In recent years, the Internal Revenue Service (IRS) has been aggressively attacking drilling businesses that sell what they label "merchandise" and also use the easier "cash" method of accounting. All-too-often the IRS is successful in forcing them to switch to the more difficult accrual method.

Now, in a major concession, a new IRS Revenue Procedure (Rev. Proc. 2000-22, 2000-20 IRB 1) allows every qualifying drilling contractor and equipment dealer with average gross receipts of $1,000,000 or less to use the cash method of accounting.

Not only is the cash method far simpler to use, for many small contractors and dealers it better reflects reality. Income becomes taxable when received, not when billed, and expenditures become deductible when the money is actually spent. And, don't forget those drilling contractors and equipment dealers who are allowed to use the cash method of accounting can also use the installment method to account for sale of the business -- if or when it is sold.

Small business firms are often purchased using installment sales. However, because use of installment sales was denied to those using the accrual method of accounting as part of last year's so-called "extenders bill," sellers are required to pay all capital gains taxes on sale of a business in the first year, rather than over the period when payments are received.

Cash vs. Accrual

The cash basis accounting method recognizes revenue and expenses when cash is received or spent rather than when earned or incurred. Accrual accounting recognizes revenue when it is earned and expenses when incurred. In other words, under the accrual method, income and expenses are recorded at the end of an accounting period even though cash has not been received or paid.

Under our tax rules, every drilling-related business required to use inventories must use the accrual method to account for purchases and sales. Until now, that meant almost every regular (eCO) corporation. Despite the general rule, however, the cash method of accounting could still be used by any taxpayer that met the $5 million or less gross receipts test for all prior years. An entity meets the $5 million gross receipts test if average annual gross receipts for the three tax years ending with the prior tax year do not exceed $5 million.

Conforming

Under the new Revenue Procedure every driller, regardless of size, that wishes to take advantage of this safe harbor and use the cash method of accounting must satisfy a conformity requirement.

Thus, a driller "must use the cash method to ascertain income, profit or loss of trade or business for purposes of its books and records (including financial statements) to shareholders, partners, other proprietors or beneficiaries and for credit purposes for the current and prior three tax years."

A drilling business that uses the cash method of accounting for its books, records and reports but occasionally prepares financial reports using an accrual method (for example, on a one-time basis to obtain a bank loan) will be considered to have satisfied the conformity requirement.

Changing Methods

Any driller that qualifies for the small taxpayer exception of this revenue procedure that wants to change to the cash method must follow the automatic change in accounting method provisions -- with certain modifications. In fact, a unique loophole exists for some drilling contractors and equipment dealers making an automatic change in accounting methods for its first tax year ending on or after December 17, 1999 -- if it files its original Federal income tax returns for that year on or before July 14, 2000.

In this unique situation, the change in accounting methods may be accomplished merely by filing an original copy of Form 3115 (Request For Change In Accounting Method) with the drilling operationOs amended Federal income tax return for that year.

This amended return must be filed no later than November 13, 2000. A copy of the Form 3115 must be filed with the IRSOs National Office no later than when the operationOs amended return is filed.

Ordinarily, a driller must secure IRS permission to change accounting methods. Either under rules requiring prior permission or with the new automatic change rules, the driller must make certain adjustments to prevent amounts from being duplicated or omitted.

When there is a change in the method of accounting, income for the taxable year preceding the year of change must be determined under the method of accounting that was then employed. Income for the year of change and the following taxable years must be determined under the new method of accounting as if the new method had always been used.

Summary

Under this revenue procedure, a small taxpayer is defined as one with average annual gross receipts of $1,000,000. The averaging period is three years, beginning with tax years ending on or after December 17, 1998.

Obviously, the right to use the cash method of accounting, unchallenged by the IRS, is a boon to many small drilling businesses. The $1,000,000 gross receipts test does not mean those drillers that exceed that ceiling will be denied use of the cash method, only that their right to use the cash method under the still existing $5 million ceiling may be questioned.

While this new Revenue Procedure provides some relief, if is not major relief. Thus, every driller should evaluate their situation carefully before changing to the cash method. If the drilling operation's receipts are near the threshold, or growing rapidly, it may not make sense to switch. Of course, if the business qualifies, perhaps the cash method of accounting makes sense for your drilling or drilling equipment business. But, you will never know unless you seek professional advice.