Accountants CPA Hartford
William Brighenti, Certified Public Accountant
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Automatic Change to the Cash Method of Accounting
from the Accrual Basis for Tax Return Reporting

by William Brighenti, Certified Public Accountant, Certified QuickBooks ProAdvisor
Accountants CPA Hartford, LLC

Accountants CPA Hartford, LLC: William Brighenti, Certified Public AccountantThe issuance of Revenue Procedure 2001-10 by the Internal Revenue Service in 2001 allowed most small businesses with average annual revenues of $1 million or less to use the cash method of accounting even though these businesses had inventories, which previously had necessitated their use of the accrual method of accounting.  Then in 2002 the issuance of Revenue Procedure 2002-28 by the IRS extended the use of the cash method of accounting to certain qualifying small businesses with average annual revenues of between $1million and $10 million.

To qualify to use the cash method of accounting under Revenue Procedure 2002-28, your small business cannot have the following NAIC industry classifications:
  1. 211:  Gas and Oil
  2. 212:  Mining
  3. 42:  Wholesale Trade
  4. 31 - 33:  Manufacturing
  5. 44 – 45:  Retail
  6. 5111:  Newspaper, Periodical, Book, and Directory Publishers
  7. 5112:  Software Publishers
Moreover, your company cannot be in the farming business.  Finally, your company cannot be prohibited from the cash basis of accounting by Internal Revenue Code Section 448:  that is, it cannot be a C corporation with average annual revenues exceeding $5 million, a partnership with a C corporation as a partner, or a tax shelter.

In spite of these restrictions, Revenue Procedure 2002-28 allows the use of the cash method of accounting by many companies previously prohibited from its use, including those in the construction, transportation, warehousing, health care, finance and insurance, entertainment and recreation, lodging, professional and technical services, food services, repair and maintenance, and personal services industries.

If your company has revenues of less than $1 million in revenues, or if your company is a qualifying business with revenues of less than $10 million, and your business is currently on the accrual method of accounting, you might wish to consider changing to the cash method of accounting.  First of all, the change would be automatically approved by the Internal Revenue Service under the provisions of Revenue Procedure 2001-10 or 2002-28 and it would not require any Form 3115 user fee by the Internal Revenue Service.  Secondly, the adjustment required to convert from the accrual to the cash method of accounting likely would result in a significant tax deduction for the year in which the change occurs.  And lastly, your business would continue to benefit from only reporting taxable income on revenues received rather than earned, since the current recession and the tightness of money is expected to have lingering effects for years to come, leaving businesses struggling to collect on receivables.  Not readily collecting on receivables is devastating enough for any small business; however, paying taxes on receivables requiring many more months to collect may make all the difference for that business’ cash flow to remain solvent.

Basically, the steps for changing to the cash method of accounting under Revenue Procedure 2001-10 and Revenue Procedure 2002-28 are very similar, if not identical.  Both changes require the filing of Form 3115, completing all applicable parts of the form.  Since this is an automatic request and there is no need for a request of an advanced consent from the Internal Revenue Service, Part III of Form 3115 and Part II of Schedule A are irrelevant and should not be completed.

If the change to the cash method were to be elected under Revenue Procedure 2001-10, you would need to write “Filed under Rev. Proc. 2001-10” at the top of Form 3115.  And under Part I on line 1 (a) of the form, you would indicate that the designated automatic accounting method change number is 32.  If you will not be capitalizing costs under section 263A for inventories and wish to treat them as materials and supplies that are not incidental under Treasury Regulation 1.162-3, then you will also need to include that designated automatic accounting method change number on line 1(a), too:  in that case, insert numbers “32 and 50” here.  By treating materials and supplies as not incidental results in deduction of their costs in the year they are consumed or used or in the year in which you actually pay for them, whichever is later.  You would not need to file a separate Form 3115 for this additional election since you may file a single Form 3115 for both changes.

If the change to the cash method were to be elected under Revenue Procedure 2002-28, then you would need to write “Filed under Rev. Proc. 2002–28” at the top of Form 3115.  The designated automatic accounting method change numbers for the change to the cash method and treating materials and supplies as not incidental under Treasury Regulation 1.162-3 would be 33 and 51, respectively, and similarly would be inserted on line 1(a) if you were to elect both changes on Form 3115.

A change from the accrual to the cash method of accounting requires a section 481(a) adjustment, reflecting the resulting increases and decreases in the account balances of accounts receivable, accounts payable, and inventory to prevent duplication or omission of income and expense items.  While a negative section 481(a) adjustment decreases taxable income and would be reported in the year of change, a positive section 481(a) adjustment increases taxable income and is generally spread over four years; however, if the postive adjustment is less than $25,000, you are allowed to recognize the entire amount in the year of change:  you would request that election on line 26 under Part IV of Form 3115.

To illustrate section 481(a)’s computation, assume that at the beginning of the year of change, that the only following account balances relevant to its computation exist:

Accounts Receivable
  $160,000
Accounts Payable
  $125,000

Accounts Receivable
<$160,000>
Accounts Payable
<$125,000>
Section 481(a) Adjustment
<$ 35,000>

You would insert these amounts and the adjustment in Part I on Schedule A.  You would also enter the net amount of this section 481(a) adjustment amount on Part IV, line 25 of Form 3115.

Form 3115 Schedule A Change in Overall Method of Accounting

Since the section 481(a) adjustment is the heart of Form 3115 for a change to the cash method of accounting, it is essential that all computations be correctly presented since the adjustment affects taxable income in the year of change.  In the example presented above, you would recognize the entire $35,000 negative adjustment in the year of change.  Be sure to include as supporting documents copies of the prior year’s income statement and balance sheet as well as a statement indicating the accounting method upon which the financial statements were based.

Upon completion of Form 3115, file it with your tax return for the year of change.  Make a duplicate of the form to mail to the National Office of the IRS no later than the due date of your tax return, including extensions.  Be sure to include the designated automatic accounting method change number for the requested change at the top of the first page of all statements, directly above your company’s name and employer identification number.

With the severe downturn in the economy and the inevitable prospect of customer receivables significantly increasing, this might be the opportune time to change your tax accounting method to the cash basis.  Rev. Proc. 2001-10 allows virtually all companies under $1 million in revenues to take advantage of the cash method of accounting, while Rev. Proc. 2008-28 allows an additional number of companies with revenues under $10 million to adopt it use as well.  If you qualify, the change is automatic:  merely file Form 3115 and compute the 481(a) adjustment.  If you have any questions on making this change or need assistance in filing Form 3115, please contact Accountants CPA Hartford, LLC:  we would be pleased to help you.

This article is provided for informational purposes and is not intended to be construed as legal, accounting, or other professional advice.  For further information, please consult appropriate professional advice from your attorney and certified public accountant. 

Have a tax, a QuickBooks, or an accounting question?  Please feel free to submit it under "Comments" on our blog, Accounting, QuickBooks, and Taxes by William Brighenti, Certified Public Accountant, Accountants CPA Hartford, LLC.  For information and assistance on any tax, QuickBooks, or accounting issue, please visit our website:  Accountants CPA Hartford, LLC.

If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.  The above tax advice was written to support the promotion or marketing of the accounting practice of the publisher and any transaction described herein.  The taxpayer recipients of this offering memorandum should seek tax advice based on their particular circumstances from an independent tax advisor.

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