In recent years many small contractors were pushed to abandon the cash method of accounting. The reason for this was the IRS’s strict interpretation of inventory accounting rules. In many cases, materials sold by contractors to customers in connection with a job were considered to be income producing inventory, which requires accrual accounting.

Recently, however, the IRS changed its position and proposed rules allowing many contractors and other small businesses to switch back to the cash method. The proposed rules allow qualifying businesses with three-year average annual gross receipts between $1 million and $10 million to use the cash method. (Businesses with gross receipts of $1 million or less already qualify under existing rules.)

A business can qualify to use the cash method by meeting one of the following safe harbors:

Its principal business activity is something other than retailing, wholesaling, manufacturing, mining, publishing, or sound recording.

Its principal business activity is the provision of services, even if it provides property incident to the services.

Its principal business activity is custom manufacturing (as defined by the proposed rules).

In addition, a taxpayer may use the cash method, regardless of its primary business activity, for any separate and distinct trade or business that satisfies one of the three safe harbors described above.

Should You Switch Back?
Although the rules won’t be finalized until later this year, the IRS has said that a business can switch to the cash method as early as the 2001 tax year. If you’re on the accrual method and think you may be entitled to switch back to cash, contact your tax advisor to conduct a thorough analysis to determine whether you’re eligible and to evaluate whether the cash method would produce more favorable tax results. The cash method offers significant tax advantages for many contractors, but it’s not for everyone.