Publication 538 - Accounting Periods And Methods (Page 13 of 19) in pdf

Table 2. Are You a Qualifying Small

other property to cover the payment of the as-

must clearly reflect income. Your inventory prac-

Business Taxpayer for

serted liability. The money or other property

tices must be consistent from year to year.

transferred must be beyond your control. If you

2002?

The rules discussed here apply only if

transfer it to an escrow agent, you have met this

they do not conflict with the uniform

requirement if you give up all authority over the

a) Are your average

b) Do you

capitalization rules of section 263A and

CAUTION

money or other property. However, buying a

annual gross receipts

meet the test

the mark-to-market rules of section 475.

bond to guarantee payment of the asserted lia-

$10,000,000 or less for

in a) for each

each 3-year period

tax year

bility, making an entry on your books of account,

below?

or transferring funds to an account within your

control will not meet this requirement.

Exceptions

(1)

(2)

(3)

Test Year

Liability deductible. The liability must have

The following taxpayers can use the cash

been deductible in the year of payment, or in an

1999

2000

2001

method of accounting even if they produce,

earlier year when it would have accrued, if there

1998

1999

2000

purchase, or sell merchandise. These taxpayers

had been no contest.

can also choose to not keep an inventory, even if

c) If your answer is Yes to a) and b), you

Economic performance rule satisfied.

they do not change to the cash method.

are a qualifying small business taxpayer for

You generally cannot deduct contested liabilities

2002.

•

until economic performance occurs. For work-

A qualifying taxpayer.

ers’ compensation or a tort liability, economic

•

A qualifying small business taxpayer.

In addition, a qualifying small business taxpayer

performance occurs as payments are made to

is any taxpayer that is not prohibited from using

the person. The payment or transfer of money or

A qualifying small business taxpayer can use

the cash method under section 448.

other property into escrow to contest an as-

the cash method for an “eligible business” (de-

serted liability is not a payment to the claimant

Eligible business. An eligible business is

fined later).

that discharges the liability. This payment does

any business for which a qualified small busi-

not satisfy the economic performance test, dis-

ness taxpayer can use the cash method and

Qualifying taxpayer. You are a qualifying tax-

cussed earlier.

choose to not keep an inventory. You have an

payer only if you meet the gross receipts test for

eligible business if you meet any of the following

each prior tax year ending after December 16,

Recovered amounts. An adjustment is usu-

requirements and did not previously change

1998. To meet the test for a prior tax year, your

ally necessary when you recover any part of a

(and were not required to change) from the cash

average annual gross receipts must be

contested liability. This occurs when you deduct

method to an accrual method for any business

$1,000,000 or less for the 3 tax years ending

the liability in the year of payment and recover

as a result of becoming ineligible to use the cash

with the prior tax year. For example, you must

any part of it in a later tax year when the contest

method.

test 1998, 1999, 2000, and 2001 to see if you

is settled. Include in gross income in the year of

are a qualifying taxpayer that can use the cash

1) Your principal business activity is de-

final settlement the part of the recovered amount

method and choose to not keep an inventory for

scribed in a North American Industry Clas-

that, when deducted, decreased your tax for any

2002. Use Table 1 to determine if you are a

sification System (NAICS) code other than

tax year.

qualifying taxpayer for 2002.

any of the following.

Foreign taxes and taxes of U.S. possessions.

Table 1. Are You a Qualifying

a) NAICS codes 211 and 212 (mining ac-

The rule allowing the deduction of contested

Taxpayer for 2002?

tivities).

liabilities in the tax year of payment does not

b) NAICS codes 31 – 33 (manufacturing).

apply to the deduction for income, war profits,

a) Are your average

b) Do you

and excess profits taxes imposed by any foreign

c) NAICS code 42 (wholesale trade).

annual gross receipts

meet the test

government or U.S. possession. This means

$1,000,000 or less for

in a) for each

d) NAICS codes 44 – 45 (retail trade).

that an accrual method taxpayer deducts these

each 3-year period

tax year

liabilities in the tax year in which the contested

below?

e) NAICS codes 5111 and 5122 (informa-

foreign tax or U.S. possession tax is finally de-

tion industries).

termined.

(1)

(2)

(3)

Test Year

Contested foreign taxes accrued for the for-

2) Your principal business activity is the pro-

1999

2000

2001

eign tax credit are not covered under this provi-

vision of services, including the provision

sion but relate back to and are credited in the tax

of property incident to those services.

1998

1999

2000

year in which they would have been accrued had

3) Your principal business activity is the

1997

1998

1999

they not been contested.

fabrication or modification of tangible per-

1996

1997

1998

sonal property upon demand in accor-

dance with customer design or

c) If your answer is Yes to a) and b), you

specifications.

Inventories

are a qualifying taxpayer for 2002.

Information about the NAICS codes can be

found at

An inventory is necessary to clearly show in-

In addition, a tax shelter cannot be a qualifying

come when the production, purchase, or sale of

taxpayer.

Business not owned or not in existence for 3

merchandise is an income-producing factor. If

years. If you did not own your business for all

you must account for an inventory in your busi-

of the 3-tax-year period used in figuring your

Qualifying small business taxpayer. You

ness, you must use an accrual method of ac-

average annual gross receipts, include the pe-

are a qualifying small business taxpayer only if

counting for your purchases and sales.

riod of any predecessor. If your business has not

you meet the gross receipts test for each prior

However, see Exceptions, next. See also Ac-

been in existence for the 3-tax-year period, base

tax year ending on or after December 31, 2000.

crual Method, earlier.

your average on the period it has existed includ-

To meet the test for a prior tax year, your aver-

To figure taxable income, you must value

ing any short tax years, annualizing the short tax

age annual gross receipts must be $10,000,000

your inventory at the beginning and end of each

year’s gross receipts.

or less for the 3 tax years ending with the prior

tax year. To determine the value, you need a

tax year. For example, you must test 2000 and

method for identifying the items in your inven-

Not keeping an inventory. If you choose to

2001 to see if you are a qualifying small busi-

tory and a method for valuing these items. See

not keep an inventory, you will deduct the cost of

Identifying Cost and Valuing Inventory, later.

ness taxpayer that can use the cash method for

the items you would otherwise include in inven-

your eligible business and choose to not keep an

The rules for valuing inventory cannot be the

tory in the year you sell the items, or the year you

inventory for 2002. Use Table 2 to determine if

same for all kinds of businesses. The method

pay for them, whichever is later. If you are a

you are a qualifying small business taxpayer for

you use must conform to generally accepted

producer, you can use any reasonable method

accounting principles for similar businesses and

2002.

to estimate the raw material in your work in

Page 13

Publication 538 - Accounting Periods And Methods Page 13

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