Revenue Procedure 2002-28 and 2001-10 (Accrual Method Exception for Small Business)
Generally, if inventory is an income-producing factor in your business, tax rules require you to use the accrual method for purchases and sales and to account for inventory at the beginning and end of each year. However, two IRS Revenue Procedures provide an exception to this rule and permit certain taxpayers to use the cash method of accounting.
1. Qualifying taxpayer exception under Revenue Procedure 2001-10.
To be a qualifying taxpayer under this exception:
- Your average annual gross receipts for each prior tax year ending on or after December 17, 1998, is $1 million or less.
- Your average annual gross receipts for a tax year is figured by adding the gross receipts for that tax year and the 2 preceding tax years and dividing by 3.
- Your business is not a tax shelter, as defined under section 448(d)(3) of the Internal Revenue Code.
2. Qualifying small business taxpayer exception under Revenue Procedure 2002-28.
A qualifying small business taxpayer is any taxpayer with average annual gross receipts of $10,000,000 or less that is not prohibited from using the cash method under section 448 (see below - Prohibited Principal Activities Under Revenue Procedure 2002-28).
This cash method safe harbor applies to service businesses, custom manufacturrers, and any other taxpayer whose pricipal activity is not specifically ineligible under Revenue Procedure 2002-28 (see prohibited activities below).
See the text of Revenue Procedure 2002-28 - including examples.
Principal Business Activity
If your business is engaged in two or more activities, for example, you operate a pool cleaning service and also sell pool supplies, the activity that accounts for the largest percentage of gross receipts in the prior year or the largest average percentage of gross receipts in the three previous years, is the principal activity.
The principal activity does not have to account for more than 50% of gross receipts if your business conducts more than two business activities, for example, one activity could account for 40%, a second for 25%, and a third for 35%. The 40% activity would be the principal activity.
Prohibited Principal Activities Under Revenue Procedure 2002-28
- Retail sales
- Wholesale sales
- Manufacturing (other than eligible custom manufacturing)
- Sound recording
If only one set of books is kept, and any of the prohibited activities are the principal activity of the business, then, even if the $10 million gross receipts test is met, the cash method cannot be used for any activity of the business.
Separate Set of Books
If a separate and complete set of books and records is maintained for each business activity, then, if the principal business activity is a prohibited activity, you can use the cash method for an eligible activity but must use the accrual method for the prohibited activity.
To be a qualifying small business taxpayer under the Revenue Proceedure 2002-28 exception:
- Your average annual gross receipts for each prior tax year ending on or after December 31, 2000, is more than $1 million but not more than $10 million.
- You are not prohibited from using the cash method under section 448 of the Internal Revenue Code.
- Your business entity is not prohibited from using the cash method. See Publication 538, pages 9 and 10, and Revenue Procedure 2002-28.
Under Revenue procedure 2002-28, businesses with average annual gross receipts of $10 million or less over the previous three years whose principal business activity is not a prohibited activity may use the cash method even if...
- inventory is held for resale, or
- inventory is held for use as raw materials to produce finished goods for resale, or
- inventory is used in the performance of a service.
As of December 31, 2001, Revenue Procedure 2002-28 expanded the number of small businesses eligible to use the cash method of accounting by increasing the average annual revenue amount from $1 million to $10 million.
Prior to Revenue Procedure 2002-28, under Revenue Procedure 2001-10, only taxpayers with average annual gross receipts of $1 million or less for the previous three years (other than tax shelters) were exempted from using the accrual method.
A taxpayer has average annual gross receipts of $10,000,000 or less if, for each prior taxable year ending on or after December 31, 2000, the taxpayer's average annual gross receipts for the three taxable-year period ending with the applicable prior taxable year do not exceed $10,000,000.
If a taxpayer has not been in existence for three prior taxable years, the taxpayer must determine its average annual gross receipts for the number of years (including short taxable years) that the taxpayer has been in existence. See section 448(c)(3)(A).
The stated purpose of Revenue procedure 2002-28 is to:
- Simplify the recordkeeping requirements of a qualifying small business taxpayer
- Reduce the administrative and compliance burdens of qualifying small businesses
- Minimize disputes with the IRS
An Eligible Business May Not Have to Keep An Inventory
An eligible business may choose not to keep and inventory and treat inventoriable items as nonincidental materials and supplies.
This means, you deduct the cost of inventoriable items:
- In the year you pay for them or
- In the year they are provided to customers
- Whichever is later.
- You're a self-employed roofing contractor on a calendar year.
- You treat inventoriable items as nonincidental materials and supplies.
- You're hired to install a roof in December 2014.
- In December 2014 you purchase and pay for roofing materials and supplies needed to install the roof.
- You install the roof in December 2014.
- You get paid for your service in January 2015.
- You deduct the cost of materials and supplies in 2014 because that's when you paid for them and used them in the performance of your service.
In the above example, had you started and completed the job in January 2015, you would deduct the cost of materials and supplies in 2015 even though you paid for them in 2014.
OBSERVATION: As indicated in the above example, the rules for deducting inventoriable items that are treated as nonincidental materials and supplies may result in an inconsistent application of a true cash method of accounting.
Under the cash method, you deduct the cost of an item in the year you pay for it. However, the rules for deducting inventoriable items that are treated as nonincidental materials and supplies state that you may deduct the cost in the year paid or in the year consumed or provided to the consumer, whichever is later.
The principal business activity is the activity that produces the largest percentage of gross receipts in the prior year or the largest average percentage over the three prior years.
It is not necessary for the principal activity to produce over 50% of gross receipts.
For example, if your business has three activities, and one produces 40% and the other two produce 30% each, the one that produced 40% is the principal activity.
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