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Taxpayers Allowed to Use the Cash Method

The following taxpayers may use the cash method:

  • Individuals
  • Service businesses
  • Custom manufacturers
  • Qualified Personal Service Corporations
  • Farming businesses
  • C corporations with average annual gross receipts of $5 million or less for the three previous years
  • Partnerships with a C corporation as a partner with $5 million or less in average annual gross receipts for the three previous years.

1. Individuals:

Individuals may use the cash method.

2. Service Businesses:

A service business with average annual gross receipts of $10 million or less in the previous three years can use the cash method even if it sells merchandise related to the service or must use materials and supplies in the performance the service.

Example:

You provide a service and sell merchandise related to the service and would like to use the cash method for both activities.

You use only one set of books to account for both activities.

  • You're a sole proprietor.
  • You run a pool cleaning service.
  • In addition to cleaning pools, you sell pool supplies and pool recreational items out of a retail store.
  • Your average annual gross receipts for the last three years were under $10 million.
  • The pool service is your principal activity; it accounted for 70% of gross receipts in the prior year.
  • Sales of pool supplies and recreational items accounted for 30% of gross receipts in the prior year.
  • The retail part of your business is one of the five principal activities listed in the North American Industry Classification System (NAICS) codes as prohibited from using the cash method:
    • Retail
    • Wholesale
    • Manufacturing
    • Mining
    • Information industries

Result:

  • You can use the cash method for both the service and retail activities.
    • Even though the retail activity is a prohibited activity, in terms of using the cash method, it is not the principal business activity.

Had the retail activity been the principal activity, then, you must use the accrual method for both activities (assuming you only use one set of books to account for both activities).

Using two sets of books:

If you use two separate and complete sets of books to account for each activity, then, you could account for the eligible activity (the service) under the cash method.

However, you must account for the prohibited activity (retail sales) under the accrual method.

3. Custom Manufacturers:

If you operate a custom manufacturing business with average annual gross receipts of $10 million or less for the three previous years, you can use the cash method.

The cost of materials and supplies used in the performance of the service must be deducted when:

  • Provided to customers or
  • When you pay for them,
  • Whichever is later.

Custom manufacturing refers to fabricating or modifying property upon demand in accordance with customer design or specifications.

4. A Qualified Personal Service Corporations (PSC) may use the cash method if it meets both the function and ownership tests:

Function Test:

At least 95% of its activities are in the performance of services in the fields of:

  • Accounting
  • Actuarial Science
  • Architecture
  • Consulting
  • Engineering (including surveying and mapping)
  • Health
  • Law
  • Performing Arts
  • Veterinary Services

Ownership Test:

At least 95% of its stock is owned, directly or indirectly at all times during the year by one or more of the following:

  • Employees performing services for the corporation in a field qualifying under the function test.
  • Retired employees who had performed services in those fields.
  • The estate of an employee described in (1) or (2).
  • Any other person who acquired the stock by reason of the death of an employee referred to in (1) or (2), but only for the 2-year period beginning on the date of death.

5. Farming Businesses:

Generally, a taxpayer engaged in the business of farming may use the cash method for its farming business.

Family corporations engaged in farming can use the cash method if gross receipts were $25 million or less for each tax year beginning after1985.

See publication 225, Farmer's Tax Guide, for more information.

Family corporation:

A family corporation is generally a corporation that meets one of the following ownership requirement:

  • Members of the same family own at least 50% of the total combined voting power of all classes of stock entitled to vote and at least 50% of the total shares of all other classes of stock of the corporation.
  • Members of two families have owned, directly or indirectly, since October 4, 1976, at least 65% of the total combined voting power of all classes of voting stock and at least 65% of the total shares of all other classes of the corporation's stock.
  • Members of three families have owned, directly or indirectly, since October 4, 1976, at least 50% of the total combined voting power of all classes of voting stock and at least 50% of the total shares of all other classes of the corporation's stock. For more information on family corporations, see Internal Revenue Code section 447.

6. Corporations and partnerships:

A C corporation or a partnership with a C corporation as a partner may use the cash method if:

  • The production, purchase, or sale of merchandise is not an income-producing factor, and
  • The corporation's average annual gross receipts for the three previous years were $5 million or less.