SECTION 6. EXAMPLES

For purposes of the following examples, assume that:

(1) the taxpayers use the calendar year;

(2) the taxpayers are not prohibited from using the cash method under § 448 (except Example 4 ); and

(3) the taxpayers satisfy the average annual gross receipts test of section 5.02 of this revenue procedure (except Examples 2 and 3 ).

Example 1 - Principal Business Activ- ity Not an Ineligible NAICS Code . Taxpayer is a graphic design firm. Taxpayer plans, designs, and manages the production of visual communications that convey specific messages or concepts. Taxpayer’s activities include the design of

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printed materials, packaging, advertising, signage systems, and corporate identification (logos). Taxpayer reasonably determines that its principal business activity is described in NAICS code 541430 (graphic design services), which is not one of the ineligible NAICS codes listed in section 4.01(1)(a)(i)–(v) of this revenue procedure. Taxpayer may use the cash method for its graphic design business.

Example 2 - Satisfaction of the Aver- age Annual Gross Receipts Test . Taxpayer is a plumbing contractor that installs plumbing fixtures in customers’ homes and businesses. Taxpayer reasonably determines that its principal business activity is construction, which is described in NAICS code 23. Taxpayer’s gross receipts at the end of the three preceding taxable years are:

Gross receipts

1998: $ 6,000,000

1999: 9,000,000

2000: 12,000,000

Taxpayer’s average annual gross receipts for the three taxable-year period ending in the 2000 taxable year are $9,000,000 (($6,000,000 + $9,000,000 + $12,000,000) / 3 = $9,000,000). Taxpayer may use the cash method for all its trades or businesses pursuant to this revenue procedure for its 2001 taxable year because its average annual gross receipts for each prior taxable year ending on or after December 31, 2000, is $10,000,000 or less and its principal business activity is not described in the ineligible NAICS codes listed in section 4.01(1)(a)(i)–(v).

Example 3 - Failure of the Average Annual Gross Receipts Test . Same as Example 2, except that Taxpayer’s gross receipts in 2001 equal $15,000,000. Taxpayer’s average annual gross receipts for the three taxable-year period ending in the 2001 taxable year are $12,000,000 (($9,000,000 + $12,000,000 + $15,000, 000/3) = $12,000,000). Taxpayer is not a qualifying small business taxpayer for purposes of this revenue procedure for its 2002 taxable year or any subsequent year because its average annual gross receipts for each prior taxable year ending on or after December 31, 2000, is not $10,000,000 or less.

Example 4 - Inability to Use this Rev- enue Procedure When § 448 Applies . Same as Example 2, except that Taxpayer is a C corporation. Because Taxpayer’s average annual gross receipts for the previous three years ($9,000,000) exceed $5,000,000, Taxpayer is prohibited from using the cash method under § 448. Consequently, Taxpayer is not eligible to use the cash method under this revenue procedure. The same result would apply under § 448 if, instead of being a C corporation, Taxpayer were a tax shelter (regardless of Taxpayer’s average annual gross receipts) or Taxpayer were a partnership with a C corporation as a partner.

Example 5 - Principal Business Activ- ity Prior Year Test . Taxpayer is a plumbing contractor that installs plumbing fixtures in customers’ homes and businesses. Taxpayer also has a store that sells plumbing equipment to homeowners and other plumbers who visit the store. During its prior taxable year, Taxpayer derived 60 percent of its total receipts from plumbing installation (including

amounts charged for parts and fixtures used in installation) and 40 percent of its total receipts from the sale of plumbing equipment through its store. Under the principal business activity prior year test, Taxpayer reasonably determines that its principal business activity is plumbing installation, which is a construction activity described in NAICS code 23. Because Taxpayer’s principal business activity— plumbing installation—is not described in the ineligible NAICS codes listed in section 4.01(1)(a)(i)–(v), Taxpayer may use the cash method for both business activities (plumbing installation and retail sales).

Example 6 - Principal Business Activ- ity Three-Year Average Test . Same as Example 5, except that for the prior taxable year, Taxpayer derived 40 percent of its total receipts from plumbing installation (including amounts charged for parts and fixtures used in installation) and 60 percent of its total receipts from the sale of plumbing equipment through its store. Under the principal business activity prior year test, Taxpayer’s principal business activity is retail, which is described in an ineligible NAICS code. Thus, Taxpayer is not eligible to use the cash method for all of its trades or businesses under the principal business activity prior year test. However, Taxpayer may still be eligible to use the cash method for all of its trades or businesses under section 4.01(1) of this revenue procedure if Taxpayer reasonably determines that its principal business activity is plumbing installation under the principal business activity three-year average test. Taxpayer’s gross receipts for the prior three taxable years are as follows:

2000 1999 1998 3 Year Average Plumbing installation $2,000,000 $6,000,000 $4,000,000 $4,000,000

Retail sale of equipment $3,000,000 $2,000,000 $4,000,000 $3,000,000

Total $5,000,000 $8,000,000 $8,000,000 $7,000,000

The approximate percentage of Taxpayer’s average annual gross receipts for the prior three taxable years is 57 percent ($4,000,000/$7,000,000 total average gross receipts) for plumbing installation and 43 percent ($3,000,000/$7,000,000) for the retail sale of plumbing equipment

through its store. Thus, Taxpayer reasonably determines that its principal business activity is plumbing installation under the principal business activity three-year average test. Because Taxpayer’s principal business activity—plumbing installation—is not described in the ineli

gible NAICS codes listed in section 4.01(1)(a)(i)-(v), Taxpayer may use the cash method for both business activities (plumbing and retail sales).

Example 7 - Application of Section 4.01(2) Where Taxpayer Is Ineligible to Use the Cash Method Under Section

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4.01(1) . Same as Examples 5 and 6, except that Taxpayer’s principal business activity is retail sales under both the principal business activity prior year test and the principal business activity three-year average test. Taxpayer is not eligible to use the cash method for all of its trades or businesses under section 4.01(1) because Taxpayer’s principal business activity (retail sales) is described in an ineligible NAICS code under section 4.01(1)(a)(iv) and is neither the provision of services under section 4.01(1)(b) nor the fabrication or modification of tangible personal property under section 4.01(1)(c). Taxpayer, however, maintains its retail sales and plumbing installation activities as separate and distinct businesses with a complete and separable set of books and records for each business. Under section 4.01(2) of the revenue procedure, Taxpayer may use the cash method for its separate plumbing installation business notwithstanding that its principal business activity (retail sales) is ineligible under section 4.01(1)(a)–(c).

Example 8 - A Principal Business Activity Can Account for Less Than 50 Percent of Gross Receipts . Taxpayer has four activities, Activities A through D. During the prior taxable year, Taxpayer derived 35 percent of its gross receipts from Activity A, 25 percent from Activity B, 20 percent from Activity C, and 20 percent from Activity D. Under the principal business activity prior year test, Activity A would be Taxpayer’s principal business activity because it represents the largest percentage of gross receipts. Similarly, if the percentages of Taxpayer’s average annual gross receipts for the prior three taxable years were 35 percent from Activity A, 25 percent from Activity B, 20 percent from Activity C, and 20 percent from Activity D, under the principal business activity three-year average test, Activity A would be Taxpayer’s principal business activity because it represents the largest percentage of average annual gross receipts.

Example 9 - Taxpayer Does Not Sat- isfy the NAICS Code Exception in Section 4.01(1)(a), the Service Exception in Sec- tion 4.01(1)(b), or the Custom Manufac- turing Exception in Section 4.01(1)(c) . Taxpayer sells refrigerators. As part of the sale price, Taxpayer delivers the refrigerator to the customer and confirms that

the refrigerator is functioning properly at the customer’s site. Taxpayer’s principal business activity is described in the ineligible NAICS code 44. Moreover, Taxpayer’s principal business activity is not the provision of services under section 4.01(1)(b). Taxpayer does not provide refrigerators incident to the performance of services. Rather, Taxpayer performs certain services (delivery and confirmation of functionality) incident to the sale of refrigerators. In addition, Taxpayer does not fabricate or modify tangible personal property under section 4.01(1)(c). Taxpayer may not use the cash method under this revenue procedure.

Example 10 - Taxpayer Does Not Sat- isfy the NAICS Code Exception in Section 4.01(1)(a), the Service Exception in Sec- tion 4.01(1)(b), or the Custom Manufac- turing Exception in Section 4.01(1)(c) . Taxpayer is a sofa manufacturer that only produces sofas upon receipt of a customer order. Customers are allowed to pick among 150 different fabrics offered by the Taxpayer or to provide their own fabric, which the Taxpayer will use to finish the customer’s sofa. Taxpayer’s principal business activity is described in the ineligible NAICS code 33. Taxpayer does not provide sofas incident to the performance of services for purposes of section 4.01(1)(b). Rather, Taxpayer performs certain services (upholstering) incident to the sale of sofas. Taxpayer also does not fabricate or modify tangible personal property for purposes of section 4.01(1)(c) because customers merely choose among pre-selected options offered by Taxpayer and Taxpayer only makes minor modifications to the basic design of its sofa. Taxpayer may not use the cash method under this revenue procedure.

Example 11 - Taxpayer Does Not Sat- isfy the NAICS Code Exception in Section 4.01(1)(a), the Service Exception in Sec- tion 4.01(1)(b) or the Custom Manufac- turing Exception in Section 4.01(1)(c) . Taxpayer is a publisher who produces and sells high school and college yearbooks. Taxpayer’s principal business activity is described in the ineligible NAICS code 5111 (newspaper, periodical, book, and database publishers). Taxpayer is not providing a service for purposes of section 4.01(1)(b) because Taxpayer’s principal business activity is the production of

yearbooks for customers. In addition, Taxpayer is not a custom manufacturer for purposes of section 4.01(1)(c) because Taxpayer, although it produces yearbooks to the detailed specifications of schools, is producing yearbooks in quantities. As such, Taxpayer may not use the cash method under this revenue procedure.

Example 12 - Taxpayer Creating Pro- totype Does Not Satisfy the NAICS Code Exception in Section 4.01(1)(a) but Does Satisfy the Custom Manufacturing Excep- tion in Section 4.01(1)(c) . Taxpayer makes tools based entirely on specific designs and specifications provided to it by customers. Taxpayer produces the customer’s prototype and gives the prototype to the customer for production. Taxpayer’s principal business activity is described in the ineligible NAICS code 33. However, Taxpayer’s principal business activity is the fabrication of tangible personal property upon demand in accordance with customer design or specifications for purposes of section 4.01(1)(c). Taxpayer may use the cash method under this revenue procedure (subject to the potential application of § 460).

Example 13 - Taxpayer Producing Quantities of Prototype Does Not Satisfy the Custom Manufacturing Exception in Section 4.01(1)(c) . Same as Example 12, except that instead of producing the customer’s prototype and giving the prototype to the customer for further production, Taxpayer is also the producer of the customer’s goods using the prototype. Taxpayer’s principal business activity would not fall under the custom manufacturer exception of section 4.01(1)(c).

Example 14 - Application of Accounts Receivable 120 - Day Rule in Section 4.03 . Taxpayer is eligible to use the cash method under this revenue procedure. Taxpayer chooses to use the cash method and to account for inventoriable items as non-incidental materials and supplies under § 1.162–3. In December 2001, Taxpayer transfers property to a customer in exchange for an open accounts receivable (due in full in 120 days or less). In February 2002, the customer satisfies the accounts receivable when it pays cash to Taxpayer. As provided by section 4.03 of this revenue procedure, Taxpayer would not include any amount attributable to the accounts receivable in income in 2001. Rather, Taxpayer would include the full

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amount of the accounts receivable in income in 2002 when it actually receives the cash payment from the customer.

Example 15 - Timing of Deduction for Inventoriable Items Treated as Non- Incidental Materials and Supplies Under § 1.162–3—Construction . Taxpayer is a roofing contractor that is eligible to use the cash method under this revenue procedure. Taxpayer chooses to use the cash method and to account for inventoriable items as non-incidental materials and supplies under § 1.162–3. Taxpayer enters into a contract with a homeowner in December 2001 to replace the homeowner’s roof. Taxpayer purchases roofing shingles from a local supplier and has them delivered to the homeowner’s residence. Taxpayer pays the supplier $5,000 for the shingles upon their delivery later that month. Taxpayer replaces the homeowner’s roof in December 2001, and gives the homeowner a bill for $15,000 at that time. Taxpayer receives a check from the homeowner in January 2002. The shingles are non-incidental materials and supplies. The cost of the shingles is deductible in the year Taxpayer uses and consumes the shingles or actually pays for the shingles, whichever is later. In this case, Taxpayer both pays for the shingles and uses the shingles (by providing the shingles to the customer in connection with the performance of roofing services) in 2001. Thus, Taxpayer deducts the $5,000 cost of the shingles on its 2001 federal income tax return. Taxpayer includes the $15,000 in income in 2002 when it receives the check from the homeowner.

Example 16 - Timing of Deduction for Inventoriable Items Treated as Non- Incidental Materials and Supplies Under § 1.162–3—Construction . Same as in Example 15, except that Taxpayer does not replace the roof until January 2002 and is not paid until March 2002. Because the shingles are not used until 2002, their cost can only be deducted on Taxpayer’s 2002 federal income tax return notwithstanding that Taxpayer paid for the shingles in 2001. Thus, on its 2002 return, Taxpayer must report $15,000 of income and $5,000 of deductions.

Example 17—Timing of Deduction for Non-Inventoriable Items—Speculative Home Sales . Taxpayer is eligible to use

the cash method as described in this revenue procedure. Taxpayer is a speculative builder of houses that are built on land it owns. In 2001, Taxpayer builds a house using various items such as lumber, piping, and metal fixtures that it had paid for in 2000. In 2002, Taxpayer sells the house to a buyer. Because the house is real property held for sale by Taxpayer, the house and the material used to build the house are not inventoriable items under this revenue procedure. Thus, Taxpayer may not account for the items used to build the house as non-incidental materials and supplies under § 1.162–3. Rather, Taxpayer must capitalize the costs of the lumber, piping, metal fixtures and other goods used by Taxpayer to build the house under § 263. Upon the sale of the house in 2002, the costs capitalized by Taxpayer will be offset against the house sales price to determine Taxpayer’s gain or loss from the sale.

Example 18 - Timing of Deduction for Inventoriable Items Treated as Non- Incidental Materials and Supplies Under § 1.162–3—Construction . Same as in Example 17, except that (1) Taxpayer builds houses on land its customers own, and (2) the houses are built in three months with payment due at completion. Because Taxpayer does not own the house, the lumber, piping, metal fixtures and other goods used by Taxpayer in the provision of construction services are inventoriable items, not real property held for sale. Taxpayer elects to treat the goods used to build the house as non-incidental materials and supplies under § 1.162–3. Taxpayer must deduct the cost of the lumber, piping, metal fixtures and other nonincidental materials and supplies that are used by it to build the house in 2001 (the year those items were used by Taxpayer to build the house) notwithstanding that Taxpayer had paid for the items in 2000. Taxpayer will report income it receives from its customer as the income is actually or constructively received.

Example 19 - Timing of Deduction for Inventoriable Items Treated as Non- Incidental Materials and Supplies Under § 1.162–3—Reseller . Taxpayer is a veterinarian that also sells pet supplies from its clinic. Taxpayer reasonably determines that its principal business activity is veterinary services, which is not described in one of the ineligible NAICS codes in sec

tion 4.01(1)(a)(i)–(v). Consequently, Taxpayer is eligible to use the cash method for all its business activities (veterinary services and retail sales). For both business activities, Taxpayer chooses to use the cash method and to account for inventoriable items (such as pet food) as nonincidental materials and supplies under § 1.162–3. In December of 2001, Taxpayer purchases and pays for pet food to be resold from its clinic. Taxpayer sells the pet food from its clinic (and receives cash payment from the customer) in 2002. Because the pet food is not provided to customers until 2002, its cost can not be deducted until 2002.

Example 20 - Timing of Deduction for Inventoriable Items Treated as Non- Incidental Materials and Supplies Under § 1.162–3—Manufacturer . Taxpayer is a landscape designer that also manufactures lawn ornaments. Taxpayer does not manufacture lawn ornaments pursuant to customer contracts. Taxpayer reasonably determines that its principal business activity is landscape design, which is not described in an ineligible NAICS code under section 4.01(1)(a)(i)–(v). Consequently, Taxpayer is eligible to use the cash method for all its business activities (landscape design and lawn ornament manufacturing). For both business activities, Taxpayer chooses to use the cash method and to account for inventoriable items (such as raw materials) as nonincidental materials and supplies under § 1.162–3. In 2001, Taxpayer purchases and pays for raw materials to be used in its manufacturing business and uses the raw materials to produce lawn ornaments. During 2002, Taxpayer sells the lawn ornaments to customers. Because the lawn ornaments are not provided to customers until 2002, the cost of the raw materials used to produce the lawn ornaments can not be deducted until 2002.

Example 21 - Application of Long Term Contract Rules - § 460 Applicable . Taxpayer is a specialty tool and die manufacturer. Taxpayer receives a request from a large automobile manufacturer to design and produce a custom-made die that the customer will use in its manufacturing operation. The contract to manufacture the die is entered into in December 2001 but is not completed until May 2002. Because it satisfies the requirements of section 4.01(1)(c) of this

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revenue procedure, Taxpayer is eligible to use the overall cash method of accounting. Notwithstanding the Taxpayer’s eligibility to use the overall cash method, however, because the contract to manufacture the custom-made die requires the production of a “unique item” and will not be completed in the year it is entered into, it is a “long term contract” for purposes of § 460, and the income and expense relating to that contract must be accounted for under the percentage-ofcompletion method of accounting described in § 460 and the underlying regulations.

Example 22 - Application of Long Term Contract Rules - § 460 Not Appli- cable . Taxpayer is a residential home builder that specializes in modest single family homes whose construction period averages six months. Taxpayer uses an overall accrual method of accounting, and although it is not required to do so, Taxpayer has elected to use the percentageof-completion method of accounting, as described in § 1.460–4(b), in accounting for its home construction activities. Because its principal business activity is not described in an ineligible NAICS code described in section 4.01(1)(a), Taxpayer may elect the overall cash method described in this revenue procedure. Further, because its home construction activity is not required to be accounted for using the percentage-of-completion method described in § 460, Taxpayer is eligible (but not required) to change its method of accounting for that activity to the cash method.

Example 23 - Taxpayer Satisfies the NAICS Code Provision in Section 4.01(1)(a) . Taxpayer is a licensed medical clinic that provides specialized chemotherapy treatment to cancer patients. The medication provided to patients accounts for 26 percent of Taxpayer’s average annual gross receipts. Taxpayer does not sell the medications separately from its provision of services, selects the medications to be used in a particular session based on its own professional skill and judgment, and does not maintain medications for more than two weeks. Because the provision of medical services (NAICS code 62) represents Taxpayer’s principal business activity, Taxpayer qualifies to use the cash method under section 4.01(1)(a) for all of its trades or busi

nesses. Even if the cost of the chemotherapy medications represented Taxpayer’s principal source of gross receipts, Taxpayer nonetheless would qualify to use the cash method under section 4.01(1)(a) of this revenue procedure, because its principal business activity would still be providing medical services, with goods being provided only incident to the provision of those services. See Osteopathic Medical Oncology and Hematology, P.C. v. Commissioner, 113 T.C. 376 (1999), acq. in result 2000–1 C.B. xvi.

Example 24 - Change in Principal Business Activity . Taxpayer owns a hardware store and a small appliance repair business. Following the issuance of this revenue procedure, Taxpayer reasonably determined that its principal business activity was its appliance repair business, which is not described in an ineligible NAICS code under section 4.01(1)(a)(i)– (v). Consequently, Taxpayer was eligible to use the cash method under this revenue procedure for both its business activities (appliance repair and retail sales). Over time, Taxpayer’s hardware store began to generate a larger portion of Taxpayer’s gross receipts than its repair business. In 2005, Taxpayer’s retail business became its principal business activity. Because retail trade is described in ineligible NAICS code 44, starting in 2006, Taxpayer is no longer eligible to use the cash method for all its trades or businesses under section 4.01(1). Accordingly, Taxpayer must change to an accrual method for its retail business. If Taxpayer maintains a complete and separable set of books and records in 2006 for its repair business, Taxpayer may continue to use the cash method for its repair business under section 4.01(2). If Taxpayer does not maintain a complete and separable set of books and records in 2006 for its repair business, Taxpayer also must change to an accrual method for its repair business —however, in any subsequent taxable year that Taxpayer maintains complete and separable books and records for its repair business, Taxpayer will be eligible under section 4.01(2) to change to the cash method for its repair business.

Example 25 - Change in Principal Business Activity . Same as Example 24, except that Taxpayer’s repair business again becomes its principal business

activity in 2009. Taxpayer is no longer eligible to use the cash method for its retail business under section 4.01(1). For section 4.01(1) to apply, Taxpayer must not have previously changed (or have been previously required to change) from the cash method to an accrual method for any trade or business as a result of becoming ineligible to use the cash method under this revenue procedure. Because Taxpayer was required to change to an accrual method for its retail business in 2006 as a result of becoming ineligible to use the cash method under this revenue procedure, Taxpayer is not eligible to rely on section 4.01(1) for 2006 or any subsequent taxable year. Example 26 - Change in Principal Business Activity . Same as Example 24, except that following the issuance of this revenue procedure, Taxpayer’s principal business activity was retail sales and Taxpayer used an accrual method for both businesses (retail and repair). Over time, Taxpayer’s repair business began to generate a larger portion of Taxpayer’s gross receipts than its retail business. In 2007, Taxpayer’s repair business became its principal business activity. Starting in taxable year 2008, Taxpayer is eligible under section 4.01(1) to use the cash method for all its trades and businesses because Taxpayer did not change (and was not required to have changed) from the cash method to an accrual method for any trade or business as a result of becoming ineligible to use the cash method for that trade or business under this revenue procedure, and Taxpayer’s principal business activity is no longer described in an ineligible NAICS code under section 4.01(1)(a)(i)–(v).