Ability to use cash method expanded.

• Author: O'Connell, Frank J., Jr.
• Position: Accounting

Generally, a taxpayer can choose its accounting method, as long as the method clearly reflects income. However, the IRS often prohibits taxpayers from using the cash method of accounting under Regs. Sec. 1.446-1(c)(2)(i), which requires taxpayers with inventories to use the accrual method of accounting (absent the Service's approval).

Sec. 471 mandates the use of inventories whenever necessary to clearly determine a taxpayer's income. Regs. Sec. 1.471-1 requires that taxpayers must use inventories whenever the production, purchase or sale of merchandise is an income-producing factor. Under these rules, the IRS requires most taxpayers that engage in the sale of tangible property to use the accrual method.

In recent months, the Service has expanded a taxpayer's ability to use the cash method. Sec. 471 has been challenged in a string of Tax Court cases dealing with service providers that sell tangible property as part of their services; see Galeridge Construction, Inc., TC Memo 1997-240, Osteopathic Medical Oncology and Hematology, PC, 113 TC 376 (1999), and RACMP Enterprises, Inc., 114 TC No. 16. In addition, the IRS issued Rev. Proc. 2000-22, which allows small taxpayers to use the cash method.

The Service issued Rev. Proc. 2000-22 under the discretion given under Secs. 446(b) and 471 to except small taxpayers from using inventories and to allow them to use the cash method. The procedure provides numerous benefits to taxpayers whose average gross receipts fall under $1 million. The use of the cash method allows taxpayers to control the recognition of taxable income, through management of the timing of receipts and disbursements. It also allows relief from the prohibition against using the installment sale rules for accrual-basis taxpayers. Further, exempting taxpayers from keeping inventories under Sec. 471 allows taxpayers that would otherwise capitalize certain expenses into inventory under Sec. 263A to avoid this requirement.

While Rev. Proc. 2000-22 expressly exempts taxpayers from keeping inventories under Sec. 471, they must still track inventory purchases. A qualified taxpayer that does not want to account for inventories must treat merchandise inventory in the same manner as a material or supply not incidental under Regs. Sec. 1.162-3. Therefore, taxpayers can only expense purchases in the year consumed (i.e., the year the taxpayer either sells or uses the inventory).

To qualify under the procedure, taxpayers must have average annual...