Cash Method of Accounting

The cash method of accounting is the method that reports an item of income in the year it is actually or constructively received, and deducts an expense in the year it is actually paid. Section 446(c)(1) of the Internal Revenue Code names it the "cash receipts and disbursements method," and lists it first among the permissible methods. It is what most individuals and most small businesses use, and Publication 538 says so.

The naming is worth a sentence, because three phrasings are official and a fourth is not. The Code calls it the cash receipts and disbursements method. The heading of section 448, the provision that limits who may use it, calls it the "cash method of accounting." Publication 538 heads its section "Cash Method" and writes "cash method of accounting" in the running text. What neither the Code nor the publication ever uses is "cash basis," which is financial-accounting and bookkeeping vocabulary. It means the same thing in ordinary conversation and it is not the tax term, which matters only when you are looking something up.

The choice of method is not made on a form. Section 446(a) computes taxable income "under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books," so the books decide the method rather than the other way round, and changing it later requires the IRS's consent under section 446(e).

The most useful correction on this page: section 448 does not reach most readers at all. The gross-receipts test is almost universally described as the test for whether a business may use the cash method, and that is not what the statute says. Section 448(a) applies only "in the case of a" C corporation, a partnership which has a C corporation as a partner, or a tax shelter. An individual, a sole proprietor, a single-member LLC and an S corporation are not on that list, so for the overwhelming majority of small businesses there is no entity-level bar to clear and no receipts threshold to watch. What governs them is section 446(a) and 446(b): use the method your books use, and the method must clearly reflect income.

For the entities section 448 does reach, three exceptions in section 448(b) lift the bar: a farming business, a qualified personal service corporation, and any corporation or partnership that meets the gross-receipts test of section 448(c). Read the exceptions carefully and one thing is obvious. Each of them lifts only "paragraphs (1) and (2) of subsection (a)." None of them reaches paragraph (3). So a tax shelter is barred from the cash method absolutely, at any size, and the gross-receipts test cannot rescue it. Section 448(d)(3) defines the term by cross-reference to section 461(i)(3).

The gross-receipts test, and the mechanics that go with it. An entity meets the test for a taxable year if its average annual gross receipts for the three-taxable-year period ending with the preceding year do not exceed $32,000,000. Section 448(c)(1) sets the base figure and 448(c)(4) indexes it from a 2017 base, rounding to the nearest million, which is why the number moves most years. Three further rules apply: 448(c)(2) treats all persons treated as a single employer under section 52(a) or (b), or section 414(m) or (o), as one person; 448(c)(3)(B) annualizes the receipts of a taxable year shorter than twelve months; and 448(c)(3)(C) reduces gross receipts by returns and allowances. An entity that fails the test cannot use the cash method and must change to an accrual method effective for the year it fails, on Form 3115.

One sourcing note, because it is a live trap: Publication 538 was last revised in January 2022 and still prints "$26 million or less (indexed for inflation)" for this test. That figure is several years stale. The publication remains reliable for structure, definitions and the mechanics above, and it is not the place to read the amount.

The qualified personal service corporation route. A corporation that meets a function test and an ownership test may use the cash method whatever its receipts. The two sources describe the function test slightly differently and the difference should not be smoothed over: Publication 538 requires that "at least 95% of its activities are in the performance of services in the fields of health (including veterinary services), law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts, or consulting," while section 448(d)(2)(A) says "substantially all of the activities" in a list of the same fields. The ownership test at 448(d)(2)(B) requires substantially all of the stock by value to be held by employees performing services in a qualifying field, retired employees who did, their estates, or a person who acquired the stock by reason of such an employee's death, and Publication 538 limits that last category to the two-year period beginning on the date of death. Failing either test at any time in a year means the corporation is not a qualified personal service corporation for any part of that year and must change to an accrual method effective for it.

Income: receipt is not the same as collection. Publication 538's rule is that under the cash method you include "all items of income you actually or constructively received during the tax year," and that property and services received are included at fair market value. Constructive receipt is the reason the method is not a timing lever: an amount credited to your account or made available without restriction is income then, whether or not you took it, and the publication states directly that you cannot hold checks or postpone taking possession of property from one year to the next in order to postpone the tax. The doctrine has an important limit, that control subject to substantial restrictions or limitations is not constructive receipt, which is a subject of its own.

Expenses: paying early does not always deduct early. The general rule is that you deduct an expense in the year you actually pay it. The exception that costs people money runs the other way: Publication 538 provides that "an expense you pay in advance is deductible only in the year to which it applies, unless the expense qualifies for the 12-month rule." Under that rule, amounts paid to create rights or benefits need not be capitalized if the benefit does not extend beyond the earlier of twelve months after the right or benefit begins, or the end of the tax year after the tax year in which payment is made. Two dates, and the earlier one governs. A one-year policy bought mid-year is usually deductible in full; a multi-year policy bought at the same moment is not, and has to be spread.

The hybrid restrictions, which are four and are easy to trip. A taxpayer may generally combine cash, accrual and special methods if the combination clearly reflects income and is used consistently, subject to the limits Publication 538 sets out. Where an inventory is necessary to account for income, an accrual method must be used for purchases and sales. If you use the cash method for income, you must use it for expenses. If you use an accrual method for expenses, you must use one for income. And "any combination that includes the cash method is treated as the cash method for purposes of section 448," which is the rule that stops an entity inside section 448's reach from escaping it by mixing methods. Separately, section 446(d) allows a taxpayer with more than one trade or business to use a different method for each, and Publication 538 adds the condition: no business is separate and distinct "unless a complete and separate set of books and records is maintained for each business." Business and personal items may also be accounted for on different methods.

For a cash-method taxpayer the year's return is built from what moved, with two adjustments.

1. Include everything actually received, plus anything constructively received, plus the fair market value of any property or services taken instead of money.

2. Deduct what was actually paid during the year, including amounts paid under a contested liability.

3. Test each prepayment against the general rule and the 12-month rule before deducting it in full.

4. Check the hybrid restrictions if any part of the books is on a different method, and check whether an inventory forces an accrual method for purchases and sales.

A hypothetical example of step 3, which is where the method surprises people. Assume a calendar-year taxpayer.

A two-year policy. Jonah pays $7,200 on October 1 of year 1 for a liability policy that runs 24 months, to September 30 of year 3. The benefit extends beyond the earlier of twelve months after it begins (September 30 of year 2) and the end of the year after payment (December 31 of year 2), so the 12-month rule does not apply and the general rule does. He deducts the portion applicable to each year: 3 ÷ 24 × $7,200 = $900 in year 1, 12 ÷ 24 × $7,200 = $3,600 in year 2, and 9 ÷ 24 × $7,200 = $2,700 in year 3. Those add back to $7,200, which is the point: nothing is lost, only moved.

A one-year policy, same day, same money. Suppose instead he pays $3,600 on October 1 of year 1 for a policy running exactly twelve months, to September 30 of year 2. Twelve months after the benefit begins is September 30 of year 2, which is earlier than December 31 of year 2, and the benefit does not extend beyond it. The 12-month rule applies and the whole $3,600 is deductible in year 1, even though nine of the twelve months of coverage fall in the next year.

The two paragraphs differ only in the length of the contract, and that is the whole of what decides the answer. Writing a check in December does not by itself buy a December deduction.

Pros

• It tracks the bank account, so the return can be built from records the business already keeps and the tax generally falls in the year the money did.
• It is the default for individuals and for most small businesses, since the entity-level bar in section 448 does not reach a sole proprietor, a single-member LLC or an S corporation.
• It gives some genuine control over timing at the margin, because paying a deductible expense before year end generally accelerates the deduction.
• It is cheaper to maintain than an accrual method, which needs receivable and payable ledgers to produce a return at all.

Cons

• It misstates profitability whenever work and payment fall in different periods, so a strong month of invoicing can look like nothing.
• Constructive receipt removes the obvious deferral: income made available to you is yours for tax purposes whether or not you take it.
• Prepaying more than a year of an expense does not accelerate the deduction, and the taxpayer has to know that before writing the check.
• An inventory forces an accrual method for purchases and sales regardless of preference.
• Growing into section 448's reach, by taking on a C corporation partner or by failing the gross-receipts test, forces a change of method in the year it happens.
• A tax shelter is barred outright, and no receipts figure changes that.