CHAPTER 5 SELECTING TAX ACCOUNTING PERIODS AND METHODS

Transcription

1 TCH 3/18 CHAPTER 5 SELECTING TAX ACCOUNTING PERIODS AND METHODS Table of Contents Section Description Page 500 INTRODUCTION CHOOSING AN INITIAL TAX YEAR Selecting an Acceptable Tax Year Considering the Tax and Nontax Factors Using a Calendar Year Benefiting from a Fiscal Year Benefiting from a Natural Tax Year Benefiting from a week Year CHOOSING A TAX YEAR FOR A PERSONAL SERVICE CORPORATION Recognizing when a Corporation is a PSC Establishing a Business Purpose for a Fiscal Year Establishing a Fiscal Year Based on Natural Business Year Establishing a Fiscal Year Based on the Facts and Circumstances Electing a Fiscal Year under IRC Sec Meeting the Minimum Distribution Requirement Electing S Status to Avoid PSC Restrictions Recognizing When PSC Status Is Desirable TAX YEAR CONSIDERATIONS WHEN ELECTING OR TERMINATING S STATUS Changing Fiscal Year-end before Electing S Status Changing Year-end following the Termination of S Status Allocating Income and Losses in the S Termination Year Prorata versus Specific Accounting Method Specific Accounting Method for Each Short Year Taking Advantage of Post-termination Transition Period C Corporation Short Year Income Must Be Annualized CHANGING TAX YEARS WITH AUTOMATIC CONSENT Complying with the Additional Conditions Changing to or from a week Year Changing Tax Year of a Consolidated Group Meeting the Filing Requirements REQUESTING APPROVAL TO CHANGE TAX YEARS Meeting One of the Tests for a Natural Business Year Using the Annual Business Cycle Test Using the Seasonal Business Test Using the 25% Gross Receipts Test Comparing the Seasonal Business Test and 25% Gross Receipts Test Changing Tax Year Based on the Facts and Circumstances Filing Form

2 TCH 3/18 CHAPTER 5 SELECTING TAX ACCOUNTING PERIODS AND METHODS Table of Contents (Continued) Section Description Page 506 CHANGING A PERSONAL SERVICE CORPORATION S TAX YEAR Electing a Fiscal Year under IRC Sec Establishing a Business Purpose for a Fiscal Year Establishing a Natural Business Year Meeting the Procedural Requirements Establishing a Fiscal Year Based on Facts and Circumstances CHOOSING AN APPROPRIATE ACCOUNTING METHOD Recognizing the Acceptable Accounting Methods Reporting Income under the Cash Method Deducting Prepaid Expenses under the Cash Method Weighing the Pluses and Minuses of the Cash Method Reporting Income under the Accrual Method Financial Conformity Rule under the Tax Cuts and Jobs Act (TCJA) Applicable Financial Statements under the Financial Conformity Rule Deducting Expenses under the Accrual Method Weighing the Pluses and Minuses of the Accrual Method Using Multiple Methods of Accounting Consolidated and Controlled Groups Deducting Costs under the Intangible Property Rules Deducting Costs under the Tangible Property Regulations USING THE CASH METHOD [IRC SEC. 448(c)] $25 Million Gross Receipts Test Making Accounting Method Changes to Reflect TCJA Changes Requirement to Keep Inventory [IRC Sec. 471(c)] Completed Contract Method [IRC Sec. 460(e)] Uniform Capitalization (UNICAP) [IRC Sec. 236A(i)] Qualifying as a Farming Business Qualifying for Farm Corporation Cash Method Privilege Qualifying as a Personal Service Corporation Meeting the Ownership Test Meeting the Function Test PSC Test for Tax Year Purposes Forming a Separate Corporation Losing Status as a Qualified PSC Handling Materials That Are an Indispensable Part of Services USING THE ACCRUAL METHOD OF ACCOUNTING Income Inclusion for Tax Purposes [IRC Sec. 451(b)] Recognizing Income from Advance Payments [IRC Sec. 451(c)] Deferring Prepaid Income Gift Cards Issued as Refund for Returned Goods

3 TCH 3/18 CHAPTER 5 SELECTING TAX ACCOUNTING PERIODS AND METHODS Table of Contents (Continued) Section Description Page Advance Payments for Warranty Contracts Prepaid Rent, Premiums, or Interest Deferring Income under the Nonaccrual Experience Method Deducting Expenses under the Accrual Method Determining Economic Performance for Deduction Purposes Deferred Bonuses Month Exception Deducting Recurring Items Recurring Item Deduction Cannot Be Prorated Recurring Item Requirements Deducting Prepaid Expenses Deducting Expenses upon Execution of Contract Ratable Service Contract Economic Performance Safe Harbor Deducting Real Property Taxes CHANGING ACCOUNTING METHODS Recognizing Changes that Receive Automatic Consent Making Nonautomatic Changes in Accounting Method Handling Involuntary Changes Tangible Property Regulations Section 481(a) Adjustment USING ACCOUNTING METHODS TO MINIMIZE TAXES Minimizing Corporate Tax Liabilities IDENTIFYING THE APPLICABLE ACCOUNTING RULES BASED UPON THE CORPORATION S GROSS RECEIPTS APPENDIXES 5A Checklist for Permissible Year-end for a Newly Formed (First Year) Personal Service Corporation B Determining If a Corporation Is a Personal Service Corporation C 5D Checklist for Determining If an Existing Personal Service Corporation Can Change Its Year-end Treatment of Commonly Encountered Items under Cash and Accrual Accounting Methods E Accounting Method Changes under the Tangible Property Regulations F C Corporation Gross Receipts Tests

4 TCH 3/18 CHAPTER 5 SELECTING TAX ACCOUNTING PERIODS AND METHODS Table of Contents (Continued) Appendix Description Page 5G Citation of Sources Used in This Chapter

5 TCH 3/ If the financial results of a taxpayer are reported on the AFS for a group of entities, that statement may be treated as the AFS of the taxpayer [IRC Sec. 451(b)(5)]. Deducting Expenses under the Accrual Method Businesses using the accrual method of accounting recognize expenses as they are accrued (or incurred ). For generally accepted accounting principle (GAAP) purposes, an expense is accrued if it is both fixed and determinable. Tax law adopts this two-part requirement [known as the all-events test under IRC Sec. 461(h)] but adds an additional requirement that economic performance must occur. (See section 509 for more on deducting expenses under the accrual method.) Economic performance is deemed to occur when the business has, from an economic perspective, completed the business transaction. Generally, this is when the property or services are provided by (or to) another party or the property is used, as follows: Provided to the Business. If a liability arises from property or services provided to the business by another person, economic performance occurs as the property or services are provided. Property can be treated as provided to the business when it is delivered or accepted, or when title to the property passes. The method used to determine when property is provided must be used consistently from year to year and cannot be changed without the IRS s consent. Provided by the Business. If a liability arises from the business providing services or property to others, economic performance occurs as the business provides the property or services. For this purpose, property or services are deemed to be provided as the business incurs costs in connection with satisfying the liability. Weighing the Pluses and Minuses of the Accrual Method Under the accrual method, income generally is reported in the year earned, and expenses are deducted in the year incurred. The underlying principle behind the accrual method is to match income and expenses in the appropriate year. For this reason, the accrual method is generally required for purchases and sales of inventory [Reg (c)(2)]; income would not be clearly reflected if purchases were deducted in a different period from when sales of those items were recognized The accrual method generally requires more recordkeeping than the cash method, is more complex, and, in some cases produces a less certain result than the cash method. Furthermore, the accrual method is less likely than the cash method to match the tax liability with the taxpayer s ability to pay the tax. However, because of special rules allowing or requiring accrual method taxpayers to recognize some income as payments are received (such as under the installment method or when advance payments are received), and to defer the recognition of other items of income beyond the year of receipt, the accrual method can approximate the end result from using the cash method, or even defer the recognition of income compared to the cash method. Using Multiple Methods of Accounting A corporation engaged in more than one trade or business may use a different method of accounting to compute the taxable income for each trade or business [IRC Sec. 446(d)]. This rule applies only if the taxpayer has two or more trades or businesses that are truly separate and distinct, and the method of accounting adopted for each one clearly reflects the income of that trade or business and the corporation s overall income. (For example, the operations of a personal service business may be kept on the cash method and a manufacturing business on the accrual method if the businesses are separate and distinct and the methods clearly reflect income.) However, no trade or business will be considered separate and distinct unless a complete and separable set of books and records is kept [Reg (d)] Observation: As noted in paragraph , Rev. Proc allows use of the cash method for separate and distinct trades or businesses (for which a complete and separable set of books are maintained)

6 5-24 TCH 3/18 if the principal trade or business activity of the separate business is not one of the prohibited North American Industry Classification System (NAICS) codes, even if the corporation s principal business activity fits within an ineligible NAICS code Law Change Alert: After December 31, 2017, IRC Sec. 448 permits taxpayers (excluding tax shelters) with average annual gross receipts of $25 million or less to be eligible for the cash method of accounting. This replaces the $10 million gross receipts exception in Rev. Proc with a $25 million gross receipts exception, the authors believe that taxpayers can continue to rely on Rev. Proc for guidance related to using the cash method for separate and distinct trades or businesses noted in paragraph Another common strategy for preserving use of the cash method is to place the activity involving the sale of merchandise in a separate entity that adopts the accrual method. This preserves the primary entity as operating exclusively in the fee-for-service area, for which the cash method is allowable. Example 5-12: Segregating eyeglass sales from optometrical services Dr. Eckleburg s incorporated optometrical practice has about 60% of its gross receipts from personal services and 40% from the retail sales of eyeglasses and frames. The business has qualified for continued use of the cash method of accounting under IRC Sec. 448, as its average three year annual gross receipts has been under $25 million and its principal business activity, based on gross receipts percentage, is an eligible health services NAICS code. Due to an extremely successful targeted internet marketing campaign, the doctor anticipates that average gross receipts will soon exceed $25 million, and the practice will no longer qualify for Section 448 protection. To prevent the entire practice from having to convert to the accrual method, Dr. Eckleburg can establish a separate company to conduct the sale of eyeglasses and frames. This company will maintain separate books, records, and billing activity and will report on the accrual method, whereas the entity rendering optometrical services will be able to continue using the cash method of accounting. Consolidated and Controlled Groups Generally, corporations joining a group filing a consolidated return are not required to adopt the accounting methods of the group. Each corporation in the consolidated group determines its accounting methods as if it were filing a separate return [Reg (a)]. However, members of a controlled group generally are treated as one corporation when calculating the various gross receipts tests [IRC Sec. 448(c)(2); Temp. Reg T(f)(2)(ii)]. Deducting Costs under the Intangible Property Rules Normally, cash method corporations deduct expenses in the year paid, and accrual method corporations deduct expenses in the year incurred (provided the expenses meet the all-events test and economic performance has occurred). However, regulations under IRC Sec. 263(a) require several costs to be capitalized as intangible assets. In general, the regulations require capitalization of amounts paid to [Reg (a)-4]: a. Acquire certain intangible assets, including but not limited to, an ownership interest in a corporation or partnership and Section 197 intangibles. b. Create certain intangibles, including the costs to create (which generally includes negotiating, extending, or renegotiating) a financial interest (such as an interest in a partnership, corporation, or other entity), a lease, a noncompete agreement, and prepaid expenses. Capitalization is limited to the assets described in the regulations (i.e., if the asset is not described in the regulations, costs to create it do not have to be capitalized). c. Create or enhance a separate and distinct intangible asset, which is a property interest of ascertainable value that is subject to protection under applicable state, federal, or foreign law and

7 TCH 3/ For more detailed discussion of the final regulations, including the regulations cited in the tables in paragraph , see section 609. Section 609 also discusses a second set of final regulations addressing the disposition of tangible property, including partial dispositions. Coverage of accounting methods and accounting method changes under the final regulations can be found in section 510 and Appendix 5E Note: When applying the tangible property regulations, the terms amount paid and payment for accrual method taxpayers mean a liability incurred within the meaning of Reg (c)(1)(ii). A liability cannot be taken into account before the tax year in which it is incurred [Reg (a)-1(c)(1)] Some of the provisions in the final tangible property regulations require an election on the tax return, while others require a change in accounting method. Elections are made by attaching the required statement to the taxpayer s timely filed original tax return (including extensions) for the year. Accounting method changes are automatically approved by the IRS if the appropriate procedures are followed. This means a Form 3115 (Application for Change in Accounting Method) must be attached to the taxpayer s timely-filed (including extensions) tax return for the year of change and a copy of the form must be filed with the IRS s Covington, Kentucky Service Center no later than the date the original tax return is filed. See Appendix 5E for the commonly encountered tangible property provisions requiring a change in accounting method An election does not require the filing of Form For example, the de minimis safe harbor election under Reg (a)-1(f) for materials and supplies is an annual election that does not require an accounting method change. While simpler, at least initially, than requesting an accounting method change, this creates compliance issues in future years, since taxpayers will need to attach an election statement to their tax return every year they intend to use an elective provision. 508 USING THE CASH METHOD [IRC SEC. 448(c)] For tax years beginning after 2017, the ability to use the cash method is greatly expanded. Any entity (other than a tax shelter) that meets the $25 million gross receipts test can use the cash method regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. Likewise, C corporations and partnerships with C corporation partners can use the cash method if they meet the $25 million gross receipts test. For years beginning before 2018, if the purchase, production, or sale of merchandise was an income-producing factor, inventories were required to be maintained, and the cash method was not allowed unless the taxpayer met a $1 million gross receipts test under Rev. Proc or a $10 million gross receipts test under Rev. Proc (which only applied if the taxpayer s principal business activity was an eligible activity). Also, Rev. Proc did not apply to C corporations or LLCs with C corporation members. For tax years beginning after 2017, both of those revenue procedures are rendered obsolete. Also, for years beginning before 2018, C corporations and partnerships with a C corporation partner with average annual gross receipts over $5 million could not use the cash method. $25 Million Gross Receipts Test For tax years beginning after 2017, taxpayers other than a tax shelter can use the cash method if their average annual gross receipts are $25 million (adjusted for inflation for years after 2018) or less [IRC Sec. 448(c)]. The test is based on the three tax-year period before the testing year. All taxpayers treated as a single employer under IRC Sec. 52(a) or (b) or IRC Sec. 414(m) or (o) are treated as a single taxpayer. If a taxpayer has not been in existence for the three-year period, the test period includes the number of years the taxpayer has existed. Finally, gross receipts for short tax years must be annualized [IRC Sec. 448(c)(3)]. Gross receipts are computed using the taxpayer s tax accounting methods for the year in which the receipts were recognized and include gross receipts from the sale of goods (less returns and allowances) and from services, investment income (including tax-exempt income), and gains from the sale of assets [Temp. Reg T(f)(2)(iv)] Observation: This is the same test as that used to determine whether a taxpayer is required to maintain inventories for tax [IRC Sec. 471(c)]

8 5-30 TCH 3/ Law Change Alert: The $25 million threshold that applies to tax years beginning after 2018 is applied to each test year based on the three tax-year period ended immediately before the test year. For years beginning before 2017, the $5 million test required the taxpayer to meet the gross receipts test for every prior year since A similar rule applied to the $1 million and $10 million exceptions. Under the pre-2018 tests, once the threshold was exceeded, the exception no longer applied to the test year and all future years. Example 5-15: $25 million threshold. Asta, LLC, a calendar-year taxpayer that provides consulting services, is classified as a partnership and has a C corporation member. To determine whether it can use the cash method in 2018, Asta s gross receipts are tested as follows: Gross receipts for the year ended 12/31/2015 $ 30,000,000 Gross receipts for the year ended 12/31/ ,250,000 Gross receipts for the year ended 12/31/ ,000,000 Total $ 80,250,000 Average for the test period ($80,250,000 3) $ 26,750,000 For 2018, the average annual gross receipts for the test period exceed $25 million. So, Asta cannot use the cash method for Variation: Assume that in 2018, Asta loses a substantial client and has gross receipts for the year of $10 million. Asta can use the cash method in 2019 because, based on the following gross receipts test, the average gross receipts for the 2019 test period are not more than $25 million: Gross receipts for the year ended 12/31/2016 $ 25,250,000 Gross receipts for the year ended 12/31/ ,000,000 Gross receipts for the year ended 12/31/ ,000,000 Total $ 60,250,000 Average for the test period ($60,250,000 3) $ 20,083, Note: A change in accounting method under IRC Sec. 448(c)(1) is treated as initiated by the taxpayer and made with IRS consent [IRC Sec. 448(d)(7). Taxpayers that use the accrual method and now fall under the $25 million gross receipts threshold should consider filing for an accounting method change. (Rev. Proc provides the current list of automatic accounting method changes.) Making Accounting Method Changes to Reflect TCJA Changes Taxpayers that are eligible to use the automatic change procedures found in Rev. Procs and can follow the procedures in Rev. Proc to obtain automatic consent to change accounting methods for the following changes made by qualifying small taxpayers that meet the $25 million average annual gross receipts test added by the 2017 Tax Cuts and Jobs Act (TCJA): a. Change to the cash method of accounting (IRC Sec. 448) b. Change from their current method of accounting for inventory under IRC Sec. 471 to either treating inventories as non-incidental material and supplies under Reg , or conforming to the taxpayer s financial accounting treatment of inventory

9 TCH 3/ c. Change by producers or re-sellers to stop applying the UNICAP rules (IRC Sec. 263A). d. Change from accounting for exempt long-term construction contracts under the percentage of completion method (PCM) or change to stop applying the UNICAP rules to home construction contracts (IRC Sec. 460) Form 3115 (Application for Change in Accounting Method) is required to be filed for requesting these changes; however, there is a reduced filing requirement and only certain questions are required to be answered based on the accounting method change that is being requested. Taxpayers that are making more than one of the changes listed in item a., b., or c. of paragraph may make all of the changes on one Form 3115, provided all of the designated automatic accounting method change numbers are properly entered on the form Rev. Proc generally provides that an accounting method change made using the automatic change procedures for a specific accounting method cannot be made for the same item more than once within a five-year period. This restriction will not apply to any of the changes described in paragraph for a taxpayer s first, second, or third tax year beginning after 2017 [Rev. Proc ] If a taxpayer has existing Section 481(a) adjustments from prior, but related, accounting method changes, those adjustments can either continue to be accounted for separately or netted against any new Section 481(a) adjustment that results from one of these accounting method changes resulting from the TCJA. Requirement to Keep Inventory [IRC Sec. 471(c)] Under IRC Sec. 446, taxpayers that are required to maintain inventories under IRC Sec. 471 (generally, those for whom the purchase, production, or sale of merchandise is an income-producing factor) must use the accrual method of accounting [Reg (c)(2)(i)]. For tax years beginning after 2017, taxpayers (other than tax shelters) with average annual gross receipts of $25 million or less are not required to maintain inventories for tax and, thus, not required to use the accrual method under IRC Sec. 446 [IRC Sec. 471(c)]. If the taxpayer is not a corporation or partnership, the $25 million gross receipts test is applied as if each of that taxpayer s trades or businesses is a corporation or partnership [IRC Sec. 471(c)(3)] Taxpayers who are exempted from maintaining inventories under the $25 million test can either (a) treat inventory as nonincidental materials and supplies or (b) account for inventory using a method that conforms to the accounting method used in their applicable financial statement (or if they do not have an AFS, the accounting method used in their books and records prepared in accordance with their accounting procedures) [IRC Sec. 471(c)(1)(B)]. Under Reg , cash method taxpayers deduct the cost of nonincidental materials and supplies only as they are consumed or used in the taxpayer s business or, if later, when the taxpayer pays for the items. Because the cost of inventory is potentially capitalized under the nonincidental supplies rule and not the inventory rules, the Section 263A uniform capitalization rules do not apply Note: A change in accounting method under IRC Sec. 471(c)(1) is treated as initiated by the taxpayer and made with IRS consent [IRC Sec. 471(c)(4). Rev. Proc provides the current list of automatic accounting method changes. Completed Contract Method [IRC Sec. 460(e)] The completed contract method (CCM) allows qualifying taxpayers to defer the recognition of revenue earned on a contract until the year the contract is completed [Reg (d)]. To qualify, the (a) contract must be a construction contract (manufacturing contracts are ineligible), (b) taxpayer must estimate that the contract will be completed within the two-year period beginning on the contract commencement date, and (c) taxpayer s average annual gross receipts meet the $25 million gross receipts threshold under IRC Sec. 448(c) [IRC Sec. 460(e)(i)(B)]. Note that for years beginning before 2018, a $10 million gross receipts threshold applied

10 5-32 TCH 3/ Note: A change in accounting method under IRC Sec. 460(e) is treated as initiated by the taxpayer and made with IRS consent. However, unlike the other method changes discussed here, the change is made on a cut-off basis [IRC Sec. 460(e)(2)(B)]. Uniform Capitalization (UNICAP) [IRC Sec. 236A(i)] For any tax year starting after 2017, taxpayers that qualify to use the cash method of accounting because of the $25 million gross receipts test under IRC Sec. 448(c) are not subject to the Section 263A UNICAP requirements [IRC Sec. 263A(i)]. This exception from UNICAP applies to taxpayers that produce real or personal property, as well as to taxpayers that acquire such property for resale. Note that for tax years beginning prior to 2018, this exception applied only to personal property acquired for resale, and only to those taxpayers with three-year average annual gross receipts of $10 million or less Note: A change in accounting method under IRC Sec. 263A(i) is treated as initiated by the taxpayer and made with IRS consent [IRC Sec. 263A(i)(3)]. Rev. Proc provides the current list of automatic accounting method changes. Qualifying as a Farming Business Farmers and ranchers enjoy a unique opportunity in our income tax system the ability to report income and expenses under the cash method of accounting, despite operating a business where the sale of goods (as opposed to services) is material to the production of income [IRC Sec. 448(b)(1)] Law Change Alert: After December 31, 2017, IRC Sec. 447 permits farming C corporations (and certain partnerships) with average annual gross receipts of $25 million or less to be eligible for the cash method of accounting. More discussion on this topic begins at paragraph The cash method affords a number of distinct advantages to farmers. Under the cash method, income and expenses for the year are readily determinable, without the uncertainties that accompany the valuation and quantification of beginning and ending inventories. Further, the cash method provides the ability to plan and adjust income through year-end acceleration or deferral of sales and expenditures. This allows the cash method farmer to target an optimum level of net income for the year, and will, over time, result in the ability to maintain a stable taxable income from year to year. On the other hand, farmers on the accrual method will often find wildly fluctuating taxable income from year to year, due to variations in production quantities and farm commodity prices in annual year-end farm inventories A farm, for purposes of the cash method privilege, includes livestock, dairy, poultry, fruit, truck farms, nurseries, and sod farms, as well as plantations, ranches, orchards, and all land used for farming operations. A farm also includes a fish farm where fish are grown and raised, as opposed to merely caught or harvested. Farmers cultivate, operate, or manage farms for profit, either as owners or tenants (Reg ). Generally, a taxpayer engaged in forestry or the growing of timber is not considered to be farming. However, raising timber is treated as farming for purposes of the exception to the prohibition on the use of the cash method by C corporations and partnerships having a C corporation as a partner [Temp. Reg T(d)(2)(ii)]. Also, a farm operated for recreation or pleasure, rather than for profit, is excluded (Reg ) Processing or merely reselling agricultural commodities does not result in farmer status. However, where there is significant participation in the raising and growing functions, but the business activity also extends into processing, it is still possible to meet the farming definition and qualify for the cash method. In a 1990 private letter ruling, a seed corn processing business that raised about 50% of its corn was allowed to use the cash method. The business participated to a significant degree in the growing process, even with respect to corn contracted for growing by others (Ltr. Rul ). Qualifying for Farm Corporation Cash Method Privilege A corporation engaged in the trade or business of farming, as well as a partnership in the business of farming that has a corporation as a partner, must use the accrual method under IRC Sec. 447(a).

11 TCH 3/ After December 31, 2017, farming C corporations and partnerships with C corporation partners with average annual gross receipts of $25 million or less are eligible for the cash method of accounting. The dollar limit is adjusted for inflation after Average annual gross receipts are calculated using the three-tax-year period ending with the tax year that precedes the tax year that the cash method is used. The gross receipts of all related entities must be considered for purposes of the exception. Entities are related if they are treated as a single employer under IRC Sec. 52(a) or 52(b) (commonly controlled business rules) or 414(m) (affiliated service group rules) [IRC Sec. 448(c)] Prior to 2018, IRC Sec. 447 included special provisions and definitions for family farm corporations or controlled groups of corporations whose gross receipts for each tax year beginning after 1985 were less than $25 million. Under these prior rules, family farm corporations that met these provisions were eligible for the cash method of accounting. However, the new $25 million (adjusted for inflation after 2018) exception of IRC Sec. 448(c) negated the exception for family farm corporations and removed the special provisions and definitions for family farm corporations previously contained in IRC Sec The new gross receipts exception applies to all farming corporations and therefore the special provisions for family farms was no longer needed. Example 5-16: Qualifying for cash method using the average annual gross receipts test. Flat Top Corporation (Flat Top) is a calendar year C corporation and is engaged in farming. After taking into account aggregation rules of IRC Sec. 448(c), Flat Top has gross receipts of only $20 million in 2015, $25 million in 2016, and $30 million in Average annual gross receipts for 2015, 2016, and 2017 is $25 million. Because Flat Top s average gross receipts for 2015, 2016, and 2017 do not exceed $25 million, IRC Sec. 447 does not require Flat Top s use of the accrual method in The use of the cash method implies that revenue is recognized when cash is received or made available, and disbursements are deductible when made. However, there are exceptions, as follows: a. The costs of inventory (e.g., livestock) purchased for resale can only be deducted by a cash method taxpayer in the year the sale occurs [Reg (a)(2)]. b. The installment method is specifically allowed for reporting the sale of inventory of cash method farmers [IRC Sec. 453(l)(2)(A)]. c. A statutory deferral is allowed for crop insurance proceeds and for gain from the sale of livestock sold early due to weather-related conditions [IRC Sec. 451(f)]. d. A statutory 50% limit exists on the amount of prepaid expenses that a cash method farmer may deduct [IRC Sec. 464(d)]. e. While fertilizer expenditures are normally deducted under the cash method when incurred, there is an annual elective opportunity to capitalize and amortize fertilizer costs (IRC Sec. 180). f. Soil and water conservation expenditures, which might otherwise be capital in nature, are allowed current deductibility, limited to 25% of current farm gross income [IRC Sec. 175(a)]. g. Cash method farmers raising plants with a preproductive period of more than two years are subject to the Section 263A uniform capitalization rules [IRC Sec. 263A(d)(1)]. Qualifying as a Personal Service Corporation Qualified personal service corporations (PSCs) can use the cash method [IRC Sec. 448(b)(2)]. This privilege is intended to allow PSCs rendering professional services to retain the use of the cash method, even if their gross receipts exceed the $25 million threshold. (C corporations whose average annual gross receipts exceed $25 million are required to use the accrual method under IRC Sec. 448.) As noted in section 108 and Appendix 1G, the definition of a PSC varies depending on the limitation/rule to which the definition applies. For accounting method purposes, a qualified PSC is any corporation meeting an ownership test and a

12 5-34 TCH 3/18 function test [IRC Sec. 448(d)(2); Temp. Reg T(e)(3)]. See Appendix 5B for a checklist that practitioners can use to determine if a corporation is a qualified PSC for using the cash method of accounting Some practitioners have construed the PSC statutory cash method privilege as implying that every corporation conducting services in one of the licensed professions (health, law, engineering, etc.) is entitled to the cash method. However, the Section 448 rules do not override the general requirements of Reg (c)(2), which hold that an accrual method must be used with regard to the purchase and sale of inventory [Temp. Reg T(c)]. Nevertheless, C corporations with a principal business activity of professional services and with gross receipts equal to or less than $25 million should qualify for the cash method. This means that a C corporation with over $25 million of average annual gross receipts could be forced to use the accrual method if its activities begin to involve the sale of merchandise, and if it fails to meet the qualified PSC definition Observation: The Tax Court held that chemotherapy drugs administered by a medical clinic to its patients were not merchandise within the meaning of Reg , so the taxpayer could continue using the cash method of accounting. The drugs were in the nature of a supply and were an integral and inseparable part of the taxpayer s medical services (Osteopathic Medical Oncology and Hematology) Meeting the Ownership Test. The ownership test requires that 95% or more (substantially all) of the value of the corporation s stock be owned (directly or indirectly through partnerships, S corporations, or qualified PSCs) by employees of the corporation (or retired employees, or estates or heirs of deceased employees) at all times during the tax year. The employees must provide (or, in the case of retired or deceased employees, have provided before their retirement or death) services in connection with one of the qualified fields noted under the function test, as discussed in the paragraphs that follow. (Special rules apply when stock is owned by heirs of deceased employees [Temp. Reg T(e)(5)].) Community property laws are ignored when applying this test [IRC Sec. 448(d)(4)(A)] Meeting the Function Test. The function test requires that substantially all (at least 95%) of the corporation s activities involve performance of services in one or more of the following fields [Temp. Reg T(e)(4)]: health, law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts, and consulting Temp. Reg T(e)(4)(i) notes that services related to the actual performance of the qualified services are generally included when applying the 95% test (e.g., investment advice provided by a financial planner would qualify, but the actual sale of investment products would not). Services related to the performance of actual qualifying services include administrative and supervisory services. Example 5-17: Failing the function test to be treated as a PSC. PS Corporation (PS) is owned 100% by Pat, an optometrist. Currently, PS provides only eye examination services, which generate revenues exceeding $1 million per year. Pat is planning to expand by selling glasses, frames, and contact lenses. Ownership of the corporation will not change. Four new full-time employees will be hired to provide all services related to sales and will not perform any examinations. Pat estimates that after the expansion, 56% of the current employees time (hours of current full-time employees divided by number of hours of full-time employees after expansion) will be spent on qualified services. PS uses the cash method of accounting because it is a qualified personal service corporation. PS meets the 95% ownership test (100% of the stock is owned by Pat, an employee of the corporation) and it meets the function test (100% of its services are health-related). Pat wants the corporation to continue using the cash method of accounting. After the proposed expansion, PS will continue to meet the ownership test since Pat, an employee providing qualified health field services, owns 100% of PS. Determining whether PS will meet the function test after the expansion is more difficult

13 TCH 3/ In the consulting field, sales provided in conjunction with consulting are not considered consulting services [Temp. Reg T(e)(4)(iv)]. In an example in the regulations, a data processing consulting business designed and recommended a data processing system and ordered the equipment for the client. Fees for the corporation s services were based on the equipment orders. The services are not treated as consulting services [Temp. Reg T(e)(4)(iv)(B), Example 6]. Based on this example, the selling of glasses will not be considered qualified health field services. However, as long as the examination services remain separate with separate fees, the selling of glasses will not alter the qualification of the examination services as health field services. If PS provides eyewear sales, it will lose its status as a qualified PSC because it will not meet the requirements of the function test. (After the expansion, only 56% of PS s activities are health-related. The function test requires that at least 95% of activities be from qualified services.) Pat should consider forming a separate corporation (see paragraph ) for eyewear sales PSC Test for Tax Year Purposes. A corporation may not be a qualified PSC for using the cash method of accounting because of the function test and ownership test, but still be a PSC for purposes of establishing a tax year under IRC Sec. 441 if the three tests discussed in paragraph are met. Example 5-18: Qualifying as a PSC for tax year or cash method purposes. Assume the same facts as in Example Pat is an employee-owner because she owns more than 10% of PS s stock. Also, assume that 56% of PS s compensation costs are related to time spent on qualified personal services. The principal activity of PS will be the performance of personal services because compensation costs for performing personal services exceed 50% of the corporation s total compensation costs. Also, assume that more than 20% of PS s compensation costs are attributable to payments made to Pat, an employee-owner, for personal services. PS qualifies as a PSC for tax year purposes even though PS did not qualify as a PSC to use the cash method of accounting Forming a Separate Corporation. When a company expands its activities such that it will no longer meet the definition of a qualified PSC, the owners should consider forming a new corporation for the new activities. Thus, the status of the original corporation as a qualified PSC would not change The new corporation formed will be required to use the accrual method unless it can meet one of the exceptions. For example, the $25 million exception authorized by IRC Sec. 448(c) might apply. However, the two activities (sales and service) must be combined when applying this test even if the activities are placed in separate corporations [IRC Sec. 448(c)(2)]. Thus, if the projected gross receipts for the old and the new corporation combined are $25 million or less, the new corporation would meet the exception However, the use of separate corporations would not insulate either corporation from other provisions of the Code that preclude the use of the cash method. For example, if a corporation selling products maintains inventories, it would be required to use the accrual method of accounting [Reg (c)(2)]. Exceptions to this rule apply where the merchandise inventory is a relatively small percentage of overall sales (Ltr. Rul ) or to corporations with average annual gross receipts of $1 million or less, or gross receipts of $25 million. Example 5-19: Retaining use of the cash method by forming a new corporation. Assume the same facts from Example By forming a new corporation, Pat can ensure PS s ability to continue to use the cash method even if gross receipts exceed $25 million. If the new corporation does not qualify for the $25 million exception, it must use the accrual method (at least for its inventories) because its operations will involve inventories (of glasses, frames, and contact lenses) Losing Status as a Qualified PSC. Qualified PSCs may be able to use the cash method regardless of their gross receipts, but they are also subject to a flat 21% tax rate under IRC Sec. 11(b)(2). Prior to 2018, lower graduated tax rates for C corporations may have incentivized PSCs with taxable incomes below $335,000 (incomes eligible for tax rates below 35%) to lose PSC status. However, with the passage of the flat

14 5-36 TCH 3/18 tax rate of 21% for all C corporations, including PSCs, there is no federal income tax benefit associated with losing PSC status One way to lose PSC status is to increase product sales so that less than 95% of the company s activities are from the performance of qualified services. The company can continue using the cash method for its service activities if it qualifies for the $25 million exception. However, the accrual method would be required for the product sales activity since it probably involves maintaining inventories When the corporation s sales increase to the point where it no longer qualifies for the $25 million gross receipts exception, there are planning opportunities available to help mitigate the impact of switching to the accrual method of accounting. One possibility is for the corporation to elect S corporation status because S corporations are allowed to use the cash method. Before electing S status, however, the potential for built-in gains tax problems must be carefully considered. A second possibility (as previously discussed) is for the business to be realigned so that it continues to meet the qualified PSC standards If neither of these two options is possible, the corporation should consider building up its accounts receivable in the year before the accounting method change to take advantage of the required four-year spread. At the same time, it should reduce liabilities by paying accounts payable and accrued expenses. The net effect of these two steps is to reduce taxable income in the current year and increase the income that will be spread over four years, thereby deferring a portion of the income tax to a later year. Handling Materials That Are an Indispensable Part of Services In several cases, the IRS attempted to force corporations to use the accrual method due to the presence of materials and supplies, which the IRS attempted to recharacterize as inventoriable merchandise. These cases have mainly involved professional service providers and construction contractors. Fortunately, the courts have not agreed with the IRS position Law Change Alert: After December 31, 2017, taxpayers (excluding tax shelters) with average annual gross receipts of $25 million (indexed for inflation after 2018) or less are exempt from the UNICAP rules [IRC Sec. 263A(i)] In Osteopathic Medical Oncology and Hematology, a professional corporation specializing in outpatient chemotherapy treatment used the cash method of accounting. Although the corporation s billing statements itemized charges for the drugs, this was mainly to comply with Medicare and private insurance guidelines. The drugs could not be obtained or administered separately from the chemotherapy treatment. The Tax Court ruled that the furnishing of chemotherapy drugs was an inseparable part of rendering medical services and did not constitute the sale of merchandise The IRS later acquiesced in this decision and stated that, under circumstances comparable to those presented in this case, prescription drugs or similar items administered by healthcare providers are not merchandise within the meaning of Reg A similar finding was made in three cases involving construction contractors furnishing a product (asphalt or concrete) that becomes unusable in a short period and is delivered along with the service provided (Galeridge Construction, Inc., RACMP Enterprises Inc., and Jim Turin & Sons, Inc.). The courts found that the materials were an indispensable and inseparable part of the services provided by the corporation and did not constitute merchandise Thereafter, the IRS announced that corporations in similar businesses (particularly contractors involved in paving, painting, roofing, drywall, and landscaping) will not be required to use inventory accounts and an accrual method of accounting. This interim policy does not apply to resellers, manufacturers, or others required by IRC Sec. 448 to use an accrual method, or to situations subject to prior Reg (Chief Counsel Notice CC )

15 TCH 3/ USING THE ACCRUAL METHOD OF ACCOUNTING Taxpayers using the accrual method recognize income in the year it is earned and deduct expenses in the year incurred to properly match income and expenses within the appropriate year. This is why the accrual method is required when the production, purchase, or sale of merchandise is a material income producing factor. Income would not be clearly reflected if purchases were deducted in a tax year different from (typically prior to) the year when the sale of the items was recognized. Income Inclusion for Tax Purposes [IRC Sec. 451(b)] Taxpayers using the accrual method report income when all the events fixing the entity s right to the income have occurred and the amount can be determined with reasonable accuracy. The first part of the test (the right to the income is fixed) is met on the earliest of (a) the date the required performance occurs, (b) the date payment is due, or (c) the date payment is made (Rev. Rul ) Law Change Alert: For tax years beginning after 2017, the all-events test for recognizing income is met no later than when it is recognized on the taxpayer s (a) applicable financial statement (AFS) or (b) other financial statement as specified by the IRS [IRC Sec. 451(b)(1)(A)]. This is referred to as the AFS conformity rule An AFS is a statement that is (in order of priority) [IRC Sec. 451(b)(3)] a. a Form 10-K or annual statement to shareholders required by the SEC and certified as being prepared in accordance with GAAP; b. an audited financial statement prepared in accordance with GAAP and used for a substantial nontax purpose (such as obtaining credit or reporting to owners); c. certified as prepared in accordance with GAAP and filed with a federal agency (other than the IRS or SEC); d. a financial statement based on international financial reporting standards and filed with an agency of a foreign government that is the equivalent to the U.S. SEC; and e. a financial statement filed by the taxpayer with any other regulatory or governmental body specified by the Secretary of Treasury Note: If the taxpayer has more than one of these financial statements, the one with the highest priority is the AFS Note: If a taxpayer s financial results are reported on an AFS for a group of entities, the AFS for that group is the AFS for the taxpayer [IRC Sec. 451(b)(5)] Note: If the taxpayer has a contract that contains multiple performance obligations, the allocation of the transaction price to each obligation is equal to the amount allocated to that obligation for including it in the revenue in the AFS [IRC Sec. 451(b)(4)] The AFS conformity rule does not apply to (a) taxpayers that do not have an AFS or another financial statement as specified by the IRS for a tax year, or (b) any item of gross income in connection with a mortgage servicing contract [IRC Sec. 451(b)(1)(B)]. These taxpayers continue to recognize income in accordance with the pre-2017 Tax Cuts and Jobs Act (TCJA) rules for such items of gross income In addition, the AFS conformity rules do not apply to any item of gross receipts for which the taxpayer uses a special method of accounting provided under any other provision of Chapter 1 of the Code, as described in IRC Sec. 451(b)(2)