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Cash vs. Accrual Accounting Revisited
IMR, July 27, 1998
In the February 10, 1997, issue, the IMR reported that a DMIA distributor member learned from the Internal Revenue Service that his firm needed to switch from a cash basis of accounting to an accrual basis, even if the firm technically owned no inventory. According to the IRS, distributors who buy products from manufacturers to resell to end users possess inventory at some point. Physical possession of the goods is not necessary to be classified as inventory. If you possess inventory, you cannot use a cash basis for accounting. The IRS says this has always been policy, but it is enforcing its position more vigorously than in the past. A cash accounting basis is more convenient and less costly in some cases for some sole proprietors and other types of firms than an accrual basis of accounting.
B. Timothy Hanigan, president of Hanigan Business Forms, a distributorship in Riverside, Calif., found out about the IRS's policy the hard way when his personal taxes were audited. The IRS then audited his corporation. Although the IRS found nothing wrong with Hanigan Business Forms' tax returns, it forced the company to go to an accrual basis. The distributorship was handed a bill for $850,000. Recently, after more than 18 months of frustration and worry, Hanigan Business Forms, with the help of its accounting firm, reduced its bill to $280,000.
Tim Hanigan says a distributor friend was in the same situation with a tax bill of $300,000. This distributor hired an attorney and got the bill down to $220,000, but had to pay the attorney $80,000 after six months of wrangling with the IRS. "Sooner or later, [distributors] are going to get [an IRS audit]," says Hanigan. Based on his experience, he advises distributors to save themselves aggravation, time and money by switching to an accrual basis before the IRS forces them to switch.
Tax consultant Noelle Allen, CPA, chair of the California Tax Committee in Cupertino, Calif., says, "There are more options available to you if you switch [from cash to accrual basis] than if the IRS switches you. You can pay your tax over four years, but if the IRS converts [your firm from a cash to an accrual basis of accounting], it's all in one year, and the IRS can go back three years [for back taxes and penalties]."
However, in the March 17, 1997, issue of the IMR, Dr. Bart Basi, CPA/Attorney and president of the Center for Financial and Tax Planning Inc. in Marion, Ill., said "...If you have been consistent in your application over the years [either cash or accrual], there is no reason to change it now unless contacted by the IRS. Voluntary conversion could raise eyebrows." He also noted that certain IRS offices may be more sensitive to the issue than others, and the issue of property title transfer is defined individually by each state. Therefore, the IMR recommends that you consult your tax advisor before changing anything that may affect your business accounting procedures.
For more information, try the IRS's Web site. There is a wealth of information available on small business tax issues and a section called "Tax Trails for Business," which answers specific questions based on information you type in. Topics covered include capital gains and losses, business use of the home office deduction and other thorny issues. The site also discusses how the IRS conducts audits.