An accounting method is a set of rules used to determine when and how income and expenses are reported.
You choose an accounting method for your business when you file your first income tax return.
There are two basic accounting methods.
Cash methodUnder the cash method, you report income in the tax year you receive it. You usually deduct or capitalize expenses in the tax year you pay them.
Accrual methodUnder an accrual method, you generally report income in the tax year you earn it, even though you may receive payment in a later year. You deduct or capitalize expenses in the tax year you incur them, whether or not you pay them that year.
For other methods, see IRS Publication 538.
If you need inventories to show income correctly, you must generally use an accrual method of accounting for purchases and sales. Inventories include goods held for sale in the normal course of business. They also include raw materials and supplies that will physically become a part of merchandise intended for sale.
Certain small business taxpayers may be eligible to adopt or change to the cash method of accounting and may not be required to account for inventories.
You must use the same accounting method to figure your taxable income and to keep your books. Also, you must use an accounting method that clearly shows your income. In general, any accounting method that consistently uses accounting principles suitable for your trade or business clearly shows income. An accounting method clearly shows income only if it treats all items of gross income and expense the same from year to year.
More than one business. When you own more than one business, you can use a different accounting method for each business if the method you use for each clearly shows your income. You must keep a complete and separate set of books and records for each business.
Changing your method of accounting. Once you have set up your accounting method, you must get IRS approval before you can change to another method. A change in accounting method not only includes a change in your overall system of accounting, but also a change in the treatment of any material item. For examples of changes that require approval and information on how to get approval for the change, see Publication 538 (referenced above, with link).
Historically, a taxpayer has been required to use an accrual accounting method with regard to purchases and sales of merchandise whenever the taxpayer was required to account for inventories. In Revenue Procedure 2001-10, 2001-1 C.B. 272 and Revenue Procedure 2002-28, 2002-1 C.B. 815, the Commissioner has exempted some qualifying taxpayers from having to use an accrual accounting method and from having to account for inventories.
Revenue Procedure 2001-10 is available for use by "qualifying taxpayers." A qualifying taxpayer is a taxpayer (1) who has average annual gross receipts of $1,000,000 or less and (2) who is not a tax shelter within the meaning of Internal Revenue Code Section 448(a)(3).
Revenue Procedure 2001-10 provides detailed procedures for determining whether you satisfy the average annual gross receipts test. Review section 5 of Revenue Procedure 2001-10 for these procedures.
Revenue Procedure 2002-28, exempts "qualifying small business taxpayers" from the requirements to use the accrual accounting method and permits treatment of inventorial items as materials and supplies that are not incidental. You are a qualifying small business taxpayer if your average annual gross receipts are in excess of $1,000,000 but are not more than $10,000,000, and your principle business activity is an eligible business. Review Sections 3 and 4 of Revenue Procedure 2002-28 for the qualification requirements or use this easy flow-chart.
If you are a qualifying taxpayer under Revenue Procedure 2001-10 or a qualifying small business taxpayer under Revenue Procedure 2002-28 you may choose to:
Use the cash accounting method and treat your inventoriable items as inventory within the meaning of IRC Section 471,
Use the cash accounting method and treat your inventoriable items as materials and supplies that are not incidental within the meaning of Treasury Regulation Section 1.162-3, or
Use an accrual accounting method and treat your inventoriable items as materials and supplies that are not incidental within the meaning of Treasury Regulation Section 1.162-3.
You can also follow the historic rule, that is, use an accrual accounting method and treat your inventoriable items as inventory within the meaning of IRC Section 471.
Be aware that Revenue Procedure 2001-10 & Revenue Procedure 2002-28 specifically state when you can deduct the costs for the inventoriable items that are being treated as materials and supplies that are not incidental within the meaning of Treasury Regulation 1.162-3. In the case of a cash method taxpayer, the cost for these items cannot be deducted until the year in which (1) you sell the items or (2) you pay for them, whichever is later.
A taxpayer wishing to change to the cash method or to change its method of accounting for inventory under the rules in Revenue Procedure 2001-10 or Revenue Procedure 2002-28 must follow the provisions of Revenue Procedure 2002-9, 2002-1 C.B. 327, as modified and clarified by Announcement 2002-17, 2002-1 C.B. 561, modified and amplified by Rev. Proc. 2002-19, 2002-1 C.B. 696, and amplified, clarified, and modified by Rev. Proc. 2002-54, 2002-2 C.B. 432.
It is the position of the Service that a change in recovery period is a change in accounting method. Accordingly, a taxpayer is required to obtain the consent of the Commissioner by filing a timely Form 3115.
Recent LitigationIn recent years, the historical position of the Service was challenged in several court cases. The Fifth Circuit, affirming the Tax Court, held that the reclassification of gas station properties as 15-year property for MACRS purposes was not a change in accounting method requiring the Secretary's consent [Brookshire Brothers Holding, Inc. & Subsidiaries v. Commissioner, 320 F.3d 507 (5th Cir. 2003), aff'g T.C. Memo. 2001-150, reh'g denied (March 31, 2003)]. The Circuit Court agreed with the Tax Court that the then existing regulations were meant to allow taxpayers to make temporal changes in their depreciation schedules without the consent of the IRS. The Court also affirmed that Brookshire's change in the classification of its gas station properties from straight-line depreciation of non-residential real estate to declining balance depreciation of 15-year property was not a change in Brookshire's method of accounting under IRC 446.
The decision of the Fifth Circuit in Brookshire conflicts with the opinion of the Tenth Circuit in Kurzet v. Commissioner, 222 F.3d 830, 842-845 (10th Cir. 2000). In Kurzet, the taxpayer sought to change the classification of a reservoir from nonresidential real property to 15-year property under 168, thereby resulting in a change in recovery period from 31.5 years to 15 years. The taxpayer did not change the method of depreciation for the reservoir, which was the straight-line method of depreciation. Although the Tenth Circuit found "some persuasive value to the [taxpayer’s] argument that a change in recovery period under MACRS should be treated like a change in useful life," the court concluded that the Commissioner's interpretation of 1.446-1(e)(2)(ii) as requiring a taxpayer to obtain permission for a change in recovery period is not "plainly erroneous" or "inconsistent" with 1.446-1(e)(2)(ii).
In addition, the Tax Court in Standard Oil Co. (Indiana) v. Commissioner, 77 T.C. 349, 410-411 (1981), held that a change in depreciation method resulting from a reclassification of depreciable property from section 1250 property to section 1245 property is a change in method of accounting. In reaching its decision, the court cited to 1.167(e)-1 and 1.446-1(e)(2)(ii)(a), and explained "It is unquestioned that a change in the method of computing depreciation is a change in method of accounting." Id. at 410. (But see, Green Forest Manufacturing Inc. v. Commissioner, T.C. Memo. 2003-75, which followed Brookshire by holding that a change in computing depreciation from the general depreciation system in 168(a) (GDS) to the alternative depreciation system in 168(g) (ADS) is not a change in method of accounting, and O’Shaughnessy v. Commissioner, 332 F.3d 1125 (8th Cir. 2003), reversing in part 2002-1 U.S.T.C. (CCH) 50,235 (D. Minn. 2001), which also followed Brookshire by holding that a change in classification under MACRS is not a change in method of accounting).
This information is provided as a public service, and should not be construed as individual accounting or tax planning advice. For information on how these general principles apply to your situation, please consult your Cook & Co. Agent.
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Gregory J. Cook, EA, CPA+
Accredited Tax Advisor
Past President Alabama Society of Enrolled Agents
Past President Alabama Association of Accountants
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Historical Service Position
In any subsequent year after the placed-in-service year, a change in depreciation method, recovery period, or convention resulting from a reclassification of such property, results in a change in method of accounting. Such a change requires the consent of the Commissioner (i.e., the taxpayer must generally file Form 3115, Application for Change in Accounting Method), and the adjustment to income is made pursuant to IRC 481(a).
If a taxpayer has adopted a method of accounting, the taxpayer may not change the method by amending its prior income tax returns. See Rev. Rul. 90-38, 1990-1 C.B. 57. Accordingly, amended returns or claims for adjustment, based on a cost segregation study performed after the original return was filed (for the placed-in-service year), should generally be disallowed on the basis that the taxpayer is attempting to make a retroactive method change.
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