|The Quiet War on the Cash Method of Accounting|
2003, The Tax Resource Group, all rights reserved.
information set forth below has been rendered moot for most taxpayers and
is presented here for historical perspective. In general, almost all
taxpayers with average gross receipts for the three most recent tax years
of $1 million or less can retain or switch to the cash method of
accounting. That is the case even if the taxpayer sells what might
otherwise be considered merchandise items. See Rev. Proc. 2001-10.
many taxpayers with average gross receipts for the three most recent tax
years in excess of $1 million but not exceeding $10 million may also be
able retain or switch to the cash method of accounting, but more
restrictions apply to such taxpayers. See Rev. Proc. 2002-28.
be eligible under Rev. Proc. 2002-28, the taxpayer must: A) reasonably
determine that its principal business activity is not described in NAICS
codes 211 and 212 (mining), 31-33 (manufacturing), 42 (wholesale trade),
44 and 45 (retail trade), 5111 and 5122 (information industries); B)
reasonably determine that its principal business activity is that of a
service provider even if property is provided incident to those services;
or C) reasonably determine that its principal business activity is the
fabrication or modification of tangible personal property upon demand in
accordance with customer design or specification.
A war is going on right under our noses!
The IRS is actively attacking the cash method of accounting. Vanquished taxpayers are learning that something as arcane as an accounting method can be essential to their financial well-being. The war has been going on for many years, yet few practitioners have taken notice. If Paul Revere were alive today, he would be riding through the quiet countryside screaming, "the IRS is coming." This column discusses IRS tactics and how practitioners and taxpayers can best prepare to withstand attack.
My firm, The Tax Resource Group, provides tax research and consulting services for other tax professionals. About once a month, we get a desperate call from a tax professional with a client under IRS exam. The conversation usually goes something like this.
My client is a medium-sized company in a service business. The taxpayer uses the cash method of accounting and is not required by Section 448 to use the accrual method. The IRS has disallowed the cash method of accounting and proposed a large adjustment. My client is very upset--thinking, of course, this is somehow all my fault.
Taxpayers are required to use the accrual method of accounting if purchase, production, or sale of merchandise of any kind is an income-producing factor. Regulation Sections 1.446-1(a)(4)(i) and 1.446-1(c)(2)(i). The term merchandise is defined very broadly.
A taxpayer in a traditional merchandise-type business, particularly if there is substantial inventory on hand, is obviously subject to this rule. However, a far less obvious application is a service-type business with an associated product or, alternatively, a related product sold as a side-line. The IRS has forced many such taxpayers, because of the product element, to adopt the accrual method of accounting.
This all started in the early 1970's when the IRS attacked use of the cash method of accounting by a mortuary. The taxpayer provided all the services normally associated with the funeral industry, but as part of that package of services, the taxpayer also provided a casket. The cost of caskets amounted to 15% of the taxpayer's gross receipts. The IRS pointed out, and the court agreed, that the taxpayer was not in a pure service business: sale of a product was also involved. As such, the accrual method of accounting was mandatory. Wilkinson-Beane, Inc., 420 F2d 352, 70-1 USTC ¶9173 (1st Cir., 1970).
Since the Wilkinson-Beane facts represent a fairly flagrant example of substantial merchandise sales masquerading as a service business, the case taken alone is not particularly troubling. Subsequently, however, the IRS elevated the attack on the mixed-product-and-service business to an art form, finding that all sorts of unsuspecting taxpayers are really dealing in merchandise.
Here are a few examples.
1. Newspaper company--paper and ink considered raw materials for manufacture of the product, a newspaper.
2. Optometrist--sale of lenses and frames.
3. Maker of artificial limbs and orthopedic devices.
4. Building maintenance service--sale of replacement light bulbs.
5. Sale of electricity.
6. Contractors of all types!
7. Health-care providers--sale of drugs and various
medical supplies and devices.
Perhaps the group of taxpayers most visibly and aggressively attacked is contractors. Contracting is widely viewed as a service business. Technically, however, the contractor briefly takes title to materials, applies his own knowledge and skill, applies the labor and skill of others, and produces a product--a building, a building component such as a roof, an air conditioning system, a road, a bridge, a boiler, a storage tank, etc.--to which the customer takes title. Stated in this fashion, the activities of a contractor look more a manufacturing operation than a service business.
Based on a good deal of anecdotal evidence gleaned from my practice
as well as the activity in the courts, it seems clear that
the IRS is systematically and aggressively targeting contractors of all sorts.
If contractors are vulnerable, it isn't difficult to develop a list of other types of businesses that might be. This is just a short list and not meant to be comprehensive.
- Movie theaters
- Physicians and other health care providers who sell items such as vitamins, weight- loss products, etc.
- Repair services if parts are involved.
Again, the IRS attack plan is based on Regs. 1.446-1(a)(4)(i) and 1.446-1(c)(2)(i) requiring the accrual method of accounting when production, purchase, or sale of merchandise is an income-producing factor. Most practitioners have heard this rule before. Most of us think we know what it means: the accrual method must be used when inventory on hand is an income-producing factor. I think we practitioners have a mental block about this rule. Look carefully at how the rule is worded: it says production, purchase, or sale of merchandise. Although it is often the case that taxpayers who produce, purchase or sell also have quantities of inventory on hand, as you can see, the rule focuses on producing, purchasing, or selling merchandise rather than having it on hand. Whether the taxpayer has inventory on hand is irrelevant.
Having seen the technical side, what do we tell our clients to do?
The first step is to identify clients that potentially have a problem. How much revenue and gross profit does the taxpayer generate from merchandise sales? How does that relate to the taxpayer's overall operation? Is the merchandise portion material--either in absolute terms or relative to the client's overall business? I suggest a very conservative approach to determining what is material. Remember, the IRS is highly motivated to assert that the merchandise portion of your client's business is an income-producing factor. Since there is no safe harbor standard for materiality, I think it is wise to set the standard of materiality at a fairly low level. I suggest being particularly conservative if the client also has significant levels of accounts receivable. Obviously, the higher the level of receivables, the larger the potential adjustment and the greater motivation to attack this issue.
Having determined who is potentially vulnerable, now determine the amount of the adjustment resulting from a change in accounting method. This exercise may yield surprising (even alarming) results.
Your clients now have two or three options at this point, depending on their circumstances.
In some cases, it may be possible to carve out the merchandise business and put it into a different entity from the service business. Since each entity generally has the independent ability to elect its own accounting method, election of the accrual method of accounting for the merchandise entity shields the service entity from a forced change in accounting methods.
Let's take optometrists and opthalmologists as an example. These professionals have a huge problem--particularly in the case of opthalmologists. The service side of the business--eye examinations, surgery, etc.--very often has a considerable book of receivables. On the other hand, these same professionals (or someone acting on their behalf) normally sell eyeglass lenses and frames. Lenses are custom manufactured and sold along with frames. Also, it is necessary to have a considerable physical inventory of eyeglass frames. This is a prime example of a mixed service and merchandise business. These professionals have a problem that cannot be ignored. Note that I chose them because the problem is so blatant. Don't conclude that the issue must be this obvious to be a problem.
What do the optometrists and opthalmologists do? Often they set up a separate company of some sort to deal with the merchandise business. The separate company elects the accrual method of accounting while the service entity safely remains on the cash basis. This is an elegant solution to a very difficult problem.
It is tempting, as a matter of convenience, to set up a separate schedule C, a one-member LLC, or a qualified subchapter-s subsidiary owned by the service entity. I don't think that really works in this case. To be safe, choose an entity for the merchandise business that has a separate existence from the service entity, both legally and for tax purposes.
If the separate entity method is not a viable option--perhaps for practical or regulatory reasons--the taxpayer must choose between taking a risk or voluntarily changing to the accrual method of accounting.
Note that a voluntary change protects prior years. This prevents the IRS from presenting you with a huge tax bill for tax returns that have already been filed. Also, any tax adjustment required by the change can generally be spread out over time (up to four years). See Rev. Proc. 97-37.
Basically, your client's choice is as follows.
Does your client...
- A) for all future tax years pay tax a bit earlier than otherwise would have been the case based on the present method of accounting; or
- B) enjoy lower taxes now and risk a potentially large tax assessment plus interest and perhaps penalties in the event of a future income tax examination?
Obviously, your client's choice is affected by present cash flow, perceived ability to raise cash in a crisis at some point in the future, and the attitude toward taking tax risks. Remember too that your role as an advisor is not to make this decision, but rather to make the client aware of the choices available.
Good luck! The Tax Resource Group has considerable experience in these matters. If we can be of service, please do not hesitate to call us. 800-578-3498.