The cash method for small businesses.

• Author: Beck, Allen M.

Taxpayers can generally adopt any permissible accounting method, as long as it dearly reflects income. An accounting method will not do this unless taxpayers treat gross receipts and expenses consistently from year to year. Following is a brief summary of major points in a recent revision to the cash-basis rules.

An area of contention between the IRS and many small businesses that provide services and also maintain small amounts of inventory, is the mandated use of the accrual method. According to Secs. 461 and 471 and the regulations, taxpayers must use this method to clearly show income when manufacture, purchase or sale of merchandise is an income-producing factor. A taxpayer with inventory may use either the overall accrual method or a hybrid method (using accrual for sales and purchases of inventory and cash for all other transactions).

Cash-Basis Rules

The IRS retreated from this stance with Rev. Procs. 2000-22 and 2001-10. Taxpayers with average annual gross receipts of $1 million or less can use the cash method even if they have inventories. However, they must account for the inventories in the same manner as nonincidental materials and supplies under Regs. Sec. 1.1623, if they deduct the cost of inventory when sold. The advantage of using the cash method under these two revenue procedures is that taxpayers need not recognize accounts receivable income until they collect the receivables. Special rules exist for determining average annual gross receipts for purposes of the gross receipts cap and for changing from the accrual to the cash method.

The Service continued to ease restrictions for using the cash method by issuing Notices 2001-76 and 2002-14 and Rev. Proc. 2002-28. These pronouncements allow more small businesses to use the cash method, provided they:

1. Have annual average gross receipts greater than $1 million, but less than $10 million (average of prior three years);

2. Are engaged in an eligible principal business activity; and

3. Do not fall under Sec. 448 restrictions.

The definition of "qualifying small businesses" excludes entities with certain activities defined by North American Industry Classification System (NAICS) codes:

* Codes 211-212: Oil extraction and mining activities;

* Codes 31-33: Manufacturing;

* Code 42: Wholesale trade;

* Codes 44-45: Retail trade; and

* Codes 5111 and 5122: Information industries (e.g., newspapers, books, periodicals, database publishers and sound-recording industries).

The NAICS...