Change of accounting method for small taxpayers with inventory under rev. proc. 2000-22.

Under Rev. Proc. 2000-22, a qualifying small 'taxpayer with merchandise inventory, that was previously required to account for sales and inventory using the accrual method of accounting, may automatically change to the cash method of accounting and the inventory rules under Sec. 471 will no longer apply. A qualifying small taxpayer is one whose average annual gross receipts for the previous three years (or shorter period if in existence for less than three years) is $1 million or less. For this test, aggregation rules apply to include gross receipts of related parties. Finally, there is a financial statement conformity requirement. The taxpayer must not regularly use arty accounting method other than the cash method to determine profit or loss for its financial statements, other financial records and reports to owners, creditors, etc., for the current or prior three tax years (years ending before Dec. 17, 2000 are excluded from this rule). The conformity requirement will not apply, however, if accrual-method reports are prepared by the taxpayer on an isolated basis (e.g., on a one-time basis for a lender).

If a taxpayer makes the change to the overall cash method of accounting under Rev. Proc. 2000-22, inventories are not accounted for under the pure cash method. Instead, they must be accounted for in the same manner as nonincidental supplies (i.e., inventoried and deducted only when sold or consumed by the taxpayer). How, then, does the cash method of accounting work with inventories? For inventory that has been paid for by the taxpayer, inventory accounting is customary (i.e., inventory is an asset when on hand and is deducted when sold). But how does a taxpayer account for inventory not paid for by year-end?

According to Treasury officials, although the cost recognition rules for nonincidental supplies apply, they must be applied within the cash-basis method of accounting. Accordingly, cost of sales is recognized as of the later of (1) when paid for by the taxpayer or (2) when sold by the taxpayer. In other words, income from the sale of an item can be recognized in a tax year prior to when the cost of sale is deducted. The cost of sale, however, cannot be recognized in a year prior to the year of sale. Also, an inventory item is not recorded until paid for, even though it is on hand at year-end. Accordingly, accounting adjustments to the results of physical inventories must be made.

Sole proprietors and Form 3115. A taxpayer applying for the automatic accounting change under Rev. Proc. 2000-22 must file Form 3115, Application for Change in Accounting Method (original with the tax return effecting the change and a signed copy to the national office). For a sole proprietorship, however, the form and instructions are less than clear about who is the "applicant." The first line is "Name of Applicant," but parenthetically notes that the spouse's name is to be included if a joint return is filed. The names of the individual taxpayers, of course, do not identify the sole proprietorship business, but there is nowhere else on the form to distinguish the business that is making the actual application for change.

According to Treasury officials, the "applicant" in this case is the sole proprietor, rather than the taxpayer or spouse. The "Name of Applicant" to be entered on the form is the business name of the sole proprietorship, followed by "c/o" and the taxpayer's name (e.g., "ABC Flower Shop, c/o John and Jane Smith"). Further, the sole proprietorship's Federal taxpayer identification number (TIN) should be entered on the form as the applicant's "Identification Number." If, however, the business has no Federal TIN, the taxpayer's Social Security number should be entered.

FROM BARRY S. SHIPP, CPA, AND CAROL T. BARNES, CPA, COLE, EVANS & PETERSON, CPAs, SHREVEPORT, LA

Editor's note: Mr. Ely is the immediate past chair of the AICPA Tax Division's Relations with the IRS Committee. Messrs. VanDeveer and Corbet, and Mdmes. Barnes, Hyde and Gervie, are committee members.

Mark H. Ely, J.D., CPA Partner Washington National Tax KPMG LLP Washington, CD