Cash vs Accrual Accounting: Which a Small Business Should Use

Cash or accrual: which should a small business use?

For taxes, many small businesses may choose either method, and the choice is made on the first return. Cash is simpler to keep, which is why many sole proprietors without stock use it (Publication 334). Accrual counts income and expenses in the year they belong to, whether or not money moved. The books can follow either one (Publication 538).

The limits on the tax return turn on four things: the type of entity, average gross receipts (total sales and other income, not profit) for the three prior years, whether stock on hand is a factor in making income, and whether the business is a tax shelter, which can include an ordinary LLC with passive investors.

A case is not simple when:

• the business is a C corporation, or a partnership with a C corporation partner, because a receipts limit applies;
• it makes or sells goods, because inventory rules apply;
• its receipts, added to those of related businesses, are near the $32,000,000 limit;
• a lender, investor or buyer wants accrual statements while the return is on cash;
• an earlier return may have used a method the rules did not allow;
• it already filed on one method and wants the other, because a change needs IRS approval.

Gather the gross receipts for the last three tax years of every related business, the entity's tax classification, the stock on hand at year-end, the last filed return (it shows the method; Schedule C line F for a sole proprietor), and what the lender or investor asked for in writing.

What is the difference between cash and accrual accounting?

Cash basis (the cash method) counts income when received, however the customer pays, and expenses when paid. Accrual basis counts income when the right to it is fixed and the amount can be determined with reasonable accuracy, and an expense when the liability is fixed, the amount can be determined with reasonable accuracy and the goods or services have been provided (Publication 538; Reg. 1.446-1).

Loans, owner contributions and owner withdrawals are neither income nor expense on either basis.

Three traps. On cash, income counts when it is credited to your account or made available without restriction, even if you have not withdrawn it, and an expense paid ahead is deductible only for the year it covers, unless it meets the 12-month rule. On accrual, a payment received in advance is generally income when received, though an election can defer part of it by one year (Publication 538). An accrual payer also cannot deduct an amount owed to a related person on the cash method, such as an owner or family member, until it is paid and the payee includes it in income (Publication 538; section 267).

For rent, insurance or payroll that crosses year-end, see prepaid expenses at year-end and accrued payroll at year-end.

Which is better for a small business, cash or accrual?

Neither is better in every case. Cash is simpler to keep when there is no inventory, few invoices or bills sit unpaid at year-end, and nobody outside the business asks for accrual. Accrual shows more when sales are on credit, bills are paid in later months, or an outside reader needs to see what is owed to and by the business.

Can my business use the cash method for taxes?

Usually yes. A C corporation, a partnership with a C corporation partner, and a tax shelter are the entities the law restricts (Publication 538; section 448).

The sources for the rows are the instructions for Schedule C, Form 1120-S, Form 1065 and Form 1120.

A qualified personal service corporation partner does not count as a C corporation partner. A partner that is itself a partnership with one does, and so does a corporation that was a partner for any part of the year (section 448(b)(2); Reg. 1.448-2). Even where section 448 does not bar cash, the IRS can require another method if cash does not clearly reflect income (Reg. 1.448-2(f)).

A tax shelter is any of these (Reg. 1.448-2):

• an enterprise that is not a C corporation and ever offered its interests in an offering that had to be registered with a federal or state securities regulator, or that required a notice of exemption from registration, whether or not the notice was filed (an S corporation is excepted only for a state notice that every corporation offering securities in that state must file);
• a syndicate: a partnership or other entity that is not a C corporation and allocates more than 35% of its losses to limited partners or limited entrepreneurs, meaning owners who do not actively manage the business. Active managers, their close family and five-year active managers are not counted (Form 1065 instructions; section 1256(e)(3)). Losses here are deductions over recognized income, leaving out sales of capital assets and business property. Each year the partnership or S corporation (not its owners) may elect to test the prior year's allocations instead, by attaching a statement citing Reg. 1.448-2(b)(2)(iii)(B) to its timely filed original return, extensions included; the election covers that year only and cannot be revoked;
• an entity or arrangement with a significant purpose of avoiding federal income tax (section 6662(d)(2)(C)).

Does an LLC or an S corporation have to use accrual?

Not because of its legal form. An S corporation is shut out of cash only if it is a tax shelter. If stock on hand is a factor and it is not a small business taxpayer, it must use accrual for purchases and sales (Form 1120-S instructions).

An LLC follows its tax classification. The IRS treats a one-member LLC as part of its owner's return, a multi-member LLC as a partnership, and an LLC that elects corporate treatment as a corporation (IRS: LLC). So the table above applies by classification and owner: a one-member LLC takes its owner's row (whether the owner is an individual, a corporation or a partnership), a multi-member LLC the partnership rows, and an LLC taxed as a corporation the S corporation or C corporation row. A multi-member LLC with a C corporation as a member is caught by the partnership rule.

When must a C corporation, or a partnership with a C corporation partner, use accrual?

Unless an exception below applies, when average annual gross receipts for the three tax years before the current year exceed $32,000,000 (Rev. Proc. 2025-32, section 4.30; section 448(c)). The corporation or partnership must then change to accrual effective for the year the test fails, and files Form 3115 to do it (Publication 538).

• Add the gross receipts of the three prior years and divide by three, then repeat the test every year with the three years before it. Short years, a business under three years old and a predecessor's receipts change the figure.
• Gross receipts are sales net of returns and allowances, amounts received for services, and income such as interest, dividends, rents and royalties. Cost of goods sold is not subtracted, and sales tax that the law puts on the buyer is left out (Reg. 1.448-2, paragraph (c)(2)(iv)).
• Businesses treated as a single employer under the section 52 and section 414 rules count as one person, and sales between them are left out (section 448(c)(2)). A business with modest sales of its own can fail the test once a related company's sales are added. Who counts as related depends on ownership facts.
• A qualified personal service corporation can use cash at any size. It is a corporation whose activities are substantially all in health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, and whose stock is substantially all held by the people who do that work, retired employees, their estates or, for two years, a person who inherited the stock (Publication 538).

What counts as gross receipts for a marketplace or platform seller is in gross or net revenue for a marketplace. How the test is figured, and the forced switch itself, are in switching from cash to accrual.

Does holding inventory force accrual?

Not for a small business taxpayer. That is a business that is not a tax shelter and has average gross receipts for the three prior years within $32,000,000. It may choose not to keep a formal inventory, though its inventory method must still clearly reflect income (section 471(c); Publication 334). For an individual owner, the receipts of all the owner's trades or businesses count, plus the owner's share of any partnership or S corporation receipts; wages and other personal amounts do not (Reg. 1.471-1(b)(2)). How it treats its stock is in inventory or supplies for small sellers.

For any other business whose income depends on making, buying or selling goods, and for a small business taxpayer that chooses a formal inventory, inventory forces accrual for purchases and sales and a yearly valuation of stock. It can use cash for everything else, which is a hybrid, but only if cash is open to it at all. A tax shelter, or a C corporation or partnership with a C corporation partner over the receipts limit, must use accrual for every item (Publication 538; Reg. 1.446-1; Reg. 1.448-2(a)(3)). Changing the inventory method takes Form 3115 (Publication 538).

What is a hybrid or modified cash method?

A hybrid method mixes cash and accrual. The IRS allows any combination that clearly reflects income and is used consistently, with three limits (Publication 538):

• if inventory is needed, purchases and sales use accrual;
• if income is on cash, expenses are on cash;
• if expenses are on accrual, income is on accrual.

A combination that includes cash counts as cash for the receipts limit.

"Modified cash basis" is not one of the methods Publication 538 lists for a return; the IRS word is hybrid. If a lender or accountant asks for modified cash statements, ask which items they want on accrual, such as loans, depreciation, or unpaid invoices and bills, and get the answer in writing.

Does the choice change my taxes, or only when income and expenses are counted?

It mainly changes the year an item falls in. A December sale paid in January is this year's income on accrual and next year's on cash, so a given year's profit, and its tax, can differ between methods. On accrual, tax can be due on a sale before the customer pays, though some service businesses may leave out billed amounts they expect not to collect (section 448(d)(5)).

When a business changes method, an adjustment may be required so that income or expense is not duplicated or omitted (Schedule C instructions; Instructions for Form 1120).

Does the choice change what a lender sees?

Yes. Cash statements show money in and out. Accrual statements also show unpaid invoices and unpaid bills.

A business already on accrual for tax has one more link to its statements: it cannot treat income as earned later than an audited GAAP statement used for credit or for reporting to its owners does (section 451(b)).

No tax rule or IRS source says which basis a lender must accept. Each lender sets its own. Ask in writing: which basis, how many periods, who must prepare the statements, and whether they are compared to your filed returns. See financial statements for a bank loan and SBA loan financial statements.

Can I keep accrual books while filing a cash-basis return?

Yes, if the business may use the cash method for tax and keeps a reconciliation of the accrual books to the return, with records that support it. IRS guidance says that satisfies the rule tying the return to the books (Rev. Proc. 2015-13, sec. 2.01(4); Reg. 1.446-1(a)(4)). Publications 334 and 583 say more simply to use the same method for both, and the method must still clearly reflect income, so have a preparer confirm the position. See accrual books and a cash-basis tax return.

Can I choose either method when I start, and can I change later?

You can choose any permitted method on your first return without IRS approval, then must use it consistently (Publication 538; Reg. 1.446-1). A new business of an existing taxpayer can adopt a method for that business.

After the first return, a change from cash to accrual, or back, generally needs IRS approval on Form 3115 (IRS: About Form 3115). Some changes are automatic and others need approval first; a change forced by the receipts limit is made with automatic consent on the same form (Reg. 1.448-2(g)). See switching from cash to accrual and, for a new LLC, setting up books for a new LLC.

Example

All figures are illustrative, in US dollars.

A solo consultant

A sole proprietor consultant bills $90,000 a year, holds no stock and files Schedule C on cash. A $6,000 invoice sent in December is paid in January. On cash, that $6,000 is next year's income. A bank that asks for accrual statements would count it in the year of the sale. Unless the business is a tax shelter, nothing bars cash for tax, and books on the same basis are the simplest to keep.

An S corporation selling from stock

An S corporation with no related businesses and no tax-shelter status sells $2,000,000 a year of product it keeps in stock. It is not barred from cash. Its average receipts are well under the $32,000,000 inventory limit, so it is not required to keep a formal inventory. If it keeps one instead, purchases and sales use accrual and the rest can stay on cash.

A C corporation over the limit

A C corporation that is not a qualified personal service corporation, does not farm and has no related businesses reports $36,000,000, $40,000,000 and $44,000,000 of gross receipts in Years 1 to 3. The average is $40,000,000, above the $32,000,000 limit (taken as the limit in every year here), so Year 4 must be on accrual. Year 4 receipts fall to $30,000,000. The Year 5 test uses Years 2 to 4: $40,000,000, $44,000,000 and $30,000,000 average $38,000,000, still over the limit, so Year 5 stays on accrual.

Different for you?

• A lender, investor or buyer wants accrual statements while you file on cash: the differences between the books and the return should be reconciled in the records. See accrual books and a cash-basis tax return. If the books are cash-only or behind, see bookkeeping help.
• You must switch, or your sales and related businesses' sales are near the limit: the count is group-wide and fact-dependent. Switching from cash to accrual covers Form 3115 and the adjustment. If the books also need converting, see bookkeeping help.
• Stock on hand has crept into the business: inventory or supplies for small sellers and cost of goods sold on Schedule C.
• Past returns may have used a method the rules did not allow, such as cash after average receipts passed $32,000,000, or no inventory when you held stock. See switching from cash to accrual, fixing inventory missing from past returns and bookkeeping help.
• Your partnership has a corporate partner, or investors who do not run the business or came in through a funding round: the C corporation partner and tax shelter rules can bar cash. See bookkeeping help.
• You are in Canada: cash or accrual in Canada.