The accrual basis trap.

Many small companies that use the cash basis of accounting for tax purposes should be careful to avoid slipping into the accrual basis because of oversights in reporting. Companies should be particularly careful when reporting inventory, accounts receivable and accrued expenses. For example, inventory

In recent years, the Internal Revenue Service has sought through rulings and cases to ensure that taxpayers properly use the cash basis. In private letter ruling 9524001, the IRS required a general construction contractor to use the accrual basis because the construction materials it acquired and sold were inventory. Internal Revenue Code section 1.446-1(c)(2) mandates the use of the accrual basis for companies required to have inventory. The ruling also refers to IRC section 1.471-1, which provides for the use of inventories whenever a company's production, purchase or resale is income producing.

There are very few exceptions under this regulation. An example is a taxpayer that can prove there would be no significant difference in the business's operating results between the cash and accrual bases.

Observation: It is important for small businesses purchasing any items used in the ordinary course of operation to be careful at the end of the fiscal year. It may be wise to be conservative and clear out any inventory on hand at the end of the year. Companies also should watch their yearend purchases. If, as in the above ruling, materials are supplied by customers or subcontractors, then payment should be made by the customers or subcontractors directly to the vendors. No inventory should be stored on the company's premises at the end of the year, particularly if purchased for use in income-producing activities. In essence, there should be a "clean house" policy in place to be sure that nothing remains at the end of the business year. --Stanley Person, CPA, partner of Person & Company, New York City.