Best of www.BestZips.com (Collector's Edition)/Best of WWW.BESTZIPS.COM Collector's Edition (JCSM Shareware) (JCS Marketing).ISO/legal___/sba964.zip/F306.SBE

Text File | 1996-11-06 | 30KB | 840 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 -- generally
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
accrual 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
method, for most large taxpayers).  It is usually quite
difficult to change accounting methods, once your company has
already 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
another permissible method of accounting, but don't count
on getting IRS approval any time soon if the change would
appear to be beneficial to you for tax purposes.  Certain
warm places in the universe may freeze over first.

However, the IRS will generally permit a "cash-basis"
taxpayer (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
requirements 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 actually
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 accounts
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 shifting
income between taxable years, by either paying or not paying
various accrued expenses shortly before year-end.  Also, 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
accounting method where the production, purchase, or sale of
merchandise is a significant income-producing factor in the
business, thus requiring the use of inventories, and therefore
the accrual method of accounting, unless the IRS consents to
use of another method.  (Which is not likely.)

  QUESTION:  Is the production, purchase, or sale of
             merchandise 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
accounting, 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 methods 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
inventories, 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
corporations 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
             average annual gross receipts of more than $5
             million 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 on "Personal Service
Corporations," to see if your C corporation is treated as a
"qualified personal service corporation" for tax purposes).

QUESTION:  Is your C corporation (or the C corporations that
  are partners in your partnership) a "qualified personal
  service corporation"?  (Or is it in the farming 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 Corporation"; 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
immediately change over to the accrual method of accounting,
beginning with that taxable year, under the Income Tax
Regulations. -- 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
qualified to use the cash method.

Note, however, that if you are engaged in long-term contracts
for manufacture, building, installation, or construction 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" method
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
tax year in which it began and which is for the manufacture,
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 the
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 contract
is, say, 85% complete at the end of the next year, another
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 reported.
(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
contract (or take into account any costs allocable to such
contract) 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
beneficial for companies that are allowed to adopt it, since
it allows the taxpayer to defer all profit on a long-term
contract 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
taxpayers, except for small firms doing construction and
certain 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
eligible 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 advantageous
method of accounting.  However, we strongly advise that you
consult your tax adviser as to whether you can actually
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
completed contract method and even if none of them are
completed during that tax year.

(But the completed contract method is not treated as a
tax preference item if the contract is considered a "home
construction contract," where 80% or more of the estimated
total contract costs are reasonably expected to be
attributable 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
construction contracts may still qualify for use of the
completed contract method of accounting, if you are engaged
in construction, reconstruction or rehabilitation of
residential dwelling units.

  QUESTION:  Are you engaged in such construction of dwelling
             units, and do you have contracts where 80
             percent or more of the estimated total contract
             costs are expected to be attributable to
             building, 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 accounting,
since your firm does not appear to qualify for the "small
contractor" exception and is not engaged in construction,
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 buildings
             consisting of 4 or fewer dwelling units?

@YN
01\Q24
02\Q25

@Q24

FURTHER CONCLUSION:  Then you should be able to fully
utilize the completed contract method, with regard to 100%
of the income and costs under any such home construction
contracts for buildings of 4 dwelling units or less.  Any
tax advantages you derive from using the completed contract
method 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
income 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
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 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
contract 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
preference" under the alternative minimum tax rules, which
may somewhat detract from the benefits you might otherwise
derive 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 value,
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
contracts 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,
             according to your most reasonable estimate?

@YN
01\Q20
02\Q21

@Q27

@STOP

@RD\01
NOTE:  Because you do not meet the "small contractor"
exception (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
additional complexity, and may also somewhat dilute the tax
benefits of using the completed contract accounting method.

@RD\02
NOTE:  Because you do not meet the "small contractor"
exception (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
complexity, 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 consulting session deals
only with OVERALL  methods of accounting
(cash, accrual, etc.).

@H\02

Among  the various  IRS  conditions  on
allowing you to have 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
accrual method, the accrual  method may
actually be better in a few situations.
For example, if your business makes few
of  its  sales on  credit,  and  it 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  your firm is a  service
business. 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
accounting  may  be  permissible,  you
have to be consistent. That is, if you
report gross  income on  a cash basis,
you  cannot  report  expenses of  that
trade or business on am 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  filed
an S corporation election on Form 2553,
it is an C corporation.  Therefore, you
should answer this  question "N" ("NO")
if your  company  is an  S corporation,
or is not a corporation at all.

@H\07

C corporations are generally banned from
using  the  cash method  of  accounting,
except for certain farming corporations,
small C corporations with average annual
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 three years,  then compute its
average  annual  gross receipts  for the
period it has been in existence.

If it had a predecessor entity (e.g., if
a  corporation  had  previously  been  a
partnership),  then count gross receipts
of the predecessor  (the partnership  in
this example), for purposes of the test.

@H\10

 Answer "Y"  ("YES") if  the answer to
 either of the two questions is "Yes."

 Answer "N" ("NO")  if the corporation
 is NOT a "qualified  personal service
 corporation" AND your  company is not
 in the 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
accounting, 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 35%, 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
accrual method,  the accrual method may
actually be better in a few situations.
For example, if your business makes few
of  its  sales on  credit,  and  it 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
involves 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
    inventory.

@H\16

A "look-back" rule applies to percentage
of completion contracts.  Except certain
contracts that are  less than $1 million
and under  1% of  average  annual  gross
receipts for the last 3 years, taxpayers
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 building, construction,
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 generally
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
     completed 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 3 years, include gross receipts
of any predecessor  business (such as an
unincorporated  business which you  have
just   recently   incorporated).   Also,
include  gross  receipts  of  any  other
business which is under common ownership
with the business in question.

If  the  previous  number  of  years  in
business  is less than three,  take  the
average 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,
irrespective  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
expenses, or expenses incurred in
connection with negotiating the
contract) are incurred.

@END