Cash vs accrual accounting for taxes comes down to timing. The cash method reports income when you receive it, and the accrual method reports it when you earn it. Section 448 of the Internal Revenue Code decides which businesses still get to choose. This blog will walk you through who can use cash and how to switch to accrual.
Who can use the cash method under section 448(c)
Section 448 restricts the cash method for three groups: C corporations, partnerships with a C corporation partner, and tax shelters. The first two can still use cash if their average annual gross receipts for the three prior tax years are $32 million or less for 2026. Tax shelters never qualify.
|
Business type |
Can it use the cash method? |
Rule |
|
Sole proprietor filing Schedule C |
Yes, if it clearly reflects income |
Not covered by section 448 |
|
S corporation |
Yes, if it clearly reflects income |
Not covered by section 448 |
|
Partnership or multi-member LLC with no C corporation partner |
Yes, if it clearly reflects income |
Not covered by section 448 |
|
Partnership with a C corporation partner |
Only while it passes the gross receipts test |
Section 448(a)(2) and (c) |
|
C corporation |
Only while it passes the gross receipts test, or if it is a qualified personal service corporation |
Section 448(a)(1), (b) and (c) |
|
Tax shelter |
No |
Section 448(a)(3) |
The threshold is indexed each year. It was $31 million for tax years beginning in 2025 under Rev. Proc. 2024-40, and it is $32 million for 2026 under Rev. Proc. 2025-32. IRS Publication 538, last revised in January 2022, still prints $26 million, so use the annual revenue procedure for the current figure.
To run the test, add the gross receipts for the three prior tax years and divide by 3. Annualize any short year. Members of a controlled group of corporations or an affiliated service group add their gross receipts together. A C corporation with gross receipts of $28 million, $31 million and $36 million for 2023 to 2025 averages $31.67 million, so it passes for 2026 even though its latest year was above $32 million.
A qualified personal service corporation is one where substantially all activities are services in fields such as health, law, accounting, engineering, architecture, actuarial science, performing arts or consulting, and substantially all stock is held by employees doing that work. It keeps the cash method at any size. Our C corporation returns start with this test each year, and an S corporation election takes a business outside section 448 entirely.
How cash and accrual time income and expenses
|
Cash method |
Accrual method |
|
|
Income |
When actually or constructively received |
When all events fix your right to it and the amount can be determined with reasonable accuracy, and no later than when it appears in an applicable financial statement |
|
Expenses |
When paid; a prepayment counts only in the year it applies, unless the 12-month rule covers it |
When the all-events test is met and economic performance has occurred |
|
Advance payments |
Income when received |
Income when received, unless you elect the deferral method under section 451(c) |
|
Inventory |
Small business taxpayers can skip keeping an inventory |
Required if you keep an inventory |
Cash method
Under the cash method, income counts when you receive it, actually or constructively. Constructive receipt means the money was credited to your account or made available to you without restriction. You don’t need to have it in hand. A check you could have cashed on December 31 is income for that year even if you deposit it in January.
Expenses count when you pay them. IRS Publication 538 limits prepaid expenses to the year they apply to, unless the payment qualifies for the 12-month rule.
Accrual method
Under the accrual method, income counts when the all-events test is met: every event that fixes your right to the income has happened, and you can work out the amount with reasonable accuracy. If you have an applicable financial statement, such as an audited statement, the income goes on the return no later than it appears in that statement.
An expense is deductible when the liability is fixed, the amount is known, and economic performance has occurred, which for most purchases means the goods or services were provided. A recurring item exception lets you deduct certain regular expenses in the year the all-events test is met if economic performance happens within 8½ months after year-end, or by the date you file a timely return if earlier.
Worked example: one invoice and one bill across year-end
A consulting firm bills a client $40,000 on December 20, 2026 for work finished that month and is paid on January 15, 2027. It also receives a $6,000 bill for December office services, which it pays on January 10, 2027.
|
Cash method |
Accrual method |
|
|
$40,000 fee |
2027 income |
2026 income |
|
$6,000 expense |
2027 deduction |
2026 deduction |
|
Net effect on 2026 taxable income |
$0 |
+$34,000 |
The total over the two years is the same. The method moves $34,000 of taxable income from one year to the other, which is why the switch between methods needs its own adjustment. Clean year-end cutoffs depend on monthly bookkeeping that records invoices and bills in the right period.
Hybrid method
Publication 538 lets you combine cash, accrual and special methods if the combination clearly reflects income and you use it consistently. The common version is accrual for inventory purchases and sales, and cash for everything else. The same section 448 limits apply: an entity barred from the cash method cannot use a hybrid that includes it.
Inventory and the small business taxpayer exception
A business that keeps an inventory has to use an accrual method for purchases and sales and value the inventory each year to figure cost of goods sold. Section 471(c) gives small business taxpayers another option. If your average annual gross receipts pass the same test ($32 million for 2026) and you are not a tax shelter, you can choose not to keep an inventory and instead:
- treat the inventory as non-incidental materials and supplies, deducted when used or consumed; or
- follow how your applicable financial statement treats inventory, or your books and records if you have no such statement.
This test applies to every type of business, including sole proprietors and S corporations. Passing it also exempts a business from the uniform capitalization rules of section 263A.
Changing from cash to accrual
You choose your accounting method when you file your first return. After that, changing it needs IRS consent, which you request on Form 3115, Application for Change in Accounting Method.
Some changes are required. A corporation or partnership that fails the gross receipts test for a tax year cannot use the cash method that year and must change to accrual effective for that same year, according to Publication 538. Rev. Proc. 2025-23 treats this as an automatic change under section 15.01 with designated change number (DCN) 257. The rule that bars a second overall method change within five years does not apply to this mandatory change.
Other businesses can switch by choice. A voluntary change from the overall cash method to an accrual method is also automatic under section 15.01, as DCN 122. It is available if you have not made or requested an overall method change in any of the five tax years ending with the year of change.
How to file Form 3115 for an automatic change
The Instructions for Form 3115 set two filings:
- Attach the original Form 3115 to your timely filed federal income tax return for the year of change, including extensions. The attached original does not need a signature.
- Send a signed copy to the IRS National Office at the address in the instructions. File it no earlier than the first day of the year of change and no later than the date you file the original with your return.
A change that is not on the automatic list goes through the non-automatic procedure: you file during the tax year of change and pay a user fee. For either route, Schedule A of Form 3115 covers a change in overall method of accounting.
The section 481(a) adjustment
Switching methods would otherwise drop or double count items that straddle the change, so the IRS requires a section 481(a) adjustment. A negative adjustment, which lowers income, is taken in full in the year of change. A positive adjustment is spread over four years: the year of change and the next three. If you are under IRS examination when you change, a positive adjustment is spread over only two years, with limited exceptions.
Here is a simplified example. On January 1, 2026, a cash method business switching to accrual has $150,000 of receivables it has never reported and $30,000 of accrued expenses it has never deducted. The net positive adjustment is $120,000, reported at $30,000 a year for 2026 through 2029.
We’d file the change in the first year the business fails the test, or the first year we decide accrual fits better, rather than waiting. An examination that starts first cuts the four-year spread to two. Our business tax consulting team works out the adjustment before the return is filed.
Accrual books with a cash basis tax return
Your financial statements and your tax return can use different methods. A business can keep accrual books for a lender or investors and still file on the cash method if it qualifies. The differences are reconciled on Schedule M-1 or Schedule M-3 of the business return.
The method you use for the books does not decide your tax method, but an applicable financial statement does affect accrual method timing under section 451(b). If you are setting up new books, our guide on what to check in an accounting system lists the reports that support both.
Which method fits your business
The cash method suits most service businesses that qualify: income follows the bank account, and a December invoice paid in January falls into the next year. Accrual fits better when receivables or payables are large, when lenders want accrual statements, or when the business is close to $32 million in average gross receipts and would rather change on its own schedule.
California follows the federal small business accounting method rules for taxable years beginning on or after January 1, 2019, under AB 91, which brought the state in line with the 2017 federal changes to sections 448, 471 and 263A.
For a C corporation or a partnership with a corporate partner, we’d run the gross receipts test every year before the return is prepared, because the change to accrual is due in the first year the test fails. For business tax preparation in Irvine or anywhere in the U.S., schedule a consultation and bring your last three years of returns.
Frequently asked questions
Can an LLC use the cash method of accounting?
Yes, in most cases. An LLC taxed as a sole proprietorship, an S corporation or a partnership without a C corporation member is not limited by section 448, so it can use cash if the method clearly reflects income. An LLC taxed as a C corporation must pass the gross receipts test.
Can a business with inventory use the cash method?
Yes, if it is a small business taxpayer: average annual gross receipts of $32 million or less for 2026 and not a tax shelter. Under section 471(c), it can treat inventory as non-incidental materials and supplies or follow its financial statements, instead of keeping a formal inventory.
Does the cash or accrual method save more tax?
Neither changes your total income over the life of the business. The method changes the year income and deductions land, so it can raise or lower the tax for a given year. The section 481(a) adjustment exists to stop a switch from dropping or doubling any income.
Do I need IRS permission to change my accounting method?
Yes, after your first return. You request consent on Form 3115. Most changes from cash to accrual are automatic, using DCN 122, or DCN 257 when the gross receipts test forces the change. Automatic changes need no user fee and are filed with your timely return.
Does California follow the federal cash method rules?
Yes, for taxable years beginning on or after January 1, 2019. California’s AB 91 adopted the federal small business accounting method rules for sections 448, 471 and 263A, so the same entity limits and small business exceptions apply on the California return.
What happens if my gross receipts go over $32 million?
If you are a C corporation or a partnership with a C corporation partner, you lose the cash method for that tax year and must change to accrual, filing Form 3115 under DCN 257. Sole proprietors, S corporations and partnerships without corporate partners are not affected by this test.
