Construction Industry - Audit Technique Guide - Uncle Fed's Tax ...

§ 460, the contractor may adopt a method of accounting for its long-term contracts onthe initial income tax return, or in the first year it has long-term contracts. Once amethod of accounting is adopted, this method must be used for all long-term contractsin the same trade or business. Generally, a change is not permitted without obtainingprior permission from the Commissioner.Cash Method of AccountingGenerally, the cash method of accounting is an acceptable method for smallcontractors. However, there are limitations on the use of the cash method.IRC § 448 prohibits the use of the cash method by "C" corporations and partnershipswith a "C" corporation partner, unless such entities have annual gross receipts that donot exceed $5 million. This section also prohibits use of the cash method by all taxshelters.IRC § 448 does not allow the use of the cash method. It merely limits the use of thecash method for certain entities.Example:An S Corporation that files a Form 1102-S is not subject to the $5 million gross receiptslimitation of I.R.C. § 448. An S corporation that has gross receipts of $50 million mayuse the cash method of accounting as long as there are no other sections prohibiting it(e.g., taxpayer required to use accrual method to account for inventory; IRC § 460requires the use of PCM for long-term contracts).Cash vs. Accrual IssueIn prior years, the IRS won many cases supporting the change from cash to accrualwhen merchandise was considered an income-producing factor. Treasury RegulationSection 1.446-1(c)(2)(i) requires the use an accrual method of accounting, if thetaxpayer is required to account for inventories per IRC § 471. Treasury Regulation§1.471-1 requires an accounting of inventory in every case in which the production,purchase, or sale of merchandise is an income-producing factor.After much litigation in this area, a safe harbor allowing the use of the cash method (viaRevenue Procedure 2001-10 and Revenue Procedure 2002-28) was provided totaxpayers that would otherwise have been required to use an accrual method ofaccounting.Revenue Procedure 2001-10Revenue Procedure 2001-10 permits eligible small businesses (with average grossreceipts equal to or less than $1 million) to use the cash method when an accrual3-7