ASP Advantage 1993/The Association of Shareware Professionals Advantage CD-ROM 1993.iso/files/business/sba93_3a/f306.sbe

Text File | 1993-07-01 | 30KB | 836 lines

@Q01

     ┌─────────────────────────────────────────────────┐
     │ WHAT TAX ACCOUNTING METHOD MAY MY BUSINESS USE? │
     └─────────────────────────────────────────────────┘

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