Who Can Use Cash Method Of Accounting

EXECUTIVE SUMMARY

THE IRS RELEASED REVENUE Procedure 2000-22 and revenue process 2001-ten to give small-scale businesses some much needed guidance on choosing or irresolute their accounting method for tax purposes.

Acquirement Procedure 2000-22 ALLOWS ANY Visitor —sole proprietorship, partnership, Southward or C corporation—that meets the sales exam to use the greenbacks method of bookkeeping for tax purposes. If a company'due south average acquirement for the final three years is less than $one million, the cash method is allowed merely not required.

COMPANIES THAT Neglect THE $one MILLION Boilerplate revenue exam are not afflicted by the revenue procedure. For them, determining whether to use the cash or accrual method hinges on two issues: the material income-producing factor examination and their type of entity.

COMPANIES SELLING MERCHANDISE By and large must apply the accrual method to account for purchases and sales. In a 2000 case, the courts held that the material income-producing factor exam does not apply when the material is inseparable from the services and the auction or utilize of the textile is subordinate to providing services.

C CORPORATIONS (OTHER THAN FARMS) MUST USE the accrual method if their average annual gross receipts for the previous iii years were more than than $5 million. Tax shelters and general partnerships that have C corporations as partners and fail the $5 million test likewise must use the accrual method.

ROBERT JENNINGS, CPA, is president of Jennings Advisory Group, LLC, in Clarksville, Indiana. He is as well offshoot lecturer in taxation in the equine industry programme at the University of Louisville in Kentucky. His e-postal service address is taxspeaker@aol.com .

ith the release of revenue procedure 2000-22, the IRS provided minor businesses with much needed guidance on choosing or changing their accounting methods for tax purposes. This commodity summarizes the rules that apply when businesses must pick an accounting method and examines some of the other factors that influence their decision.

THE SALES TEST

Revenue process 2000-22 allows whatsoever company that meets a sales test to use the cash method of accounting for tax purposes. This includes sole proprietors, partnerships, S corporations and regular corporations. If a taxpayer meets the sales exam, it no longer matters whether information technology is selling merchandise that is a "cloth income-producing cistron" (discussed beneath).

To compute the sales examination, a company averages revenue from the last three years. If the average is less than the $one million threshold, the cash method is always allowed (but not required). For purposes of this exam gross receipts include almost normal items, such every bit sales revenue, services, involvement, dividends, rents, royalties and the like, but not sales tax the taxpayer collects.

Companies that are role of controlled groups must combine receipts for all entities included in the grouping to determine if they meet the $ane one thousand thousand exam. Short years require an annualization adjustment. For taxpayers in business less than three years, the average is computed using revenue from only the years in beingness.

The revenue process originally had included 1 other requirement: the conformity rule. Except in isolated circumstances, such as on a 1-fourth dimension ground to obtain a bank loan, the taxpayer was required to apply the greenbacks method of accounting for financial statements prepared for any party—management, investors or creditors—and for any year ending after December 16, 2000. This requirement would have undoubtedly caused bug when an accountant prepared accrual-ground fiscal statements for a small business client. The IRS remedied the problem early this twelvemonth in revenue procedure 2001-ten, which removed the conformity requirement but reemphasized the need for adequate books and records—as required past IRC department 446—and reminded companies to maintain a reconciliation between volume and tax income.

Pass/Neglect

Revenue process 2000-22 does non apply to companies that fail the $1 million boilerplate revenue test. For these entities, determining whether to use the cash or the accrual method is based on two problems: the material income-producing factor test and the blazon of entity. Generally companies that sell merchandise must use the accrual method for purchases and sales. This dominion is more properly known, under Treasury regulations section 1.446-1, equally the material income-producing factor rule.

In the past, the IRS used this rule to forcefulness taxpayers to modify to the accrual method, arguing the greenbacks method did not clearly reverberate income. In early 2000, the IRS lost a cardinal court example ( Osteopathic Medical Oncology and Hematology, 113 TC No. 16). The courts held that the material income-producing factor examination would not apply when

Material was inseparable from the services.

Auction or use of the material was subordinate to providing the services.

Although the IRS acquiesced in upshot simply, this instance forms the basis for arguments that entities such as medical specialists, architects or contractors may nowadays to support their use of the cash method in like situations when they accept more than $1 one thousand thousand in almanac sales.

Additional court cases and informal IRS statements seem to indicate that, when the cost of purchases is 8% or less of total receipts, the cash method would be immune in sure entities. For purposes of this article, an entity that meets either the requirements in Osteopathic Medical or the 8% test will be chosen a service business organization and volition be considered to see the requirements to use the greenbacks method, except as discussed below.

The 2d issue companies must consider is their type of entity. C corporations (other than farms) must employ the accrual method if they have average annual gross receipts for the previous three taxation years of more than $5 million [IRC section 448(b)(3)]. The accrual method is likewise required for revenue enhancement shelters [IRC section 448(a)(iii)], and for general partnerships failing the $5 million examination that take a C corporation as a partner (section 448(a)(ii)).

THE RUNDOWN

Other than for farmers and the unusual tax shelter and corporate partner exceptions discussed higher up, the rules in revenue procedure 2000-22 can be summarized as follows:

For sole proprietors, S corporations, limited liability companies and partnerships:

The cash method is always allowed if the entity meets the $1 million average acquirement exam.

The entity examination does not apply.

The cash method is allowed if the visitor has more than $1 million in sales and meets the service business test.

The accrual method is required if the entity fails both the $i million boilerplate revenue and the material income-producing factor tests.

For C corporations:

The cash method is allowed if the company is a qualified personal service corporation.

The cash method is always immune if the corporation meets the $1 meg average revenue test.

The greenbacks method is allowed if average sales are over $1 one thousand thousand but less than $5 million and the company meets the service business examination.

The accrual method is required if the entity fails both the $1 million and the material income-producing factor tests.

The accrual method is required if the company has more than $five million in average sales.

The exhibit below includes a flow nautical chart to help minor businesses select the proper bookkeeping method.

A GOOD Kickoff

Acquirement procedure 2000-22 and the subsequent revenue process 2001-10 will not solve the cash or accrual questions that have plagued CPAs for the last 25 years. They are, however, a needed beginning effort at easing the recordkeeping and compliance burdens of small businesses. Small business groups, as well every bit many members of Congress, go on to push for a further relaxation of the sales examination and so that information technology volition bear upon only companies with sales betwixt $2.v million and $five million annually. With the election of a Republican administration bent on tax changes, the likelihood of future increases in the sales threshold seems greater.

Selecting the Right Bookkeeping Method