@Q01 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� � WHAT TAX ACCOUNTING METHOD MAY MY BUSINESS USE? � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� Every new business (or newly-incorporated existing business) must choose an overall tax accounting method, which is gener- ally the cash method, accrual method, or one of the long-term contract methods of accounting (percentage-of-completion or completed contract). As a rule, any business can use the ac- crual method. Only certain types of businesses and taxpayers are allowed to use the cash method of accounting, however, and the use of long-term contract methods is strictly limited (or even forbidden, in the case of the completed contract me- thod, for most large taxpayers). It is usually quite diffi- cult to change accounting methods, once your company has al- ready adopted a method of accounting for tax purposes. QUESTION: Has your company already filed at least one tax return (and thereby already elected an accounting method)? @YN 01\Q02 02\Q03 @Q02 CONCLUSION: Then you are probably stuck with your existing method of accounting, for tax purposes. It is possible, of course to apply to the IRS for permission to change to ano- ther permissible method of accounting, but don't count on getting IRS approval any time soon if the change would ap- pear to be beneficial to you for tax purposes. Hell may freeze over first. However, the IRS will generally permit a "cash-basis" tax- payer (one using the cash method) to switch to the accrual basis of accounting on an expedited basis, without actually having to receive IRS approval, by filing a Form 3115 with the IRS, stating that one agrees to all the provisions of Rev. Proc. 85-37 (or Rev. Proc. 85-36, if your business uses inventories), and if one complies with certain other IRS re- quirements regarding the change of method. While many taxpayers will find the cash method is better for them than the accrual method, the accrual method may actual- ly be preferable in a few situations. For example, if your business makes most of its sales for cash, rather than on credit, and has relatively low levels of accounts receivable outstanding at the end of each year, compared to its ac- counts payable for expenses, then you might want to consider applying to the IRS to change over to the accrual method. @STOP @Q03 QUESTION: Which overall method of accounting do you want to know if your new business can adopt? 1 - Cash method 2 - Accrual method 3 - Percentage-of-completion (long-term contract) 4 - Completed contract (long-term contract) @MC\04 01\Q04 02\Q13 03\Q14 04\Q17 @Q04 The cash method is often desirable, if you are permitted to use it. On the one hand, it gives you flexibility in shift- ing income between taxable years, by either paying or not paying various accrued expenses shortly before year-end. Al- so, if you anticipate that your firm will generally have more accounts receivable at the end of each tax year than accounts payable, the cash method will generally result in a deferral of taxes for you, as compared to the accrual method. However, the cash method is not allowed as the overall accoun- ting method where the production, purchase, or sale of mer- chandise is a significant income-producing factor in the bus- iness, thus requiring the use of inventories, and therefore the accrual method of accounting, unless the IRS consents to use of another method. (Not likely.) QUESTION: Is the production, purchase, or sale of merch- andise a significant income-producing factor in your business? @YN 01\Q05 02\Q06 @Q05 CONCLUSION: Then you cannot use the cash method as the main or overall method of accounting for your businesses (for tax purposes). A business that is required to use inventories must use the accrual method of accounting, generally. (However, it may be possible to use a hybrid method of ac- counting, such as one where you use the cash method for the service portion of your business and the accrual method with respect to purchases and sales of goods from inventory.) Note that if your firm carries on two or more separate trades or businesses, you may be able to use different meth- ods of accounting for the different businesses, so long as each separate business elects a method of accounting that is permissible for its particular type of operation. @STOP @Q06 QUESTION: Is your business a "C corporation," or a partnership that has a C corporation as one of its partners? @YN 01\Q08 02\Q07 @Q07 CONCLUSION: Then it appears that your new business should be able to use the cash method of accounting. (This will also be true in the case of a new business entity, if, for example your existing business has just been incorporated as an S corporation to continue to carry on a previously- operating partnership or sole proprietorship, and thus gets to newly elect an accounting method on its first tax return as a corporation.) Most service businesses, or businesses that do not have in- ventories, are allowed to use the cash method of accounting, except that most C corporations with average annual gross receipts of $5 million or more cannot use the cash method, in general. @STOP @Q08 Large C corporations, or large partnerships with C corpora- tions as partners, are generally not allowed to use the cash method of accounting. However, there are exceptions for small C corporations (or partnerships with C corporations for partners). "Small" corporations or partnerships are those with average annual gross receipts for the three preceding years of no more than $5 million a year. QUESTION: Has your corporation (or partnership) had aver- age annual gross receipts of more than $5 mil- lion a year for the last 3 years? (Certain closely-linked entities may have to be counted as one business, for purposes of computing annual gross receipts.) @YN 01\Q10 02\Q09 @Q09 CONCLUSION: Then your business should be able to elect the cash method of tax accounting (at least for now). It appears that your C corporation or partnership qualifies for the small firm exception to the limitation on use of the cash method. @STOP @Q10 Then you PROBABLY cannot use the cash method of accounting for your C corporation (or partnership). However, certain special types of C corporations with average annual gross receipts of over $5 million may still qualify for use of the cash method (as well as partnerships whose C corporation partners are "qualified personal service corporations"): . "Qualified personal service corporations"; or . Farming businesses (which does not include firms that process farm products). (You may want to select Consulting Topic #3, "Personal Service Corporations," on the XPERT Consultation Menu, to determine if your C company is a "qualified personal service corporation"). QUESTION: Is your C corporation (or the C corporations that are partners in your partnership) a "qualified personal ser- vice corporation"? (Or is your firm in the farm business?) @YN 01\Q11 02\Q12 @Q11 CONCLUSION: It appears that your firm should be entitled to utilize the cash method of accounting, at least for now, since you have indicated that either: . Your C corporation is a "Qualified Personal Service Corporation" as defined by the tax laws; or . Your business is a partnership with one or more C corporations as partners, and each such corporate partner is a "Qualified Personal Service Corpora- tion"; or . Your C corporation (or partnership) is engaged in the business of farming. Note, however (for example), that if during a particular tax year, a "qualified personal service corporation" ("QPSC") were to cease to meet the definition of a QPSC at any time (as an example), then it would be necessary for it to im- mediately change over to the accrual method of accounting, beginning with that taxable year, under the Income Tax Reg- ulations. -- Regs. Sec. 1.448-1T(e)(6) @STOP @Q12 CONCLUSION: Then it appears that your business does not meet any of the tests that would permit it to use the cash method of accounting. It appears that your overall method of accounting will have to be the accrual method. (Even if you choose a long-term contract method of accounting, you would have to use accrual method, rather than cash method, principles in applying the long-term contract method.) @STOP @Q13 CONCLUSION: No problem. The IRS is quite pleased to let a new firm like yours choose the accrual method as its method of accounting. However, the accrual method may not be the best choice for your business (provided that your business is one that is eligible to use the another method). Thus, you may want to consider the cash method if your company is one that is qual- ified to use the cash method. Note, however, that if you are engaged in long-term con- tracts for manufacture, building, installation, or construc- tion of property, you may be required to use one of the long- term contract methods of accounting, either the percentage- of-completion method or, if you so elect and are eligible, the completed contract method. @STOP @Q14 A taxpayer can only use the "percentage-of-completion" meth- od or "completed contract" method of accounting for "long- term contracts." For tax accounting purposes, a "long-term contract" is any contract that your company will not complete during the same taxable year in which it is begun and which is for the manu- facture, building, installation, or construction of property. (A contract that is estimated to be completed within the tax year, but in fact is not completed until the next tax year, is treated as a long-term contract.) QUESTION: Is your business engaged in performing "long- term contracts," as described above? @YN 01\Q16 02\Q15 @Q15 CONCLUSION: Then the use of long-term contract methods of accounting is not relevant to your business, and you cannot use long-term contract accounting (either percentage-of- completion or completed contract) as your main method of accounting. @STOP @Q16 CONCLUSIONS: If, as you have indicated, your business is engaged in doing long-term contract work, it should be able to elect, on its initial tax return, to use the percentage-of- completion method of accounting. In general, the percentage- of-completion method is a specialized method of accounting for long-term contracts, where the estimated total income and expenses attributable to a particular contract are estimated in advance, to arrive at an expected net profit or loss to be incurred on the particular contract. Then, if the contract is estimated to be, say, 65% complete at the end of the first year of work on it, you would report 65% of the total expected profit as taxable income for that year. If the con- tract is, say, 85% complete at the end of the next year, an- other 20% of the total expected profit would be reported that year. Then, if the contract is finished in the third year, any remaining (actual) income or loss would be repor- ted. (Adjustments must be made if prior year estimates proved to be wrong.) An election is also available to use the "10% method," under which you may elect not to recognize any income under a con- tract (or take into account any costs allocable to such con- tract) for the taxable year if, as of the end of the taxable year, less than 10% of the estimated total contract costs have been incurred. In the first tax year in which the 10% threshold is reached, the income and expenses relating to the contract that were not reported in prior years are all taken into account. Once the 10% election is made, all long-term contracts of the taxpayer that are entered into during that year and in subsequent taxable years must be reported using the 10% method (unless the election is later revoked). @STOP @Q17 The completed contract method of accounting can be quite ben- eficial for companies that are allowed to adopt it, since it allows the taxpayer to defer all profit on a long-term con- tract until the year in which the contract is completed, at which time the total net income or loss from the contract in question is includible in taxable income. There's just one problem. The Revenue Reconciliation Act of 1989 repealed the completed contract method for most tax- payers, except for small firms doing construction and cer- tain residential construction contracts. (There is also an exception for "qualified ship contracts," but unless you are a shipbuilder, it will not be of interest to you.) QUESTION: Is your business engaged in doing real estate "construction contracts"? @YN 01\Q19 02\Q18 @Q18 CONCLUSION: It appears that your business will not be eli- gible to use the completed contract method of accounting for long-term contracts. (There is one possible exception: If you are involved in shipbuilding, and your contracting activities include "qualified ship contracts"). @STOP @Q19 Firms in the construction business may use the completed contract method in 3 instances: . The "small contractor" exception, where the firm's annual gross receipts for the last 3 taxable years have averaged $10 million or less, but only for construction contracts estimated not to take more than 2 years to complete); or . Where a firm is engaged in constructing, reconstructing or rehabilitating residential property, consisting of dwelling units contained in buildings containing 4 or fewer dwelling units; or . Where engaged in constructing dwelling units in buildings containing 5 or more dwelling units (limited--can only use completed contract method for 30% of such a contract). QUESTION: Are your construction firm's average annual gross receipts for the last 3 years more than $10 million a year? @YN 01\Q21 02\Q26 @Q20 CONCLUSION: Then it appears that your company is one of the relatively few that are still entitled to use the completed contract method of accounting, under the "small contractor" exception. (And note that the "Uniform Capitalization Rules" of Section 263A of the tax law do NOT apply to such contracts, which is also a good thing, but one we won't go into here.) From the answers you have given, it appears that you may well be eligible to use this highly advanta- geous method of accounting. However, we strongly advise that you consult your tax adviser as to whether you can ac- tually choose the completed contract method of accounting for your business and, if so, whether you SHOULD, in your particular situation. The down side of using the completed contract method under this exception for small companies is that the difference between taxable income computed using the completed contract method and the income that would have been reported if the percentage-of-completion method had been used is a TAX PREFERENCE ITEM under the alternative minimum tax, which means that you may still have to pay some tax in a given tax year even if all of your contracts are under the com- pleted contract method and even if none of them are com- pleted during that tax year. (But the completed contract method is not treated as a tax preference item if the contract is considered a "home con- struction contract," where 80% or more of the estimated total contract costs are reasonably expected to be attrib- utable to building, reconstructing, or rehabilitating of dwelling units contained in buildings of 4 or fewer dwelling units.) @STOP @Q21 You are down, but not out. All or some part of your con- struction contracts may still qualify for use of the comple- ted contract method of accounting, if you are engaged in construction, reconstruction or rehabilitation of residen- tial dwelling units. QUESTION: Are you engaged in such construction of dwel- ling units, and do you have contracts where 80 percent or more of the estimated total contract costs are expected to be attributable to build- ing, reconstructing, or rehabilitating such residential dwelling units? @YN 01\Q23 02\Q22 @Q22 CONCLUSION: Then there does not appear to be any way you can qualify to use the completed contract method of account- ing, since your firm does not appear to qualify for the "small contractor" exception and is not engaged in construc- tion, etc., of residential units (as narrowly defined for this purpose under the tax law). @STOP @Q23 CONCLUSION: It appears then, that your firm will be able to use the completed contract method of accounting for either all, or 30%, of each such residential construction contract. Whether you can account for all of the income and expense under such a contract under the completed contract method, or only 30% (with 70% being accounted for under another method of accounting, such as percentage-of-completion), depends on your answer to the following question: QUESTION: Are the dwelling units you construct under these long-term contracts contained in build- ings consisting of 4 or fewer dwelling units? @YN 01\Q24 02\Q25 @Q24 FURTHER CONCLUSION: Then you should be able to fully uti- lize the completed contract method, with regard to 100% of the income and costs under any such home construction con- tracts for buildings of 4 dwelling units or less. Any tax advantages you derive from using the completed contract meth- od with regard to such residential construction contracts will NOT be a "tax preference" under the alternative minimum tax rules, which is also good news. If you also do larger apartment buildings, you may also use completed contract accounting with regard to 30% of the in- come and cost items relating to those contracts, but the other 70% of the items related to those contracts will have to be reported according to the percentage-of-completion method of accounting. Also, the tax advantages derived from these utilizing the completed contract method for these contracts, if any, WILL be considered "tax preference" items for purposes of the alternative minimum tax. While the ability to use, and the actual application of, the completed contract method of accounting are rather com- plex matters, it appears from your responses to the preced- ing questions that it may be a viable option for your busi- ness. However, rather than accepting this conclusion at face value, we strongly recommend that you consult your tax adviser to see if he or she agrees that you are eligible to use completed contract accounting for tax purposes; and, if so, whether it makes good sense in your particular situation to do so. @BR\24 @Q25 FURTHER CONCLUSION: Since it appears that you are building large, multi-unit residential buildings (such as apartment buildings of 5 or more units), you will still be allowed to use the completed contract method with regard to such long- term construction contracts, but ONLY for 30% of the amount of each such contract. That is, the other 70% of the income and cost items with respect to any such contract must be accounted for under the percentage-of-completion method of accounting, ordinarily. Any tax advantages you derive from using the completed con- tract method with regard to such residential construction contracts, where only 30% of the contract can be accounted for under the completed contract method, WILL be a "tax pre- ference" under the alternative minimum tax rules, which may somewhat detract from the benefits you might otherwise de- rive from using this method of accounting. While the ability to use, and the actual application of, the completed contract method of accounting are rather complex matters, it appears from your responses to the preceding questions that it may be a viable option for your business. However, rather than accepting this conclusion at face val- ue, we strongly recommend that you consult your tax adviser to see if he or she agrees that you may be eligible to use completed contract accounting for tax purposes; and, if so, whether it makes good sense in your particular situation to do so. @BR\25 @Q26 You may qualify for the "small contractor" exception that allows small firms to use the completed contract method for construction contracts. But only if, at the time the con- tracts are entered into, you reasonably estimate that any such contract will be completed within the two-year period beginning on the contract commencement date of the contract. QUESTION: Will your construction contracts, for which you wish to use the completed contract method of accounting, be completed within 2 years of the commencement date of the contract, accord- ing to your most reasonable estimate? @YN 01\Q20 02\Q21 @Q27 @STOP @RD\01 NOTE: Because you do not meet the "small contractor" excep- tion (since your average annual gross receipts exceed $10 million), your use of the completed contract method will be subject to the Uniform Capitalization Rules of Internal Revenue Code Section 263A, which will introduce some addi- tional complexity, and may also somewhat dilute the tax ben- efits of using the completed contract accounting method. @RD\02 NOTE: Because you do not meet the "small contractor" excep- tion (your average annual gross receipts do not exceed $10 million, but you don't meet the 2-year maximum duration test), your use of the completed contract method will, it appears, be subject to the Uniform Capitalization Rules of IRC Section 263A, which will introduce some additional com- plexity, and may also somewhat dilute the tax benefits of using the completed contract accounting method. @HELP @H\01 There are also numerous special kinds of accounting methods that only apply to a particular kind of income or expense, such as inventory accounting methods, installment sale reporting, treatment of research and development expenses, and the like. This question and answer ses- sion deals only with OVERALL methods of accounting (cash, accrual, etc.). @H\02 Among the various IRS conditions on al- lowing you to obtain expedited approval for changing from the cash method to the accrual method is the following: Any decrease in taxable income for the year of the change that may result from the change in accounting method cannot all be taken in the year of change, but must be spread over a period of years, up to ten years, so that you do not get all the tax benefit (if any) at once. @H\03 While many taxpayers will find the cash method is better for them than the ac- crual method, the accrual method may actually be preferable in a few situa- tions. For example, if your business makes few of its sales on credit, and has relatively low levels of accounts receivable outstanding at the end of each year, compared to its accounts payable for expenses, then you might want to consider applying to the IRS to change over to the accrual method. For long-term contracts, the completed contract method is usually preferable. @H\04 Generally speaking, you are most likely to be able to use the cash method of accounting if yours is a service busi- ness. Most retailing, wholesale, and manufacturing businesses are required to use inventory accounting, and thus must be on the accrual method, at least in part. @H\05 While certain "hybrid" methods of ac- counting may be permissible, you have to be consistent. That is, if you re- port gross income on a cash basis, you cannot report expenses of that trade or business on the accrual basis. @H\06 A "C corporation" is a technical term, but, fortunately, is a relatively easy one to understand. A C corporation is, quite simply, any corporation (other than a not-for-profit one) OTHER THAN an "S corporation" (formerly known as a Subchapter S corporation). Thus, unless your corporation is one that has made an election to be taxed as an S corpor- ation, it is an C corporation. There- fore, answer this question "N" ("NO") only if your company is an S corpora- tion, or is not a corporation at all. @H\07 C corporations are generally banned from using the cash method of accounting, ex- cept for certain farming corporations, small C corporations (with average annu- al gross receipts of not more than $5 million for the 3 preceding tax years), and certain "qualified personal service corporations." @H\08 If the entity has been in existence for less than 3 years, then compute its av- erage annual gross receipts for the per- iod it has been in existence. If it had a predecessor entity (say that a corporation was previously a partner- ship), then count the gross receipts of the predecessor (the partnership in this example), for purposes of the test. @H\10 Answer "Y" ("YES") if the answer to ei- ther of the two questions is "Yes." Answer "N" ("NO") if the corporation is NOT a "qualified personal service cor- poration" AND your company in not in business of farming. @H\11 You should be aware, if your firm is a qualified personal service corporation, as defined in the tax law, that while QPSC status may be helpful with regard to its ability to use cash method ac- counting, there is also a major tax disadvantage associated with such QPSC status: The corporation's taxable income will all be subject to tax at the maximum federal corporate tax rate of 34%, with no right to use the lower corporate tax brackets on the first $75000 of income. @H\13 While many taxpayers will find the cash method is better for them than the ac- crual method, the accrual method may actually be preferable in a few situa- tions. For example, if your business makes few of its sales on credit, and has relatively low levels of accounts receivable outstanding at the end of each year, compared to its accounts payable for expenses, then you might want to consider applying to the IRS to change over to the accrual method. @H\14 Note that a manufacturing contract is not considered a long-term contract for tax accounting purposes, unless it in- volves either: . The manufacture of an item that ordinarily requires more than 12 calendar months to complete; or . a unique item not normally included in a taxpayer's finished goods in- ventory. @H\16 A "look-back" rule applies to percentage of completion contracts. Except for cer- tain contracts smaller than $1 million and under 1% of average annual gross re- ceipts for the last 3 years, a taxpayer must pay interest on any additional tax due at completion of the contract if the prior year estimates of total profit to be earned on it were too low (or receive interest from the IRS if prior estimates were too high). @H\17 "Construction contracts" are long-term contracts for the building, construc- tion, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property (real estate). @H\18 "Qualified ship contracts" are, in gen- eral, contracts for construction, in the United States, of 5 or fewer ships, if: . Such ships will not be constructed, directly or indirectly, for the Federal Government; and . The taxpayer reasonably estimates that such contracts will be com- pleted within five years of the contract commencement date. (Section 10203(b)(2) of Public Law 100-203) @H\19 In calculating annual gross receipts for the last three years, include gross re- ceipts of any predecessor business (such as an unincorporated business which you have just recently incorporated). Also, include gross receipts of any other bus- iness which is under common ownership with the business in question. If the previous number of years in busi- ness is less than three, take the aver- age gross receipts of that number of years, instead of three. @H\21 Residential dwelling units means houses, condominiums, townhouses, or apartments. Hotels, motels or other facilities used on a transient basis, or where over half the units in the structure are used on a transient basis, are not considered to be "dwelling units" for purposes of this question @H\23 For purposes of this 4-dwelling unit test, each townhouse or rowhouse is to be treated as a separate building, ir- respective of the number of attached units. @H\26 The "contract commencement date" is the first date on which any costs allocable to the contract (other than bidding ex- penses, or expenses incurred in connec- tion with negotiating the contract) are incurred. @END