Switching From Cash to Accrual Accounting: When You Must and How

When do we have to switch from cash to accrual for tax?

A C corporation, or a partnership with a C corporation partner, must leave the cash method for any tax year in which its average annual gross receipts for the 3 prior tax years pass $32,000,000 (section 448; Rev. Proc. 2025-32). An S corporation or a partnership with no corporate partner is not forced off cash by size alone, but one with inventory must use accrual for purchases and sales once it passes the limit. Below the limit, investors wanting accrual financials is a reason to change the books, not the tax return.

What makes a case less simple: a parent or fund that owns more than half of the company, inventory, long-term contracts, a year already filed on the wrong method, or an IRS examination under way. Gather the gross receipts for the last 3 tax years of every company in the group, the ownership chart, and lists of unpaid customer invoices, unpaid bills and inventory as of the first day of the year.

Investors want accrual financials: can the books be accrual while the tax return stays on cash?

Yes. A company under the limit can keep monthly accrual books for its board and file its return on cash. The tax records must then include "a reconciliation of any differences between such books and his return" (Reg. 1.446-1(a)(4)), which carries to Schedule M-1 of Form 1120 (the schedule that reconciles book income to taxable income).

• Trap: a C corporation with total assets of $10,000,000 or more at year-end files Schedule M-3 instead of Schedule M-1; below a higher asset line it may complete only Part I and use Schedule M-1 for the rest (Instructions for Form 1120). A funded startup with a large raise in the bank often crosses that line long before it crosses the receipts limit.
• Choosing to switch anyway: a company under the limit may move its return to accrual by choice (Form 3115, change number 122, the number that identifies the change on the form). The choice is sticky: no automatic overall method change is allowed within five years of the last one (Rev. Proc. 2015-13, sec. 5.01(1)(e)), and moving back to cash speeds up any part of the earlier adjustment not yet taken (Rev. Proc. 2025-23, sec. 15.17(7)(a)). A company forced onto accrual in its mandatory year is not held to the five-year wait if its receipts later drop back under the limit (sec. 15.17(6)).

Can a C corporation, an S corporation or a partnership use the cash method?

The answer turns on the type of entity, the receipts test and inventory.

A partnership, LLC or S corporation is a syndicate in a year when more than 35% of its losses go to limited partners or owners who do not actively manage the business. "Losses" means a net loss for the year, so a profitable year cannot trip the rule (Reg. 1.448-2(b)). C corporations are outside this test.

How do we figure the gross receipts test?

Add the gross receipts for the 3 tax years before the year being tested and divide by 3. A company in existence for less time uses the years it has (section 448(c)(3)).

• Annualize a short tax year: multiply by 12 and divide by the months in it.
• Reduce receipts by returns and allowances, and include any predecessor's receipts.
• Count receipts under the method used in each year.
• Include interest, dividends, rents, royalties and other investment income (Reg. 1.448-1T(f)(2)(iv)), so interest earned on a large raise counts. The money investors pay for shares is none of these, so it generally stays out.
• Leave out loan repayments and sales tax the company only collects and remits for a state.

Does a parent's sales count?

Usually yes. Section 448(c)(2) treats as one company everyone treated as a single employer under section 52(a) or (b), which uses the controlled group rules. A parent that owns more than 50% of the company brings in its own sales and those of its other subsidiaries, and a fund or partnership that controls the company counts too. Companies owned directly by the same few people, such as one family's two corporations, are combined only under a separate, stricter ownership test (IRS aggregation FAQs, Q-3, which are not binding). The rule that drops foreign corporations from a controlled group sits in a part of section 1563 that section 52(a) does not bring in, so a foreign parent and foreign sister companies generally count. No IRS guidance says this directly; it follows from the wording of sections 52(a) and 1563. Sales between group members drop out (Reg. 1.448-1T(f)(2)(ii)).

A new US subsidiary of a large group can therefore be barred from cash from its first return. Choosing a method on a first return needs no Form 3115; see your first business tax return.

What else changes in the year we pass the limit?

Several small business exemptions use the same test, so they end in the same year: the first tax year whose prior-3-year average passes the limit.

Is cash to accrual an automatic change, and how do we file Form 3115?

Yes. A change from cash to accrual is an automatic change under Rev. Proc. 2025-23, sec. 15.01: change number 257 in the first year section 448 bars cash (the "mandatory year"), and 122 otherwise. A change forced by section 448 is treated as made with IRS consent, and in the mandatory year the five-year rule is waived (sec. 15.01(5)).

1. Attach the original Form 3115, with Schedule A, to the timely filed return for the year of change, extensions included (Instructions for Form 3115).
2. Send a signed copy to the IRS in Ogden (M/S 6111), or by fax, no earlier than the first day of the year of change and no later than the day the return is filed. The IRS sends no acknowledgment.
3. List every concurrent change on the same Form 3115, such as inventory, section 263A and the deferral method for advance payments (sec. 15.01(3)(d) and 22.20(4)). The change is not allowed if the company skips a special method it is required to use.

A company that finds out while closing the year that it passed the limit can still make the change for that year, as long as the Form 3115 goes with that year's timely filed return.

Can we switch from cash to accrual mid-year?

No, not for tax. The year of change is a whole tax year (Rev. Proc. 2015-13, sec. 3.19), so the books are converted back to the first day of that year. Changing a report setting in bookkeeping software changes what the reports show, not the tax method.

How is the section 481(a) adjustment figured, and over how many years?

The adjustment exists "to prevent amounts of income or expense from being duplicated or omitted" (Instructions for Form 1120). Figure it as of the first day of the year of change.

• Start with unpaid customer invoices, subtract unpaid deductible bills and accrued expenses, and add or subtract inventory and other items.
• Leave out receivables already worthless at the end of the prior year (Rev. Proc. 2025-23, sec. 15.01(3)(a)).

A corporation reports a positive amount on Form 1120 line 10 and a negative one on line 26; a partnership uses Form 1065 line 7 or line 21 (Instructions for Form 1065). Ceasing the business speeds up the rest (Rev. Proc. 2015-13, sec. 7.03(4)(a)). A positive adjustment on a change filed while under examination is generally taken over 2 years instead of 4 (sec. 7.03(3)(b)).

How do we switch the books without counting income twice?

Record opening balances as of the first day of the year, then post later cash against them rather than to revenue or expense.

• Opening receivables, payables, accrued wages and accrued colocation power.
• Unearned customer prepayments as deferred revenue; annual software contracts paid up front as prepaid assets.
• Inventory on hand and amounts owed to contract manufacturers.
• The offset goes to opening retained earnings.

Collections and payments in the first weeks of the year then clear those balances. The tax adjustment starts from the same balances but can differ item by item:

• whether customer prepayments can be deferred: see customer prepayments and deposits;
• when an expense is incurred for tax, where the recurring item exception can be adopted with the change (sec. 15.01(1)(a)(i));
• amounts owed to a related foreign party, generally deductible only when paid (Reg. 1.267(a)-3); see foreign company entering the US.

Revenue policy for audited or reviewed statements belongs to the auditor. Who keeps the books and how they are reconciled is covered in doing your own books or hiring a bookkeeper.

We should have switched last year: what now?

File Form 3115 (change number 122) with the current year's return. Sec. 15.01 also covers a year other than the mandatory year, and a timely Form 3115 generally means the IRS will not require the change for earlier years (Rev. Proc. 2015-13, sec. 8.01). That protection is generally lost if the company is under examination when it files (sec. 8.02(1)), so timing matters. The company does not amend old returns to switch.

How does Canada compare?

Why this matters for AI infrastructure companies

Accrual books show prepaid GPU capacity as deferred revenue and amounts owed to an AI chip startup's contract manufacturer as payables. A switchgear, power or liquid cooling supplier riding AI data center orders can pass the limit in one year, before its systems and staff change. More for this industry: data centers.

Example

All figures are illustrative, in US dollars.

A GPU cloud startup under the limit

A Delaware C corporation formed in January 2024 runs a GPU cloud. It closes a $20,000,000 Series A in March 2026, and the board wants monthly accrual statements. Receipts were $2,000,000 in 2024 and $8,000,000 in 2025: a $5,000,000 average over its two years, far under the limit.

• 2026: the books go to accrual from January 1; the 2026 Form 1120 stays on cash. At year-end it has $1,500,000 of unpaid customer invoices and owes $600,000 to its Dallas colocation provider and network vendors; none were open on January 1. Book income runs $900,000 above the cash return.
• Reconciliation: year-end total assets top $10,000,000, so it files Schedule M-3, at least Part I. Assume it has a tax loss under either method; then the method changes the loss carried forward, not 2026 tax.
• 2027, if it is still under the limit and chooses to switch (change number 122): the same balances on January 1, 2027 give a positive $900,000 adjustment, taken at $225,000 a year for 2027 through 2030. The $1,500,000 collected in January 2027 clears receivables and is not taxed again.

A cooling and switchgear supplier over the limit

An Ohio calendar-year C corporation supplies liquid cooling and switchgear. Receipts were $18,000,000 in 2023, $30,000,000 in 2024 and $54,000,000 in 2025: a $34,000,000 average, over the $32,000,000 limit. 2022 receipts were $12,000,000, so its 2022-2024 average of $20,000,000 stayed under the 2025 limit, so 2026 is its mandatory year. It finds out while closing 2026.

• Conversion: it converts the 2026 books back to January 1, 2026 and attaches Form 3115 (change number 257) to its 2026 Form 1120, due April 15, 2027, or October 15 with an extension. The signed copy goes to Ogden or by fax by the filing date.
• Adjustment: opening receivables of $9,000,000, less $4,000,000 of payables and accrued wages, give a positive $5,000,000 adjustment: $1,250,000 a year for 2026 through 2029. Its inventory and section 263A changes go on the same Form 3115 with their own adjustments, left out here.
• Same year: the inventory and section 263A exemptions end and the interest limit starts. New installation contracts signed in 2026 lose the small contractor exemption.

A foreign group's new US subsidiary

A Taiwanese power equipment maker with $400,000,000 of sales forms a wholly owned Texas subsidiary in 2026. The parent's sales count toward the subsidiary's test, and sales between them drop out. The parent's outside sales alone pass the limit, so, on the reading of section 52 above, the subsidiary generally cannot use cash on its first return: it adopts accrual there, with no Form 3115. Interest on the parent's loan falls under the interest limit from the first year.

Different for you?

• Books months behind: catching up on overdue books.
• Tariffs and duties in inventory cost: tariffs and duties on imported equipment.
• S corporation ending its election to take venture or foreign money: switching an S corporation to a C corporation.
• Missed filings found in due diligence: tax clean-up before investor due diligence.
• How a C corporation's loss carries forward: how C corporations are taxed.
• Canadian startup moving under a Delaware parent: moving a Canadian startup under a Delaware parent.
• Need monthly accrual books, the conversion, and the Form 3115 with your return: bookkeeping.