Choosing or changing a method for tax purposes.
Cash or Accrual? By Robert Jennings.
With the release of revenue procedure 2000-22, the IRS provided small
businesses with much needed guidance on choosing or changing their
accounting methods for tax purposes. This article 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 procedure 2000-22 allows any 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 test, it no longer matters whether it
is selling merchandise that is a "material income-producing factor"
(discussed below).
To compute the sales test, a company averages revenue from the last
three years. If the average is less than the $1 million threshold,
the cash method is always allowed (but not required). For purposes
of this test gross receipts include most normal items, such as sales
revenue, services, interest, dividends, rents, royalties and the like,
but not sales tax the taxpayer collects.
Companies that are part of controlled groups must combine receipts
for all entities included in the group to determine if they meet the
$1 million test. 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 existence.
The revenue procedure originally had included one other requirement:
the conformity rule. Except in isolated circumstances, such as on
a one-time basis to obtain a bank loan, the taxpayer was required
to use the cash 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 problems when an accountant prepared accrual basis financial
statements for a small business client. The IRS remedied the problem
early this year in revenue procedure 2001-10, which removed the conformity
requirement but re-emphasized the need for adequate books and record,-
as required by IRC section 446 and reminded companies to maintain
a reconciliation between book and tax income.
PASS/FAIL
Revenue procedure 2000-22 does not apply to companies that fail the
$1 million average revenue test. For these entities, determining whether
to use the cash or the accrual method is based on two issues: the
material income-producing factor test and the type of entity. Generally
companies that sell merchandise must use the accrual method for purchases
and sales. This rule is more properly known, under Treasury regulations
section 1.446-1, as the material
