Cash method now available to small businesses with inventory.

• Author: Moore, Philip E.

With the release of Rev. Proc. 2000-22, small businesses that would normally be required to use the accrual method of accounting for tax purposes for the purchase and sale of merchandise may now be able to use the cash method.

Generally, a taxpayer may adopt any permissible method of accounting, subject to certain restrictions, such as when a business has inventory. Regs. Sec. 1.471-1 requires a taxpayer to account for inventories when the production, purchase or sale of merchandise is an income-producing factor in the taxpayer's business. Once inventory has been determined to be an income-producing factor, Regs. Sec. 1.446-1 requires the taxpayer to account for the inventory by using the accrual method for purchases and sales of merchandise. In addition, once it has been established that inventory exists, the taxpayer may be required to include an allocable portion of indirect costs in its inventory under Sec. 263A.

In its effort to simplify bookkeeping requirements for small businesses, the IRS will allow the cash method of accounting for certain small taxpayers. This does not mean the taxpayer can expense the inventory on hand at the end of the year. If the taxpayer meets the requirements and does not want to account for inventories, it still "must treat merchandise inventory in the same manner as a material or supply that is not incidental under section 1.162-3." Under this regulation, materials and supplies can only be expensed in the year actually consumed and used in operations. Inventories, therefore, must still be accounted for as materials and supplies and recorded on the taxpayer's balance sheet. The benefits are that Sec. 263A no longer applies and, more importantly, inventory sales are not included in income until received.

To qualify for the automatic consent to change to the cash method under Rev. Proc. 2000-22 (and to continue to use the cash method), a taxpayer must meet the following requirements:

1. The average annual gross receipts for each of the three prior tax years ending after Dec. 16, 1998 must be $1 million or less. The gross receipts test is a three-year rolling average lookback, and the taxpayer must meet the requirements each year. Gross receipts are defined by Temp. Regs. Sec. 1.448-1T(f) (2)(iv). Sec. 52(a) and (b), as well as Sec. 414(m) and (o), should be considered to determine if the taxpayer nmst aggregate gross receipts from two or more related businesses.

2. With limited exceptions, a conformity...