Use of cash method by small businesses: notice 2001-76 introduced new rules to simplify use of the cash method for qualifying small businesses with average gross receipts of $10 million or less.

In a move welcomed by the small business community, the IRS issued Notice 2001-76 (1) in December 2001. In the interest of simplification for both taxpayers and the Service, the notice significantly increases the availability of the cash method of accounting for qualifying small business taxpayers with average gross receipts of $10 million or less. This article explains and illustrates the key provisions of the notice and of Rev. Proc. 2002-28, (2) which implemented the notice (see Exhibit 1 on p. 524).

Background

Sec. 446 offers taxpayers a choice of tax accounting methods, generally between cash and accrual. However, Sec. 471 significantly inhibits the freedom to choose the cash method; it imposes the accrual method on a taxpayer required to account for inventory. According to Regs. Sec. 1.471-1, the inventory requirement is triggered whenever the production, purchase or sale of merchandise is an income-producing factor in the taxpayer's business. Sec. 448 further limits taxpayers from choosing the cash method: the method cannot be used by a C corporation or by any partnership with a C corporation as a partner, unless average gross receipts are $5 million or less. Further exceptions (independent of the dollar threshold) exist for farming businesses and qualified personal service businesses.

The inventory requirement is the principal source of complexity and controversy. Frequently, it is difficult to determine whether the production, purchase or sale of merchandise is an income-producing factor in the taxpayer's business, particularly when the taxpayer sells merchandise as an incidental part of its larger business (e.g., a plumber who also sells plumbing supplies). This difficulty has given rise to considerable litigation. Unfortunately, the court decisions have not resulted in clear lines of authority. The cost of litigation is particularly daunting to small businesses. Litigation has also consumed a considerable portion of government resources better used elsewhere.

Recent Developments

In 2000, the Service permitted taxpayers with average gross receipts of $1 million to use the cash method (free of the inventory requirement). (3) In 2001, the Joint Committee on Taxation, as part of its simplification study, recommended an increase in the dollar threshold to $5 million. (4)

Notice 2001-76

Many outside observers thought the IRS believed it lacked the authority to raise the exclusion threshold to as high as $5 million, let alone $10...