Qualifying For the Cash Method

Revenue Procedure 2002-28

As of December 31, 2001 Revenue Procedure 2002-28 expanded the number of small businesses eligible to use the cash method.

To qualify for the cash method under Revenue Procedure 2002-28, your business must meet two tests:

  1. Dollar Test
  2. Eligible Business Activity Test

Here's a handy flow chart from the IRS dealing with the application of Rev. Proc. 2002-28.

The Dollar Test

Under Revenue Procedure 2002-28, to be a qualifying small business taxpayer, your average annual gross receipts for the previous three years cannot exceed $10 million.

Average annual gross receipts is determined by adding the previous three years' gross receipts and dividing by three.

This three-year averaging test for gross receipts began in tax year 2000. So, if you began business operations anytime during tax year 2000 or later, the three-year averaging test applies.

Test Years
Test Years If Your Current Year is...
1998-2000 2001
1999-2001 2002
2000-2002 2003
2001-2003 2004
2002-2004 2005
2003-2005 2006
2004-2006 2007
2005-2007 2008
2006-2008 2009
2007-2009 2010
2008-2010 2011
2009-2011 2012
2010-2012 2013
2011-2013 2014
2012-2014 2015
2013-2015 2016
2014-2016 2017
2015-2017 2018

Example 1:

  • Your current tax year is 2015.
    • Your gross receipts for the three prior years are::
      • 2012 gross receipts: $6 million
      • 2013 gross receipts: $9 million
      • 2014 gross receipts: $12 million

Result:

  • Average annual gross receipts for the three prior years are $9 million ($27 million divided by 3).

Example 2:

  • Using the above example, assume you had the same gross receipts for 2012 ($6 million) and 2013 ($9 million). But for 2014 your business had gross receipts of $16 million.

Result:

  • The cash method would not be permitted.
  • Your average annual gross receipts exceeded $10 million.
    • $31 million divided by 3 equals $10,333,333.

Eligible Business Activity Test

Certain activities are prohibited from using the cash method

Prohibited Activities and their NAICS code (North American Industry Classification System) include:

  • Retail trade: Code 44 and 45
  • Wholesale trade: Code 42
  • Manufacturing: Code 31-33
  • Mining activity: Code 211-212
  • Information industries: Code 5111 and 5122
    • Examples: Newspapers, books, periodicals, database publishers and sound-recording.
  • Information about NAICS codes can be found at www.census.gov.

Your 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 more than 50% of gross receipts if your business has more than two activities, only the largest percentage.

For example, if your business has three activities and one produces 40% of gross receipts and the other two produce 30% each, the one that produced 40% is the principal activity.

You must use a separate set of books to account for each separate activity

Caution! If your business had previously changed from the cash method to the accrual method as a result of becoming ineligible to use the cash method under Revenue Procedure 2002-28, it may not change back to the cash method.

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