Is Your Business Required to Use an Accrual Method of Accounting?

Taxpayers may generally adopt or change to any permissible method of accounting; however, some taxpayers must use an overall accrual method. This article is a high-level discussion of which taxpayers have to use an accrual method of accounting and the gross receipts exception to that requirement, as well as making accounting method changes to an overall accrual method. 

Who Must Use an Accrual Method?

Internal Revenue Code Section 448(a) generally requires C corporations, partnerships with a C corporation partner, and tax shelters to use an overall accrual method of accounting. Further, any type of entity that engages in the production, purchase, or sale of merchandise as an income-producing factor must use an inventory method and an accrual method of accounting for purchases and sales of inventory — but may use the cash method for other items if it does not want to use an accrual method for all items. (Note that when determining whether a partnership has a C corporation partner, a partner that is a partnership must “look through” to its partners.)

An important exception to those rules is the small business taxpayer exemption, which allows qualifying taxpayers to use the cash method of accounting. To meet the small business taxpayer exemption, Section 448(c) provides a gross receipts test that is met if a taxpayer has average annual gross receipts not exceeding $25 million adjusted for inflation for the three prior tax years. (For a tax year beginning in 2023, a taxpayer meets the gross receipts test if it has average annual gross receipts for the three prior tax years of $29 million or less.) Importantly, taxpayers meeting the definition of a tax shelter may not use the small business taxpayer exemption and must always use an accrual method, regardless of their gross receipts. 

Accounting Method Changes to an Overall Accrual Method

A C corporation or partnership with a C corporation partner using the overall cash method of accounting — or an accrual method for purchases and sales of inventory and cash for all other items — will need to change to an overall accrual method of accounting if its business grows so that its gross receipts exceed the gross receipts test. Also, it is not uncommon for a taxpayer to be acquired into a consolidated group or for a partnership to have a new partner that is a C corporation and be required to change to an accrual method. In those situations, even though an accrual method is mandated, Form 3115 must be filed to implement the accounting method change.

In general, changes from the overall cash to accrual method can be complicated and time consuming because they require a thorough review of all income and expense items. Contrary to a common misconception that the Section 481(a) adjustment is a straightforward reversal of the prior year’s accrual to cash adjustment, the taxpayer must evaluate when each item of income or expense meets the tax rules to be recognized under an accrual method. In addition, the Tax Cuts and Jobs Act introduced new Section 451(b), which accelerates the recognition of income for some accrual-method taxpayers and adds a layer of complexity to the overall method changes. 

Under new Section 451(b), specific accrual-method taxpayers meet the all-events test no later than when an item of gross income is taken into account as revenue in the taxpayer's applicable financial statement (AFS). Accordingly, that section effectively requires taxpayers to include an item in gross income at the earliest of when the item is due, received, earned, or taken into account as revenue in its AFS (an AFS includes Forms 10-K or audited financial statements used for credit purposes; reporting to shareholders, partners, or other proprietors; or any other substantial nontax purpose). An understanding of the taxpayer’s revenue streams and revenue recognition for financial reporting and tax purposes is required. 

To change to an overall accounting method, a taxpayer with an AFS must include a detailed description in the Form 3115 explaining how income will be recognized under the taxpayer’s accrual method and any required tax adjustments the taxpayer will make to its AFS revenue in calculating its taxable income. Once a taxpayer changes to its accrual method income recognition methods as part of its cash to accrual method change, it is generally prohibited from making another automatic accounting method change for any of those income recognition methods for five tax years.

A taxpayer that receives advance payments as defined under Section 451(c) will need to consider whether to use the full inclusion or deferral method for those payments. Further complications can arise if the taxpayer’s contracts span multiple years (e.g., a software license agreement with a term of 48 months) because the final Section 451 regulations provide for a complicated multiyear contract rule to determine the amount of income to be recognized for every tax year.  The multiyear contract rule is effective for tax years beginning on or after January 5, 2021. Thus, whether a taxpayer uses the full inclusion or deferral method for advance payments, the rule may cause the amount of income recognized each year to be different than when those advance payment methods were applied for tax years beginning before that date.

In addition, former small business taxpayers that must capitalize costs under Section 263A starting in the current tax year should analyze as soon as possible the proper UNICAP methods to use because they cannot make the automatic change to an accrual method without concurrently changing to a permissible UNICAP method. Gathering information and performing the necessary calculations to properly effectuate a UNICAP method change can be time consuming. If a proper UNICAP method change cannot be completed in time, a taxpayer may have to defer both the Section 263A change and the cash to accrual change to a future tax year. Note that deferring the cash to accrual change to a future tax year that is not the first year the taxpayer is required to use an accrual method may prevent a taxpayer from subsequently making an automatic accounting method change back to the overall cash method within five years, should its gross receipts permit it to do so.  

Filing the method change

Taxpayers that are currently on a cash method of accounting (or an accrual method for purchases and sales of inventories and the cash method for all other items) can generally file an automatic accounting method change to an overall accrual method by the due date (including extension) of their federal income tax return for the tax year of change. Automatic change procedures are provided for both taxpayers changing to an accrual method because they are prohibited from using the cash method and taxpayers voluntarily changing to an accrual method. However, in addition to the five-year rule mentioned above, several rules under the automatic procedures (including those specified in section 15.01 of Rev. Proc. 2023-24 and section 5.01 of Rev. Proc. 2015-13) must be considered when ascertaining whether a taxpayer is eligible to file an automatic method change. 

BDO Insights

Taxpayers currently using the cash method under the small business exemption should annually review whether they will maintain that status for the current tax year as early in the year as possible. Taxpayers that no longer meet the gross receipts test will generally be required to file a method change to switch to an accrual method. If any accounting method changes need to be made, taxpayers should establish whether they have made accounting method changes in the previous five years for those items or overall method to determine whether the current changes can be made using the automatic change procedures. Further, taxpayers should consider the impact of any Section 481(a) adjustments on their current-year tax returns and book-to-tax differences.