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Updated for 2011

Accounting Methods

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Revenue Procedure 2002-28

The Accrual Method Exception Under 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 of accounting.

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.

This normally means, income from sales must be reported in the year earned even if payment is received in the following tax year.

However, under Revenue Procedure 2002-28 there is an exception to the requirement of having to use the accrual method and to keep an inventory even if inventory is an income-producing factor.

In addition, income from sales can be reported in the year payment is actually or constructively received (cash method) rather than in the year earned (accrual method).

Under Revenue Procedure 2002-28, if average annual gross receipts for the previous three years do not exceed $10 million, certain businesses may use the cash method of accounting.

Prior to Revenue Procedure 2002-28, under Revenue Procedure 2001-10, 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.

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

Accrual Method Exception:

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.

An eligible business may choose not to keep and inventory and treat inventorial 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.

Example:

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 2011.
In December 2011 you purchase and pay for roofing materials and supplies needed to install the roof.
You install the roof in December 2011.
You get paid for your service in January 2012.

Result:

You deduct the cost of materials and supplies in 2011 because that's when you paid for them and used them in the performance of your service.

Note: In the above example, had you started and completed the job in January 2012 you would deduct the cost of materials and supplies in 2012 even though you paid for them in 2011.

OBSERVATION: As indicated in the above box, 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. But the rules for deducting inventoriable items that treated as nonincidental materials and supplies states that, you may deduct the cost in the year paid or the year consumed (or provided to consumer), WHICHEVER IS LATER.

For example, as previously demonstrated, if you start and complete a job in January 2012, and you purchased and paid for the materials and supplies for that job in December 2011, you may not deduct the cost of those materials and supplies in 2011; you must deduct them in 2012.

BUT, if you do complete the job in 2011, THEN, you can deduct the cost of the materials and supplies in 2011.

Principal Business Activity

If your business is engaged in two or more activities, 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.

Prohibited Principal Activities:

If only one set of books is kept, and any of the following activities are the principal activity of the business, even if the $10 million gross receipts test is met, the cash method cannot be used for any activity of the business:

Retail
Wholesale
Manufacturing
Mining
Information industries

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.

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.

Accounting Methods-Cash Method: Businesses That Could Benefit From Revenue Procedure 2002-28

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