Cream of the Crop 1/Cream of the Crop 1.iso/BUSINESS/SBA62.ARJ/FSBA.EXE/F306.SBE

Text File | 1992-04-30 | 30KB | 788 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 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 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 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.
Hell 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 require-
ments 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 ac-
counts 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 de-
ferral 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 account-
ing, unless the IRS consents to use of another method.  (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 busi-
ness 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 busi-
nesses, 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 account-
ing.

However, there are exceptions for small C corporations (or partnerships
with C corporations for partners).   "Small" corporations or partner-
ships are those with average annual gross receipts for the three pre-
ceding 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 corpora-
tions"):

            .  "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 Corpor-
ations," on the XPERT Consultation Menu, to determine whether the C
corporation in question 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 indi-
cated that either:

      .  Your C corporation is a "Qualified Personal Service Corpor-
         ation" 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 busi-
ness (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 taxable year in
which it is begun and which is for the manufacture, building, instal-
lation, 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 con-
tract 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 ex-
pected 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 con-
tract 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 tax-
payer 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 re-
pealed 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 "construc-
             tion 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 con-
tracts.   (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 re-
      habilitating residential property, consisting of dwelling units
      contained in buildings containing 4 or fewer dwelling units; or

   .  Where engaged in constructing dwelling units in buildings con-
      taining 5 or more dwelling units (limited--can only use completed
      contract method for 30% of any such 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 account-
ing.  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 downside of using the completed contract method under this excep-
tion 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 rehabilita-
ting 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 rehabilitat-
             ing 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 com-
pleted 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 com-
pleted 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 conclu-
sion 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 com-
pleted 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 con-
tract 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 conclu-
sion 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 com-
             pleted 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 con-
tract method will, it appears, be subject to the Uniform Capitaliza-
tion 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 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