Rev. Proc. 2000-22 allows certain taxpayers to use cash method.

• Author: Hesse, Christopher W.

Generally, taxpayers with inventory are required to use the accrual method of accounting. However, a new revenue procedure allows taxpayers meeting certain requirements to use the cash method. This article explains why the procedure may cause more problems than it solves.

An accrual-method taxpayer generally must recognize income when all events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. An accrual-method taxpayer may deduct the amount of any receivable previously included in income that becomes worthless during the year. Such taxpayers are not required to include in income amounts to be received for the performance of services that, on the basis of experience, will not be collected (the nonaccrual experience method). The availability of this method is conditioned on the taxpayer not charging interest or a penalty for failure to timely pay the amount charged. An expense is deductible when incurred; however, there are exceptions, which include complying with the rules for economic performance and accruals to related-party, cash-method taxpayers under Sec. 267.

A cash-method taxpayer is not required to include an amount in income until it is actually or constructively received. An expense, if deductible, is allowed when paid. The prepayment of an expense is generally not deductible until the expense is incurred. (There are various exceptions for cash-method farm taxpayers.) Hybrid methods of accounting, combining various aspects of the cash and accrual methods, have been allowed if consistently applied.

Restrictions on Cash-Method Use

Treasury Tax Legislative Counsel Joseph Mikrut summarized the restrictions on the use of the cash method in testimony(1) before the House Committee on Small Business, as reproduced in Exhibit 1 on p. 872.

Treasury has long held that taxpayers with inventory must use the accrual method. But, when does a taxpayer have inventory such that the accrual method must be used? This issue has been exacerbated by the repeal of the installment method for accrual-method taxpayers.(2) Now, taxpayers desiring a tax deferral on the sale of qualifying assets will seek to use the cash method. Constituents and lobbyists have contacted Congress to overturn the installment-method repeal or ease the restrictions on use of the cash method. Rev. Proc. 2000-22(3) now provides an administrative exception for small taxpayers.

What Is "Inventory"?

Sec. 471(a) provides:

Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.

Congress provided that Treasury determines when "inventory" must be recorded as such to clearly reflect income, but never defined "inventory" The ongoing dispute is whether a particular item is inventory. If inventory exists, the regulations require use of the accrual method (absent Rev. Proc. 2000-22).

Merchandise bought for resale is not inventoriable unless the sale is intended for profit.(4) However, in Thompson Electric, Inc.,(5) a taxpayer could not avoid recording inventory of electrical supplies on hand consumed in its provision of contracting services. In Osteopathic Medical Oncology and Hematology P.C.,(6) the court focused on what the customer (patient) was buying. The supplies or materials on hand were provided as part of the taxpayer's provision of medical services. The supplies were not otherwise "sold" to the patients, but were administered by the medical professionals.

Even when a taxpayer has no materials on hand at the end of the day, the courts have ruled that the accrual method must be used. Acquiring ownership of sand and gravel (even if only for a few hours) was sufficient to force a taxpayer to the accrual method in Von Euw & L.J. Nunes Trucking, Inc.(7) However, use of wet concrete, sand, drain rock, wire mesh, rebar and other materials was not inventory in RACMP Enterprises...