New IRS rules help small businesses
The IRS has released a new revenue procedure, 2000-22, that is a much needed first effort at easing the recordkeeping and compliance burdens on small businesses. Here are some guidelines concerning the rules that apply when businesses must pick an accounting method, as well as some other factors that influence that decision.
The new IRS procedure allows any company that meets a sales test to use the cash method of accounting for tax purposes as opposed to the accrual method. Regardless of whether the company is a sole proprietorship, a partnership, an S corporation or a C corporation, it is eligible for the cash method. In addition, if the company meets the sales test, it no longer matters whether it is selling merchandise that is a material income-producing factor. That is a topic that will be discussed later in this column.
What is the sales test? To compute it, a company averages revenue from the last three years. If the average is less than the $1 million threshold, the cash method is always allowed, although it is not required.
For this test, gross receipts include most normal items, such as sales revenue, services, interest, dividends, rents, royalties and such, but not sales tax the company collects.
Companies that are part of controlled groups must combine receipts for all entities included in the group to determine if they meet the $1 million test. If the company has had a short year, an annualization adjustment is required. If the company has been in business for less than three years, the average is computed using revenue from only the years in existence.
The revenue procedure originally had one other requirement – the conformity rule. Except in isolated circumstances, such as a one- time basis to obtain a bank loan, the company was required to use the cash method of accounting for financial statements for any party – from management to investors – and for any year ending after December 16, 2000.
This requirement would have undoubtedly caused problems when an accountant prepared accrual-basis financial statements for a small business client. The IRS remedied the problem this year with revenue procedure 2001-10, which removed the conformity requirement but reemphasized the need for adequate books and records. The procedure also reminded companies to maintain a reconciliation between book and tax income.
However, revenue procedure 2000- 22 does not apply to companies that fail the $1 million average revenue test. For these companies, determining whether to use the cash or the accrual method is based on two issues: the material income-producing factor test and the type of entity.
Generally, companies that sell merchandise must use the accrual method for purchases and sales. This rule is more properly known by the IRS as the material income – producing factor rule.
In the past, the IRS used this rule to force companies to change to the accrual method of accounting, arguing the cash method did not clearly reflect income. In early 2000, the IRS lost a key court case. The courts held that the material income-producing factor test would not apply 1) when material was inseparable from the services; and 2) when sale or use of the material was subordinate to providing the service.
Although the IRS acquiesced in result only, this case forms the basis for arguments that entities such as medical specialists, architects or contractors may use to support their use of the cash method in similar situations although they may have more than $1 million in annual sales.
The second issue companies must consider is their type of entity. C corporations (other than farms) must use the accrual method if they have average annual gross receipts for the previous three tax years of more than $5 million. The accrual method is also required for tax shelters, and for general partnerships failing the $5 million test that have a C corporation as a partner.
Other than for the above exceptions, the rules in revenue procedure 2000-22 are as follows:
For sole proprietors, S corporations, limited liability companies and partnerships:
— The cash method is always allowed if the entity meets the $1 million average revenue test.
— The entity test does not apply.
— The cash method is allowed if the company has more than $1 million in sales and meets the service business test.
— The accrual method is required if the entity fails both the $1 million average revenue and the material income-producing factor test.
For C corporations:
— The cash method is allowed if the company is a qualified personal service corporation.
— The cash method is always allowed if the corporation meets the $1 million average revenue test.
— The cash method is allowed if average sales are more than $1 million but less than $5 million and the company meets the service business test.
— The accrual method is required if the entity fails both the $1 million and the material income-producing factor tests.
— The accrual method is required if the company has more than $5 million in average sales.
Revenue procedure 2000-22 and the subsequent revenue procedure 2001-10 will not solve the cash or accrual questions that have plagued CPAs for the past 25 years. They are, however, a needed first effort at easing the burden of recordkeeping for small businesses.
Small business groups, as well as many members of Congress, continue to push for further relaxation of the sales test so that it will affect only companies with sales between $2.5 million and $5 million annually. Who knows what the current climate for tax changes will produce? However, one thing is certain. The IRS tax code is a continually evolving entity that presents endless challenges to tax professionals and their clients.
Michelle M. Cain, CPA is a Manager at Mengel, Metzger, Barr & Co. LLP. Her specialization varies and includes professional distribution, not-for-profits, and professional service firms.
Copyright 2001 Dolan Media Newswires
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