Scott E. Vincent
Shughart, Thomson & Kilroy
Kansas City

The Internal Revenue Service recently relaxed accounting rules, allowing many more small businesses to use the cash method of accounting. Current IRS rules allow many businesses with gross receipts of $1,000,000 or less to use the cash method. These existing rules remain in effect, and do apply to a wider range of taxpayers than the new rules. A new proposed revenue procedure effective now, set forth in IRS Notice 2001-76, allows small businesses with average annual gross receipts of $10,000,000 or less to use the cash method. The IRS estimates that more than 500,000 businesses will be eligible for the new relaxed rules.

The cash method of accounting generally allows taxpayers to defer income until payments are actually or constructively received, instead of having to take income into account as receivables are created. It does similarly apply to deductions for inventory or materials items, deferring deductions of these expenses until the later of payment or use. Generally, the cash method is considered simpler and less burdensome for small businesses, so the new IRS position should be great news for many taxpayers.

Effective Date

The new rules were issued in proposed form, but taxpayers may rely on them beginning with tax years ending on or after December 31, 2001. In addition, the IRS has indicated that it will not challenge use of the cash method in earlier years, or failure to account for inventories in those years, by a business that otherwise qualifies for the new rules.

Eligibility

To be eligible for use of the cash method of accounting under the new rules, a taxpayer must have average annual gross receipts of more than $1 million but less than or equal to $10 million for the three taxable years ending with the prior taxable year, and meet one of the following four safe harbors:

1. The taxpayer's principal business activity, as determined by reference to the codes in the North American Industry Classification System (found at www.census.gov) is not wholesale trade, retail trade, manufacturing, mining, publishing, or sound recording. These industries are excluded from the new safe harbors.

2. The taxpayer's principal business activity is provision of services, even if property is provided incident to those services.

3. The taxpayer's principal business activity is custom manufacturing. There are detailed rules regarding the ordering and manufacturing process for this safe harbor.

4. Regardless of the taxpayer's primary business activity, the new cash method rules can be used with respect to any separate and distinct trade or business that satisfies one of the first three safe harbors, and is separately accounted for by the taxpayer.

Inventory Accounting Requirements

Taxpayers qualify to use the cash method under this new revenue procedure, and that choose not to account for inventories under the code, must treat all inventoriable items as "materials and supplies that are not incidental" under the regulations. These "materials and supplies that are not incidental" will be deductible only in the year in which they are actually consumed or used in the taxpayer's business. Thus, inventory type purchases do not receive the benefit of accelerated deductions pursuant to the new rules.

Formal Change in Accounting Method

Choosing to use the cash method of accounting pursuant to the new proposed revenue procedure is a formal change in a taxpayer's method of accounting, which triggers requirements under the code and IRS regulations. There are "automatic change in accounting method" provisions that apply, with certain modifications, so that formal IRS permission to begin using the cash method is not required. However, certain filings must be made with the IRS.