ACCOUNTING & AUDITING

Accounting

Using the Cash Method of Accounting Under Revenue Procedure 2002-28

By Mark A. Segal and Bruce M. Bird

Revenue Procedure 2002-28 allows certain qualifying small business taxpayers with gross receipts of up to $10 million dollars to use the cash method of accounting and to treat inventoriable items as nonincidental materials and supplies. In addition, the revenue procedure sets forth procedures by which eligible taxpayers may obtain automatic consent to change to the cash method of accounting. This procedure is effective for tax years ending on or after December 31, 2001.

Background

In Revenue Procedure 2001-10 (which superceded Revenue Procedure 2000-22), the IRS exempted certain businesses—other than tax shelters—from being required to use the accrual basis of accounting for purchases and sales of merchandise. A qualifying taxpayer must have average annual receipts of $1 million or less and must treat its merchandise inventory in the same manner as a nonincidental material or supply. For such merchandise inventory, the uniform capitalization rules under IRC section 263A do not apply.

A taxpayer has average annual gross receipts of $1 million or less if, for each prior tax year ending on or after December 17, 1998, the taxpayer’s average annual gross receipts for the three-tax-year period ending with the applicable prior tax year do not exceed $1 million. Gross receipts include total sales—net of returns and allowances—and all amounts received from services, interest, dividends, and rents. Gross receipts do not, however, include sales taxes or other similar state and local taxes where such tax is legally imposed upon the purchaser and the taxpayer merely collects and remits the tax to the taxing authority.

A taxpayer who has been in existence for less than a three-tax-year period must determine the average annual gross receipts for the number of years that it has been in existence. In making this computation, the gross receipts of any short tax year must be annualized.

Under Revenue Procedure 2001-10, merchandise inventory must be treated in the same manner as nonincidental materials or supplies. Under Treasury Regulations section 1.162-3, the cost of such inventoriable items is deductible in the later of the year in which they are consumed (or used) or the year in which the taxpayer actually pays for them. To reflect this treatment, for tax purposes, the taxpayer must typically make a year-end adjustment to inventory.

Although inventory is treated as a nonincidental supply or material under the provisions of Revenue Procedure 2001-10, noninventory items are deductible as incidental supplies or materials if all of the following conditions are satisfied:

Taxpayers having gross receipts of up to $1 million dollars that qualify for the small business exception under Revenue Procedure 2001-10 can receive automatic consent from the IRS by filing Form 3115. The automatic consent provision applies both to the taxpayer’s change in accounting method (from accrual to cash) and to the taxpayer’s treatment of inventory as nonincidental materials or supplies. At the top of Form 3115, the taxpayer should write “Filed under Revenue Procedure 2001-10.” Where applicable, a taxpayer under examination, under administrative appeal, or in federal court can rely upon this automatic consent procedure. Accordingly, the taxpayer should file a copy of Form 3115 with the National Office of the IRS and provide a copy to the other party to the dispute.

Safe Harbor Under Revenue Procedure 2001-10

Revenue Procedure 2001-10 provides some measure of relief for qualifying small business taxpayers wishing to use the cash method of accounting. The major benefit of the revenue procedure is that, in superceding Revenue Procedure 2000-22, it retroactively eliminated the onerous requirement forcing certain small business taxpayers to keep their books and records on the cash method for both tax and financial reporting purposes. By eliminating this requirement, Revenue Procedure 2001-10 expanded the group of small business taxpayers potentially qualifying for relief.

Revenue Procedure 2002-28

Revenue Procedure 2002-28 permits certain qualifying taxpayers, under certain conditions, to use the cash method of accounting. The main requirement of Revenue Procedure 2002-28 is that the taxpayer have average annual gross receipts of $10 million or less.

Revenue Procedure 2002-28 does not apply to taxpayers prohibited from using the cash method of accounting under IRC section 448. Nor does this revenue procedure apply to a “farming business.” Stated alternatively, assuming the taxpayer has average annual receipts of more than $1 million but not more than $10 million, is not prohibited by IRC section 448 from using the cash method of accounting, and is not engaged in a “farming business,” then the taxpayer may be able to use the cash method of accounting under Revenue Procedure 2002-28.

Revenue Procedure 2002-28 first requires an examination of the taxpayer’s principal business activity. Where the taxpayer’s principal business activity code, as described in the North American Industry Classification System (NAICS), involves retail, wholesale, mining, or certain information industries, the taxpayer generally may not rely upon Revenue Procedure 2002-28 when attempting to use the cash method of accounting.

Regardless of whether the taxpayer’s NAICS principal activity code is described above, if the taxpayer’s principal activity code involves the provision of services—including the provision of property incident to those services—the taxpayer may avail itself of Revenue Procedure 2002-28 for all of its business activities. This revenue procedure will also apply where the taxpayer’s principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications.

Example. In 2002, Taxpayer Smith, a carpenter, derived 75% of his total gross receipts of $6 million from providing on-site carpentry services, such as installing cabinets in his clients’ homes. The taxpayer derived the remaining 25% of his gross receipts for 2002 by operating a retail store selling carpentry supplies. The taxpayer may use the cash method of accounting for both businesses.

Where the taxpayer’s principal business activity falls within one of the above situations, the taxpayer may use Revenue Procedure 2002-28 for all of its business activities. Where the taxpayer has previously used this revenue procedure for all of its business activities and then later becomes ineligible, however, it cannot use the cash method for all of its business activities.

Example. In 2002, Taxpayer Smith used the cash basis for both his carpentry business and his retail store. In 2003, the sales at his retail store increase dramatically. He now derives 70% of gross receipts from sales at his store. In 2003, he may not use the cash method for both his carpentry business and retail store. If separate records are not kept for both businesses, he must use the accrual basis for both. If separate records are kept, then he can use the cash basis for his carpentry services business but must use the accrual basis for his retail store.

Where the taxpayer’s NAICS principal business activity code is as described above (retail, wholesale, mining, publishing, or sound recording), other conditions and restrictions apply. The taxpayer must next determine whether it has a trade or business that is separate from its principal business activity and for which it keeps a complete and separate set of books and records. If not, the taxpayer may not use the cash method of accounting for any of its business activities.

If the taxpayer has a trade or business that is separate from its principal business activity and for which it keeps a complete and separate set of books, the taxpayer must determine whether the principal business activity of that separate trade or business is described by the above NAICS codes. If the answer is no, then the taxpayer may use Revenue Procedure 2002-28 only for that separate trade or business.

If the taxpayer has a trade or business described by the above NAICS codes that is separate from its principal business activity, and for which the taxpayer keeps a complete and separate set of books, then the principal activity of the separate trade or business should next be examined. If it involves either the provision of services (including the provision of property incident to those services) or the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications, then the taxpayer may use the cash method for its separate trade or business. If not, then the taxpayer may not use Revenue Procedure 2002-28 for any of its business activities.

Analyzing the $10 million safe harbor. A taxpayer whose principal business activity includes retailing, wholesaling, manufacturing, mining, publishing, or sound recording typically may not qualify to use the cash method of accounting safe harbor under Revenue Procedure 2002-28. This general rule has a number of exceptions. For example, where the taxpayer’s principal activity code is the provision of services, the taxpayer may avail itself of this revenue procedure for all of its business activities. As a result, a plumber who sells or provides plumbing supplies incident to his services can use the cash method. While manufacturing is an impermissible principal business activity, custom manufacturing is not. Thus, a custom home builder or remodeler having gross receipts of up to $10 million can qualify for the cash method of accounting.

Interplay with Other Rules

Certain entities, under certain conditions, are required to use the accrual basis of accounting. In general, regular (C) corporations having average annual gross receipts for the three-year period ending with the applicable prior tax year of more than $5 million must use the accrual method. If such a corporation is a corporate partner, then the partnership itself must use the accrual method. As a result, such taxpayers cannot use the cash method safe harbor under Revenue Procedure 2002-28.