By Thomas R. Chiavetta

In May 2002, the IRS issued Revenue Procedure 2002-28, “Providing for Use of Cash Accounting Method by Qualifying Small Business Taxpayers.” The purpose of this revenue procedure is to reduce the administrative and tax compliance burdens of small business taxpayers and minimize disputes with the IRS over the use of the accrual method of accounting because of the requirement to account for inventories. The revenue procedure provides qualifying small business taxpayers with guidance on obtaining automatic consent to change to the cash method of accounting and to a method of accounting for inventories as materials and supplies that are not incidental under Treasury Regulations section 1.162-3.

Qualifying Small Businesses

To fall under the provisions of Revenue Procedure 2002-28 for an automatic change to the cash method of accounting, a taxpayer must be classified as a qualifying small business by meeting several tests:

Gross receipts test. A qualifying small business taxpayer is any taxpayer with average annual gross receipts of more than $1 million, but not more than $10 million. Taxpayers with less than $1 million of gross receipts are generally allowed to use the cash method of accounting pursuant to Revenue Procedure 2001-10. A small business taxpayer does not qualify if it is prohibited from using the cash method under IRC section 448 (e.g., a C corporation with average annual gross receipts in excess of $5 million) or if it is in the business of farming. Farmers should look to IRC sections 447 and 448 for guidance regarding the appropriate method of accounting.

Principal business activity. A taxpayer that has satisfied the preceding criteria next determines whether its principal business activity code under the North American Industry Classification System (NAICS) is an ineligible one. The following NAICS codes are ineligible:

Detailed information about NAICS codes may be found at www.census.gov.

Revenue Procedure 2002-28 provides exceptions for taxpayers that fall under an ineligible NAICS code. For example, a taxpayer that provides services, including the provision of property incidental to the services, may change to the cash method of accounting pursuant to the revenue procedure even if its principal business activity code makes it ineligible. Another exception is provided for taxpayers in the business of fabrication or modification of tangible personal property upon demand in accordance with customer designs or specifications. Fabrication or modification does not include arrangements where a customer merely chooses among preselected items (e.g., sizes, colors, or materials that the taxpayer already offers), or where the taxpayer makes minor modifications to a basic design.

Qualifying small business taxpayers changing to the cash method of accounting pursuant to the revenue procedure may choose not to account for inventories. In such a case, the taxpayer must treat all inventoriable items as materials and supplies not incidental under Treasury Regulations section 1.162-3. Such inventoriable items are consumed and used in the business only in the year sold to a customer or in the year the taxpayer actually pays for them, whichever is later. The taxpayer may determine the amount of the deduction by using either a specific identification method, a first in, first out (FIFO) method, or an average cost method. The method must be used consistently. The last in, first out (LIFO) method may not be used. The taxpayer’s method of accounting for inventories for financial accounting purposes will not affect its eligibility to use the cash method or to treat inventoriable items as nonincidental materials and supplies under Treasury Regulations section 1.162-3.

Revenue Procedure 2002-28 defines gross receipts consistent with temporary Treasury Regulations section 1.448-1T(f)(2)(iv). Therefore, gross receipts include all receipts derived from a taxpayer’s trade or business that must be recognized under the taxpayer’s method of accounting. Gross receipts would include total sales net of returns and allowances, amounts received from services, interest, dividends, and rents. Amounts received for sales tax or similar state and local taxes remitted to a taxing authority are not included in gross receipts. Gross receipts from transactions between taxpayers treated as a single employer under IRC sections 52(a) or (b), or 414(m) or (o), will not be considered for the gross receipts test.

A taxpayer has average annual gross receipts of $10 million or less if for each prior taxable year ending on or after December 31, 2000, the taxpayer’s average annual gross receipts for the three- year period ending with the applicable prior taxable year do not exceed $10 million. If a taxpayer has not been in existence for the three-year period, the taxpayer should use the number of years it has been in existence, including short taxable years. Gross receipts for a short year must be annualized.

A change in a taxpayer’s method of accounting pursuant to Revenue Procedure 2002-28 is treated as a change in method of accounting to which the provisions of IRC sections 446 and 481 apply. For qualifying small business taxpayers, the change is automatic, and they must follow the automatic change of accounting method procedures in Revenue Procedure 2002-9 as modified by Revenue Procedure 2002-19 and Announcement 2002-17. Revenue Procedure 2002-28 also makes further modifications to the requirements of Revenue Procedure 2002-19 and Announcement 2002-17.

The Revenue Procedure provides instructions for completing specific sections of Form 3115. Taxpayers should review these instructions before filing. Taxpayers should write “Filed under Revenue Procedure 2002-28” at the top of page 1 of Form 3115.

Revenue Procedure 2002-28 is effective for taxable years ending on or after December 31, 2001.

©2002 CPA Journal. Legal Notices