Business Entities and Considerations · Business entities

Accounting methods

Accounting method questions come in two kinds, and it helps to know which one you are looking at. “May this taxpayer use the cash method” is a question about size and entity type with a mechanical answer. “When is this item taken into account” is a question about the all events test and economic performance, with an analytical one. They meet at a single number: the same gross receipts figure now governs three separate small-business exemptions, so one threshold decides whether a business faces the cash method limit, the inventory rules and uniform capitalisation at all.

The rule

The method follows the books. taxable income is computed under the method of accounting on the basis of which the taxpayer regularly computes income in keeping its books; where no method has been regularly used, or the method used does not clearly reflect income, the computation is made under such method as in the opinion of the Secretary does clearly reflect it (IRC § 446(a), (b))^TY2026

What the methods are. the permissible methods are the cash receipts and disbursements method, an accrual method, any other method permitted by chapter 1, or any combination of them permitted under regulations (IRC § 446(c))^TY2026

One taxpayer, more than one method. a taxpayer engaged in more than one trade or business may, in computing taxable income, use a different method of accounting for each trade or business (IRC § 446(d))^TY2026

Changing a method. a taxpayer who changes the method of accounting on which it regularly computes income in keeping its books must secure the consent of the Secretary before computing taxable income under the new method; the absence of that consent is not taken into account to prevent or reduce any penalty or addition to tax where no request was filed (IRC § 446(e), (f))^TY2026

Who may not use cash. a C corporation, a partnership having a C corporation as a partner, and a tax shelter may not compute taxable income under the cash receipts and disbursements method — subject to exceptions for a farming business, a qualified personal service corporation, and an entity meeting the gross receipts test (IRC § 448(a), (b))^TY2026

The gross receipts test. $32,000,000 — a corporation or partnership meets the gross receipts test for a taxable year beginning in 2026 if its average annual gross receipts for the 3-taxable-year period ending with the preceding taxable year do not exceed that amount. The figure for taxable years beginning in 2025 was $31,000,000, and the unindexed statutory base in IRC § 448(c)(1) is $25,000,000^TY2026

How the test is computed. all persons treated as a single employer under IRC § 52(a) or (b) or § 414(m) or (o) are treated as one person for the test; an entity not in existence for the whole 3-year period applies it over the period it existed; gross receipts for a taxable year of less than 12 months are annualised; gross receipts are reduced by returns and allowances; and a reference to an entity includes any predecessor (IRC § 448(c)(2), (3))^TY2026

Inventories, for a business under the threshold. a taxpayer other than a prohibited tax shelter that meets the IRC § 448(c) gross receipts test is exempt from the inventory requirement, and its inventory method does not fail to clearly reflect income if it either treats inventory as non-incidental materials and supplies or conforms to the method reflected in its applicable financial statement, or in its books and records prepared under its accounting procedures where it has no such statement (IRC § 471(c))^TY2026

Uniform capitalisation, likewise. {fig:method.small_263A}

When an accrual item is incurred. the all events test is not treated as met any earlier than when economic performance occurs. Where the liability arises out of services or property provided to the taxpayer, economic performance occurs as they are provided; where it requires the taxpayer to provide property or services, as the taxpayer provides them; and where it requires a payment under a workers compensation act or arising out of a tort, as the payments are made (IRC § 461(h)(1), (2))^TY2026

The recurring item exception. an item may be treated as incurred before economic performance where the all events test is otherwise met, economic performance occurs within the shorter of a reasonable period after the close of the year or 8½ months after it, the item is recurring and consistently treated that way, and either the item is not material or accruing it earlier produces a more proper match against income — the treatment on financial statements being taken into account (IRC § 461(h)(3))^TY2026

The adjustment on a change. in the year of a change of accounting method there must be taken into account those adjustments determined to be necessary solely by reason of the change, in order to prevent amounts from being duplicated or omitted (IRC § 481(a))^TY2026

Current figures

How it works in practice

Start with IRC § 446(a), because it is more restrictive than it looks. The method for tax is the method on which the taxpayer regularly computes income in keeping its books — not a method chosen on the return each year. A business whose books are on the accrual basis does not have a free election to file on cash; it has a book method, and filing differently is either an error or an unconsented change of method.

The one genuine freedom is IRC § 446(d): a taxpayer with more than one trade or business may use a different method for each. The condition implicit in that is separate and complete books for each business, since the method attaches to the books. A sole proprietor with a woodworking business and a restaurant may keep one on cash and the other on accrual, and the reason it works is that there are two sets of records, not that there are two Schedules C.

The cash method prohibition in IRC § 448(a) has three targets, one of which surprises people: C corporations, tax shelters, and any partnership having a C corporation as a partner, however small the partnership and however small that partner’s interest. The exceptions do most of the work: a farming business, a qualified personal service corporation, and — the one that matters for nearly every ordinary business — an entity meeting the gross receipts test.

The gross receipts test is the single most consequential number in small business tax accounting, because three separate regimes now hang from it. Meet it and the cash method is available notwithstanding IRC § 448(a); the inventory requirement of IRC § 471(a) does not apply; and the uniform capitalisation rules of IRC § 263A do not apply. Fail it and all three arrive together. That concentration is recent and it means a business crossing the threshold faces three changes of method in one year, not one.

Three mechanics are worth holding. The test looks at the three years preceding the year in question, so a business is judged on history. It aggregates across commonly controlled entities (IRC § 448(c)(2)), so splitting a business into two entities does not split the receipts. And short years are annualised, so a business that started in July is not flattered by half a year of receipts.

On the timing side, the all events test alone is no longer sufficient for an accrual taxpayer’s deductions. IRC § 461(h) adds economic performance, and the principle to remember is that economic performance tracks the actual doing of the thing: services received as they are rendered, property received as it is provided, workers compensation and tort liabilities as the money is actually paid. An accrual for a lawsuit that has been settled but not paid fails economic performance no matter how certain the amount.

The recurring item exception softens this and is frequently mis-stated as a general 8½-month rule. It is not general. Four conditions must hold — the all events test met, economic performance within the shorter of a reasonable period or 8½ months, the item recurring and consistently treated, and either immaterial or better matched — and workers compensation and tort liabilities are expressly outside it.

A change of method requires consent whether it increases or decreases income (IRC § 446(e)), and the IRC § 481(a) adjustment makes the change coherent by sweeping up items that would otherwise be counted twice or not at all. Note what IRC § 446(f) does: failing to request consent neither makes the change effective nor shelters the taxpayer, since the absence of consent cannot be used to argue a penalty away.

Scenarios

How this has changed

The small business rules were rewritten in 2017 and the rewrite is the reason this topic looks the way it does. Before it, the cash method threshold, the inventory rules and the uniform capitalisation rules each had their own test at its own level, and the levels differed from one another and, for inventories, by activity. They were consolidated onto the single IRC § 448(c) gross receipts test at a much higher figure, inflation-adjusted annually. Any material describing separate thresholds for these three regimes is pre-2018, and the old figures are low enough that citing one by mistake would exclude almost every business the exemptions were widened to reach.

The indexed figure itself moves every year, and moving between years matters because the test looks back three years: the figure applied is the one for the year being tested, not the one in force when the receipts were earned. The 2025 and 2026 figures differ, and a business between them is on one side of the line in one year and the other side in the next.

Economic performance itself has not moved, but its reach has: a business under the threshold may use the cash method and never meet IRC § 461(h) at all, so a provision that once caught almost every business of any size now applies to a much smaller population.

Exam focus

Expect the eligibility questions rather than the timing ones. The standard shape gives an entity type and a receipts figure and asks whether the cash method is available: run entity type first (C corporation, partnership with a corporate partner, tax shelter), then the exceptions (farming, qualified personal service corporation, gross receipts). Where the question gives receipts for several years, check whether they are the three years preceding the year asked about.

The second recurring shape is IRC § 446(d): one taxpayer, two businesses, and whether the methods may differ. They may, and the condition is separate books. Distractors usually offer either “must be the same” or “may differ if records are combined”, and both are wrong for the same reason.

For the timing questions, look for a tort or workers compensation liability, where the answer is that economic performance occurs on payment and the recurring item exception does not apply.

Check yourself

1. A partnership with average annual gross receipts of $8 million for the three preceding years has four partners, one of which is a C corporation holding 2 percent. May the partnership use the cash method for 2026?

Answer: yes. IRC § 448(a)(2) would prohibit it, because the partnership has a C corporation as a partner, but IRC § 448(b)(3) disapplies that prohibition for an entity meeting the gross receipts test, and $8 million is well under the 2026 figure. The small size of the corporate partner’s interest is not why — it would not have helped at all if receipts had been above the threshold.

2. A sole proprietor operates a bookshop and a consulting practice, keeping a separate general ledger for each. May the bookshop use accrual and the consulting practice cash?

Answer: yes. IRC § 446(d) allows a taxpayer engaged in more than one trade or business to use a different method of accounting for each. Separate and complete books are what make the two businesses distinct for this purpose; combining the records would leave one trade or business and one method.

3. An accrual-basis company is contractually liable at 31 December 2026 for $60,000 of repairs to be carried out by an outside contractor in February 2027, and it pays in March 2027. May it deduct the $60,000 in 2026?

Answer: potentially, under the recurring item exception, but not under the general rule. Economic performance for services provided to the taxpayer occurs as the services are provided (IRC § 461(h)(2)(A)(i)), which is 2027. IRC § 461(h)(3) may allow a 2026 deduction if the all events test was met, economic performance occurs within 8½ months of the year end — February does — the item is recurring and consistently treated, and it is either immaterial or better matched. All four must hold.

4. A corporation’s average annual gross receipts for 2023 to 2025 are $33 million. For the 2026 tax year, is it exempt from the uniform capitalisation rules?

Answer: no. IRC § 263A(i) exempts a taxpayer meeting the IRC § 448(c) gross receipts test, and for a taxable year beginning in 2026 that test is met only if average annual gross receipts for the three preceding years do not exceed the 2026 inflation-adjusted figure. At $33 million it exceeds it, so uniform capitalisation applies — and the cash method and the inventory exemption are lost in the same year.

5. A taxpayer changes from the cash method to an accrual method with consent. Accounts receivable of $90,000 were never taken into income under the old method. What happens to them?

Answer: they enter income through the IRC § 481(a) adjustment. The section requires that the year of change take into account the adjustments necessary solely by reason of the change to prevent amounts being duplicated or omitted. Without it the receivables would be omitted entirely — earned under a method that did not count them, collected under a method that treats collection as irrelevant.