is met if substantially all the activities of the corporation are the performance of services in the field or fields of health, law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts or consulting.

The ownership test is met if substantially all (i.e., 95 percent) of the value of the outstanding stock in the corporation is owned, directly or indirectly, by employees performing services for the corporation in connection with the qualified services performed by the corporation, retired individuals who performed such services for the corporation or its predecessor(s), the estate of such an individual, or any other person who acquired stock by reason of the death of such an employee (for the 2-year period beginning with the death of such employee).

For the purpose of applying the ownership test, stock owned by a partnership, an S corporation or a qualified personal service corporation will be considered as owned by its partners or shareholders. In applying the ownership test, the applicable community property laws of any State are to be disregarded, stock held by any plan described in section 401(a) that is exempt from tax under section 501(a) is treated as held by the employees of the entity and, at the election of the common parent of an affiliated group, all members of such affiliated group may be treated as a single entity for the purpose of applying the ownership test if substantially all of the activities of such affiliated group involve the performance of services in the same qualified field. 2a

Any other ownership of stock as a result of any attribution rule of the Code is to be disregarded. For example, stock held by a father is not to be attributed to his children. Thus, the ownership test would not be considered to be met if nonemployee-children owned more than 5 percent of the stock, despite the fact that their father might be an employee of the corporation.

Farming businesses

The Act provides that, for the purpose of determining whether an entity is engaged in a farming business, the definition of farming shall include the raising or harvesting of trees (including evergreen trees that are not subject to the capitalization provisions of section 263A).

Gross receipts test

An entity is considered to meet the gross receipts test and, therefore, is eligible to use the cash method of accounting, if the entity had "average annual gross receipts" of $5 million or less for all prior taxable years (including the prior taxable years of any predecessor entity) beginning after December 31, 1985. "Average annual gross receipts" are determined by averaging the gross receipts of the three taxable year period ending with such prior taxable year. For example, a calendar year entity had gross receipts of $4 million in 1984, $5 million in 1985, $6 million in 1986 and $7 million in 1987. Average annual gross receipts are $5 million for 1986 and $6 million for 1987. In calendar year 1987, the entity is not prohibited

2 A technical correction may be needed to reflect this intention.

from using the cash method, since it had "average annual gross receipts" of $5 million or less for all prior taxable years beginning after December 31, 1985 (i.e., 1986). In 1988, the entity may not use the cash method (unless it meets one of the other exceptions) since "average annual gross receipts" for a prior taxable year (1987) exceed $5 million.

Any taxable year included in the average annual gross receipts calculation which is a year of less than 12 months must be annualized. If the entity (or any predecessor entity) was not in existence for all three of the taxable years to be used in the calculation, average annual gross receipts is calculated of the period during which such entity (or predecessor) was in existence.

In determining whether a taxpayer has average annual gross receipts in excess of $5 million, the gross receipts of all related entities are aggregated if such entities would be treated as a single employer under subsection (a) or (b) of section 52 or subsection (m) or (o) of section 414, regardless of whether the entities have any employees.

In determining the gross receipts of entities aggregated under this rule, intercompany receipts of such entities are to be excluded. Accrual of service income

A taxpayer is not required to accrue as income any amount to be received for the performance of services that, on the basis of experience, will not be collected, as long as unpaid balances do not bear interest or result in a late payment charge. The offering of a discount for early payment of an amount billed does not result in the balance bearing interest or a late charge if the full amount billed is accrued as income and the discount for early payment recorded as an adjustment to income in the year the payment is made.

The amount of accruals that, on the basis of experience will not be collected is equal to the total amount of the accrual, multiplied by a fraction whose numerator is the total amount accrued and determined not to be collectible within the most recent five taxable years of the taxapayer, and whose denominator is the total amount of such accruals within the same five year period. If the taxpayer has not been in existence for the prior five taxable years, the portion of such five year period which the taxpayer has been in existence is to be used.

For example, an accrual-basis taxpayer has accrued $100,000 of income for the performance of services during the most recent five taxable years. Of the $100,000 that has been accrued, $1,000 has been determined to be uncollectible. The amount, based on experience, which is not expected to be collected is equal to 1 percent ($1,000 divided by $100,000) of any accrued income for the performance of services that does not bear interest or a late charge, and that is not collected by the close of the taxable year.

A taxpayer that has not recognized income on amounts not expected to be collected must recognize additional income in any taxable year in which payments on amounts not recognized are received. If an amount that would otherwise be accrued as income is determined to be partially or wholly uncollectible, no portion of the loss arising as a result of such determination, that was not recog

nized as income at the time the receivable was created, is deductible.

The Congress intended that the Secretary of the Treasury be allowed to provide a periodic system of accounting for accruals that, on the basis of experience, will not be collected if the periodic system results in the same taxable income as would be the case if each accrual were recorded separately.

Tax shelters

The Act provides that the cash method of accounting may not be used by any tax shelter. For this purpose, a tax shelter is defined in the same manner as under section 461(i) of prior and present law. Thus, a tax shelter is (a) any enterprise (other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or State agency having the authority to regulate the offering of securities for sale, (b) any syndicate within the meaning of section 1256(e)(3), or (c) any tax shelter within the meaning of section 6661(b)(2)(C)(ii). In the case of an enterprise engaged in the trade or business of farming, a tax shelter is (a) any tax shelter within the meaning of section 6661(b)(2)(C)(ii) or (b) a farming syndicate within the meaning of section 464(c).

The denial of the use of the cash method of accounting to tax shelters applies whether or not the tax shelter is a C corporation. Also, the exceptions to the general rule for farming businesses, qualified personal service corporations, and entities with average annual gross receipts of $5 million or less do not apply in the case of tax shelters.

A tax shelter may not take advantage of the recurring item exception under section 461(h)(3) to the rule requiring economic performance before an accrual basis taxpayer may deduct an item of expense. In the case of a tax shelter, however, economic performance with respect to the drilling of an oil and gas well will be considered to have occurred if the drilling of the well commences within 90 days of the close of the taxable year.

Certain pre-effective date transactions

Taxpayers may elect to continue to report income from loans, leases, certain real property contracts, and transactions with related parties entered into before September 25, 1985, using the cash method. This rule applies to tax shelters as well as other entities. Tax-exempt organizations

The Act provides that a tax-exempt organization that is organized as a trust is treated as a corporation with respect to any of its unrelated business income. Therefore, where a tax-exempt trust has gross receipts from its unrelated business activities in excess of $5 million, the unrelated business taxable income of that trust cannot be computed on the cash method of accounting. Similarly, in the case of a tax-exempt organization organized as a corporation, the Congress intended to require the use of an accrual method only

with respect to the unrelated business taxable income of such an organization.3

Effective Date

The provision is effective for taxable years beginning after December 31, 1986. Any change from the cash method required by this provision is treated as initiated by the taxpayer with the consent of the Secretary of the Treasury. Any adjustment required by section 481 as a result of such change generally shall be taken into account over a period not to exceed four years. It is the intent of the Congress that this apply to all changes resulting from the provision, including any changes necessitated by the rule that certain accrual taxpayers, including taxpayers presently on an accrual method of accounting, need not recognize income on amounts statistically determined not to be collectible.

In the case of a hospital, the adjustment shall be taken into account ratably over a ten-year period. For this purpose, a hospital is a taxable or tax-exempt institution that

(1) Is accredited by the Joint Commission of Accreditation of Hospitals (JCAH), or is accredited or approved by a program of the qualified governmental unit in which such institution is located if the Secretary of Health and Human Services has found that the accreditation or comparable approval standards of such qualified governmental unit are essentially equivalent to those of the JCAH;

(2) Is primarily used to provide, by or under the supervision of physicians, to inpatients diagnostic services and therapeutic services for medical diagnosis, treatment, and care of injured, disabled, or sick persons;

(3) Has a requirement that every patient be under the care and supervision of a physician; and

(4) Provides 24-hour nursing services rendered or supervised by a registered nurse and has a licensed practical nurse or registered nurse on duty at all times.

In order to qualify as a hospital, an institution is not required to be owned by or on behalf of a governmental unit or by a 501(c)(3) organization or operated by a 501(c)(3) organization.

The Congress intended that the timing of the section 481 adjustment (other than for a hospital) generally will be determined under the provisions of Revenue Procedure 84-74, 1984-2 C.B. 736. In addition, the Congress intended that (1) net operating loss and tax credit carryforwards will be allowed to offset any positive section 481 adjustment; (2) for purposes of determining estimated tax payments, the section 481 adjustment will be recognized in taxable income ratably throughout the year in question; and (3) the timing of a negative section 481 adjustment shall be determined as if the adjustment were positive.

Revenue Effect

The provision is estimated to increase fiscal year budget receipts by $290 million in 1987, $595 million in 1988, $631 million in 1989, $646 million in 1990, and $650 million in 1991.

3 A technical correction may be needed to reflect this intention.

B. Simplified Dollar Value LIFO Method for Certain Small Businesses (Sec. 901 of the Act and sec. 474 of the Code) 4

In general

Prior Law

Under present and prior law, if the production, purchase or sale of merchandise is a material income producing factor to a taxpayer, a taxpayer is required to keep inventories and to use an accrual method of accounting with respect to the production, purchase or sale of merchandise. Acceptable methods of accounting for inventories include specific identification, first-in first-out (FIFO), last-in first-out (LIFO), and, in certain limited circumstances, average cost. One method of applying the LIFO method to inventories is the dollar-value method. Under the dollar-value LIFO method, the taxpayer accounts for its inventories on the basis of a pool of dollars rather than on an item-by-item basis. Each pool of dollars includes the value of a number of different types of inventory items. Generally, for wholesalers, retailers, jobbers and distributors, items of inventory are pooled by major lines, types or classes of goods. In the case of manufacturers, all inventory items which represent a natural business unit may be combined into a single pool. Similarly, taxpayers may assign inventory items to one of a number of pools determined by the similarity of the different types of items to each other. A taxpayer with average annual gross receipts of no more than $2 million for its three most recent taxable years may elect to use a single pool for all items of inventory.

The dollar-value method measures each pool of dollars in terms of the equivalent dollar value of the inventories at the time the portion of the pool of dollars was first added to the inventory account. In order to measure the pool of dollars in terms of equivalent dollar values, the use of the dollar-value LIFO method requires the development of an index which will discount present dollar values back to the equivalent dollar values of the first year the taxpayers uses the LIFO method (called the "base year"). This is normally done by comparing the dollar amount of inventory items measured in present year prices against the dollar amount of the same inventory items in base year prices (the "double-extension" method). If the permission of the Secretary of the Treasury is obtained, however, the index may be developed by comparing the dollar amount of inventory items measured in present year prices against the dollar amount of the same inventory items measured in the immediate prior year's prices. This computation yields an annual index component that, when applied to all prior annual

*For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 901; H. Rep. 99-426, pp. 598–604; and H. Rep. 99-841, Vol. II (September 18, 1986), pp. 290–292 (Conference Report).