By Paul N. Gada, Business Owner's Toolkit Staff Writer

The IRS issued new proposed rules on December 10, 2001, that may change the way you do business, at least where your accounting and recordkeeping are concerned.

The new rules allow certain small service businesses that also sell related products and have average annual gross receipts under $10 million to use the cash method of accounting for their income and expenses. An estimated 500,000 businesses are expected to take advantage of this relief.

Under long-standing IRS regulations, a taxpayer must generally keep inventories and use the more complicated accrual method of accounting if the purchase, production or sale of merchandise is an income-producing factor in the taxpayer's business. For many small businesses, especially service providers, it was unclear whether the taxpayer was selling merchandise and if that sale of merchandise was an income-producing factor. The newly released rules clarify this situation and provide a break to small service providers.

"We believe this guidance provides substantial administrative relief to qualified small business taxpayers by simplifying their bookkeeping requirements and providing certainty about what the rules are. The certainty the guidance provides will resolve the long-running controversy between small business taxpayers and the IRS about the use of the cash method," stated Mark Weinberger, Treasury Assistant Secretary for Tax Policy. "Resolution of this issue will permit taxpayers to use their resources to expand their businesses and the IRS to devote its resources to pressing compliance issues," he added.

The proposed rules provide four safe harbors permitting certain taxpayers to use the cash method of accounting. To consider the new safe harbors, taxpayers must have average annual gross receipts between $1 million and $10,000,000 for the previous three-year period. Under an earlier safe harbor issued in 2000, small businesses with average annual gross receipts of $1 million or less are already allowed to use the cash method.

The four new safe harbors are:

• The taxpayer may use the cash method if its principal business activity is not retailing, wholesaling, manufacturing, mining, publishing or sound recording. The taxpayer determines its principal business activity by reference to the codes in the North American Industry Classification System, published by the Department of Commerce (www.census.gov).
• The taxpayer may use the cash method if its principal business activity is the provision of services, even if the taxpayer is providing property incident to the services.
• The taxpayer may use the cash method if its principal business activity is custom manufacturing as defined in the guidance.
• Regardless of the taxpayer's primary business activity, the taxpayer may use the cash method with respect to any separate and distinct trade or business that satisfies one of the first three safe harbors.

A taxpayer, trade, or business meeting one of above four safe-harbors must defer deductions for items purchased for resale and raw materials purchased for use in producing finished goods until the taxpayer sells the item to a customer. Also, if a taxpayer has separate businesses (e.g. a retail plumbing store and a plumbing repair service), the cash method can be used as long as a separate business qualifies under one of the safe harbors and separate business records are kept.

Here is an example of how the new rules work:

A plumbing contractor installs plumbing fixtures for customers and also sells plumbing equipment through a retail store. The contractor determines that she derives 60 percent of her total receipts from plumbing installation (including amounts charged for parts) and 40 percent from the sale of equipment through the store. The contractor is eligible to use the cash method for both activities because her principal business activity is service-oriented.
If the percentages were reversed, the contractor could not use the cash method unless completely separate books and records are kept for each activity. Then, the cash method could be used for her plumbing installation business.

The new rules are effective for tax years beginning after 2001. The IRS also assures small business owners that they can rely on the new rules for 2001, as well. As a matter of fact, the IRS already stopped auditing and taking taxpayers to court on this issue earlier in the year.

Senator Kit Bond, ranking member of the Senate Committee on Small Business and Entrepreneurship, applauded the new accounting rules as "a momentous step forward" for small business taxpayers. "This change amounts to a home run for small business," Bond said. "In the real world, this will free the independent home builder or repairman from having to account for every nail, board, can of paint or shingle used over the course of a year. And it will significantly simplify the lives of other service providers, like dentists and veterinarians, who must use some merchandise as part of the service they provide."

All political rhetoric and posturing aside, these changes are a big relief from some of the bookkeeping minutia that small service-oriented businesses are bogged down with on a regular basis. By lightening this burden, small business owners can spend more time looking beyond their record books and, instead, figuring out a way to help turn our sluggish economy around.

If you want to personally thank the IRS for this or otherwise comment on the changes, feel free to send your e-mail to: Notice.Comments@m1.irscounsel.treas.gov.