Unexpected change of accounting method.

• Author: Hofsommer, Kenneth

Generally, an accounting method is chosen when establishing a business, and it does not change. If the method is changed, a Form 3115, Application for Change in Accounting Method, is often filed and must be approved by the IRS. However, there is a scenario wherein one does not have an option to choose a method. Instead, the accounting method must be changed by operation of law.

Sec. 446 allows a taxpayer to choose the method of accounting when establishing the business. The Code also states that the tax method must conform to the method used for book purposes. The law does state that the selected method must clearly reflect income, and, if it does not, the law further provides that the IRS has the power to select a method that does.

Another item affecting a business and its choice of accounting method is the existence of inventory. Sec. 471(a) allows the IRS to determine whether inventories are required to clearly reflect income. Regs. Sec. 1.471-1 requires the use of inventories whenever the "production, purchase, or sale of merchandise is an income-producing factor." Taxpayers often assume inventory is only merchandise held for sale to customers, but it also includes items that are substantial in the construction industry. In the construction industry, merchandise is commonly called materials. Materials are generally considered to be substantial when they are at least 10% to 15% of gross income for the year. This percentage is not a hard-and-fast rule but has been a guideline for some court cases. If an entity has inventory, its method of accounting cannot be on a cash basis.

It should be mentioned that Sec. 448 prohibits the use of the cash method of accounting by a C corporation, a partnership that has a C corporation as a partner, or a tax shelter.

The following example illustrates the limitations on the selection of accounting methods.

Example: A corporation performs installation services for customers in buildings for communication needs, installing telecommunication or data cabling. When it was started, the business elected to be taxed as an S corporation. The company chose to use the cash basis of accounting and the completed-contract method of accounting for its long-term contracts. Since it is an S corporation, it does not have any limitations as discussed above regarding Sec. 448 and the use of the cash method. However, the company has done well and now is achieving gross annual revenues that average greater than S10 million...