Change of accounting method for small taxpayers with inventory under rev. proc. 2000-22.

• Author: Ely, Mark H.

Under Rev. Proc. 2000-22, a qualifying small 'taxpayer with merchandise inventory, that was previously required to account for sales and inventory using the accrual method of accounting, may automatically change to the cash method of accounting and the inventory rules under Sec. 471 will no longer apply. A qualifying small taxpayer is one whose average annual gross receipts for the previous three years (or shorter period if in existence for less than three years) is $1 million or less. For this test, aggregation rules apply to include gross receipts of related parties. Finally, there is a financial statement conformity requirement. The taxpayer must not regularly use arty accounting method other than the cash method to determine profit or loss for its financial statements, other financial records and reports to owners, creditors, etc., for the current or prior three tax years (years ending before Dec. 17, 2000 are excluded from this rule). The conformity requirement will not apply, however, if accrual-method reports are prepared by the taxpayer on an isolated basis (e.g., on a one-time basis for a lender).

If a taxpayer makes the change to the overall cash method of accounting under Rev. Proc. 2000-22, inventories are not accounted for under the pure cash method. Instead, they must be accounted for in the same manner as nonincidental supplies (i.e., inventoried and deducted only when sold or consumed by the taxpayer). How, then, does the cash method of accounting work with inventories? For inventory that has been paid for by the taxpayer, inventory accounting is customary (i.e., inventory is an asset when on hand and is deducted when sold). But how does a taxpayer account for inventory not paid for by year-end?

According to Treasury officials, although the cost recognition rules for nonincidental supplies apply, they must be applied within the cash-basis method of accounting. Accordingly, cost of sales is recognized as of the later of (1) when paid for by the taxpayer or (2) when sold by the taxpayer. In other words, income from the sale of an item can be recognized in a tax year prior to when the cost of sale is deducted. The cost of sale, however, cannot be recognized in a year prior to the year...