[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]





 
HEARING ON CASH VERSUS ACCRUAL: THE POLICY IMPLICATIONS OF THE GROWING 
       INABILITY OF SMALL BUSINESSES TO USE SIMPLE TAX ACCOUNTING

=======================================================================

                                HEARING

                               before the

                      COMMITTEE ON SMALL BUSINESS
                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED SIXTH CONGRESS

                             SECOND SESSION

                               __________

                     WASHINGTON, DC, APRIL 5, 2000

                               __________

                           Serial No. 106-49

                               __________

         Printed for the use of the Committee on Small Business

                     U.S. GOVERNMENT PRINTING OFFICE
65-508                       WASHINGTON : 2000





                      COMMITTEE ON SMALL BUSINESS

                  JAMES M. TALENT, Missouri, Chairman
LARRY COMBEST, Texas                 NYDIA M. VELAZQUEZ, New York
JOEL HEFLEY, Colorado                JUANITA MILLENDER-McDONALD, 
DONALD A. MANZULLO, Illinois             California
ROSCOE G. BARTLETT, Maryland         DANNY K. DAVIS, Illinois
FRANK A. LoBIONDO, New Jersey        CAROLYN McCARTHY, New York
SUE W. KELLY, New York               BILL PASCRELL, New Jersey
STEVEN J. CHABOT, Ohio               RUBEN HINOJOSA, Texas
PHIL ENGLISH, Pennsylvania           DONNA M. CHRISTIAN-CHRISTENSEN, 
DAVID M. McINTOSH, Indiana               Virgin Islands
RICK HILL, Montana                   ROBERT A. BRADY, Pennsylvania
JOSEPH R. PITTS, Pennsylvania        TOM UDALL, New Mexico
JOHN E. SWEENEY, New York            DENNIS MOORE, Kansas
PATRICK J. TOOMEY, Pennsylvania      STEPHANIE TUBBS JONES, Ohio
JIM DeMINT, South Carolina           CHARLES A. GONZALEZ, Texas
EDWARD PEASE, Indiana                DAVID D. PHELPS, Illinois
JOHN THUNE, South Dakota             GRACE F. NAPOLITANO, California
MARY BONO, California                BRIAN BAIRD, Washington
                                     MARK UDALL, Colorado
                                     SHELLEY BERKLEY, Nevada
                     Harry Katrichis, Chief Counsel
                  Michael Day, Minority Staff Director







                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on April 5, 2000....................................     1

                               Witnesses

Mikrut, Joseph M., Tax Legislative Counsel, United States 
  Department of the Treasury, Washington DC......................     5
Mieras, Shane, Project Manager, Mid-Ceitling and Drywall, 
  Rockford, Michigan.............................................    28
Wulkopf, David E., CPA, Treasurer, Beckner Painting Midwest, 
  Inc., St. Louis, Missouri......................................    30
Harris, Roger, President, Padgett Business Services, Athens, 
  Georgia........................................................    33
Olson, Pamela F., Chair-Elect, Section of Taxation, American Bar 
  Association....................................................    34
Satagaj, John S., Managing Partner, London and Satagaj, 
  Washington, DC.................................................    36
Schneier, Abraham L., Partner, McKevitt & Schneier, Washington, 
  DC.............................................................    40

                                Appendix

Opening statements:
    Talent, Hon. James...........................................    50
    Velazquez, Hon. Nydia........................................    53
    Manzullo, Hon. Donald A......................................    55
    Tubb-Jones, Hon. Stephanie...................................    56
Prepared statements:
    Mikrut, Joseph M.............................................    61
    Mieras, Shane................................................    68
    Wulkopf, David E.............................................    73
    Harris, Roger................................................    77
    Olson, Pamela F..............................................    82
    Satagaj, John S..............................................    93
    Schneier, Abraham L..........................................   103
Additional material:
    Written statement of American Dental Association.............   108
    Written statement of the Associated General Contractors of 
      America....................................................   113
    Written statement of Anthony Shaker, President, Air 
      Conditioning Contractors of America........................   116
    Written statement of the Plumbing-Heating-Cooling 
      Contractors-National Association...........................   122


HEARING ON CASH VERSUS ACCRUAL: THE POLICY IMPLICATIONS OF THE GROWING 
       INABILITY OF SMALL BUSINESSES TO USE SIMPLE TAX ACCOUNTING

                              ----------                              


                        WEDNESDAY, APRIL 5, 2000

                          House of Representatives,
                               Committee on Small Business,
                                                    Washington, DC.
    The Committee met, pursuant to call, at 10:00 a.m., in Room 
2360 Rayburn House Office Building, Hon. James M. Talent, 
[Chairman of the committee] presiding.
    Chairman Talent [presiding]. We will now call the hearing 
to order. I want to welcome our witnesses here today and take a 
moment to thank, in particular, Mr. English and Mr. Manzullo 
and Mr. Sweeney of the Committee for their legislative efforts 
on the small business issues before us today.
    It's easy for our eyes to glaze over when we hear the terms 
``cash versus accrual'' or ``installment method of 
accounting.'' These terms are the rules that govern and 
determine when, not if, small businesses and other taxpayers 
have to pay taxes on their income.
    The cash method is a simple method of accounting allowed by 
the tax code that most closely mirrors the way many small 
businesses operate. It allows them to pay taxes on income in 
the year that they actually receive the income. This is, at 
best, a brief deferral of tax, not any special exemption or 
waiver.
    In contrast, forcing small businesses, including small 
contractors and service providers and, especially including 
small contractors and service providers, to switch to the 
accrual method of accounting means that they have to pay now 
and collect later on their accounts receivable. In reality, 
most small entities are willing to forego deductions to use 
simple accounting and have used the cash method consistently 
for years, if not for decades. An example is Beckner Painting, 
a constituent of mine who will testify later today, who has 
used cash accounting consistently since 1965.
    Accounting issues have become increasingly important and 
controversial because of the underlying implications of recent 
Treasury proposals and consequent IRS enforcement activities 
that are hurting small businesses. We will explore these policy 
implications and the pending regulatory guidance that the 
Treasury Department plans to issue on who must use accrual 
accounting.
    Unfortunately, the Treasury Department's recent policy 
statements and proposals demonstrate an increasingly aggressive 
position designed to deny American small business taxpayers the 
ability to use simple and lawful tax accounting, including the 
installment method repeal successfully advocated into law by 
the Treasury Department last year.
    Similarly, the Treasury Department has announced it will 
soon issue guidance regarding the rules related to the cash and 
accrual methods of accounting. Specifically, the Department 
intends to issue guidance regarding when merchandise used by a 
taxpayer requires the use of inventories and, thus, the accrual 
method of accounting. The Treasury's plans, therefore, are 
critical in determining whether small businesses will find real 
relief or increasing controversy in their ability to use simple 
accounting in paying their taxes.
    When testifying here today and moving forward on any 
regulations, I urge the Department to keep in mind that tax 
policy is distinct from financial accounting. Many important 
considerations, including fairness and simplicity, outweigh the 
need, if any, for mathematically precise matching of income and 
expenses for tax collection purposes.
    Moreover, what you may consider in your accounting changes 
inside the Beltway harshly affect the lifeblood of small 
contractors and service providers, their cash flow. Having to 
pay taxes on income small entrepreneurs have not received 
strangles their cash flow and their businesses. Accordingly, 
the use of Treasury and IRS resources to litigate and audit 
small business contractors and service providers who regularly 
use cash accounting seems both cost ineffective and 
unreasonable.
    Congress has made great strides in the last few years to 
provide tax relief for small businesses and to reform the 
Internal Revenue Service. I may say this Committee has been at 
the forefront of those efforts. The Committee appreciates the 
new direction the Commissioner is obviously taking the IRS in 
its responsiveness to the small business community. I hope any 
new policies, regulations, or legislation that the Treasury 
Department proposes and the Congress considers will make this 
important job easier.
    In this regard, I want to make two more points. First of 
all, I appreciate Treasury's recognition of the damage last 
year's installment change is causing small business. I believe 
its policy position on installment sales is fundamentally 
flawed. I urge the Department to support H.R. 3594 to fully 
reverse last year's repeal of the installment method of 
accounting for accrual basis taxpayers.
    This bill would restore the ability of small businesses to 
sell their businesses without losing between 5 to 20 percent of 
their value, 8.2 percent on average. In many cases, this value 
represents the small business person's life's work and 
retirement savings, which are now unexpectedly slashed.
    Two, I urge the Treasury to support a proposed legislation 
to allow small businesses with gross receipt of $5 million or 
less to use the cash method of accounting without limitation. 
In the current law, Congress explicitly recognizes that 
allowing small business C corporations to use cash accounting 
outweighs any inherent distortions in the timing of their 
income and expenses. Setting a lower-than-$5 million threshold 
for other small businesses, including sole proprietors, 
partnerships, and S corporations makes no sense and would lead 
to additional and unnecessary complexity.
    I'm happy now to recognize the distinguished gentlelady 
from New York for any comments that she may wish to make.
    Ms. Velazquez. Thank you, Mr. Chairman. Over the past few 
years, America has experienced an unprecedented economic boom. 
And no one can deny the importance of small business in 
creating this growth and supporting our communities. Our 
nation's entrepreneurs provide jobs and represent the major tax 
base for our schools and roads, embodying the spirit of 
entrepreneurship that has made this country great.
    However, too often small businesses lack the capital they 
need to grow or they don't have the money at the end of the day 
to make being their own boss a reward. One reason for this is 
that our tax system often creates road blocks for our nation's 
small businesses.
    Today's hearing is a continuation of what I believe is one 
of the most important roles that this Committee plays to 
educate the rest of Congress about the tax challenges facing 
our nation's small businesses.
    I would like to commend the Chairman for bringing before 
this Committee an issue essential to small businesses, the 
issue of tax simplification and specifically the cash versus 
accrual methods of accounting.
    With no two small businesses facing the exact set of 
issues, the sides on this debate are clear. Many small 
businesses argue that the accrual method is too complicated and 
requires many small businesses to retain an accountant, tax 
expert, or hire a full-time employee who is skilled enough to 
use this accounting method.
    I believe that there is one component of this debate that 
the Committee specifically has a responsibility to highlight, 
because it is a perfect example of the rule of unintended 
consequences, that is the repeal of the installment method of 
accounting, a variation of cash accounting.
    The issue arose last year when Congress passed the Work 
Incentives Improvement Act. This legislation has many vital tax 
provisions, like the R&D tax credit, work opportunities tax 
credit, and alternative minimum tax credit, all significant 
provisions. As an offset to pay for this, the installment 
method was done away with.
    The result was to force most small businesses to use the 
accrual method. Unfortunately, this change created more 
problems than it solved. Forcing small businesses to use the 
accrual method placed an especially disproportionate burden on 
those small business owners attempting to sell their 
businesses.
    Unlike the installment method that allowed the owners to 
pay the taxes as the payment was received, the accrual method 
forces them to be liable for the full amount immediately, even 
if they only have partial or no payments. This has created an 
unintended burden on the business owner and a disincentive for 
business sales.
    I am pleased Congress recognized this and corrected it 
through the repeal of the prohibition on the installment 
method.
    Clearly, given this chain of events, we need to do much 
more educating our colleagues about the tax challenges facing 
small business owners. We need to continue to push for a tax 
system that is progressive but does not place the 
disproportionate burden on small business.
    One again, I would like to thank the Chairman for holding 
today's hearing. Creating a fair and equitable tax structure 
for our nation's small businesses is crucial to their long-term 
success. At the same time, we must work to ensure that, by 
solving one problem, we do not create a more serious problem 
elsewhere. I look forward to hearing the testimony of today's 
witnesses and I thank the Chairman again for his hard work on 
this issue.
    [Ms. Velazquez's statement may be found in appendix.]
    Chairman Talent. All right. Before we get to our first 
panel, and while it's our practice for only the ranking member 
and I to have opening statements, in this case, Mr. Manzullo, 
who does chair the Tax Subcommittee wanted to make a brief 
opening statement, so I'll allow him to do it.
    Mr. Manzullo. Thank you, Mr. Chairman. I commend you for 
holding this hearing today. As Chairman of the Tax 
Subcommittee, I realize this issue is perceived by some as 
being very dry, but it's really a matter of life and death for 
thousands of small businesses which have to sell some product 
associated with their services or at least use a product 
associated with their services.
    I first became aware of this issue in 1996 when a dentist 
in the district that I represent became an IRS, ``test case,'' 
forcing him to move from the cash method of accounting to the 
accrual method. This changeover required him to pay cash on 
income he had not even received. Medical professionals have no 
problem paying taxes on what they collect on their billings, 
but they object to paying taxes on outstanding invoices, 
particularly unpaid bills. This is another illustration of the 
IRS trying to collect taxes early.
    In 1998, I offered legislation to give physicians and 
dentists the choice to remain with the cash method of 
accounting. It was reintroduced as H.R. 1004 in this Congress. 
I ask unanimous consent that the Chairman include in the 
hearing record a written statement of the American Dental 
Association on this issue.
    [American Dental Association's statement may be found in 
appendix.]
    Mr. Manzullo. Over the past few years, I've learned that 
this issue impacts more than the small business community, such 
as landscapers, building contractors, and plumbers. That's why 
I'm proud to be a cosponsor of your bill, Mr. Chairman, that 
would allow any small business with gross receipts of up to $5 
million the choice to remain with the cash method of 
accounting.
    I could not have said it better than Judge Power when she 
reached a decision by the U.S. tax court. She said the IRS, 
``abused its discretion when it required the contractor to 
change from the cash method to the accrual method of 
accounting.'' I was pleased to have a few conversations with 
Commissioner Charles Rossotti. I observed he was sympathetic to 
the plight of small business owners on this issue.
    I understand from previous testimony, the Treasury 
Department announced that small business owners with gross 
receipts of $1 million or less will be free to use the cash 
method of accounting. Mr. Chairman, it's a good step in the 
right direction, but I trust, after this hearing, that the new 
administration policy will be more in the direction of Chairman 
Talent's bill.
    Chairman Talent. I thank the gentleman. And the gentlelady 
from Ohio has sought recognition. I'm happy to recognize her.
    Ms. Tubbs Jones. Mr. Chairman, thank you. I was seeking 
unanimous consent to have an opening statement on this issue 
submitted for the record.
    Chairman Talent. I thank the gentlelady and, without 
objection.
    And without objection, any member who wishes to submit an 
opening statement, it will be entered into the record.
    And I truly thank the members for their interest in this 
issue which is vital to small business. And we'll just 
introduce the first panel and we have one witness on the panel, 
Mr. Joseph M. Mikrut, who is the tax legislative counsel for 
the United States Department of the Treasury. Mr. Mikrut, it's 
your first time before the Committee. We're pleased to have you 
and thank you for coming in. You can give us your statement.

STATEMENT OF JOSEPH M. MIKRUT, TAX LEGISLATIVE COUNSEL, UNITED 
      STATES DEPARTMENT OF THE TREASURY, WASHINGTON, D.C.

    Mr. Mikrut. Thank you, Mr. Chairman. Mr. Chairman, Ranking 
Member Velazquez, distinguished members of the Committee, thank 
you for inviting me today.
    I appreciate not only talking about this issue, but at the 
Treasury we have come to understand the importance of tax 
issues for the small business community and we hope this will 
be a continuing dialogue to discuss these matters with the 
Committee.
    I especially appreciate the opportunity to discuss with you 
today the important topic of the proper method of accounting as 
applied to any small business. Indeed, the choice and use of a 
method of accounting is one of the most fundamental aspects in 
determining a taxpayers' tax liability and these matters, 
although some may have described them as dry and uninteresting, 
are matters of great concern to the taxpayer.
    This morning, I would like to focus on four main topics. 
One, I would like to discuss with you the current law and rules 
regarding the choice of accounting method; two, the tax policy 
rationale of such rules; three, the administrative guidance 
that we and the IRS are developing in this area; and four, 
recent developments with respect to the installment method.
    Items of taxable income and deduction generally are taken 
into account by a taxpayer in a taxable year based on the 
taxpayer's method of accounting. Code section 446 requires that 
the selected method clearly reflect the taxpayer's income and 
grants the Secretary of the Treasury broad discretion in 
determining whether a method of accounting clearly reflects 
such income. Once a method is established by the taxpayer, the 
taxpayer must continue to use that method until he secures the 
consent of the Secretary to change.
    Permissible methods of accounting include the cash receipts 
and disbursements method, known as cash method, accrual 
methods, or any other method or combination of methods 
permitted under Treasury regulations.
    In general, there are two main methods, those being the 
cash method and the accrual methods. The cash method is the 
method under which most individuals operate. The cash method of 
accounting generally requires an item to be included in income 
when actually or constructively received and permits a 
deduction for when the expense is paid.
    In contrast, an accrual method of accounting generally 
requires that an item be included in income when all events 
have occurred that give rise to that income, in other words, 
when the event occurs that gives rise to the income. And 
similarly, a deduction is allowed to the accrual-method 
taxpayer when all of the events have occurred that give rise to 
the liability that gives rise to such expenditure.
    Certain restrictions are imposed on the use of the cash 
method. Long-standing Treasury regulations provide that, in 
order to clearly reflect income, taxpayers that are required to 
keep inventories for a particular trade or business must use an 
accrual method of accounting. Inventory accounting is required 
whenever merchandise is a significant income-producing factor. 
Therefore, a taxpayer who is required to keep inventories is 
also required to use an accrual method of accounting. 
Exceptions are provided for farmers, even though such taxpayers 
generally are engaged in the production and sale of 
merchandise.
    In addition, certain statutory provisions restrict the use 
of the cash method of accounting. Section 448 enacted by 
Congress in 1986 requires that C corporations and partnerships 
that have C corporate partners and have more than $5 million of 
average annual gross receipts may not use the cash method of 
accounting. An exception is provided for certain qualified 
professional service corporations that are owned by the 
employees.
    Legislative history of the 1986 Act makes it clear that 
taxpayers that are not specifically, quote, ``prohibited from 
using the cash method of accounting,'' for example, taxpayers 
with less than $5 million gross receipts, are not automatically 
eligible to use the cash method. On the contrary, legislative 
history clearly states that these taxpayers remain subject to 
other requirements, that their methods of accounting clearly 
reflect income, and that an accrual method must continue to be 
used by sellers of inventories.
    The tax policy rationale underlying the use of an accrual 
method of accounting is relatively straightforward. Accrual 
methods of accounting, when compared to the cash method, are 
acknowledged to better reflect economic income and comport to 
generally accepted accounting principles for financial 
accounting purposes.
    The clear reflection of income standard is demonstrated by 
the matching principle. Under the matching principle, gross 
receipts from sales must be matched with related costs of goods 
sold. In order to achieve such a matching of cost to revenue, 
it is necessary to keep an inventory account reflecting the 
cost of goods available for the sale so that these costs are 
not automatically deducted when paid, but are deferred until 
the year when the merchandise is sold.
    Further, the taxpayer must report income under an accrual 
method to ensure that the income from the sale, like the 
related inventory costs, are reflected and matched with the 
year's sales. Treasury regulations issued in 1918 and have been 
continued in force ever since, have contained these 
requirements. Their validity has been upheld by the Congress 
and the courts several times.
    However, as you mentioned in your opening statement, Mr. 
Chairman, there are several factors that may override a tax 
policy rationale for the use of an accrual method. The relative 
simplicity of the cash method justifies its use by small, less 
sophisticated, taxpayers where an accrual method may be 
burdensome. In addition, the cash method addresses the 
liquidity concerns of small businesses in that it provides for 
payment of tax at the time that the taxpayer is most likely to 
have the cash and ability to pay the tax.
    Although long-standing Treasury regulations require that 
inventories and accrual methods of accounting are required in 
order to clearly reflect income when merchandise is an income-
producing factor, uncertainty exists as to when a taxpayer, and 
particularly a taxpayer that provides both goods and services, 
is selling merchandise and when the sale of merchandise is an 
income-producing factor. In addition, several small, 
unsophisticated, taxpayers that do not use an accrual method of 
accounting for financial accounting have complained that the 
requirement to account for inventories and to use an accrual 
method is burdensome.
    As you mentioned, Mr. Chairman, we intend to publish 
administrative guidance that will address these concerns. 
Specifically, we will issue an exception for the use of the 
cash method of accounting when the average gross receipts of 
the taxpayer are less than $1 million.
    We believe such a rule is justified in that these taxpayers 
with less than $1 million in gross receipts are generally less 
sophisticated, less likely to use an accrual method of 
accounting for other purposes, and that the results of using a 
cash versus an accrual method of accounting will not vary very 
much. In addition, the resources of the IRS will be saved by 
not having to examine the returns of these taxpayers.
    We believe that this $1 million threshold will cover the 
majority of small business. In 1997, the most recent year for 
which we have data, approximately 78 percent of all C 
corporations, 85 percent of all S corporations, and 
approximately 95 percent of all partnerships and sole 
proprietorships had gross receipts of less than $1 million. I 
would point out that this data that I just gave you is on a 
non-aggregated level, so that if one taxpayer engaged in 
multiple businesses, there would be some double accounting.
    Finally, Mr. Chairman, I would like to discuss with you the 
installment method of accounting. The installment method of 
accounting provides an exception to the general rules regarding 
accrual and cash methods, by allowing the taxpayer to defer the 
recognition of income from the disposition of certain property 
until payment is received.
    Under the installment method, a taxpayer recognizes the 
gain resulting from a disposition of property proportionately 
as payments are received on an installment note. As such, the 
installment method more closely resembles the cash method. It 
is primarily for this reason that the Administration proposed 
and the Congress passed, as part of the Ticket to Work and Work 
Incentives Improvement Act of 1999, to limit the use of the 
installment method to cash method taxpayers.
    After the 1999 Act was passed by Congress, small business 
groups began to express concerns that the repeal of the 
installment method for accrual method taxpayers negatively 
impacted the sales of small businesses. It is clear that the 
extent of the impact of the provision on the sales of small 
businesses was unforeseen by policymakers and potentially 
affected taxpayers and their advisors during the legislative 
process.
    Treasury's Office of Tax Policy has met several times with 
interested industry groups, including the NFIB, NAM, AICPA, 
Small Business Legislative Council, and the U.S. Chamber of 
Commerce, and listened to their concerns about the effect of 
this recent legislative change. These groups have requested 
clarification on the effect of the installment sales provision 
on particular transactions. We intend to issue such guidance in 
the near-term.
    In addition, these groups have expressed a need for an 
exception for small businesses. We believe that a $1 million 
exception--that we believe is a much broader approach that 
would deal not only with the cash versus accrual method of 
accounting, but also with the installment sales provision--will 
provide much of this relief. However, we understand and we 
believe that to go further will require legislation.
    Overall, we believe the policy underlying the installment 
sales provision enacted in 1999 is appropriate. The installment 
method is inconsistent with an accrual method of accounting. 
Indeed, Congress has several times cut back the use of the 
installment method, most significantly in 1986 and 1987, when 
it disallowed the use of the installment method for sales of 
inventory.
    We now understand, however, that the legislation passed 
last year has imposed financial burdens on small businesses 
that may override this basic tax policy concern. As such, we 
are eager to work with Congress to provide a legislative 
solution to alleviate this unforeseen impact of the provision.
    Any legislative response should be targeted to address the 
legitimate concerns of affected taxpayers. For example, to 
address the liquidity concerns facing sellers of small 
businesses, we would suggest continued use of the installment 
method, perhaps with an interest charge, as provided under 
present law, for a certain defined class of small businesses, 
regardless of the sellers' method of accounting. There are 
other proposed solutions that we would be happy to work with 
Congress to address.
    Mr. Chairman, this concludes my prepared remarks. I ask my 
entire written record be submitted for the record. We look 
forward to working with Congress in developing legislative 
proposals in these and other areas. And I'd be happy to respond 
to any of your questions.
    [Mr. Mikrut's statement may be found in appendix.]
    Chairman Talent. I'm going to withhold my questions. But, 
thank you, Mr. Mikrut. I'm going to withhold my questions for 
now and defer to the gentlelady from New York for questions.
    Ms. Velazquez. Thank you, Mr. Chairman. Mr. Mikrut, many of 
the small businesses, the small business advocates I hear from, 
talk about the $5 million exception for businesses that want to 
use the cash method of accounting. Yet it is my understanding 
that the IRS does not interpret the law as containing a 
specific $5 million exception. I would like for you to shed 
some light on this issue. From the Treasury Department's 
interpretation of the current law, is there a $5 million 
exception for businesses who want to use the cash method?
    Mr. Mikrut. Ms. Velazquez, I've heard the same comment. In 
1986, Congress enacted section 448 and what section 448 says is 
that if a C corporation, which is a separate corporate 
taxpayer, or a partnership that has a C corporation as a 
partner, has gross receipts in excess of $5 million, that 
entity must use an accrual method of accounting. Some have 
interpreted that to mean that if you're under $5 million in 
gross receipts, that you may use the cash method of accounting 
or you are no longer subject to requirements to use an accrual 
method of accounting.
    However, when one looks at the legislative history to the 
1986 Act, and this is contained in the House report of the Act, 
the Senate report to the Act, the Conference report to the Act, 
as well as the General Explanation prepared by the Joint 
Committee on Taxation with respect to section 448, it is clear 
that Congress only meant to affect taxpayers with gross 
receipts in excess of $5 million. And they made it very clear 
that an exclusion did not apply if taxpayers were subject to 
then-current law.
    And Congress recognized at that time that then-current law, 
pursuant, again, to Treasury regulations that had been issued 
since 1918, provide that if merchandise is an income-producing 
factor in a trade or business, that that trade or business must 
use an accrual method of accounting.
    So I think that the current state of the law, as provided 
in Treasury regulations and based on legislative history, is 
that corporate taxpayers in excess of $5 million must use an 
accrual method of accounting and all other taxpayers must use a 
method of accounting that clearly reflects their income and if 
merchandise is a significant portion of that trade or business, 
then an accrual method is required.
    Ms. Velazquez. Do all the principals within the 
administration support the $1 million threshold for small 
businesses who wish to use the installment method?
    Mr. Mikrut. Yes, we do. Again, we have been trying to 
develop, in the last several years, several safe harbors and 
exceptions to be used with respect to small businesses in order 
to alleviate their tax compliance concerns.
    I think it is generally agreed that taxpayers with gross 
receipts of $1 million or less, and this is average annual 
gross receipts, so that as an averaging concept so if you have 
over $1 million one year, you're not automatically off, that 
those taxpayers have particular needs that may override general 
tax policy concerns. And their compliance needs may mandate 
that they should be eligible to use the cash method of 
accounting in certain instances.
    Ms. Velazquez. How, then, do you reconcile this $1 million 
threshold with the $5 million threshold under current law for 
use of the cash method?
    Mr. Mikrut. That's a very good question, Ms. Velazquez. 
Current law in section 446 requires that a taxpayer's method of 
accounting must clearly reflect income. And that we think that 
taxpayers that have gross receipts up to $1 million, that the 
results that they would obtain in using a cash method, versus 
an accrual method, are very similar. So the use of the cash 
method for those taxpayers, in many instances, will clearly 
reflect their income.
    Once you get to taxpayers that have greater gross receipts, 
approaching $5 million, it is less clear that the use of a cash 
method, particularly when they hold inventories, will clearly 
reflect their income. And, therefore, if Congress wanted to 
change that result, there should be a legislative change.
    We think the tax policy considerations are such that the 
clear reflection of income standard is very important and that 
I think Congress should go carefully in considering such 
legislation. We do recognize, however, that it will create 
greater simplicity. The Administration is concerned with the 
complexities of tax compliance. In 1997, for instance, we 
proposed and Congress enacted a provision that took businesses 
with less than $5 million of gross receipts off of the 
corporate AMT and that provided considerable simplicity.
    However, with respect to the overall method of accounting, 
one has to wonder if many of these businesses use an accrual 
method for other purposes: for purposes of reporting to their 
shareholders, to their owners, for purposes of applying for 
bank loans. It is often the case that a financial institution 
will ask them what their accounts receivables are, what their 
accounts payables are, and what their inventory accounts are. 
So, again, to the extent that tax conformity is an issue, 
perhaps for taxpayers that use accrual methods for other 
purposes, it is appropriate to use them for tax purposes as 
well.
    Ms. Velazquez. You spoke before about the fact that you 
will be issuing guidance to all qualified small businesses with 
annual gross receipts of $1 million who continue to use the 
installment method. Can you tell me if the Treasury Department 
or IRS consult with representatives from the small business 
community prior to developing the rules?
    Mr. Mikrut. Yes. Both last summer and last fall, the IRS 
and Treasury had joint meetings with representatives of the 
small business community to discuss the cash versus accrual 
issues. In addition to IRSAC, which is an IRS advisory 
committee--a group of practitioners and advisors that advise 
the Commissioner--we discussed this issue with them several 
times, and we discussed the use of the installment with the 
small business community several times. And all of these 
discussions went into our calculation in trying to develop 
guidance in these areas.
    Ms. Velazquez. Can you tell me the specific concerns by the 
small business groups when you met them?
    Mr. Mikrut. Well, I think their specific questions are 
contained in my testimony: the relative simplicity of the cash 
method of accounting, and their liquidity concerns. These are 
the ones that arise the most.
    Ms. Velazquez. And what about the $1 million?
    Mr. Mikrut. We have not had specific comments on that yet. 
We have not yet published the guidance. We're also looking if 
we can develop anything else in this area. We'd like to come up 
with a complete package. But we would expect that, as soon as 
we publish this package, this will go through the normal 
process of notices and proposed rulemaking so we will take any 
comments that they have into consideration.
    Ms. Velazquez. And you would tell me that the guidance that 
you will be issuing will reflect the concerns that have been 
raised?
    Mr. Mikrut. I believe the $1 million threshold will address 
many of the concerns. As I mentioned in my testimony, the great 
majority of these businesses are under the $1 million 
threshold.
    Ms. Velazquez. Mr. Chairman, I'll have some other 
questions, but I'll make them later. Thank you.
    Chairman Talent. Thank the gentlelady. I'll follow in line 
and then defer to other members.
    Let me go back to the legislative history of section 448, 
which was passed in 1986. First of all, Mr. Mikrut, the Act of 
1986 was supposed to be a tax simplification Act. I mean, that 
was the thrust of it, wasn't it?
    Mr. Mikrut. Yes, there were several simplification 
provisions in the Act.
    Chairman Talent. Congress was interested in simplifying 
taxes. Now, whether they actually did that or not is something 
we can all argue about, but I mean that was--I remember 
watching at the time and it was a big bipartisan deal and it 
supposed to simplify taxes.
    You made a point that the legislative history, I think you 
said, clearly reflects that you still have the authority to 
impose the accrual method on small businesses. I'm going to 
take you through the legislative history and particularly a 
part that I think takes that authority away from you. And for 
the convenience of the members, can we distribute this page 
that I'm going to be working from? Make sure Mr. Mikrut has a 
copy of it also.
    Because I'm going to work through this and just what seems 
logical to me. I'm trying to put myself in the shoes of our 
predecessors and maybe somebody--I don't know if anybody here 
was here then or not. I don't think so.
    This is Congress' explanation of what it was trying to do 
with section 448. And what section 448 says, for the members 
who have not looked at it, is that it, on its face, appears to 
say that C corporations above $5 million in receipts can't use 
the accrual method unless it's a farming operation or a 
personal service operation like a lawyer or a doctor or 
something like that.
    And on its face when I read it, I thought it was intended 
to say that a C corporation below $5 million could 
automatically use the cash method, at least if they had been 
using it in the past. Now the Treasury believes that what I 
think and I believe Congress intended as an extra measure of 
freedom and simplicity and certainty for taxpayers was actually 
a prohibition. Mr. Mikrut, and I don't want to put words in his 
mouth, is saying, no, what Congress was trying to do was 
prohibit taxpayers with above that amount using it, not make it 
clear that taxpayers with below that amount could use it. See?
    So let's look at the legislative history and the reasons 
for the change. If you look at the bottom of the first column, 
that paragraph there, and I won't read all of that, basically, 
it's a statement of Congress and an understanding that the cash 
method of accounting may not technically reflect a perfect 
match of income and expenses. And Congress is saying we 
understand that the accrual method might technically match this 
better and so, from the strict accounting principle, yes, we're 
conceding to the Treasury that this might be better from that 
standpoint.
    Then look under the exceptions point. On the other hand, 
and remember this is a tax simplification bill, ``the Congress 
also recognizes that the cash method generally is a simpler 
method of accounting and that simplicity justifies its 
continued use by certain types of taxpayers and for certain 
types of activities.'' That Congress believes--look at this 
next sentence. I draw your attention of the members to this--
``that Congress believes that small businesses should be 
allowed to continue to use the cash method of accounting in 
order to avoid the higher costs of compliance which will result 
if they are forced to change from the cash method.''
    A pretty clear statement from Congress saying yes, we 
understand, Treasury, that in the policy role of Treasury among 
the big eight accounting firms, this maybe doesn't fit, but 
we're not representing you all only; we're also representing 
the small businesses. And, for simplicity's sake, at least if 
they've been using it, they should be allowed to continue to 
use the cash method. Okay? And that's what it appears to say.
    Now you were saying, no, it doesn't say that. Tell me why 
I'm wrong in saying that. Why?
    Mr. Mikrut. Well, I don't believe you are wrong, Chairman 
Talent, because it says that for taxpayers that have used the 
cash method of accounting, nothing in this Act changes that. 
That if they were properly using it before and if they're under 
$5 million, they can continue to use it.
    I would point to a statement that I believe----
    Chairman Talent. Now you use the word ``properly.'' 
Congress didn't say, ``if they'd been properly using it.'' 
Congress says, ``Even if it's improper, according to technical 
accounting.'' That was the whole lead-up. Congress was saying, 
look, we recognize that sometimes, according to technical 
accounting principles and technically matching this and that 
and the other thing, it might not be proper. On the other hand, 
Congress is saying it's our decision to overrule those that say 
if they'd been using it, they can continue to use it, even 
though it's not proper.
    Mr. Mikrut. I don't believe, Mr. Talent, that section 448 
stands for the proposition that taxpayers that were using an 
improper method of accounting could continue to do so. In fact, 
I think I would turn the page, which isn't here, but somewhere 
else in the technical explanation, it says that under prior and 
present law, taxpayers for whom the production, purchase, or 
sale of merchandise is a material income-producing factor are 
required to keep inventories and to use an accrual method of 
accounting with respect to inventory items.
    So I can reconcile those two statements. And the 
reconciliation is that certain taxpayers have traditionally 
been able to use the cash method of accounting and nothing in 
the 1986 Act disturbs that. And that, in addition, certain 
taxpayers have been required to use an accrual method of 
accounting and nothing in the 1986 Act disturbs that.
    So the question, then, is which taxpayers have 
traditionally been required to use accrual methods of 
accounting and which are allowed to use the cash method of 
accounting? And this, again, harkens back to the regulations 
that have been in force since 1918 that say that if merchandise 
is an income-producing factor, such taxpayers must use an 
accrual method of accounting.
    Chairman Talent. No. What you're saying, in essence, is 
that the sentence, ``The Congress believes that small 
businesses should be allowed to continue to use the cash method 
of accounting or to avoid the higher cost of compliance,'' that 
the term ``should be allowed'' is not strong enough to overrule 
the other evidence in the legislative history which you cite. I 
would say there's a conflict there.
    Mr. Mikrut. No, I think they're reconcilable. Again, I look 
at the word ``continue,'' which suggests to me that if they 
were allowed to use it before, nothing in the 1986 Act says 
that they cannot continue to use it. The question is: were they 
allowed to use it before? And I think the legislation makes it 
clear that the regulations that were then in force will 
continue to be in force--that if merchandise is an income-
producing factor, Congress recognizes an accrual method is 
appropriate and required and did not change that area as well.
    Chairman Talent. Now the next sentence says, ``Congress 
believes that farming businesses, other than farming tax 
shelters and certain corporate farming businesses required to 
use an accrual method under the law, should be able to continue 
to use the cash method in order to avoid the complexity.'' Same 
language: ``should be able to continue to use the cash 
method.''
    And then it says, ``Finally, the Congress believes that 
individuals, whatever the size of activities,'' and this is, by 
the way, I think the reason why we didn't mention S corps, 
because S corps report as individuals. So I think Congress is 
saying, look, C corps are covered by the first paragraph here. 
And then S corps, S corps individuals, should be able to 
continue, okay? Whatever the size of their activities, should 
be able to continue to use the cash method.
    Is Treasury taking the position that you can force the 
accrual method on farming operations?
    Mr. Mikrut. No, we are not.
    Chairman Talent. Okay.
    Mr. Mikrut. I think it is the long-standing policy that 
farmers are allowed to use the cash method of accounting unless 
they are subject to section 447 which requires the use of the 
corporate form----
    Chairman Talent. You're not going after personal services 
corporations either, right?
    Mr. Mikrut. No, they're not.
    Chairman Talent. No changes. Because what you're doing in 
the last three years is new. Now it may not be that--it's a new 
application--you're saying it's a new application of an old 
policy, but as far as small business is concerned and as far as 
the Congress in 1986 would have been concerned, this is new. 
What you're doing is new.
    Now I guess the question I've got for you is if that 
language is not adequate to make clear that Congress intended 
small businesses to be able to use the cash method if they had 
been using it, even if it's not proper, under your thinking, 
okay, then why haven't you been able to go after the farming 
businesses now or personal services corporations? Because we 
used the same language in the legislative history with regard 
to all three and this was a tax simplification bill.
    You have read out the juxtaposition that Congress put in 
here. We recognized that, yes, it may not be proper, okay, but 
we want to allow it anyway. And now you're saying we only 
intended to allow it when it was proper.
    Mr. Mikrut. I think what the legislative history indicates 
is that whether a cash or accrual method was allowable was once 
determined under regulations since 1918. Congress decided to 
overturn those regulations for corporations with gross receipts 
over $5 million, but preserved the regulations for all other 
taxpayers.
    And I think the interpretations----
    Chairman Talent. I know what you're saying. You said, in 
fact, Congress intended by this Act to restrict what you had 
been doing, to pull back from cash accounting. What you're 
saying, basically, is that your regulations had been generous 
in certain instances as regards C corporations and big ones and 
this offended the Congress, so Congress is now pulling back and 
is restricting taxpayers.
    And I think you've turned it on its head. This is clearly 
intended to provide some greater measure of freedom and 
simplicity to some set of taxpayers, the small ones, which 
Congress went ahead and defined as $5 million; now you're 
trying to redefine as $1 million.
    And you're reasserting exactly the same considerations 
Congress considered and rejected. It said we understand that 
you all, you know, the very smart people like you and 
accountants who understand all this stuff, it may not fit your 
world precisely, but we're going to let small business people 
do it anyway.
    And I don't know how much more clear we could have made it. 
Certainly your statement is at odds with this, your statement 
that it's clear Congress didn't intend to permit this is an 
overstatement.
    Mr. Mikrut. I don't think so, Mr. Talent, no. Because, 
again, I look at the words ``continue to use'' and I believe it 
was congressional recognition of when the two methods were 
appropriate under the existing law.
    Chairman Talent. Well, and I'm not on the Ways and Means 
Committee. And that's what's frustrating because you think you 
do something here and then you turn around and you find out you 
didn't do it.
    I'll recognize Ms. Kelly. And then, on our side it's Mr. 
Sweeney and Mr. Manzullo. And then on the Democratic Ms. 
Christian-Christiensen, Ms. McCarthy, Mr. Pascrell. And then 
the rest of them are gone. Okay.
    Mrs. Kelly. Thank you, Mr. Chairman. Mr. Mitrut, I am 
looking at what you're offering here and talked about. From the 
standpoint of having been a small business owner, as a small 
business owner, one of the most important things I could do for 
my business was help it to grow.
    And when I looked at the $1 million cap that you have, I 
know full well that it's the small businesses that are driving 
the economy and you know this. This is driving the good, solid 
economy of the United States right now. The increase in the 
economy and the increasing number of jobs is being caused by 
the ability of the small businesses to grow.
    If you cap this at $1 million, I don't see why that doesn't 
act as a chill factor on the small businesses. Because what you 
then do is kick the small business, $1 million is small 
business, when you kick them in having them file in the same 
manner that some large corporation does, you're costing them a 
lot of money. And what you do is you cut into their 
profitability because they have to hire somebody, then, to fill 
out an additional packet. It's an additional, basically, acts 
as an additional tax burden on them.
    I want you to defend against what I just said. Because I 
don't see that in anything you've said in your statement.
    Mr. Mikrut. Mrs. Kelly, I may have been unclear in my oral 
statement. What the $1 million, as you said, cap is meant to be 
is relief. What we are saying is that, notwithstanding Treasury 
regulations and notwithstanding what may be in the legislative 
history, if a taxpayer is under $1 million in gross receipts 
and even if they generally maintain inventories and if 
merchandise is an income-producing factor, the IRS will not 
question the use of a cash method of accounting.
    In other words, the $1 million is a safe harbor. We are not 
changing the law with respect to taxpayers over $1 million or 
requiring them to use an accrual method of accounting. We're 
saying for those taxpayers that are under $1 million of average 
annual gross receipts, we will not question the use of the cash 
method with respect to their operations.
    Mrs. Kelly. Mr. Mikrut, what's your statutory authority for 
the $1 million?
    Mr. Mikrut. I think there are areas where--the Commissioner 
has general discretion. His discretion is generally embodied in 
446 that requires a clear reflection of income. There is a----
    Mrs. Kelly. I'm sorry, sir, but I do not believe that the 
Commissioner's discretion allows the Commissioner to create 
law. A cap of $1 million, arbitrarily, pulled out of the air, 
is essentially creating law and flies in the face of exactly 
what the Chairman was talking about.
    Mr. Mikrut. Yes, but the $1 million is a safe harbor. If 
the Congress believes that the Commissioner doesn't have that 
authority, doesn't have the authority to provide that safe 
harbor and has to repeal the $1 million, that will force 
certain small businesses that maintain inventories to use an 
accrual method of accounting. That is something that we're 
hoping to avoid, both for purposes of taxpayer compliance and 
IRS administrative concerns.
    There has been developed in the case law what is known as 
the SIR test which is Substantial Identity of Results test. 
And, basically, what the SIR test says is that if you compare 
your accrual method to a cash method and get relatively the 
same answer, that the Commissioner shouldn't change that 
taxpayer's method of accounting. And we think taxpayers that 
have less than $1 million of gross receipts generally will 
qualify for the SIR test without having to go through all the 
calculations to make that determination.
    So, again, the $1 million is a safe harbor. It is, we 
think, a significant liberalization of law and not a tightener.
    Mrs. Kelly. The test you're talking about only applies if 
you've got inventory, if I understand. I'm sitting here with 
the tax code sitting in front of me and I read it last night. 
And I want to tell you, it's really good bedtime reading. But 
it seems to me, from the court decisions that I've read, there 
seems to be confusion about inventory that I don't see any 
clarity and I don't understand what you mean by simplicity and 
I don't understand how you call this a safe harbor since it 
seems to me nobody really knows, right now, what the courts and 
you are calling inventory.
    Mr. Mikrut. I think that, Mrs. Kelly, that's why, with the 
$1 million test as it is, you don't have to make those 
inquiries. You don't have to make a determination of what is 
inventory, what is merchandise, when is it an income-producing 
factor. As long as you're under the $1 million threshold, the 
taxpayer can choose his method of accounting.
    Mrs. Kelly. But a lot of small businesses don't have 
inventory. My husband and three of my kids are in businesses 
that don't qualify for inventory. But my husband's business, 
for instance, would be over your gap. And so all of a sudden 
you kick my husband and two of my kids into a situation where 
you are arbitrarily changing the law and I really think that 
you're making law here in a way that--I'm very concerned about 
the way you're interpreting section 448 (b) and (c). Because, 
depending on how you interpret that, I think you could allow 
that $5 million and not bring it back down to $1 million. And 
that's really what I'm getting at.
    Mr. Mikrut. I'm sorry, Mrs. Kelly, but let me be clear. 
Just as we believe that the 1986 Act provision requiring 
corporations with more than $5 million gross receipts to use 
the accrual method, had no negative inference to taxpayers 
under that, our $1 million cap, so that if taxpayers are under 
the $1 million they can use the cash method, it will not have a 
negative inference to say that if you're over $1 million, you 
must use an accrual method of accounting.
    We think present law will continue to apply in those cases 
and that determination is made under current law and current 
regulations.
    Mrs. Kelly. Mr. Chairman, I'm going to yield back the 
balance of my time. I still feel I've got a lot of questions 
here, but I don't want to belabor the issue right now. I am 
going to submit some questions to you and I want some real 
answers because I still don't feel that you're doing anything 
with this except making law. And I think that's the right of 
Congress.
    Chairman Talent. I thank the gentlelady. Ms. Christian-
Christensen's next.
    Ms. Christian-Christensen. Thank you, Mr. Chairman. One of 
the next panelists, I believe it's Ms. Olson, in her testimony 
is going to say something to the effect that merchandise is 
still an unfair term because it's not clearly defined and it 
keeps changing and that should justify raising that ceiling.
    Was the fact that merchandise is still an unclearly defined 
item that is changing currently, was that something that was 
considered when the ceiling was set and do you think it could 
justify changing the ceiling?
    Mr. Mikrut. I believe that that was one of the main 
considerations. Just the general simplicity of cash versus 
accrual would probably be important enough to liberalize the 
use of the cash method. I would agree that recent case law has 
made it less clear when something is or is not merchandise.
    And we are continuing to look at trying to provide 
additional safe harbors through some guidance in that specific 
area. And, again, we would hope to try to address all of these 
as a combined package of items so not only would we use a $1 
million liberalization, but also try to provide more specific 
guidance in the merchandise area.
    Ms. Christian-Christensen. And you mentioned also and you 
mentioned it again just now that you are considering additional 
exceptions and safe harbors that would allow the use of the 
cash method. What would some of those be?
    Mr. Mikrut. Again, this would be, in determining what is 
merchandise and in determining when merchandise is significant. 
If we could provide certain safe harbors so that taxpayers meet 
those safe harbors, they wouldn't have to go through any 
further analysis. I think that would be welcome relief. And 
that's what we're trying to help along.
    Ms. Christian-Christensen. Thank you, Mr. Mikrut. I yield 
back the balance of my time.
    Chairman Talent. I thank the gentlelady. We have on the 
second panel an expert from the ABA who will be happy to 
clarify this for us, I'm sure. And will do it, by the way, for 
nothing, whereas if she was being hired to do it, it would cost 
hundreds of dollars per hour, so it's one of the advantages we 
have as Members of Congress.
    I'll recognize the gentleman from Illinois, Mr. Manzullo.
    Mr. Manzullo. Thank you very much. I would have a request, 
Mr. Mikrut, that you remain present when this panel testifies. 
Could you do that?
    Mr. Mikrut. Unfortunately, Mr. Manzullo, there is a markup 
in the Ways and Means Committee this afternoon and I'll have to 
be on hand.
    Mr. Manzullo. But this is 11:00.
    Mr. Mikrut. Well, okay, I really can't.
    Mr. Manzullo. I would like you to stay here. I think you 
need to hear what these people are saying. I think you need to 
hear about a lady from Rockford, Michigan, whose small company 
got fined $80,000 in penalties and interest based upon the fact 
of the confusion at IRS as to whether or not she's on the cash 
method of accounting. You need to hear these stories.
    The purpose of this hearing is so IRS hears the clear 
message that you are hurting the little people in America. Do 
you understand that?
    Mr. Mikrut. We have met several times, Mr. Manzullo, as I 
mentioned----
    Mr. Manzullo. Can you change your afternoon so you can stay 
here?
    Mr. Mikrut. I do not believe I can reschedule the Ways and 
Means Committee.
    Mr. Manzullo. What time is that hearing?
    Mr. Mikrut. It's at 1:30.
    Mr. Manzullo. What do you have to do before that?
    Mr. Mikrut. I have to sit in for the Assistant Secretary of 
Tax Policy who was supposed to attend the mark-up. And I'll be 
sitting in for him at the desk. So I have to review the 
statutory language, the revenue forecasts, and prepare for the 
questions that may come up at the hearing, at the markup.
    Mr. Manzullo. What really bothers me is the cavalier 
attitude of the IRS in all of this and you reflect it. I have 
thousands of small businesses in the congressional district 
that I represent. Small people. Some earning under $1 million a 
year who have been terrorized by the IRS in this cash versus 
accrual business. And you readily admit, don't you, Mr. Mikrut, 
that there's confusion as to whether or not something is 
inventory or merchandise. Didn't you say that?
    Mr. Mikrut. Yes.
    Mr. Manzullo. Would the IRS consider a regulation, waiving 
any interest or penalties on a company that has been audited 
which, in good faith, operated on a cash basis which you say 
should have operated on an accrual one? Wouldn't that be fair?
    Mr. Mikrut. Mr. Manzullo, I think that the proposal we put 
forth addresses that specific concern so that if you were, 
again, as you said, less than $1 million, this would become a 
non-issue and you will be able to use whatever accounting 
method you are allowed to use.
    Mr. Manzullo. What about over $1 million, though? $1 
million to $5 million?
    Mr. Mikrut. Again, I think, looking at the authority that 
we do have----
    Mr. Manzullo. Do you have the authority to waive any fines 
or interest on people who have in good faith and grossing 
between $1 million and $5 million who are forced to go from a 
cash method to an accrual basis based upon an IRS audit? Do you 
have the authority to waive the interest and penalties?
    Mr. Mikrut. We have the authority to waive penalties, but 
Congress has restricted the ability to waive interest.
    Mr. Manzullo. Thank you. Would you be in favor of Congress 
restricting the ability to collect interest in a situation like 
that?
    Mr. Mikrut. It's funny that you mention it, because the 
markup this afternoon is on the interest and penalty provisions 
of the Internal Revenue Code. And when one looks at interest, 
there is a distinction between interest and penalties and it is 
appropriate that penalties be waived for reasonable cause. And, 
quite frankly, more penalties are waived than imposed.
    With respect to interest, however, interest is a function 
of time, value, and money. So, to the extent that a court, for 
instance, determines that a taxpayer's liability is higher than 
it is, it seems appropriate to charge interest to that 
taxpayer, to treat him as fairly as a taxpayer that was----
    Mr. Manzullo. That's really fair. She's going to testify 
it's cost her $100,000 in interest because of the confusion of 
the IRS whether or not her business should be based on the cash 
or the accrual system. And you are sitting here justifying the 
imposition of interest in that situation. Is that correct?
    Mr. Mikrut. What I'm saying is that there is no ability for 
the IRS currently to waive interest in that situation.
    Mr. Manzullo. Would you take a position that IRS should be 
able to waive the interest if Congress gave you that authority?
    Mr. Mikrut. I think each case, with respect to the 
interest/penalty provisions, stand on their own. The IRS has--
--
    Mr. Manzullo. Let me reiterate this. You've got a business 
here between $1 million and $5 million dollars. These people 
are strictly honest. Books are open. They've done nothing 
wrong. All of a sudden, they get audited by the IRS that says, 
oh, by the way, you should be on the accrual method and not the 
cash method. You never cheated on your taxes and no one's 
saying you did anything wrong. And we're going to impose 
$80,000 in fines plus $100,000 in interest.
    And you can sit there and you can justify the imposition of 
that interest? That's what you just did.
    Mr. Mikrut. Well, Mr. Manzullo, not knowing the other facts 
than those you just said----
    Mr. Manzullo. That's the facts. That's all you need to 
know. That's what's going on here nationwide. When I met with 
Commissioner Rossotti on this issue, I told him this dentist 
was a test case to put all dentists on the accrual system 
because the little bit of gold that they may use and some of 
the dentures that they may use. And it's part of a nationwide 
pattern because now the IRS is test-casing MDs throughout the 
nation, trying to force everybody to go on the accrual system.
    I'm saying here today that this is your mission to put as 
many people on the accrual system as possible to collect as 
much money upfront as possible and, sir, that is bringing 
terror into small businesses. And I would suggest that you, if 
you issue more regulations and issue more guidelines, all you 
have to do is say, look, we're just going to back off. We're 
going to make a recommendation that anything under $5 million, 
we're going to leave the small business people alone.
    Do you realize how much easier that would make life in 
America for the hundreds of thousands of small business people?
    Mr. Mikrut. I think in developing our proposal at $1 
million, we did take that into account. Again, I believe the $1 
million threshold takes care of the bulk of them.
    Mr. Manzullo. When you met with the small business groups 
when you formulated the last policy, you mentioned that, which 
groups were those?
    Mr. Mikrut. I believe the last time we met was, again, it 
was on the installment sales provision which was the last time 
we did meet. It was the NFIB, it was Chamber of Commerce, the 
AICPA----
    Mr. Manzullo. Did you contact the Journal of Small 
Businessmen?
    Mr. Mikrut. No, we did not.
    Mr. Manzullo. You didn't. The dentist in my State that you 
forced to go on the accrual system is earning under $1 million. 
So the IRS, and I want you to listen very closely, the IRS is 
forcing small business people earning under $1 million to go on 
the accrual system. I want you to take that back to 
headquarters. Thank you.
    Chairman Talent. I thank the gentleman. Let me state for 
the record, because it's just confusing, I don't know that in 
my opening statement or the gentlelady's we laid out maybe as 
well as we should have why this makes a practical difference to 
small business people.
    If you're, say, an asphalt contractor, you've probably been 
using the cash method of accounting, which means that you 
report income as you actually receive it, not at the time when 
you're entitled to receive it. And what the Department is now 
saying, as I understand it, is that if the asphalt you use is 
more than 15 percent of your receipts in a given year, then 
that's merchandise or inventory so that you are required to 
report your income as if you were a store, as if you were a 7-
11 or a Walgreen's or something. Which means that you have to 
report the income when you're entitled to receive it.
    Now, this makes a difference when an account receivable is 
acquired in a different year than the cash is actually 
received. So, if you're entitled to payment on December 1st but 
you don't get it until January 15, then under the cash method 
you report that income in the following year; in the accrual 
method you report it in the previous year. That doesn't matter 
so much if it's only applied prospectively in that sense.
    But this is the point Mr. Manzullo was making. They come in 
and audit and then they go back a few years and say, ``Oh, you 
reported income in 1998 that you should have--or 1999 that you 
should have reported in 1998. So, you owed it for 1998.'' Even 
that is not so bad, but in the interest in penalties then add 
up to tens and tens of thousands of dollars.
    The other problem is if you report--then those businesses 
are forced to treat that as individual rate, and the accrual 
method is a harder method from an accounting standpoint. It is 
more expensive, it is more complex, particularly since it 
doesn't really fit the inventory thing. And, so it is just 
another hassle.
    And, Mr. Mikrut, we are still searching here for some 
overriding policy reason that is advanced through some reason 
of equity or something other than what accountants learn about 
matching income with expenditures that requires doing this to 
these people. Again, if this was some kind of fraud or quasi-
fraud that you needed to--this was a preventative method, you 
know, we're going to make certain they don't run. But 
nobody's--you're not claiming that, are you, that these are 
people trying to get out of it?
    [Mr. Mikrut shakes head no.]
    Chairman Talent. So, it comes down to some fairly technical 
things about--for the record, the witness shook his head saying 
no on that; he is not saying it is a fraud. So, what is the 
reason to put these people through all of this?
    Mr. Mikrut. I think, again, the statutory impetus behind 
methods of accounting are under section 446. Section 446 
requires that the method of accounting clearly reflect income. 
There are certain instances where the use of the cash method of 
accounting will clearly reflect the income of the taxpayer. 
However, financial accounting literature, which has been 
developed well before tax accounting rules, generally 
acknowledge that an accrual method of accounting better 
reflects income, particularly where inventories and merchandise 
are involved, and I think that has been the evolution of the 
law, again, since the very beginning of the income tax.
    Chairman Talent. I recognize Mr. Hinojosa for questions he 
may have.
    Mr. Hinojosa. Thank you, Mr. Chairman. I am going to 
refrain and ask my questions after I hear the second panel.
    But before I do that, I do want to echo the same concerns 
that my friend, Mr. Manzullo, has voiced for the small business 
community. We are in the 21st century, and Mrs. Kelly also 
pointed out to you that the economy is as strong as it is 
because of so many small businesses stepping in and starting up 
new businesses and expanding them to create the jobs and give 
us the economic boom that they contribute to.
    I hope that when this Committee finishes with this issue 
that we can come forth with a national policy that will make 
this a much more friendly environment for the small business 
firms, and that the IRS is cut down to size so that they will 
not be the big giant that oftentimes imposes their authority on 
small businesses and keeps them from doing their job.
    So, again, I am going to wait until we finish with the 
second panel, Mr. Chairman, and ask the questions then.
    Chairman Talent. I will finish up with a couple of 
questions, one of them I alluded to. And, first of all, Mr. 
Mikrut, let me just say that one of the kind of joint 
objectives we have on the Committee is to prevent--oh, I am 
sorry, Mr. Bartlett. I didn't see you there, Roscoe, you are 
normally so much more vocal. I am sorry, Mr. Bartlett, let me 
recognize him.
    Mr. Bartlett. Thank you very much.
    In another life I was a small business person. I ran a land 
development home construction company. At the end of the day 
when I liquidated my company, would I have paid any more or 
less total taxes regardless of whether I reported on an accrual 
basis or a cash basis?
    Mr. Mikrut. Mr. Bartlett, that would have depended on 
whether tax rates had changed over the course of your business.
    Mr. Bartlett. That is correct, but presuming that tax rates 
did not change, at the end of the day I would have paid exactly 
the same amount of taxes no matter which way I reported, 
correct?
    Mr. Mikrut. That is correct. What we are discussing here is 
a timing issue.
    Mr. Bartlett. Okay. I built spec homes and sold them. If at 
the end of the year I had five spec homes sitting there that I 
had not been able to sell and I had to use an accrual method of 
accounting, I would have to go borrow money to pay those taxes. 
I didn't have the money. Isn't it true that in the long run the 
taxpayer, the IRS, the totality of taxpayers will get as much 
money regardless of which accounting method is used? That is 
true, is it not?
    Mr. Mikrut. Yes.
    Mr. Bartlett. Then, why in God's Earth do we want to harass 
these small businesses? Because at the end of the day--you 
know, next year we are going to have as much trouble balancing 
our budget as we did this year. Why do you want to harass these 
small businesses when at the end of the day we are going to get 
exactly the same amount of money from them no matter which 
accounting method is used? Why do we want to harass them? I am 
having difficulty understanding this.
    Mr. Mikrut. Mr. Bartlett, that was one of the 
considerations again with the broad relief.
    Mr. Bartlett. But my question is, why do you want to harass 
them? At the end of the day you get exactly the same amount of 
money no matter which accounting method is used. Why do we want 
to harass them and increase their costs of doing business, 
which is what you are doing?
    Mr. Mikrut. Mr. Bartlett, in a case that you just 
hypothesized where you had five homes built but did not sell, 
would you have to pay taxes on that? The answer would be no, 
because you hadn't sold the homes yet. It is only in the case 
where you have sold the homes where you have to pay.
    Mr. Bartlett. But I improved the value of those homes. They 
are there. You could call them inventory.
    Mr. Mikrut. They would be inventory. We would not, though, 
however, require a market-to-market type system where the value 
that was in those homes would be subject to tax. We would not 
require taxation until the homes were actually sold and a 
realization had occurred. However, again, it is when the event 
occurs is at the crux of the issue of a cash versus accrual 
method of accounting.
    Mr. Bartlett. On several of those homes that I sold I held 
the mortgage. I didn't get that money except by little dribs 
and drabs over a 30-year period. If I was on an accrual method, 
then I would have to pay the tax on that total sale at the time 
of sale, wouldn't I?
    Mr. Mikrut. Whether you are on a cash or accrual method, if 
you took back paper, which you did in your case, it would be a 
constructive receipt, and you would have had to pay tax in 
either event, cash or accrual.
    Mr. Bartlett. How can I pay taxes on money I haven't 
gotten? If I sold all those and held the mortgages myself, I 
would obviously have no money with which to pay the taxes. But, 
again, my question is, why do we want to throttle the most 
important part of our economy, small businesses? At the end of 
the day your responsibility to the taxpayers is achieved--
because exactly the same amount of money is extracted from 
these small businesses, whether you harass them or not. Now, 
why don't we just let them alone and use what accounting method 
they wish, realizing at the end of the day we get exactly the 
same amount of money from them?
    Mr. Mikrut. Mr. Bartlett, nothing we are proposing today or 
any other guidance would restrict use of the cash method of 
accounting. If anything----
    Mr. Bartlett. Well, then you need to sit through our next 
witnesses here. You really do need to sit through and see what 
is happening to them as a result of what you are now doing.
    Mr. Mikrut. Again, what we are now doing is trying to 
provide guidance, broad guidance, that would allow the use of 
the cash method to address some of the concerns we have raised.
    Mr. Bartlett. One of the witnesses will be a drywall 
contractor. I build houses. I know who drywall contractors are 
and what they do. He now owes you, you say, $80,000. It may be 
$100,000 when it is finished, because he chose to use the cash 
method rather than the accrual method of accounting. You found 
nothing else wrong with his books, nothing wrong with his books 
at all. Now, I don't understand why we are doing this to small 
business. At the end of the day you get exactly the same amount 
of money from them no matter which method they use. Why don't 
we just let them alone?
    Thank you, Mr. Chairman.
    Chairman Talent. Let me just inquire of a couple areas as 
we wrap this up for this panel, because we do have another 
panel waiting.
    One of them is the $1 million figure in your proposed 
regulation. Now, Congress thought fit to use a $5 million 
figure as a cut-off, and whatever that cut-off was intended to 
signify, and I understand we disagree with that, clearly 
Congress intended a $5 million figure to be the cut-off between 
the small businesses for whom simplicity more likely would be 
allowed to override other concerns depending on how we 
interpret that. Congress felt the $5 million figure was good.
    We have in the Small Business Act certain definitions of 
what a small business is, and it varies depending on the 
sector. I am not familiar with $1 million as a test in any 
statute of which I am aware. So, would you enlighten me and 
tell me where you got the $1 million figure?
    Mr. Mikrut. Again, looking at the $1 million, we looked at 
the number of taxpayers in existence, and again, $1 million 
covers the bulk of those. We also had an income test called a 
Substantially Identical Results Test, and we thought $1 million 
would comport with that. We also looked at taxpayers as they 
get larger, in excess of $1 million, often use the accrual 
method for financial accounting purposes, and we thought full 
tax conformity might be achieved in those cases.
    Mr. Manzullo. I don't believe that; I am sorry.
    Chairman Talent. Let us let the witness finish. I mean I 
understand that--a lot of this is, if I can say, is a cultural 
thing. I mean you develop your policy over at the Treasury, and 
it is important to have all these considerations in mind. And, 
of course, we are dealing, I think it is fair to say, on a more 
regular basis with the real people who are having to deal with 
this. So, Mr. Mikrut is trying to do what he thinks is right 
from his perspective also.
    So, you go ahead and finish. If you have an additional 
question, Don, I will recognize you.
    Mr. Mikrut. And, finally, Mr. Manzullo, I do believe 
because it was Congress that put in the $5 million threshold 
for purposes of corporations required to use the accrual method 
of accounting, that this is something that would be best 
handled legislatively, and I understand you and other Members 
have bills, so this is something that is clearly, I believe, 
within the purview of Congress to provide a threshold as far as 
$5 million.
    The $5 million threshold has been used in many instances. 
For instance, the Administration proposed, and the Congress 
passed, the $5 million exemption from the corporate AMT. So, I 
mean $5 million is----
    Chairman Talent. Well, why don't we just use $5 million. I 
mean $1 million--there is no reference point for getting $1 
million, and it comes out thin air. And I will tell you, our 
experience has been, and I understand why you can't--typically, 
I will also say in defense of the witness because we have given 
you a hard time, we don't tell people to come and be prepared 
to stay for the second panel. It would be nice if somebody from 
Treasury were here to listen. And I understand Ways and Means 
is the Committee you typically report to.
    But Congress did use the $5 million. The $1 million comes 
out of no place, and our experience has been that people that 
you would just instinctively think of as small business 
people--do the old Justice Stuart test, we will know them when 
we see them--often have receipts above $1 million. I think both 
witnesses on the second panel who have really been hurt by this 
have receipts that are above $1 million.
    So, since that is what Congress used, and that is, as you 
mentioned just a minute ago, that is a test that is out there 
for a number of different things, for simplicity's sake, if we 
don't overrule this, you may want to consider the $5 million. 
And if the point is to make this simple and consistent, that, 
seems to me, would be better. The $1 million comes out of no 
place. I mean there is no statutory reference to a $1 million 
figure, is there?
    Mr. Mikrut. No, there isn't. Again, the statutory reference 
is to a clear reflection of income. We thought that taxpayers 
under $1 million, whether they use cash or accrual, their 
income would be clearly reflected in either event.
    Chairman Talent. Yes, and of course, just I will say for 
the record, it is something for Congress to deal with, and it 
is my position that that is exactly what Congress did in 1986, 
and your interpretation of it is incorrect, but I understand we 
have a difference of opinion there.
    Let us go to the installment method issue, which I don't 
think we have had many questions on, and is of even greater, I 
think, immediate and urgent importance in the small business 
community. You recognize we have a problem out there with small 
businesses not being sold that we want to be sold from a policy 
standpoint because of this installment change. You recognize 
there is a problem, don't you?
    Mr. Mikrut. Yes.
    Chairman Talent. And the Department recognizes that. And I 
will tell you that I had a--after we do this, it is quite 
embarrassing, because this is something Congress did, and I 
smiled when I read my opening statement, because my staff was 
kind enough to say that the Department recommended this and got 
us to do this. But Congress did it, and we should have caught 
it, I think, and not done it last year as a revenue raiser. A 
fellow came up to me, and he has got a classic thing. He has 
got a plumbing wholesale business. He wants to sell it, and he 
can't now. Because you recognize that very often small business 
people sell to other small business people, right? If you want 
to say yes, you----
    Mr. Mikrut. Yes, I'm sorry.
    Chairman Talent. Okay. And the purchaser is not able to get 
a bank loan financing to buy the whole business all at once; 
you understand?
    Mr. Mikrut. Yes, sir.
    Chairman Talent. And, so therefore they pay in installment 
notes, or notes with the installment payments to the original 
owner; you understand that? In essence, the owner finances it 
and gets a stream of payments over time. And the record will 
show the witness is nodding for all this. I am going to start 
asking some other questions like, aren't we right about all 
these things? [Laughter.]
    And, so the effect of the law Congress passed is to make 
people pay taxes on the whole amount of the sale when they have 
only received a fraction, like 10 percent. That is the problem, 
right?
    Mr. Mikrut. That is the problem.
    Chairman Talent. And I just suggest to you that here there 
is no reason even in accounting principles to do this, because 
just because you are an accrual taxpayer in an ongoing 
business, we want to match income and expenses. When you are 
selling the business and shutting it down, from your 
perspective, there is no reason, is there, from an accounting 
standpoint to require that you treat the whole amount as paid 
even though only a downpayment has been paid. Even from an 
accounting standpoint that is not necessary, is it?
    Mr. Mikrut. Mr. Talent, I think the effects of the repeal 
of the installment method for accrual method taxpayers upon 
small business was unforeseen, and I think that is something 
that is appropriate for us, and working on that is something 
where I think the legislation is very clear, that we need them 
simply----
    Chairman Talent. Well, I agree. This is not something where 
you have discretion, but--and if this is above your pay grade, 
just tell me--but can't the Department just come out in favor 
of repealing this?
    Mr. Mikrut. I think we, too, believe that the installment 
method is very much like a cash method. It should be restricted 
to cash method taxpayers. However, we do believe that that 
overriding tax policy--that type of tax policy concern can be 
overridden by the concerns of small businesses. We think there 
are going to be concerns, as you mentioned. Liquidity concerns 
override tax policy concern, so we look forward to working with 
you to develop something to take small businesses out of last 
year's bill.
    Chairman Talent. Was that a yes?
    Mr. Mikrut. That is a long yes.
    Chairman Talent. A long yes, very good. Well, with that in 
the record--and I will just say that I can't believe that if I 
had Secretary Summers here or if the head of the 
administration, the President, were favoring us with an 
appearance here that he would not say yes. I mean this is just 
this unintended negative hit on people, accrual and other kinds 
of taxpayers. I mean these are people who have accrued, they 
have done all this. They are not involved in all the rest of 
this stuff, and all they want to do is sell their business, and 
they have to treat large amounts of--they get large amounts of 
tax bills, and they don't have the money. I don't have to tell 
you it is quite embarrassing to go home in a town hall meetings 
and other meetings, Kiwana or rotary meetings, and have these 
people come up to you and have to say we didn't foresee this. 
Can you tell me why--and Congress shares in this--why we didn't 
foresee this? I mean to me it would seem to me to be obvious.
    Mr. Mikrut. It is hard for me to prove the negative, Mr. 
Talent.
    Chairman Talent. Yes. Well, you all have pushed this, and I 
just think we have--when did this get in, in the Conference 
Committee? The House didn't do this, did it? Well, the Senate 
did this; that explains a lot. [Laughter.]
    All right. Don, did you have a further question you wanted 
to ask?
    Mr. Manzullo. I have a follow-up question. You stated, Mr. 
Mikrut, that one of the policy reasons underlying the use of 
the accrual methods is that a small business person will sign 
for a loan, and the loan application provision will rely on the 
accrual method. You said that.
    Mr. Mikrut. I believe what I said, Mr. Manzullo, was that 
one of the policy considerations on whether to pick a cash or 
accrual method of accounting is simplicity, and to the extent 
that a taxpayer is not using an accrual method for other 
purposes, it would seem that simplicity would indicate they 
should that tax method for tax purposes as well. But to the 
extent that they perhaps are using an accrual method for other 
purposes----
    Mr. Manzullo. What are these other purposes?
    Mr. Mikrut. Financial accounting purposes, reporting to 
shareholders, reporting to creditors.
    Mr. Manzullo. Do you have actual proof of that?
    Mr. Mikrut. Well, I do not get involved with an individual 
taxpayer applying for a loan, but, yes, I have----
    Mr. Manzullo. I mean do you have actual proof of what you 
just said?
    Mr. Mikrut. Yes, there are instances where creditors will 
ask for supplemental statements with respect to the accrual 
method of accounting.
    Mr. Manzullo. Creditors.
    Mr. Mikrut. Yes.
    Mr. Manzullo. Well, what has this got to do with the small 
business person? Do you think he determines the questions that 
are asked of him by his creditors?
    Mr. Mikrut. No, Mr. Manzullo. I was just stating that there 
are instances where the accrual method is used for purposes 
other than tax purposes.
    Mr. Manzullo. State that again for me.
    Mr. Mikrut. The accrual method is generally accepted--
comports with generally accepted accounting principles. It is 
generally used to report the financial results of a business.
    Mr. Manzullo. Wait a second. Financial results? Now, this 
is a business under $5 million.
    Mr. Mikrut. I believe the accrual method is used and 
inventory methods are used for businesses under $5 million, 
yes.
    Mr. Manzullo. This is for a widely held corporation.
    Mr. Mikrut. They are mandated for widely held corporations.
    Mr. Manzullo. There are a lot of widely held corporations 
that have assets, sales under $5 million. There are just 
millions of them across this country, would you agree?
    Mr. Mikrut. No, I would not.
    Mr. Manzullo. Yes. Well, that is the whole point. So, what 
you have done is you have taken a few isolated occasions where 
someone may have used the method other than the cash method, 
and you penalize that small business person. That is what you 
have just done.
    Mr. Mikrut. Well, Mr. Manzullo, I was simply suggesting 
that there are instances where full book and income tax 
conformity are appropriate, and accounting methods are one of 
those instances. And that can be done on a case-by-case basis, 
not----
    Mr. Manzullo. But you said that as a matter of policy. You 
said one of the reasons that you want to impose an accrual 
system is that many of these businesses use an accrual system 
for purposes other than filing their income tax returns. You 
made that statement.
    Mr. Mikrut. The statement I made was that an accrual method 
of accounting, if it is used for book purposes, does not 
require any additional complexity for a small business, at 
least not for tax purposes.
    Mr. Manzullo. I want you to refer to a document in writing 
with your name on it the number of companies in this country 
that are using a cash method of accounting to the IRS, at the 
same time using an accrual method of reporting anything else to 
their shareholders. Do you have any idea how many there are 
across the nation?
    Mr. Mikrut. I can provide you with information as to how 
many taxpayers are using the cash method or the accrual method 
for tax purposes, but that does not necessarily then tell us 
for financial----
    Mr. Manzullo. You don't have the answer to my questions, 
and you have just made a very bold statement that a policy 
reason for using the accrual method is that people on the cash 
basis are out there using the accrual methods for something 
else, and you have no proof. You have none.
    Mr. Mikrut. Mr. Manzullo, I do not believe that is what I 
said.
    Mr. Manzullo. I know what you said. I want you to furnish a 
letter to my Subcommittee on Taxation and put--write this 
down--down the number of small businesses in this country that 
have receipts under $5 million, gross receipts under $5 
million, that are on the cash method, and then the number that 
are on the accrual method. And those that are on the cash 
method, how many outside activities they are doing including 
whatever you mentioned that they are using the accrual method 
of taxation.
    Chairman Talent. If the gentleman will yield. I think it is 
a fruitful line of questioning. We have another panel. So, what 
I would ask the gentleman, encourage him to do is to file in 
his Subcommittee, and maybe I am sure Mr. Mikrut would be 
pleased to come back and appear before----
    Mr. Manzullo. I will have you meet my Subcommittee along 
with the drywall man, along with the tax lady from the ABA.
    Chairman Talent. And then follow that up, and I would 
encourage the gentleman to do it. And this is something that 
the Committee is going to pressure on, both without and within 
the Congress.
    Mr. Mikrut, thank you for coming and for your patience, and 
we will look forward to working with you in the future.
    And I will adjourn the first panel and ask the witnesses 
for the second panel to come forward.
    [Recess.]
    What I am going to ask the witnesses to do is to summarize 
your testimony if your written testimony is of any length. And 
that is not because we are not interested but really because we 
are, and members are going to want to ask questions and have 
plenty of time for that. So, I imagine the questioning here may 
be a little bit less adversarial than it was in the last panel.
    Our first witness today is Mr. Shane Mieras, a project 
manager for Mid-Ceilings and Drywall in Rockford, Michigan, who 
is here on behalf of the Associated Builders and Contractors.
    Mr. Mieras.

 STATEMENT OF SHANE MIERAS, PROJECT MANAGER, MID-CEILINGS AND 
   DRYWALL, ROCKFORD, MICHIGAN, ON BEHALF OF THE ASSOCIATED 
            BUILDERS AND CONTRACTORS, WASHINGTON, DC

    Mr. Mieras. Good morning, Mr. Chairman, and members of the 
Committee. My name is Shane Mieras, and I am co-owner of Mid-
Michigan Ceilings and Drywall, located in Rockford, Michigan. 
Associated Builders and Contractors is a national trade 
association representing more than 22,000 contractors, 
subcontractors, material suppliers, and related firms from 
across the country including all specialties in the 
construction industry. ABC has 82 chapters across the country.
    Chairman Talent. Shane, if you put the microphone a little 
closer to you, it would be better.
    Mr. Mieras. Mid-Michigan Ceilings and Drywall has been a 
member of ABC for approximately three years. We would like to 
thank Chairman Talent and House Small Business Committee 
members for hosting this hearing today.
    Mid-Michigan Ceilings and Drywall is a small commercial 
drywall company that was established in 1990. I currently 
employ 22 people. I came to Washington today to testify on my 
real-life experience of currently being audited by the Internal 
Revenue Service based on my company's use of the cash method of 
accounting. As many of you know, the cash basis method allows 
deductions for expenses to be taken in the year paid and 
reporting of income in the year the cash is received.
    Approximately two years ago, the IRS called on Mid-Michigan 
Ceilings and Drywall and initiated an audit for tax years 1996 
and 1997. Our sales at the time of audit were only $1.7 
million. We have always kept our books on the cash basis, 
because it is a simple and easy method of accounting. There is 
really no need to hire outside professional accountants when 
using this method. My business never had any intention of 
converting to the more complex and time-consuming accrual 
method, because we are such a small company.
    In October 1998, the IRS informed us that we owed 
approximately $80,000 in interest and underpayments as a result 
of using the cash method of accounting. Our case is in the 
final stages of appeal, and I have been advised that the final 
assessment could be as high as $100,000.
    At Mid-Michigan Ceilings and Drywall we keep a clean set of 
books. No other tax problems were identified during the audit 
other than the fact that we were using the cash method of 
accounting. The IRS' reason for this assessment on Mid-Michigan 
Ceilings and Drywall is because they feel we are merchandisers. 
We disagree. We are not merchandisers. We install commercial 
drywall and have never sold drywall to the public without 
installing the drywall. The IRS concedes that we do not have 
inventory on hand. However, that is not good enough to refute 
the IRS' use of the merchandise argument.
    What is troubling is that the IRS can force small 
businesses to change from a legal, simple accounting method to 
the accrual method. Mid-Michigan Ceilings and Drywall is a 
small business and pays taxes on cash we collect minus expenses 
paid. By forcing us to the accrual accounting method, we will 
now incur an added expense of having to hire professionals to 
maintain our books. Speaking of professional help, we have also 
hired a tax attorney to fight this unfair assessment by the 
IRS. This has resulted in approximately $5,000 in legal fees to 
date, in addition to the assessment made by the IRS.
    Of course the obvious problem now for my company is 
determining how we are going to pay the IRS. Since this money 
is not available to us through the business, we will have to 
seek a bank loan to pay the assessed taxes, penalties, and 
interest. The bank interest payments alone will cost us between 
$10,000 and $15,000 per year. A $100,000 tax burden is a huge 
sum of money to a small business such as ours. This huge 
arbitrary assessment by the IRS will definitely hurt my 
company's growth potential and limit my ability to hire new 
employees.
    A couple of goals we have set up for year 2000 are now in 
jeopardy. We need to purchase new work trucks, and new 
equipment such as scaffolding and tools. Most importantly, we 
would like to build our own building so we can expand the 
business, and hopefully hire more employees. This tax burden 
imposed by the IRS will take away money that we could use for 
growing the business. Our bank also is withholding a line of 
credit to the tune of $50,000 until the final outcome of this 
case is determined.
    We all know that business investment is what is driving 
this economy right now. We will be forced to sit on the 
sidelines due to lack of capital because of this unfair tax 
assessment. Lastly, this tax payment will make it harder for us 
to improve our wages and benefits to our employees and is also 
forcing us to rethink charitable giving until our financial 
solvency is determined.
    I understand that any corporate business that does over $5 
million has to use accrual accounting. Someday at Mid-Michigan 
Ceilings and Drywall we hope to reach $5 million threshold and 
will plan on converting to the accrual method at that time. 
Right now it is unfair to treat Mid-Michigan Ceilings and 
Drywall any differently from other small businesses by 
converting us to big business accounting.
    The IRS' position on which businesses should be using the 
cash method or accrual accounting is not based on any specific 
section of the Internal Revenue Code, but on a series of court 
cases successfully litigated by the service. Hence, the IRS is 
not enforcing the law, they are making it. Congress should 
amend the Internal Revenue Code to clarify that small 
businesses can keep using the cash method of accounting even if 
the IRS argues that they have inventory or merchandise as a 
material income-producing factor.
    Two legislative proposals before Congress would permit 
small contractors like Mid-Michigan Ceilings and Drywall to 
continue to use the cash method of accounting without fear of 
audit, penalties, and interest. H.R. 2273, introduced by Small 
Business Committee Chairman Talent and Ways and Means Committee 
member, Phil English, and S. 2246, introduced by Senate Small 
Business Committee Chairman Christopher Bond and Senate Finance 
Committee member, Charles Grassley, have both been endorsed by 
the ABC National Tax Committee and would provide relief to 
small businesses like Mid-Michigan Ceilings and Drywall.
    Mid-Michigan Ceilings and Drywall joins ABC in urging 
members of the Committee to advance these proposals in the next 
tax bill considered by Congress. Small businesses are the 
backbone of the economy and our country's economic engine. We 
urge you to enact this legislation into law to ensure that 
small contractors can operate their businesses without living 
in fear of the IRS.
    I would like to thank Chairman Talent and the Committee 
members for allowing me to present Mid-Michigan Ceilings and 
Drywall's concerns regarding this important issue. I stand 
ready to answer any questions the Committee may have.
    [Mr. Mieras' statement may be found in appendix.]
    Chairman Talent. Thank you, Mr. Mieras. If you pay the 
whole $80,000, you at least have the pleasure of knowing you 
kept the Federal Government open for a nanosecond.
    Mr. Dave Wulkopf, who is a CPA and the treasurer of Beckner 
Painting, where he began working as a painter in 1986, 
continued working the summers until 1992, and now handles all 
tax and accounting issues. And you were promoted to treasurer 
in 1993. Appreciate your coming here, David.
    We'll go ahead with this. We haven't had the second bell 
yet, have we? I don't think so. Go ahead, and we may have to 
recess this in the middle of your testimony, but go ahead, 
please, David.

STATEMENT OF DAVID E. WULKOPF, CPA, TREASURER, BECKNER PAINTING 
                  MIDWEST, INC., ST. LOUIS, MO

    Mr. Wulkopf. Okay. My father is actually the owner of the 
company. I am the treasurer.
    Chairman Talent. Go ahead.
    Mr. Wulkopf. Beckner Painting was founded--we are a small 
painting company located in St. Louis, Missouri. The primary 
focus of our work is interior and exterior apartment painting. 
We also do some limited residential and commercial work. We 
employ up to 80 people in the summers and as few as 15 during 
the winter months as the workload slows down.
    Since the company was founded over 30 years ago, we pay our 
taxes on the cash basis of accounting, as permitted by section 
446 of the Internal Revenue Code. The company has annual 
revenues of $2 million to $3 million, and we do not maintain 
inventories. Therefore, at least we thought the company 
qualified as a small business, as defined by section 448, and 
we thought we were permitted to use the cash method of 
accounting.
    In 1995, we were the subject of a random audit of our 1992 
Federal income tax return. The IRS did not find any changes 
that needed to be made as a result of this audit. Then again in 
September of 1998 we were notified that we were going to be 
audited on our 1996 Federal income tax return. Once again, 
there were no changes that needed to be made with the exception 
of this cash basis issue that is before us today.
    The reasoning behind the proposed changes is kind of a 
stretch. Even though we provide a service and do not sell 
anything directly to the public, because our material cost, 
such as the paint, is more than 15 percent of our revenues, the 
IRS claims that we have merchandise which is an inventoriable 
item. Since we have an inventoriable item we are required to 
use the accrual method of accounting even though we do not 
carry any physical inventory.
    The reason for the change can be masked in a number of 
different ways, but the bottom line is obvious. The motive 
behind the Treasury Department policy is to speed up the 
collection of tax revenues and to collect the tax on the 
accounts receivable. If we had accounts payable that were 
higher than our accounts receivable, we would not be in a 
position of having to defend ourselves from this proposed 
change.
    It is understandable that the Treasury Department would 
want to expedite the collection of tax revenues, but it seems 
no thought is given to how unfair this policy is to small 
businesses.
    Chairman Talent. Well, David, what they basically did was 
they took an enactment, section 448, which was intended to make 
clear that businesses like yours could use the cash method if 
you had intended to do it, interpreted it as saying that you 
can only use the cash method when they would otherwise have 
said you could use the cash method anyway, and then changed 
their interpretation of when you could use the cash method so 
as to substantially restrict it and treat people who are not in 
the business of merchandising or do not have an inventory as if 
they do. So, they interpreted the law and are trying to make it 
consistent with their practices, and then they changed their 
practices in order to go back and fleece you out of, what, 
$200,000?
    Mr. Wulkopf. Yes.
    Chairman Talent. That is a good days work. Go ahead.
    Mr. Wulkopf. Under this new policy, accelerating the 
collection of tax revenues is done at the expense of small 
businesses who have been allowed to report on a cash basis for 
years. These companies are currently being selected for audit 
and forced to change accounting methods. This change in 
accounting methods causes an enormous tax liability that is a 
result of years of cash basis reporting to come due. Most small 
business do not have large sums of cash available to pay taxes 
on money that is not yet received.
    The effects of this proposed change would be devastating to 
Beckner Painting. We operate in a very competitive industry, 
and cash flow is always a concern. There are numerous sole 
proprietors in the painting industry that operate with little 
overhead and can undercut the prices of established companies 
like Beckner Painting. As an established company we do offer 
higher quality work and tend to be more reliable, but if our 
prices get too high many customers will switch to these sole 
proprietors in order to save some money.
    Therefore, we must constantly keep our costs down and our 
cash flow is usually tight. There is rarely a payroll period 
that goes by that we are not concerned about having cash needed 
to make the payroll. With the minimum wage increasing seemingly 
everyday, this cash flow gets even tighter. In addition, the 
company has to continually repair and replace painting 
equipment, like power washers, sprayers, ladders, trailers, and 
vehicles, and these costs further limit cash flow.
    Should the IRS succeed in making us change our method of 
accounting, the amount of tax due is well beyond the cash we 
have on hand. Therefore, we would be required to borrow money 
to pay the tax. Not only is forcing the company to borrow money 
to pay tax fundamentally unfair, but it would put us in a very 
vulnerable position. The amount of money we would need to 
borrow, close to $200,000, would max out our borrowing 
resources and put us a bad year away from bankruptcy.
    The primary unfairness of this new policy is that we have 
paid our taxes on a cash basis since the company was founded. 
We were not even asked to change during the 1992 audit. Then in 
1996, when our receivables had grown, we were told that we 
needed to change accounting methods. The difference between 
paying our taxes on a cash basis versus an accrual method is 
minimal year by year, but it is the one-time hit of the change 
that is damaging.
    Our case has not yet been resolved. It has been going on 
for more than a year and a half now, and the time and money 
spent on trying to defend the case has put a serious strain on 
our resources. We have spent countless hours examining 
invoices, preparing schedules, and researching position 
guidelines. We are afraid to invest in any new equipment, 
because we may need the money to try to pay the tax resulting 
from the proposed change.
    Beckner Painting has grown from a small summer hobby to a 
successful small business. Being a small business it is hard 
enough to comply with the seemingly endless stream of Federal, 
State, local, and industry regulations. Policies like this 
makes it even more difficult. Small businesses face many unique 
challenges in defending themselves from policies such as this. 
It is not only unfair, but it could jeopardize our continued 
existence. That is why we are here to support Congressman 
Talent's bill, H.R. 2273.
    [Mr. Wulkopf's statement may be found in appendix.]
    Chairman Talent. All right. I have to thank you, David. I 
have to recess the hearing now, because I have got to go vote, 
but as soon as I think Mr. Sweeney gets back we will just have 
him reopen the hearing, and then you all can begin testifying 
so we can expedite this.
    I recess the hearing.
    [Recess.]
    Mr. Manzullo [presiding]. We are reconvening the hearing. 
The next witness is Roger Harris, who is president of Padgett 
Business Services in Athens, Georgia.
    Mr. Harris.

    STATEMENT OF ROGER HARRIS, PRESIDENT, PADGETT BUSINESS 
                      SERVICES, ATHENS, GA

    Mr. Harris. Thank you, Congressman Manzullo. It is a 
pleasure to be here and to have the opportunity to speak to the 
Committee about cash versus accrual and the installment sale. 
As you mentioned, my name is Roger Harris of Padgett Business 
Services, and we have been providing accounting and tax 
services to small business for over 30 years. I have been 
involved in that for over 25 years. We have about 15,000 
businesses that we represent, and the topic of this hearing has 
become of great importance to our clients.
    I don't think we can have any discussion about this topic 
without reiterating what has been said before. What we are 
talking about here is nothing but an issue of timing. Income 
and expenses will always get reported under any method of 
accounting. And I think we also have heard this morning that 
there is no debate about the fact that the cash method is a 
much simpler method of accounting. Therefore, it seems strange 
to me that there is any argument that when all we are talking 
about is timing, why are we not looking for a way to have a 
broad definition of business that can use the simplest method 
of accounting as opposed to trying to find a way to narrow the 
definition.
    I think the problem we face today in most taxation is 
complexity, and yet we are hearing arguments that we should 
make things more complicated for some unknown reason when taxes 
are not really the issue. It is just the timing of paying the 
tax. We became aware of the difficulties in this area when we, 
through our foundation, did a survey of our client base to look 
at the effect that the current regulations would have, which is 
based on the 30-year old Wilkinson-Beane case, and we found 
many cases where people would be forced to change their method 
of accounting if the current regulations were continued to be 
enforced. That has a short-term cost, as you may have heard 
here, in taxes, interest, and penalties, but it also has a 
greater long-term cost in the complicated accounting procedures 
that must go on forever.
    Another thing I find interesting that we have not heard 
here today in any of the testimony up to this point is that 
changing from cash to accrual can also produce a refund. It is 
very possible that the change can have an effect that lowers 
income. I would challenge anyone here--if the IRS and Treasury 
are so concerned about the accurate reflection of income, 
produce the number of cases where they forced a change that 
produced a refund. I think you will find very few, if any, of 
those cases.
    So, I am not sure that the reflection of income is the real 
issue. I am also amazed when I listen to the inside the Beltway 
explanation from Treasury that a clear reflection of income 
requires our clients to pay tax on money they don't have yet. I 
don't think they will understand that logic.
    I also have to refer directly to--Mr. Manzullo, you asked a 
question about two sets of record, one for lending 
institutions, one for the business, and the answer related to 
the fact that this is done to report to the shareholders. I 
think that shows a clear lack of understanding in Treasury 
about how small business operates. In most small businesses, 
all the shareholders live in the same house. It doesn't require 
a separate set of statements to explain how the business is 
doing. They live it, and they breathe it. And I know in our 
client base it is extremely rare that we produce a second set 
of records for a bank. Small business operates a lot of 
different ways, and they don't have to produce two sets of 
records except in very rare occasions.
    I want to change the subject a minute to the installment 
sale, because, clearly, this was something that when the rule 
changed in December, created a real ripple effect through our 
offices and small businesses in terms of how serious an effect 
this change could have. As everyone, I think, recognizes on 
this Committee, people sell their business as part of their 
retirement. And it is very difficult to find someone who will 
pay cash for a small business. Financing over a number of years 
is almost a necessity.
    But in the meetings when I hear Treasury state that since 
you are using the accrual method of accounting, the only 
accurate way to bill your business is to report all the income 
up-front in the year of sale. I don't understand why they don't 
understand that selling an inventory item off the shelf and 
waiting 30 days for a payment is nothing like selling their 
business and waiting 10 years to get paid. I think the only 
real fix to this serious problem is the repeal of the 
installment sale bill that was passed, and go back to something 
that had worked extremely well for a number of years.
    I see my time is about up. I realize I deviated completely 
from what I had written, but I welcome any questions that you 
many have. Thank you.
    [Mr. Harris' statement may be found in appendix.]
    Mr. Manzullo. Thank you very much.
    Our next witness is Pamela Olson, who is the Chair-elect of 
the Section of Taxation of the American Bar Association. She is 
also partner in the Washington law firm of Skadden and Aarps.
    Ms. Olson.

STATEMENT OF PAMELA F. OLSON, CHAIR-ELECT, SECTION OF TAXATION, 
                    AMERICAN BAR ASSOCIATION

    Ms. Olson. Good morning. Thank you. I appreciate the 
opportunity to be here.
    My name is Pam Olson, and I am Chair-elect of the ABA 
Section of Taxation. I am testifying today on behalf of the 
Section of Taxation. I have another tax expert with me. Her 
name is Helen Hubbard. She is the immediate past-Chair of our 
Tax Accounting Committee and was a principal drafter of our 
testimony.
    We appreciate the opportunity to appear before the 
Committee today to address issues causing both considerable 
complexity for small business and continuing controversy 
between small businesses and the IRS. Our prepared statement 
addresses both the use of the cash method of accounting by 
small business and the repeal of the installment method of 
accounting.
    Since the House has passed legislation retroactively 
reinstating the installment method, I am going to limit my 
remarks this morning to small business use of the cash method 
of accounting, but I would be happy to respond to questions on 
either topic.
    Over the past year, the Tax Section has testified twice on 
simplification of the tax law. In February, we joined with the 
AICPA Tax Division and TEI in releasing a list of proposed 
simplification items. Permitting the use of the cash method of 
accounting for small business, which we would define as those 
with gross receipts of $5 million or less, was included in our 
testimony and on our February list of proposed simplification 
items.
    The Treasury Department recently announced that it intended 
to issue guidance permitting businesses with gross receipts of 
$1 million or less to use the cash method of accounting. We 
applaud the Treasury Department for taking this step, but we do 
not believe $1 million in gross receipts provides sufficient 
relief from the complexity the accrual method of accounting 
creates. So, we would go further than they have gone.
    Requiring small businesses to use the accrual method of 
accounting subjects them to complex rules and recordkeeping, 
substantially increases the cost of compliance for these 
taxpayers, and creates cash flow problems. The characterization 
of a taxpayer's income as income from the purchase, production, 
or sale of merchandise requires that the taxpayer use the 
accrual method, which increases income for the year of change 
by the excess of the taxpayer's accounts receivable over its 
accounts payable, and follow the inventory accounting rules, 
which defer deduction of the cost of merchandise on hand. If a 
change to the inventory and accrual methods is required on 
audit, small businesses are likely to face substantial 
adjustments attributable to the deferral of deductions and 
acceleration of income, plus, as we have heard this morning, 
interest and, in many cases, penalties.
    Generally, the permissibility of the cash method varies 
depending on the type of entity, the business and activities of 
the taxpayer and the gross receipts of the taxpayer. Current 
law requires businesses that purchase, sell, or produce 
merchandise to apply the inventory accounting rules and use the 
accrual method of accounting. Although taxpayers and the 
Service have spent considerable resources contesting whether 
particular items constitute merchandise, the issue has never 
been consistently resolved.
    For example, last week, in a case that was noted earlier 
this morning, the tax court in a deeply divided opinion held 
that concrete used by a construction contractor was not 
merchandise. This result may have appeared obvious to the IRS 
following the Tax Court's decision, we noted in our prepared 
statement, but it was not in fact obvious to them. It was also 
not obvious to the six judges of the Tax Court who dissented in 
two separate dissenting opinions. If the Tax Court cannot agree 
on whether a particular item constitutes merchandise, imagine 
how difficult it is for small businesses to make this 
determination.
    This problem will only increase with the growth of the new 
economy. For example, is electronic information inventory or is 
the business providing a service? If the business is providing 
a service, are its materials supplies or are they merchandise?
    There are other complications. Under the regulations, any 
taxpayer receiving any income from the production, purchase, or 
sale of merchandise must use the accrual method of accounting 
for its purchases and sales unless the Commissioner determines 
that another method of reporting will clearly reflect income. 
But the courts have compared the cost of merchandise with the 
taxpayer's total gross receipts in determining whether 
merchandise is an income-producing factor.
    The decisions suggest that de minimis inventory purchases 
do not necessarily make merchandise an income-producing factor. 
While this provides relief for some taxpayers, it also adds 
additional complexity and is a source of controversy between 
companies and the IRS trying to figure out whether or not they 
fit in that category. The result of all of this is some 
businesses cannot easily determine if they have merchandise 
inventory that requires them to keep inventories and 
consequently whether they must use the accrual method of 
accounting.
    We have several recommendations in our prepared statement. 
I would just note that we do recommend that small business be 
allowed to use the cash method. We also recommend that small 
businesses not be required to keep inventories and not be 
subject to the rules of section 1.162-3 of the regulations that 
defer the deduction of supplies.
    We believe the adoption of these proposals would achieve 
considerable simplification for small businesses and eliminate 
the considerable controversy that currently exists between 
taxpayers and the Service regarding inventory accounting and 
the use of the accrual method of accounting.
    We appreciate your interest in this matter. We would be 
pleased to answer your questions and to work with the staff.
    [Ms. Olson's statement may be found in appendix.]
    Mr. Manzullo. Thank you very much. Our next witness is John 
Satagaj?
    Mr. Satagaj. Satagaj. I have been a witness for the last 20 
years, and no one has gotten it right, Mr. Congressman.
    Mr. Manzullo. Well, try Manzullo. I was 14 before I could 
pronounce it myself.
    Mr. Satagaj. That is right. My wife kept her maiden name, 
25 years.
    Mr. Manzullo. Okay. All right, that is good. Anyway, John 
Satagaj is the managing--you have got a name like Talent that 
is very easy. Do you want to introduce the next witness?
    [Laughter.]
    Would you like to pronounce--why don't you pronounce his 
last name.
    John Satagaj is the managing partner from London and 
Satagaj in Washington, on behalf of the Small Business 
Legislative Council.
    Mr. Satagaj.

  STATEMENT OF JOHN S. SATAGAJ, MANAGING PARTNER, LONDON AND 
  SATAGAJ, WASHINGTON, D.C., ON BEHALF OF THE SMALL BUSINESS 
                      LEGISLATIVE COUNCIL

    Mr. Satagaj. Thank you very much.
    Mr. Manzullo. Thank you.
    Mr. Satagaj. Mr. Chairman--see that is how you get around 
it. I am happy to be here. As you noted, I am John Satagaj, 
president of the Small Business Legislative Council, and also a 
tax lawyer. Unlike Skadden and Aarps, our firm is London and 
Satagaj, and we are the two partners. So, we are on the other 
end of the size spectrum of a tax law practice.
    I want to address a couple of specific issues that we 
talked about here today rather than what is in my statement. 
Pam just mentioned a moment ago about one tax case that was 
recently decided and the precedent that was set in that case, 
all regarding this whole issue of the inventory.
    There has actually been three cases recently on this. There 
was a case in November in the medical field, there was this 
case that involved the concrete construction company, and there 
was another one the day after. The concrete case was released 
on Thursday; there was another case reported on Friday of a 
sand and gravel hauler that came out in favor of the IRS. The 
first two decisions were in favor of the taxpayer; the third 
one was in favor of the IRS. The court is split, each half 
feels very strongly a different way. It does illustrates that 
you can't fix this by the regulations, the administrative 
process, or letting this go through the courts, because it just 
is an unresolvable issue. That is why we have asked Congress to 
set the bright line, make the decision, and say this is the way 
it is going to be. We are kidding ourselves if we think we are 
ever going to resolve this through the courts.
    Interestingly enough, and it brings me to my second point, 
in all three of those cases, guess the size of the taxpayer. 
Between $1 million and $5 million. All three of them are in 
that area. And that brings me to the point about the $1 
million. First of all, we never heard a clear explanation today 
of how you can do this administratively at $1 million--and you 
went along this line of questioning--but not do it for $5 
million. And the truth of the matter is when you put the faces 
on these businesses such as we got right next to us, these 
businesses between $1 million and $5 million, a very important 
part of the small business constituency.
    The administration talked percentages, the number of 
businesses that would be exempt under $1 million. There are a 
million, business taxpayers, between a $1 million and $5 
million--a million taxpayers. That is a lot of taxpayers. But 
more importantly, not only are those, just by their numbers, 
important, those are the ones you see in the Kiwanas, the 
rotary, the local chamber, the ones who are creating the jobs 
in your communities. Those are the ones who are going to be in 
this no-man's land between $1 million and $5 million.
    There are another 750,000 with between $500,000 and $1 
million in receipts. Those are all the businesses that Ms. 
Kelly was talking about who will look and say, ``Do I grow my 
business?'' Seven hundred and fifty thousand taxpayers with 
gross receipts between $500,000 and $1 million. So, you have 
got a million seven hundred fifty thousand, and those are the 
small businesses that you see in your district.
    Chairman Talent [presiding]. Let me jump in, John, because 
I am going to have to leave, and I wanted to ask the 
witnesses--and you will have a chance to give your statement 
too, and you can answer this too--is my reading--in your 
judgment, is my reading of section 448 correct, that Congress 
already tried to address this? Ms. Olson, if you would like to 
jump in on this too. I mean what is----
    Mr. Satagaj. Abe and I were here in 1986. Unfortunately, 
the bad news, we have been representing small business a long 
time, and I would say your reading is what we believe to have 
happened. But it also illustrates how we can argue this thing 
till the cows come home, and they are never going to concede 
the point and why we need your legislation. Because we will 
debate this forever. We believe, like you, that is what it was, 
but there is no sense in beating them over the head.
    Chairman Talent. Well, I am going to talk to Mr. La Falce 
who was here and I am sure he took an interest in this issue 
and would be able to give us his opinion.
    Ms. Olson, do you have an opinion on what section 448 is 
intended to do, and don't hesitate to----
    Ms. Olson. I must admit that I actually think that section 
448 was intended as a revenue raiser; in other words, that it 
was supposed to provide clarity as to when people had to be on 
the accrual method as opposed to permission. So, I am afraid I 
sort of fall into Treasury's view on that.
    Chairman Talent. Sure, that is all right. I recognize that 
there are other points of view, although I am kind of looking 
at it less from a legal stand as if I were there at the time. 
And I am reading that language and I am thinking the sensible 
thing would have been to establish these bright line tests, and 
also there is some language in there that just is not 
consistent really with believing that it was intended to 
restrict the ability of taxpayers rather than free taxpayers.
    Abe, do you have a comment?
    Mr. Schneier. Mr. Chairman, I happened to bring my tax 
reform and a conference report, and as you were reading this 
morning, it is a section from the Conference Committee report: 
The House bill generally provides that the cash method of 
accounting may not be used by any C corporation, by any 
partnership that as a C corporation was a part of any tax 
exempt trust. Exceptions are made for foreign businesses, 
qualified personal service corporations, and entities with 
average annual gross receipts of $5 million or less for all 
prior taxable years. I didn't think it had to get much clearer 
than that.
    Chairman Talent. Yes, and this was a point I tried to make. 
The same language is used with regard to the farmers and the 
personal service corporations as is used with regard to C 
corporations under $5 million. So, if the service is correct, 
or the Department is correct, it didn't provide any extra 
rights to C corporations under $5 million, then it certainly 
did not provide any extra certain rights or certain safe 
harbors to the farmers or personal service corporations, which 
means they can go after farming operations next under that 
theory. But they haven't done it. They are starting to go after 
the personal service corporations like the dentists.
    So, maybe that is their view, but, clearly, I would say--
knowing how this Congress typically feels about agricultural 
operations, I don't think--you know, when we need to find a 
safe harbor for the farmers, by heaven, we provide the safe 
harbor for the farmers. And I read all three of those the same. 
And, so let us just get rid of this issue. And I understand how 
they get into the corporations--Mr. Harris, do you have----
    Mr. Harris. Yes, I think you can also look at the repeal of 
the installment sale provision. I remember when it first passed 
and everybody ran around and said, ``How could you do this to 
small business?'' The common answer we were given was that if 
your revenues were under $5 million, you are case basis, 
therefore you are exempt. So, when it is convenient, I think 
that is a good definition to use.
    And that would be why counsel over at Ways and Means would 
have felt this would not have a big impact on small business. 
If they are assuming that everybody under $5 million is cash 
basis that would explain, why they felt it would not have a big 
impact, and I don't have any gripes about the Ways and Means 
staff, they are not telling us something they didn't believe. 
And that would explain it, wouldn't it. Because they are 
thinking if you are under $5 million, you are reporting on the 
cash basis anyway, so the installment repeal doesn't apply to 
you.
    Mr. Satagaj. The important thing I think about the law is 
what you talked about regarding the interest and the penalties. 
Aside from how we interpreted it all and whether they meant 
that or not, look at all the taxpayers that have been following 
that rule as the way of doing business. Literally hundreds of 
thousands of small businesses continued on the cash accounting 
since 1986, and now they get whacked. They get hit with the 
interest and the penalties. So, even aside from our 
interpretation, just look at the practical impact on those 
businesses since 1986 that have continued with that type of tax 
accounting.
    Chairman Talent. Yes, you guys can jump in if you want. 
Abe, I guess we will let you give your statement at some point, 
and I want to hear what you have to say. I think we all 
understand the issues pretty well, and I think we understand 
what we need to do with regard to both issues.
    Mr. Satagaj. Do you want me to continue finishing up my 
statement.
    Chairman Talent. Oh, I am sorry. Yes, John, you can.
    Mr. Satagaj. Okay. I will be quick.
    I just want to make a couple of other points. We just 
talked about the audit. I want to talk about the installment 
sale method briefly, because there has been continuing 
confusion. It was mentioned again here today why don't we use 
this $1 million test also for use of the installment sale 
method. This is mixing apples and oranges. When you sell the 
business you are talking about the sales of assets. What we are 
talking about in their debate on cash accounting is gross 
receipts in a year. There is no way to compare these two 
things, and in fact to the case of installment sales of the 
business even the $5 million limit doesn't make sense.
    I prefer repealing the installment repeal outright. But if 
I was going to do something I would look at IRC section 1202 
where there is a definition, for venture capital purposes, of 
small business: the limit is $50 million, based on assets. If 
you are going to do limit asset sales, let us use a definition 
based on assets. That would make more sense than $1 million or 
$5 million. Repealing the darn thing would be best.
    Chairman Talent. By the way, can this raise any revenue? I 
don't think it is going to raise revenue, is it, because people 
just aren't going to sell or they are going to find some other 
way to sell.
    Mr. Satagaj. You are going to structure around it. We all 
know the advice we start giving to folks when this happens. It 
is not the best way. You are losing some money or you are going 
to lose a little bit of a premium.
    Final thing I wanted to bring up is I did sit in on a 
couple of meetings at the IRS about cash accounting, not the 
installment method repeal. This has gotten blurred here. I can 
tell you when the idea of $1 million was brought up, we said 
there is no way this makes any sense. We believe you must go 
with the $5 million limit. It makes the most sense for many 
reasons. We believe they should have done so in 1986 and 
perhaps drafted a little more clearly.
    And that concludes my statement, Mr. Chairman.
    [Mr. Satagaj's may be found in appendix.]
    Chairman Talent. Abe, we will go on to you.

STATEMENT OF ABRAHAM L. SCHNEIER, PARTNER, MCKEVITT & SCHNEIER, 
   WASHINGTON, D.C., ON BEHALF OF THE NATIONAL FEDERATION OF 
                      INDEPENDENT BUSINESS

    Mr. Schneier. Thank you, Mr. Chairman.
    Mr. Chairman, my name is Abraham Schneier. I am a partner 
in the firm of McKevitt & Schneier, and I am a consultant on 
tax issues to the National Federation of Independent Business. 
On behalf of the 600,000 members of the NFIB I appreciate the 
opportunity to present the views of small business owners on 
this short subject of the cash method of accounting.
    I would like to address a couple of points that were made 
earlier. First of all, in terms of Mr. Mikrut claiming that 97 
percent of all small businesses fell into the category of $1 
million or less, the problem with Treasury statistics of income 
is they are highly aggregated. The real measure includes many 
part-time businesses and many businesses that have no 
employees. If you really look at the number of small businesses 
that have employees, you come up with a population closer to 
six million in total, and of that population I think we would 
find that the numbers would diverge quite a bit from that $1 
million threshold.
    The $5 million number was clearly what we thought we 
achieved in 1986. It was clearly the intention of the proposals 
that took place during the committee. I was as distressed as 
anybody to find out later on that, well, the provision did not 
mean exactly what we thought it meant.
    In terms of how the regulations are being pursued, the IRS 
has, obviously, an enforcement issue involved here, and I think 
that the biggest point we can make is that enforcement would be 
assisted by a clearer line. The last thing the IRS can afford 
right now is to have a lot of agents who are just focusing on 
these very small accounting method issues. They really need to 
be focusing their resources in areas that are more productive 
in terms of policy issues and their impact on small business.
    This approach does not gain the IRS, it doesn't gain the 
Federal Treasury anything. As we have said several times here 
today, we are talking about timing shift, whether the inventory 
is deductible in 1999 or 2000. The typical small business owner 
in these circumstances clearly believe that cash flow is their 
biggest problem, day-to-day, week-to-week operations. He is 
looking to pay his rent; he is looking to pay his employees; he 
is looking to pay for supplies; he is looking to pay for the 
needed costs of running his business. Cash flow is where he 
goes.
    The accrual method of accounting puts him in a very 
difficult position, especially as you get to the end of fiscal 
years where you have artificial numbers coming into play, 
creating an artificially high tax situation. We believe, as you 
do, that the $5 million threshold really should be where the 
line should be drawn and that the rules, as they apply to 
businesses under $5 million, should be much clearer than they 
are right now. The efforts in terms of trying to define when a 
business actually has inventory, whether or not to impose 
percentages of gross profit as some kind of a line of 
demarcation really would help specific industries, but I think 
we need to really sort of clarify it across the board for all 
small businesses.
    I would be happy to answer any other questions. We have 
covered so much ground. And I want to compliment the members of 
the Committee for an excellent discourse on this issue, which 
can be pretty complex, and, frankly, I haven't heard as good a 
discussion on the Ways and Means Committee.
    [Mr. Schneier's statement may be found in appendix.]
    Chairman Talent. All right, I will recognize the gentlelady 
from New York, and thank her for her patience.
    Ms. Velaquez. Sure. Thank you, Mr. Chairman.
    Mr. Harris, in your testimony you indicate that the $1 
million gross receipts threshold, which is being proposed by 
Treasury, is inadequate to prevent hardship to small 
businesses, and that even a $5 million threshold may not be 
suitable in some cases. What standard would you propose or 
recommend?
    Mr. Harris. Well, certainly, there has to be a reality 
check of what is reasonable, but revenue is not always the best 
way to determine the size of the business. That, in large part, 
has to do with what it is that you sell--the smaller the item, 
the smaller the price. I think total assets could be used, it 
could even be a combination of things: Assets of under a 
certain amount, sales of under a certain amount. You meet one 
of two tests.
    And I think the danger is that we try to find a very simple 
solution to a very complex issue of what is a small business, 
and I really don't know where $1 million came from. That just 
came out of nowhere. I guess if I was going to be stuck with a 
revenue number, I would use $5 million, because there is 
already some precedent. But I think we should look for a real 
definition of how to define a small business, and I think 
assets may be better in some cases, as I mentioned in my 
testimony, that an insurance agency could have $25,000 worth of 
assets and one employee and do over $1 million in revenue, and 
that is not a large business under any definition. So, I would 
like to see a definition that truly defines small business and 
doesn't eliminate a true small business.
    Ms. Velaquez. Thank you.
    Mr. Schneier, with regard to installment sales, do you 
believe it necessary to repeal the restriction on the use of 
installment method as proposed in H.R. 3594 or would you 
support trying to find some sensible middle ground? For 
example, can we say that businesses with gross sales of less 
than $5 million should be allowed to choose whether they can 
use the installment method?
    Mr. Schneier. Given the confusion that this provision has 
sort of engendered, I believe that repeal really is the way to 
go. The $5 million threshold only creates, I think, an 
additional barrier for some businesses in terms of 
understanding where they are going to be when they go and sell 
their business. The issue for most businesses is who can I sell 
to? And I can only sell to another small business owner who is 
going to pay me over a period of time.
    You don't want to create a situation where the small 
business owner is going to be taxed on income he has yet to 
receive, and I think the $5 million threshold really doesn't 
achieve that for a large number of small businesses who would 
not fall into that category.
    Ms. Velaquez. Thank you.
    Mr. Satagaj.
    Mr. Satagaj. Satagaj.
    Ms. Velaquez. Thank you. Is it a problem with regard to the 
cash versus accrual accounting method and now an issue that 
primarily affects businesses which do not have large 
inventories of goods for sale or is it broader?
    Mr. Satagaj. Well, it certainly affects a lot of folks in 
that it goes beyond the people who commonly think if they have 
goods, because when you get into, for example, the osteopathic 
case I mentioned earlier, the one in the fall, or a 
veterinarian who is giving a shot to an animal and the IRS 
considers the material in the needle as merchandise. Never in 
their wildest mind would they think that that material is at 
issue here. It would have never occurred to them. So, the 
answer is it is much broader than just folks who would normally 
think of themselves as selling merchandise.
    Ms. Velazquez. If Congress were to legislate in this area, 
are there competitive implications where our decisions might 
either tip or level the playing field in a particular field of 
owners?
    Mr. Satagaj. That is a good question. The answer is 
probably no in that this is a timing issue primarily, not 
competition vis a vis another business. This has to do more 
with your personal survival. Abe talked about cash flow, and 
this is the ability of a particular taxpayer to be able to pay 
his/her taxes when he/she has to pay them. So, I don't know if 
it has a competitive advantage or disadvantage. It is more 
related to the direct survivability of that particular firm.
    Ms. Velazquez. Thank you.
    Ms. Olson, as a tax expert, are there cases where you would 
recommend to small business clients that they use the accrual 
accounting method instead of the cash method? And can you give 
specific examples of where the use of the accrual method might 
be beneficial to a small business?
    Ms. Olson. Quite frankly, no, I cannot think of a situation 
when I would recommend that a small business use the accrual 
method of accounting.
    I also want to note that there were questions about 
companies keeping books for financial purposes that would be 
kept on the accrual basis versus the cash basis. And I just 
want to note that for financial accounting purposes there are 
very different rules that apply to how you accrue your income 
and expenses versus what the tax rules are. And so just because 
a company may be keeping some financial books and records on 
the accrual basis for purposes of showing a bank or whatever 
wouldn't necessarily mean that those books and records would be 
the books and records that they would need in order to properly 
prepare their tax returns on the accrual basis.
    So, the answer to your question is no, and I also wanted to 
add that other highlight.
    Ms. Velazquez. I want to address resolve the non-taxed 
costs associated with the small business using the accrual 
method of accounting as opposed to cash method. From your 
experience, is the average small business equipped to handle 
the necessary paperwork that goes with it?
    Ms. Olson. I think the answer is no. Most small businesses 
are not equipped to either do the accrual accounting or to keep 
the inventory accounting or to keep the supply accounting that 
might be required by the section 162 regulations. And that is 
why we recommended that small businesses be allowed to use the 
cash method and to not keep inventories and to not inventory 
supplies as well.
    In addition to the costs of doing so, the controversy costs 
have to be taken into account, because to the extent that you 
end up at some point fighting with the IRS about whether or not 
you have to do it, you also obviously significantly increase 
the cost to small business.
    One other point I want to note is that with regard to the 
question about section 448 and what Congress thought they were 
doing in 1986, the IRS' administrative practice doesn't always 
stay constant; in fact, it probably generally doesn't stay 
constant. So some of the things that I think are going on today 
that have excited the gentlemen at the table with me probably 
weren't happening in 1986, because I don't think the IRS at 
that point in time was aggressively pursuing dentists or 
veterinarians or contractors.
    So while Congress may have done one thing in 1986, they 
might not have appreciated what the IRS might do with those 
rules subsequently, and so we may end up with different results 
today were Congress to look at what is happening today in IRS 
administration rather than what was happening in 1986.
    Ms. Velazquez. Can you tell me if a small business is 
forced to seek assistance from a tax lawyer or a CPA to comply 
with the accrual basis accounting requirements, what other 
kinds of additional expense would that person incur?
    Ms. Olson. I wonder whether this gentleman might not be in 
a better position to answer that question than I am.
    Mr. Harris. Are you talking about the direct cost of the 
service that they would incur versus the----
    Ms. Velazquez. Yes.
    Mr. Harris. Certainly, the size of the business would have 
a lot to do with it, but I think it is very unlikely that a 
small business owner is going to understand accrual accounting 
well enough to do most of what is needed. Maybe they can do 
some basic internal recordkeeping. But, clearly, at the end of 
the year and on a regular basis they are going to have to 
solicit an outside firm to make all the proper adjustments and 
end up with statements that they don't understand, because they 
understand the in and out of money, the money in the checkbook. 
And when all of a sudden you bring them a set of financial 
statements that have no bearing whatsoever to their money in 
their bank account, they wonder what they just paid for.
    Ms. Velazquez. Mr. Olson, can you tell us what will be the 
average payment if a person has to seek a tax expert or a tax 
lawyer or a CPA to comply?
    Ms. Olson. Yes, to prepare the return? I am not sure--
again, we probably should have had somebody here from the AICPA 
to try to answer that question, but I would guess that the fee 
is going to be something between--for a very small business, 
something between $5,000 and $10,000, probably closer to the 
high end of that. And that is probably a minimum kind of 
number. It might in fact be considerably more than that.
    Ms. Velazquez. Thank you. Thank you very much.
    If the person is doing the work, using the cash method, how 
much it would be instead of the accrual?
    Ms. Olson. So, it is the difference between keeping it--I 
mean I think that to a certain extent there is probably not a 
real big difference in the cash method versus the accrual 
method. The additional work is probably going to be 
attributable to the recordkeeping that that taxpayer had to do 
him or herself in order to make sure that they have all of the 
additional information.
    So, what you are probably talking about is, as opposed to 
somebody who, as he mentioned, can pretty much look at their 
checkbook and say, okay, it is December 31, this is my balance, 
therefore, this is my taxable income for the year. Instead you 
have got to keep all the records on the accounts payable and 
the accounts receivable and perhaps inventory, perhaps 
supplies, and factor those in as adjustments to what you see as 
the balance in your checkbook. So, I think it is going to be 
more of a burden on the taxpayer, him or herself, to keep 
records as opposed to the additional cost for the accounting.
    Mr. Harris. Yes, I would just like to second that, and say 
I think the real cost is during the year internally as opposed 
to the actual preparation of a document or tax return at the 
end of the year. And the only way I think you would see a 
substantial increase there is when people have not done a good 
job during the year, and now it is left to the firm to come in 
at the end of the year and correct all the mistakes. But I 
think the real cost is during the year as opposed to at the end 
of the year.
    Mr. Satagaj. I might make one point on this. One of the 
great ironies is you can have what I call phantom inventory. 
You can actually begin and end the year with no inventory and 
have the internal responsibility in the course of the year 
because the IRS says even if you have zero liability you still 
have to do this during the course of the year. So, you can be 
incurring this cost, the internal cost, of maintaining 
inventory. Mr. Bartlett was talking about his five houses. You 
could clean your inventory out. You could have zero houses at 
the beginning of the year, zero at the end of the year, but go 
through the year and still be required by the IRS to be on 
inventory accounting. So, you still get to go through that 
whole game for zero at the end of the year.
    Ms. Velazquez. Thank you.
    Chairman Talent. Dave, did you want to respond to that same 
question? Here is a guy, grew your family business and became a 
CPA, and now you are going to law school to fight the IRS.
    Mr. Wulkopf. I was just going to say----
    Chairman Talent. Especially with a name like David.
    Mr. Wulkopf. For a cash basis taxpayer, it is just like 
paying your individual taxes. A person who can do their taxes 
regularly can probably do the cash--their business taxes on a 
cash basis. But when you have to convert to an accrual basis 
where you have to report prepayment of expenses, accrued 
vacations, and you have to accrue expenses and payables and 
receivables, it gets a little complicated, and the average 
taxpayer probably could not, and that is when you are going to 
have to hire the outside counsel which is going to cost at 
least $5,000 to $10,000.
    Chairman Talent. That would be during the course of the 
year to keep those records----
    Mr. Wulkopf. You could have a firm come in on a quarterly 
basis or monthly basis and help you out, but if you convert it 
at the year end, that is a $5,000 to $10,000 expense every year 
that you have to incur just to report. And like we said all 
along, there is no difference in the amount of tax that is 
going to be paid. This is all a timing difference.
    Chairman Talent. I want to ask a question of Ms. Olson, but 
before I do that, Dave, I am sorry that I missed your 
testimony. I was running off to exercise my constitutional 
obligation to vote on that particular rule that we had. My 
understanding is that the IRS has come against--this is your 
family painting company?
    Mr. Wulkopf. Correct.
    Chairman Talent. And how many employees do you have?
    Mr. Wulkopf. During the summers, we can get up to around 
80, 90 painters, but in the winter months it is pretty lean, 
probably around 15, maybe 20.
    Chairman Talent. And they want $200,000?
    Mr. Wulkopf. Correct.
    Chairman Talent. Including interest?
    Mr. Wulkopf. They have said that they know it is a gray 
area, so----
    Chairman Talent. Have they waived penalties?
    Mr. Wulkopf. They waived the penalties, but they are not 
going to waive the interest.
    Chairman Talent. So, they can't waive the interest.
    Mr. Wulkopf. Correct.
    Chairman Talent. Because of the United States Congress. I 
would be interested in knowing if somebody could research the 
amount of penalties and interest that the IRS has collected 
from attacking cash payers that it forced to go from the cash 
basis to the accrual basis. Does anybody have any idea how 
much--just on this table here, Shane, it is $100,000 for you; 
David, it is $200,000, and, Shane, I have referred to you as 
the drywall man, forgive me--but you have 22 employees.
    Mr. Mieras. That is correct.
    Chairman Talent. And, David, you have normally 15, blossom 
up to 80 with the college painter signs and everything. That is 
$300,000, and you guys are little. But I would be interested in 
finding out how much is out there, and maybe that is what the 
IRS is trying to do. Where they make the money is not on the 
cash versus the accrual basis but on screwing the taxpayer with 
the interest and the penalties.
    Mr. Wulkopf. And it is the one-time hit. I mean they have 
let us report on a cash basis for years and your accounts 
receivable continue to grow, and then all of sudden they want 
the tax in one lump sum payment, which is close to $200,000, 
which obviously most small businesses don't have that kind of 
money laying around.
    Chairman Talent. Don't keep that on hand.
    Pam, my question here is--could you expand on the tax 
section simplification recommendation to allow small businesses 
at or below $5 million to use cash method even if they use 
merchandise or inventory? This is Mr. Talent still. Do you 
understand my question?
    Ms. Olson. Yes. Well, for purposes of simplifying the law, 
which is something that the ABA Tax Section has tried hard to 
be an advocate for, for a number of years, and we are making a 
big push again now, because we really think that people have 
become just overwhelmed by the complexity in the law, we think 
that the value to small business of being able to essentially 
look at that business checkbook on December 31 and know what 
their taxable income is for purposes of figuring out how to pay 
their taxes is the right way to go. Now, granted, they will 
have to go through and segregate things for purposes of putting 
them on the tax return, but we really think that is the right 
way to go.
    And we also think that inventory accounting is too 
complicated, that most small businesses just don't keep 
adequate records in order to properly do that. We think that 
the questions that have been raised over the last few years, in 
particular about whether or not things that might be called 
supplies in fact are merchandise and therefore require 
inventories, could be taken care of by eliminating the 
requirement that small businesses keep inventories.
    And then the final piece is the regulations under section 
162, which would defer deductions for supplies. We think that 
similarly should be addressed, because you don't want to end up 
with the IRS reversing course from saying, ``well, it is 
merchandise, and therefore you have to keep inventories, and 
since you have to keep inventories, you have to be on the 
accrual method of accounting'', to saying, ``well, okay, but we 
still got you on the supplies, because really these things 
aren't merchandise. Now we think they are supplies, and so 
since they are supplies you can't deduct them under section 
162''.
    There is obviously some possibility for people to play 
games in this area, but we, frankly, don't think that the 
possibility is significant, because there are too many costs. 
If you are on the cash basis, you have to shell out the cash in 
order to buy the inventory. You have to defer getting the 
payment. We don't think that people are going to incur over $1 
in expense in order to save 35 cents in taxes. We just don't 
think that is going to happen. So we really think you could 
achieve significant simplification for small business by going 
this way.
    Chairman Talent. I appreciate that.
    Let me ask you a question about our friend, the dentists. 
There is really no one from the IRS here. No one has been here 
from the IRS that knew anything today or answered any questions 
except of trying to come up with these different explanations 
as to what Congress intended. But do you feel that if a dentist 
is forced to go on the accrual system that this is going to 
make him less willing to do pro bono cases? I mean people that 
come in that he ordinarily would do as charity, they are going 
to say, hey, your services are done. You are entitled to be 
paid, and whether or not you get paid for a person who is 
indigent that is totally irrelevant.
    Mr. Satagaj. Interestingly, if you apply the textbook, you 
would end up with a liability in certain cases, I suppose an 
offsetting deduction later on for a charitable contribution of 
some kind.
    Chairman Talent. But you can't use your service, render it 
as a charitable contribution, obviously.
    Mr. Satagaj. Right, and there would be no way to do it, 
therefore it would be ridiculous.
    Chairman Talent. When I practiced law years ago, probably 
20 to 30 percent of my practice was pro bono. I mean these were 
just very unfortunate people who lived literally across the 
track. They couldn't afford an attorney, and if I had to report 
my income based upon the value of my services to them as 
finalized, that would make me less willing to do it. But I 
think this a real hit on professionals that want to help out 
the people that are faced with real problems in society.
    Mr. Harris. I think the real danger there if people are 
going to be required to report their income when they provide 
the services, there are people who could come into the dentist 
office and say, ``Look, I need this work, but I can't pay you 
today,'' the dentist won't accept them, because they are going 
to have to report the income even though they did not get any 
payment. They are only going to be able to accept people who 
either have insurance that will provide full payment or people 
that have the capability to provide full payment. It is going 
to discourage the dentists ability to work with people that 
need time to pay for the dentist services. I think that the 
real danger is that these people will find it very difficult to 
go out and have services provided, because they don't have the 
ability to pay for it up-front.
    Mr. Satagaj. There is an interesting point here with this 
also in the African trade bill. There is a provision about 
eliminating the ability of accrual taxpayers to write off based 
on experience some bad debts. And when we talk about pro bono, 
we are essentially talking about what would be a bad debt. 
Right now, in the current tax law, if you are on accrual, you 
do have a cash-like provision that allows you to write off a 
certain amount of bad debts based on what your experience is. 
The provision in the African trade bill eliminates that for 
many folks.
    So, now here is the kicker: If we move all these taxpayers 
that are currently taxpayers in the $1 million to $5 million 
range, from cash to accrual, not only do they go on accrual, 
they find out that they have lost the ability which you had in 
the past to adjust for that bad debt. So, you have double 
whammy, as if it were, because with cash bad debts don't matter 
from a tax standpoint.
    So, that is one of the ironies of this thing, how complex 
it is getting. Not only are we changing it here, but it will 
have that effect on that accrual provision in the African trade 
bill. We have the impact on the installments sales, so it is 
getting pretty complicated in terms of where we are driving 
these businesses and what they are willing to do, and I think 
the net result would be as you suggest, that you are going to 
look hard at whether you are going to provide any lenient terms 
for anybody that comes into your business, because you are 
going to say, ``Wait a minute. I am an accrual taxpayer, and I 
can't write off the bad debt. Forget it, I am not providing 
service unless you can pay for it.'' So, I think you have got a 
good point.
    Mr. Manzullo. In the case of Shane with the drywall, 
someone would give you a call and say, ``I need--'' is it 
commercial or residential?
    Mr. Mieras. It is commercial.
    Mr. Manzullo. Commercial. They would say I want my building 
done. And you would keep no drywall on hand.
    Mr. Mieras. None.
    Mr. Manzullo. None whatsoever. You have no storage, because 
essentially you operate the business out of a home if you 
wanted to.
    Mr. Mieras. Yes, you could. We would call a supplier and 
they deliver the materials, and we place them.
    Mr. Manzullo. And does the supplier bill directly the cost 
of the drywall to the owner of the building?
    Mr. Mieras. No, that is billed to us.
    Mr. Manzullo. That would be billed to you. Would the 
situation be different if there had been a direct bill from the 
supplier to the owner of the building? Suppliers don't want to 
do that, because they want to get paid, of course, and they 
rely upon you. But would that have made any difference in the 
kind of value of that drywall as inventory? Anybody?
    Mr. Satagaj. From the interpretation of the law, the issue 
is timeliness. You wouldn't have to include it in an inventory 
if it was truly billed directly to the consumer or the 
customer, because it wouldn't come into your inventory. But 
that means he doesn't take any title. Most of it is drop-
shipped.
    Mr. Manzullo. Yes, you just show up.
    Mr. Satagaj. And it shows up, and it is under the case law 
here that is considered taking title in that case. So, only if 
it went straight to the site and was billed directly to the 
owner of that building or whoever is building it, then it would 
not show up.
    Mr. Manzullo. But if it was billed directly to the 
contractor, then the contractor would have to show that as 
inventory, and it would be shift from the sub to the 
contractor.
    Mr. Satagaj. Exactly, exactly.
    Mr. Manzullo. So, everybody gets screwed.
    Mr. Satagaj. Right. It gets even worse. And, actually, 
under current circumstances that is a little bit of the 
problem, building down the process.
    Mr. Schneier. This also shows the importance of the 
regulatory process and how it affects the law, how the 
regulatory review process is so important to small business to 
be involved when the IRS is going to reinterpret a particular 
area, saying whether or not inventory is applied here or 
whether or not it should be applied in this particular 
circumstance. And the concern that we have had over the years 
of the fact that IRS has always exempted itself from the 
regulatory review process, claiming that they were simply 
interpreting the statute. Obviously these changes in 
interpretations have the effect of changing the law in many 
circumstances.
    Mr. Satagaj. That is a commercial message for Congressman 
Talent bill stuck in the House. Let us move that one forward 
too.
    Mr. Manzullo. That is what we were discussing here. I am 
trying to think back as to when I practiced law from 1970 to 
1992 when I was elected to the House of Representatives. And I 
represented a number of small business people. I am trying to 
look back at the qualitative and quantitative distinction as to 
what difference does it make if you have inventory on hand? I 
mean, it just sits there. We have problems back home--McHenry 
County is the fastest growing county in the State of Illinois; 
it is in my congressional district. And we do have lots of 
nurseries, and you nod your head.
    Mr. Satagaj. One of my favorite clients, keep going.
    Mr. Manzullo. And there they are with their stock on which 
they have to pay taxes even though it is stuck in the ground 
growing for six months. Is that correct?
    Mr. Satagaj. Well, they actually have a whole separate 
provision. I have been fighting that for 20 years. The IRS 
would like to shut that down as well. No inventory whether they 
are on cash or accrual. They are not required to inventory, 
because it is impossible to do it. So, they have a special 
exemption.
    Mr. Manzullo. Okay. Well, I would--if any of you has any 
questions that you would like me to convey in my official 
letterhead to the IRS witness, please contact Phil Eskeland 
from my staff or Ligia here, and I will be glad to work with 
Mr. Talent to formulate questions, not with regard to 
particular cases but perhaps general principles and answers 
that they have never given you. I would like to see how they 
would respond to a Member of Congress who asked that same 
question.
    Did you have anything further?
    Ms. Velazquez. No.
    Mr. Manzullo. Okay. Well, listen, we really appreciate your 
coming here, appreciate your sitting through the bells and our 
voting. Don't give up. You can tell that this really is a non-
partisan movement in order to bring some resolution to this 
problem. I would encourage you to continue to stay in contact 
with your member of your House of Representatives and your two 
Senators to keep this issue hot and not to stagnate it.
    This Committee is adjourned.
    [Whereupon, at 12:50 p.m., the Committee was adjourned.]
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