Avoiding conversion to the accrual accounting method by electing S status.

• Author: Ellentuck, Albert B.

A C corporation must consider the consequences of the built-in gains tax and its inventory reporting requirements before making an S election in an attempt to avoid a change to the accrual method of accounting.

This case study has been adapted from PPC's Tax Planning Guide: S Corporations, 30th edition (March 2016), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).

Normally, a corporation can use the cash method of accounting if services (rather than merchandise) are provided to clients or customers. However, the corporation may have to use the accrual method (at least to account for purchases and sales) if it is required to maintain inventory records because the production, purchase, or sale of merchandise is a material income-producing factor (Regs. Secs. 1.446-l(c)(2), 1.471-1).

C Corporations

Even if a C corporation otherwise qualifies to use the cash method (because it provides only services), it must convert to the accrual method when its annual gross receipts reach $5 million, unless it is in the trade or business of farming, or is a qualified personal service corporation. Under Sec. 448(b), a C corporation using the cash receipts and disbursements method of accounting must abandon that method and adopt the accrual method, unless the corporation meets the definition of one of the following three classes of exempt corporations:

* Corporations in the trade or business of farming;

* Qualified personal service corporations; or

* Corporations with gross receipts of not more than $5 million.

A qualified personal service corporation is defined as one performing services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and substantially all of the stock by value is held by current or past employees who perform such services (Sec. 448(d)).

A corporation fails the gross receipts test when its average annual gross receipts for the three-year period ending with the prior tax year exceeds $5 million.

A corporation required to change its method under this rule is allowed a four-year forward spread of the net change (Sec. 448(d)(7)).

Certain taxpayers can use the cash method if their average annual gross receipts are more than $1 million but not more than $10 million. This exception to the accrual-method requirement does not apply to C corporations with...