The question of a taxpayer's ability to use the cash receipts and disbursements method of accounting (the cash method) is often met with confusion or misunderstanding. One common misconception is that the cash method is only appropriate for individuals and small businesses. While it is true that statutory restrictions significantly limit the use of the cash method, the number of taxpayers who are eligible to use it is larger than commonly perceived.
There are also misperceptions concerning the cash method's desirability given the accrual method's better matching of income and expenses, more accurate picture of a firm's financial state, and last but certainly not least, its use under GAAP. These considerations, however, are not necessarily controlling for all taxpayers. When they are not required to use the accrual method, taxpayers should consider the benefits provided under the cash method. These benefits include:
1. The cash method is simple to implement and to maintain and does not require the level of internal accounting structure and expertise necessary for taxpayers under the accrual method. This simplicity can translate to significant administrative savings.
2. The cash method allows a better matching of cash available for income tax payments with the recognition of corresponding revenue. This ensures that funds are available for tax payments and is particularly beneficial to taxpayers with restricted or uneven cash flows.
3. The cash method of accounting often defers recognition of income to a later period, allowing taxpayers to receive the time value of money for deferred tax payments. When the deferral continues year after year, the cash method's benefit can approach permanence assuming that (a) the taxpayer receives payments after services are rendered; (b) there is no increase in tax rates; and (c) the taxpayer remains in business. To the extent tax rates decrease, a portion of the time value of money converts into a permanent benefit.
Taxpayers that are required to use or prefer the accrual method for book purposes can realize the second and third benefits above by adopting the cash method for federal income tax purposes only. This means that, unlike what commonly is believed, the availability of the cash method is not limited by the presence of GAAP reporting requirements.
Taxpayers prohibited from using the cash method
Sec. 448(a) provides a list of taxpayers that may not use the cash method of accounting. First, Sec. 448(a)(3) prohibits tax shelters from using the cash method. Second, Sec. 448(a) prohibits businesses that are C corporations or that have C corporation partners from using the cash method unless one of the following exceptions applies:
- The corporation or partnership has met the gross-receipts test for every tax year beginning after Dec. 31, 1985. To satisfy the gross-receipts test for a particular tax year, the taxpayer's average annual gross receipts for the three-year period ending with the tested tax year must not exceed $5 million (Secs. 448(b)(3)-(c)(1)); or
- The corporation or corporate partner is a qualified personal service corporation (Sec. 448(b)(2)). A qualified personal service corporation is defined as any corporation that (1) performs services in qualifying fields (health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) and (2) whose stock is substantially owned by current or retired service-providing employees or their estates (Sec. 448(d)(2)).
Special rules apply for corporate taxpayers engaged in farming (see Sec. 447 for additional details).
Taxpayers required to use the accrual method
Generally, taxpayers have broad authority to choose their own methods of accounting. There are a few instances, however, when taxpayers must use a prescribed method of accounting for a specific item. The most common among these are taxpayers with income from long-term contracts and taxpayers that have inventory. Taxpayers with long-term contracts must use the percentage-of-completion method under Sec. 460 for those contracts. Under Regs. Sec. 1.4461(c)(2)(i), where it is "necessary to use an inventory," the accrual method of accounting must be used for purchases and sales (it should be noted that this accrual requirement applies only to purchases and sales—a hybrid cash/accrual method is possible) unless otherwise authorized by the IRS. A taxpayer must account for inventories on the accrual method of accounting when (1) the taxpayer produces, purchases, or sells "merchandise," and (2) that production, purchase, or sale is an "income-producing factor" for the taxpayer's business (Regs. Sec. 1.446-1(a)(4)(i)).
Several cases and IRS rulings have addressed whether an item produced, purchased, or sold was inventoriable "merchandise" or, rather, "materials and supplies." The concurrent provision of goods with services does not, in and of itself, result in inventoriable merchandise. A common fact pattern involves customers receiving a completed service and a related, but separate, good. In other words, the identities of the service and the good remain separate after delivery. Rulings with this fact pattern suggest that goods will not be incidental materials and supplies merely due to a simultaneous delivery, high correlation of use, or close interaction with associated services. Examples of this include an undertaker's customers who receive administration of funeral affairs and a casket and a light-fixture-servicing business's customers who receive the servicing of their fixtures (cleaning, wiring repair, etc.) and new light bulbs (Wilkinson-Beane, Inc., 420 F.2d 352 (1st Cir. 1970); Technical Advice Memorandum (TAM) 8744005).
Rulings containing a second common fact pattern—a taxpayer's customers receiving a serviced good—suggest that a good cannot be incidental to a transaction whose primary purpose is to transfer that good to a customer. An example of this includes an optometrist's customers who received eyeglasses, the preparation of which involve grinding the lenses to prescription and fitting the frames (Rev. Rul. 74-279). A second example involves customers of a prosthetic limb provider receiving prosthetic limbs, the delivery of which require custom fitting and instruction services (Rev. Rul. 73-485).
Even if a good is found to be merchandise, a taxpayer may still avoid the inventory requirement of Regs. Sec. 1.471-1 if the production, purchase, or sale of that merchandise is not an income-producing factor for the taxpayer's business. Courts and the IRS typically find that merchandise purchases, sales, and production are income-producing factors when the activity level exceeds approximately 8% to 15% of gross receipts. The court in Wilkinson-Beane, for example, held that casket sales of approximately 15% of gross receipts was an income-producing factor. The IRS has also ruled that purchases of merchandise, materials, and supplies falling below 8% of gross receipts were de minimis and allowed for their deduction in the year consumed (TAM 9723006).
The last common fact pattern involves customers receiving a completed service effectuated or exhibited by a good. Unlike the prior two categories, these cases held that the good was not "merchandise" and, therefore, the inventory requirement of Regs. Sec. 1.471-1 was avoided on that element alone. Key factors include the taxpayer's being primarily a service provider, the good's being indispensable to the offered services, and the good's separate identity not surviving use or delivery. Examples include (1) patients receiving medical care effectuated by the delivery of chemotherapy drugs; (2) a contractor's customers receiving the construction of a sidewalk (not construction and some gravel); and (3) a computer repair company's customers receiving a repair of their computers (not a repair and some spare parts) (Osteopathic Medical Oncology & Hematology P.C., 113 T.C. 376 (1999); RACMP, Inc., 114 T.C. 211 (2000); Honeywell, Inc., T.C. Memo. 1992-453). Unlike in the examples above, here the goods became actual components of the serviced item or, in the case of the chemotherapy drugs, irretrievably merged with the serviced patient.
After litigating a substantial number of cases concerning the cash method and the inventory requirement, the IRS issued two revenue procedures to reduce its administrative burden from litigating the issue with small taxpayers. Rev. Proc. 2001-10 excludes taxpayers with average annual gross receipts of less than $1 million from both the requirement to account for inventory under Sec. 471 and the requirement to use the accrual method under Sec. 446. A taxpayer under this exception calculates average annual gross receipts in a manner similar to the $5 million corporate gross-receipts test, discussed above, except that the taxpayer must have satisfied the $1 million gross-receipts test for every year after Dec. 17, 1998. Qualifying taxpayers applying this revenue procedure must account for merchandise in the same manner as nonincidental materials and supplies: Taxpayers may deduct the goods when used or consumed. "Consumption" of merchandise under this revenue procedure occurs in the year the taxpayer sells the merchandise.
Rev. Proc. 2002-28 created a separate qualified small business taxpayer exception with an increased $10 million threshold for gross receipts, but it also added a new requirement that the taxpayer's principal business activity not fall within one of the following North American Industry Classification System (NAICS) codes: mining (211 and 212), manufacturing (31-33), wholesale trade (42), retail trade (44 and 45), or information industries (5111 and 5122). This guidance calculates gross receipts in a similar manner to the $5 million corporate gross-receipts test, but the taxpayer must satisfy the $10 million gross-receipts test for every year after Dec. 31, 2000.
Qualified small business taxpayers applying Rev. Proc. 2002-28 may account for merchandise by using an overall cash method of accounting with inventories accounted for under Sec. 471 or by using either the overall cash or accrual method and treating inventoriable items in the same manner as nonincidental materials and supplies under Regs. Sec. 1.162-3, similar to the method allowed under Rev. Proc. 2001-10. As a final note, the exception under this guidance will no longer apply once a taxpayer's average gross receipts exceed $10 million. The first year a taxpayer fails the gross-receipts test, it must file a change in accounting method. Rev. Proc. 2016-29 addresses the automatic filing procedures generally available for this change of accounting method.
Changing to the cash method
Luckily, taxpayers that qualify under either Rev. Proc. 2001-10 ($1 million gross receipts) or Rev. Proc. 2002-28 ($10 million gross receipts) may apply to use the cash method under the automatic consent procedures (designated change numbers (DCN) 32 and 33 under Rev. Proc. 2016-29 or successor). Specific industries may also apply to use the cash method under the automatic consent procedures, such as certain transportation industry taxpayers (DCN 126), banks (cash/hybrid method, DCN 127), and farmers (DCN 128). All other taxpayers must apply for consent to use the cash method under the nonautomatic consent procedures in Rev. Proc. 2015-13 or successor guidance.
Mindy Tyson Weber is a senior director, Washington National Tax for RSM US LLP. Trina Pinneau is a manager, Washington National Tax for RSM US LLP.
For additional information about this item, contact the author at LoriAnne.Johnston@rsmus.com.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.