Most small businesses use cash-basis accounting for their operations.
And that makes sense. First of all, cash-basis accounting makes a firm’s bookkeeping easy because it simply counts income when a firm receives cash and (generally) counts expenses when a firm disburses cash.
Second, though tax law prefers accrual-basis accounting (and in fact requires accrual-basis accounting in some situations, as discussed in later paragraphs) a special dispensation for small businesses, Rev. Proc . 2001-10, says small businesses with less than $1,000,000 in average annual gross receipts can use cash basis accounting in spite of its flaws.
Note: Even a business with less than $1,000,000 in revenues must delay expensing inventory purchases until the later of the date the inventory is sold or the date the inventory is paid for.
However, if you’re a business owner, you need to be aware of the reality that in a variety of situations, U.S. tax laws, treasury regulations, and related rules require a small business to use accrual basis accounting for a simple reason: Accrual-basis accounting provides for better measurement of profits and so a fairer calculation of taxes.
Accordingly, in this post, I’m going to talk about two things: First, when a cash-basis small business taxpayer needs to switch from cash-basis accounting to accrual-basis accounting. Second, the general process you step through to prepare Form 3115 for a cash to accrual accounting method change—which is how you report this change to the IRS.
Switch if You Answer Any Question “Yes”
Okay, this is all pretty byzantine, but probably the easiest way to determine if and when you need to switch is by asking and answering a series of questions. If you can answer any of the following questions “yes,” then you need to switch from cash-basis to either a hybrid of cash-basis and accrual-basis accounting or full-on accrual-basis accounting.
Are You a C Corporation with Average Annual Revenues Over $1,000,000 But Not Over or Equal to $5,000,000?
If you operate as a “C” corporation but not as a “personal service corporation” and your operation has generated more than $1,000,000 a year, but not more than $5,000,000, in revenues on average over the last three years, tax law (specifically IRC Sec. 448, and the related Treasury Regs at 1.448) say you can’t necessarily use 100% cash-basis accounting.
Note: A personal service corporation is a “C” corporation that sells personal services provided by the corporation’s shareholder-employees. For example, a professional services firm of lawyers, consultants or physicians if operated as a “C” corporation and owned by the lawyers, consultants or physicians may be treated as a personal service corporation.
Now if you’re totally a service business and you don’t sell inventory, sure, you can use cash basis accounting.
But if you have inventory, you do need to at least account for your revenue and inventory using accrual accounting once you trip over the $1,000,000 in revenue threshold.
People often call this mixed approach “hybrid” accounting because you use accrual accounting for your revenues and for your inventory and cost of goods sold but then cash accounting for pretty much everything else.
Note what this means, though: If you’re a “C” corporation currently using cash accounting and you trip over other $1,000,000 threshold and you sell inventory, you probably need to change either to hybrid or accrual accounting.
Are You an C Corporation with Average Annual Revenues Over $5,000,000?
If you operate as a “C” corporation (but not as a “personal service corporation”) and your operation has generated more than $5,000,000 a year in revenues on average over the last three years, tax law says you need to change your accounting method from cash to accrual method.
Note: This “C” corporation category includes any corporation that hasn’t made a Subchapter S election, including real estate investment trusts and nonprofit corporations that operate as exempt organizations.
Are You a Partnership with a C Corporation Partner and Average Annual Revenues Over $5,000,000?
A partnership with a C corporation partner must also use accrual method accounting if the annual average revenues over the last three years exceed $5 million.
Are You a Partnership, Sole Proprietorship, or S Corporation?
I already mentioned the $5,000,000 threshold which applies to “C” corporations. But a similar, though higher, $10,00,000 threshold applies to sole proprietors, “S” corporations, partnerships without “C” corporation partners, and qualified personal service corporations if taxpayers are principally service businesses or are custom fabricators or are not included in the NAICS codes for mining (NAICS codes 211 through 212), manufacturing (NAICS codes 31 through 33), wholesaling (NAICS code 42), retailing (NAICS codes 44 and 45) or information business (NAICS codes 5111 and 5122).
For businesses in these categories, as per Rev. Proc. 2002-28, the firm may generally use cash-basis accounting. But do note that if you have inventory—and you probably don’t if you qualify per the terms of Rev. Proc. 2002-28—you need to use accrual-style accounting for those inventory and cost of goods sold items. (For example, you might use the nonincidental materials and supplies rule, which essentially says the business can’t expense inventory until the later of the the point the inventory is sold or the point the inventory is paid for.)
If you’re operating a partnership, sole proprietorship, S corporation or qualified personal service corporation and you don’t qualify per Rev. Proc. 2002-28 to use cash basis accounting, you are required to use accrual basis accounting. And note what this essentially says is if you’ve got inventory in your business and you’re generating more than $1,000,000 in revenue, yup, you need to use accrual basis accounting.
Tip: Just in case you are operating an S corporation, can I mention something sort of off topic but also possibly helpful?
We’ve got a great 50pp monograph which outlines the rules for setting S corporation shareholder-employee salaries. If you or your clients wrestle with this issue, you would probably find the monograph very helpful.
More information is available here “Setting Low Salaries for S Corporations“.
Farming Corporations
Farming corporations need to know about a couple of other rules.
C corporations operating farms generally need to accrual accounting if average annual gross receipts exceed $1,000,000. But there is an exception to this general rule. If the C corporation qualifies as a family farm corporation, the corporation doesn’t have to use accrual accounting unless the average annual gross receipts (based on the last three years) exceed $25,000,000.
Note: A family farm corporation is one where the members of family own at least 50% of the corporation’s stock.
Preparing 3115 to Report Change from Cash to Accrual
If you have been using cash basis accounting or hybrid accounting and need to change to full accrual accounting, you should do that. It’s the law, after all.
But you need to do more than simply begin using accrual accounting on your tax returns. Specifically, you need to calculate any adjustment required to make sure that income or deductions don’t drop between the cracks due to the switch (this is called a Sec. 481 adjustment). And you need to explicitly document and describe the accounting method change and the Sec. 481 adjustment amount using Form 3115.
You first file one copy of the 3115 form with the IRS’s National Office (typically) and then after that you attach another copy of the Form 3115 to your tax return. You may in certain situations also need to provide copies of the 3115 to other IRS employees or workgroups, as explained in the relevant revenue procedures.
This blog post has gone on way too long—and we may publish an monograph with sample forms and full-blown instructions if people show interest. So I won’t say much more. But let me make two other points about Form 3115 and the Sec. 481 adjustment.
First about the Form 3115 you file to request permission to change your accounting from cash to accrual: You requesting permission to make this change—a change required by tax law—seems crazy, I know. But you need to follow the prescribed procedure so you don’t inadvertently let income or deductions drop between the cracks—and so you gain some special benefits afforded to people who “play by the rules.”
Second, note that normally with cash-basis accounting, a firm delays reporting income and therefore delays paying taxes on the delayed income. What this means is that this “would have been reported earlier” income drops between the cracks when you switch from cash accounting to accrual accounting. And because the IRS is full of pretty smart accountants and tax lawyers, they of course watch carefully for this. Further, what your Form 3115 with its Sec. 481 adjustment does is report this amount.
Note: If the adjustment is a bump in taxable income, you typically get to split the amount over four years to soften the burden—this is actually one of the benefits you gain when you “play by the rules.” If the adjustment is a cut in taxable income, you can report the entire adjustment at once.
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Been looking all over online for a straight answer to this question. I am a Small business, sole proprietorship. Been using Cash basis accounting. Less than 50,000 in revenue.
Will start using Hybrid method to use accrual on ticket sales inventory. Making this change specifically because New Years Eve ticket sales and expenses span over two separate years.
I read on irs.gov in regards to Hybrid method… “Any combination that includes the cash method is treated as the cash method for purposes of section 448 of the Internal Revenue Code.”
So does this mean I do not need to file form 3115 stating I am now using the hybrid method, because it is still considered Cash over all?
Thank you
IF you’re changing an existing accounting method, yes, you’re supposed to file a 3115. You do this, by the way, so you can report any adjustment necessary to make sure no income drops between the cracks.
BTW, if you’re not changing an existing accounting method–you’ve got some new transaction and for that new transaction you’ll use accrual accounting–then I don’t think you have a change in accounting method. And note, too, there’s no risk in this case of something dropping between the cracks because you’ve switched methods…
Hi Steve. Thanks for the great article.
What is a business to do if it has been using one method of accounting, say the accrual method, but erroneously designating on its federal returns that it is using another method, say the cash method? So, say Business X has been using an accrual method of accounting since it began business in 2012. However, Business X on each of its federal returns (Schedule C) has checked the “cash” accounting box. What is Business X to do? The logical thing to do, it seems to me, is to amend all the returns.
I think you could just start filling out your returns correctly going forward.
I.e., you’re not changing accounting methods. You’ve already been an accrual basis taxpayer. If IRS ever asks you, you can explain and ask them if they want you to amend returns because the wrong box got checked. I doubt the agent would care.
Steve,
Thanks for the reply. I just emailed you via the contact email on your website. Please let me know if you do not receive the email. Thanks again.
Michael
Can you use the form 3115 to change an accounting method for a prior year? for example, we have been cash basis since we started, but for several reasons, want to change to accrual. Can I submit the form 3115 for the tax year 2016 or can you only file the form for the current and future years?
Thank you
You can get automatic consent probably for a change from cash to accrual. So that should mean you can file the 3115 with the 2016 return.
In your case, you’d really be filing the 3115 to show your calculations for the Sec. 481 adjustment.
P.S. Remember that you can have a different book accounting method than tax accounting method. So you would want to be converting to tax accrual accounting method for tax reasons–like maybe a requirement to do so… or a need to use accrual to get some benefit like a Sec. 199 deduction.
More info about that here: https://evergreensmallbusiness.com/the-software-as-a-service-saas-sec-199-loophole/
Steve,
First, will i get rejected if i file form 3115 with the 2016 extension and not filed for 2015? Second, what position does the irs take for cash deposits using accrual based accounting?
You wouldn’t file a 3115 with the extension… your extension is just that little slip of paper. (The 4868 voucher thing-y.)
With regard to cash deposits and accrual accounting, the general rule for income recognition is you report income when you’ve done what you need to do to earn the income and you know the amount (Treas Reg. 1.46101(a)(2).)
Hi Steve — appreciate all the advice in this column. I’m the treasurer for a non profit bicycle club and we’ve historically filed on a cash basis. I presume that if we move to an accrual basis we would also have to report income that way — our membership renewal fee is low and many people pay 2-3 years in advance.
Thanks !
Dave.
Hi David,
Not sure if I understand your comment, but you can definitely change from cash to accrual and that will impact how you file your tax returns. I may be reading too much into your comment, but you don’t need conformity of your book accounting method and your tax accounting method for ever… just at the start. A final point: I would make sure understand the details of tax accrual accounting… the mechanics won’t match GAAP accrual accounting.
Thanks for this thread. We operate a small school of traditional herbalism and are in the process of completing the form 3115 in order to change to the Accrual Method from Cash. In Part II, question 16a it states that we must “Attach a full explanation of the legal basis supporting the proposed method…” Do you know where I can find that explanation to include?
Thanks!
You probably aren’t required to fill those parts of the form out if you’re requesting an accounting method change for which there’s automatic consent. (I don’t know the specifics of your situation… but it sounds like an automatic consent situation…)
Hello,
How does a change in accouting method affect the NYS/NYC taxation? Is there a form to file there?
Steve,
Great practical advice. Thank you from all of us who benefit from your willingness to share your knowledge of this arcane corner of the the craft. My question is probably
a basic one for you: where is a positive 481(a) adjustment entered on a 1065?
I think you report the Sec. 481 adjustment as “other income” so line 5 on an 1120S and then line 7 on a 1065.
BTW, while this is the way we do it, because of your question, I looked at an entity return prepared last year by a large firm which I happened to have. And they do or did the same thing.
Greetings, if an S Corp meets the requirements to use the accrual method due to level of sales and use of inventory is form 3115 required to be filed with the IRS? I do not believe it is because a change of accounting method is not being requested by taxpayer but the accounting change is required based on operation of law (sales threshold)???
You do need to file the 3115. In other words, yes, even though you’re required to make the change in the accounting method, you still need to file the form that asks for permission to make the change.
Two additional bits of information will make this make sense:
1. IRS gives automatic consent in these cases… so you’re not really getting their permission.
2. The reason you file the 3115 is to show your calculations of the Sec. 481 adjustment–the adjustment you make to make sure income or deductions don’t drop between the cracks when you switch from one accounting method to another accounting method.
Steve,
If I am doing Form 3115 cash to accrual change for a small construction contractor, and took in one big check in December for $182,000., but the work done in 2016 was minimal and it was finished in 2017, can I apply for an automatic change DCN 84? Deferral of most of that payment? or does that require a non automatic change. I am unclear on when advance pmts are allowed as an automatic change.
Hi Rebecca, you surely can change from cash to accrual (though that seems a little extreme for a single transaction)… But it sounds like what you need to do first is carefully map your advance payment situation to the way cash accounting and then accrual accounting treat the advance payment of your situation.
Probably, probably, cash accounting treats the advance payment as income when received. Probably accrual accounting treats the payment as income when the work is complete.
The cash to accrual is a DCN 122.
But to defer the pmt is it a DCN #84?
I thought so, but wasn’t sure, and can the deferral of this type advance pmt be considered an AUTOMATIC change?
Will the 100 page ebook you sale have a sample completed 3125 form?
Meant 3115 ….and need sample of completed 3115 when changing from cash to accrual?
Hi Will, the ebook shows completed 3115 forms… but not for a cash to accrual accounting method change. Sorry. (Your comment makes me think we should do that…)
Does anyone know if NY honors the IRS Form 3115, or do we need to ask NY separately for the change we are making to Form 3115?
Hi Steve:
A Real Estate (multi family housing rentals) Partnership filed its 1065 on the accrual basis from inception, 2014, and then again in 2015. The accounting method box page 1 was improperly checked “Cash”. When filing 2016 caught the error and will be checking “accrual”. Do we need to file form 3115? Again, in both prior years the returns were filed accounting for all transactions on the accrual basis……
Thanks,
I don’t think so. You didn’t change your accounting method… you merely checked the wrong box.
BTW, I personally wouldn’t amend the prior returns to “uncheck” the box since that would presumably restart the statute of limitations timeclock.
Steve,
A C corporation with annual gross receipts over $5 million dollars for tax years 2011 through 2016 has filed their tax returns on a cash basis. The $5 million dollar average gross receipts may have been exceeded prior to the 2011 tax year. I need to request the returns from the corporation. The returns should have been filed on an accrual basis. Should Form 3115 be filed for the 2017 return? Should the 2016 or prior returns be amended?
I think C corp should probably be using accrual and for some time. The best answer I’m going to be comfortable giving you at a blog is, you want someone who’s really comfortable with rules for making accounting method changes to help you make this change in a way that dials down costs and risks.
Sorry I can’t do better than that here…
Steve,
A C corporation with annual gross receipts over $5 million dollars for tax years 2011 through 2016 has filed their tax returns on a cash basis. The $5 million dollar average gross receipts may have been exceeded prior to the 2011 tax year. I need to request the prior year returns from the corporation. The returns should have been filed on an accrual basis. Should Form 3115 be filed for the 2017 return? Should the 2016 or prior returns be amended?
Am cash basis sole proprietor who received a sizable deposit at end of 2017 for work to be done in Spring 2018. Is the deposit taxable income in 2017 or 2018? All expenses related to the deposit will not be incurred until 2018.
If you’re a cash basis taxpayer, the cash you received in 2017 gets taxed in 2017.
Note: Your customer if a cash basis tax payer probably got to deduct payment as expense in 2017…
I am a sole-proprietor small travel business. For 2016 filing, I was advised by a CPA to to cash accounting which was ok and did not amount to much in taxes as I was a new company. For 2017, however, I have taken in a large amount and paid as many of the trip bills as could be paid before the end of 2017. However, I have just come to realize that I am paying taxes on money received that is NOT income for me, but merely money “on hold” until it comes due to be paid out in 2018. From what I read above, I should change to accrual method. While others have asked, I must ask again. Can I change the method for the 2017 return so I don’t have to pay taxes on all of this money received, simply by completing the form 3115 and submitting it along with the return? OR, is it too late to fix this for 2017?
You probably can, yes. But it’s not really a DIY project. I’d find a local tax accountant to help you check your math and then prepare the 3115 and the associated tax return.
I’m in the process of filling out the Form 3115 to file with our tax return for 2017. Just can’t figure out which DCN code to use? It’s not our first year in business so I’m thinking it’s code 122. Any insights if this is correct or where to find the correct one?
You want to look here: https://www.irs.gov/irb/2017-18_IRB
But also this comment: This is probably something you want to outsource to your CPA who does these 3115 forms all the time.
My S-Corp has been filing on a cash basis for 15 years but Probably should have been accrual. This was not much of an issue because our sales were not much but for the past 5 years our total receipts have generally been above $1 million. We design and build specialty capital equipment. If we request to refile for 2015 and 2016, the IRS would owe us money. If we include 2014, it would be a wash. Is it worth trying to refile our 1022S and my 1040 for those years? We still need to request a change for 2017.
I would think you make your accounting method change for the next tax return you file.