SECTION 4. QUALIFYING SMALL

BUSINESS TAXPAYER EXCEPTION

.01 Pursuant to his discretion under §§ 446 and 471, and to simplify the recordkeeping requirements of a qualifying small business taxpayer, the Commissioner, as a matter of administrative convenience, will allow a qualifying small business taxpayer to use the cash method as described in this revenue procedure for a trade or business described in this section 4.01 (eligible trade or business).

(1) A qualifying small business taxpayer may use the cash method as described in this revenue procedure for all of its trades or businesses if the taxpayer satisfies any one of the following three tests and did not previously change (and was not previously required to have changed) from the cash method to an accrual method for any trade or business

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as a result of becoming ineligible to use the cash method under this revenue procedure.

(a) The taxpayer reasonably determines that its principal business activity (as defined in section 5.04, below) is described in a North American Industry Classification System (“NAICS”) code other than one of the ineligible codes listed below. The ineligible NAICS codes are as follows:

(i) mining activities within the meaning of NAICS codes 211 and 212;

(ii) manufacturing within the meaning of NAICS codes 31–33;

(iii) wholesale trade within the meaning of NAICS code 42;

(iv) retail trade within the meaning of NAICS codes 44 and 45; and,

(v) information industries within the meaning of NAICS codes 5111 and 5122. Information regarding the NAICS codes can be found at www.census.gov. Visitors to the site should select “Subjects A to Z,” followed by “N,” and then should select “North American Industry Classification System.” Taxpayers also may find a partial list of NAICS codes, described as “Principal Business Activity Codes,” in the instructions to their tax return forms.

(b) Notwithstanding that a taxpayer’s principal business activity is described in one of the ineligible NAICS codes listed above in section 4.01(1)(a), the taxpayer reasonably determines that its principal business activity is the provision of services, including the provision of property incident to those services.

(c) Notwithstanding that a taxpayer’s principal business activity is described in one of the ineligible NAICS codes listed above in section 4.01(1)(a), the taxpayer reasonably determines that its principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications. For purposes of this rule, tangible personal property is not fabricated or modified in accordance with customer design or specifications if the customer merely chooses among pre-selected options (such as size, color, or materials) offered by the taxpayer or if the taxpayer must make only minor modifications to its basic design to meet the customer’s

specifications. Moreover, a taxpayer that manufacturers an item in quantities for a customer is not treated as fabricating or modifying tangible personal property in accordance with customer design or specifications.

(2) Under current law, a taxpayer with two or more trades or businesses that has a trade or business that is permitted to use the cash method may use such method for such trade or business. Therefore, notwithstanding that a taxpayer’s principal business activity is not described above in section 4.01(1) and thus the taxpayer can not use the cash method for all of its trades or businesses, a taxpayer may use the cash method with respect to any separate and distinct trade or business if the principal business activity of the trade or business is not described in an ineligible NAICS code in section 4.01(1)(a)(i) through (v) or is described in either section 4.01(1)(b) or section 4.01(1)(c). No trade or business will be considered separate and distinct unless a complete and separable set of books and records is kept for such trade or business. See § 1.446–1(d)(2).

.02 A taxpayer who satisfies the qualifying small business taxpayer exception described in section 4.01 and chooses not to use an overall accrual method with inventories being accounted for under § 471 has the following three options for an eligible trade or business under this revenue procedure:

(1) The taxpayer can use the overall cash method and account for inventories under § 471;

(2) The taxpayer can use an overall accrual method and account for inventoriable items, as defined in section 5.09 below, in the same manner as materials and supplies that are not incidental under § 1.162–3 (see sections 4.04 and 4.05 below); or

(3) The taxpayer can use the overall cash method and account for inventoriable items in the same manner as materials and supplies that are not incidental under § 1.162–3 (see sections 4.04 and 4.05 below). .03 Notwithstanding § 1001 and the regulations thereunder, qualifying small business taxpayers that use the cash method for an eligible trade or business under section 4.01 of this revenue procedure shall include amounts attributable to

“open accounts receivable” (as defined in section 5.10) in income as such amounts are actually or constructively received. However, § 1001 may be applicable to other transactions.

.04 Qualifying small business taxpayers that are permitted to use the cash method for an eligible trade or business under section 4.01 of this revenue procedure and that do not want to account for inventories under § 471 must treat all inventoriable items in such trade or business in the same manner as materials and supplies that are not incidental under § 1.162–3. For purposes of this revenue procedure, taxpayers are not required to apply § 263A to inventoriable items that are treated as materials and supplies that are not incidental. Items that would be accounted for as incidental materials and supplies for purposes of § 1.162–3 may still be accounted for in that manner. Whether an item is purchased for resale or use (and thus accounted for as a nonincidental material and supply) or is purchased to provide to customers incident to services (and thus may be accounted for as either an incidental or a non-incidental material and supply depending on the facts and circumstances) must be determined under general tax principles.

.05 Under § 1.162–3, materials and supplies that are not incidental are deductible only in the year in which they are actually consumed and used in the taxpayer’s business. For purposes of this revenue procedure, inventoriable items that are treated as materials and supplies that are not incidental are consumed and used in the year the qualifying small business taxpayer provides the items to a customer. Thus, the cost of such inventoriable items are deductible only in that year, or in the year in which the taxpayer actually pays for the goods, whichever is later. A qualifying small business taxpayer may determine the amount of the allowable deduction for non-incidental materials and supplies by using either a specific identification method, a first in, first out (FIFO) method, or an average cost method, provided that method is used consistently. See § 1.471–2(d). A taxpayer may not use the last in, first out (LIFO) method described in § 472 and the regulations thereunder to determine the amount of the allowable deduction for non-incidental materials and supplies.

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.06 The method of accounting used by a qualifying small business taxpayer for financial accounting (“book”) purposes will not affect the taxpayer’s eligibility under this revenue procedure to use the cash method or the method of accounting for inventoriable items as non-incidental materials and supplies under § 1.162–3. However, taxpayers must still comply with the requirements under § 446(a) and the regulations thereunder to maintain adequate books and records, which may include a reconciliation of any differences between such books and records and their return. See § 1.446–1(a)(4).