accounting and tax records.
The gross receipts requirement is met if the taxpayer's average annual gross receipts for the three-year period ending with the prior tax year do not exceed $1 million. Gross receipts is broadly defined to include, in addition to net sales, all amounts received from services, interest, dividends, and rents. It does not include sales or other taxes legally imposed on the purchaser where the seller (taxpayer) merely serves as a collection agent.
Example. Taxpayer A, a calendar-year taxpayer that manufactures and sells widgets, has gross receipts of $200,000 in 1996, $800,000 in 1997, and $1,100,000 in 1998. A's average annual gross receipts for 1998 is $700,000 [($200,000 + $800,000 + $1,100,000) 3]; therefore, A is allowed to use the cash method for 1999. The gross receipts test must be met each year. Taxpayer A's gross receipts for 1999 must be $1 million or less in order to continue to meet the gross receipts test. A taxpayer that fails to meet the test must change to inventory accounting and accrual method for the purchase and sale of merchandise. Although switching to the cash method is beneficial to most qualifying taxpayers, a taxpayer in a growing business that qualifies for the cash method one year but expects not to in subsequent years may want to remain on the accrual basis to avoid making two accounting method changes.
Inventory Treated as Nonincidental Materials and Supplies
A taxpayer qualifying for use of the cash method that does not want to account for inventory is required to make any necessary change from the inventory method (and the capitalized costs method under IRC section 263A, if applicable) to treat inventory in the same manner as nonincidental materials and supplies under Treasury Regulations section 1.162-3. Taxpayers carrying materials and supplies on hand should include them in expenses only when they are actually consumed and used during the tax year. Inventory items treated as nonincidental materials and supplies are treated as consumed and used in the year the taxpayer sells the merchandise or finished goods. For cash method taxpayers, such items are deductible in that year or the year paid, whichever is later.
Taxpayers may use any reasonable method of estimating the amount of raw materials in the year-end work-in-process and finished goods inventory to determine the amount used during the year, provided that method is used consistently. Section 263A does not apply to inventory treated as nonincidental materials and supplies. The IRS has promised to provide further guidance on when items may be treated as incidental materials and supplies (deductible currently) and when items are nonincidental (deductible in the year they are used or paid, whichever is later).
IRC Section 481 Adjustment
A change to the cash method under Revenue Procedure 2001-10 is treated as a change in accounting method under IRC sections 446 and 481. A qualifying taxpayer that makes a change to the cash method or a change from accounting for inventory must make a section 481(a) adjustment to prevent items of income or expense from being duplicated or omitted entirely as a result. Any resulting adjustment is generally taken into account over four years.
The net amount of the section 481(a) adjustment required as a result of a change to the cash method must consider both increases and decreases in applicable account balances, such as accounts receivable, accounts payable, and inventory. The IRS makes it clear that a taxpayer who treats inventory as nonincidental materials and supplies under Treasury Regulations section 1.162-3 must take the difference resulting from this recharacterization into account in determining the section 481(a) adjustment.
Automatic Consent to Change in Accounting Method
Taxpayers that want to change to the cash method must follow the automatic change in accounting method provisions of Revenue Procedure 99-49, as modified by Revenue Procedure 2001-10. A taxpayer that makes the accounting method change for its first tax year ending on or after December 17, 1999, and files its original return after January 16, 2001, must attach Form 3115 to its original timely filed return. Qualifying taxpayers (including taxpayers not currently accounting for inventory) may use the automatic consent provisions of Revenue Procedure 2001-10 to change the method of accounting for inventory items to match the method for nonincidental materials and supplies. Taxpayers may file a single Form 3115 for both the change to the cash method and the change in accounting for inventory.
Editor:
Robert H. Colson, PhD, CPA
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