There are
two basic accounting methods.
Cash method
Under 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 method
Under 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.
NOTE: 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.
Historical Service Position
In general, it has been the
long-standing position of the
Service that, in the year an asset
is placed in service, an accounting
method is adopted relative to the
depreciation method, recovery
period, or convention for the
depreciable property.
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.
Recent Litigation
In 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).
"Get us involved early in the process ... we will assist you in selecting the method of accounting that is most appropriate and advantageous for you.
"
Gregory J. Cook, EA, CPA+
Accredited Tax Advisor
Past President Alabama Society of Enrolled Agents
Past President Alabama Association of Accountants
contact:
secure email 1-800-551-6253 voice mail 117
Cook and Co., Enrolled Agents are licensed by the U.S. Treasury Department
to represent taxpayers before the Internal Revenue Service (IRS). Greg Cook is a
Certified Public Accountant (CPA) licensed by the states of Alabama and Tennessee.