Bookkeeping & Finance

Cash vs accrual accounting on the first tax return

Cash vs accrual for a new US company: where the method goes on your return, who cannot use the cash method, what timing changes, and how to switch later.

By save biz teamPublished

A closed deep green ledger book and a single brass coin set a few inches apart on a cream desk, suggesting the gap between when work is recorded and when cash is received

Key takeaways

  • The method is chosen on your first return. IRS Publication 538 says you do not need IRS approval to choose the initial method, and that once you have filed, you generally need approval to change it.
  • Cash method: income counts when you actually or constructively receive it, and expenses when you pay them. Accrual method: income counts when the all-events test is met, and expenses when that test is met and economic performance has occurred.
  • Under Internal Revenue Code section 448, a C corporation, a partnership with a C corporation partner, or a tax shelter cannot use the cash method. The first two get an exception if average annual gross receipts for the prior three years are $32,000,000 or less, for tax years beginning in 2026.
  • If you keep inventory and meet that gross receipts test, section 471(c) lets you treat inventory as non-incidental materials and supplies or follow your books, instead of a full inventory method.
  • On the 2025 forms, the method goes on Schedule C line F, Form 1065 item H, Form 1120-S Schedule B line 1, or Form 1120 Schedule K line 1.

Where the method is recorded, by return type

ReturnWho files itWhere the method goes (2025 forms)
Schedule C (Form 1040)A sole proprietor, including the individual owner of a single-member LLCLine F: Cash, Accrual, or Other
Form 1065A partnership, including a multi-member LLC taxed as a partnershipPage 1, item H
Form 1120-SAn S corporationSchedule B, line 1
Form 1120A C corporation, including an LLC that elected corporate taxSchedule K, line 1

The Schedule C instructions for line F say you can use the cash method, an accrual method, or any other method permitted by the Internal Revenue Code. They also say that unless you are a small business taxpayer, you must use an accrual method for sales and purchases of inventory items. The other three forms carry the same three boxes. Their instructions have no line-specific paragraph, only a general Accounting Methods section that repeats the section 448 limits described below.

What each method means for timing

Cash method. Publication 538 puts it this way: "Under the cash method, you include in your gross income all items of income you actually or constructively received during the tax year." Constructive receipt is the part that surprises people. Income is constructively received "when an amount is credited to your account or made available to you without restriction," whether or not you take possession of it. The publication's example is interest a bank credits to your account in December: it is that year's income even if you never withdraw it. Expenses work the same way: under the cash method you generally deduct them in the tax year you actually pay them.

Accrual method. Income is included in the year the all-events test is met. Publication 538 describes that test as the point when "all events have occurred which fix your right to receive the income and you can determine the amount with reasonable accuracy." An expense is deducted when the all-events test is met for the liability and economic performance has occurred. For services someone provides to you, section 461(h) says economic performance occurs as the services are provided. The publication's example: office supplies received and billed in December, paid in January, are deducted in December's year under the accrual method.

What that looks like in year one. Suppose you finish a project and send a $5,000 invoice on December 20, 2026, and the client pays on January 10, 2027. Under the cash method that is 2027 income. Under the accrual method, if the work was done and the amount was fixed in December, it is 2026 income. The same split applies to a vendor's bill you receive in December and pay in January. If you receive a Form 1099-NEC from a client, it reports what you were paid during the year. That matches the cash method. The 1099-NEC threshold also follows the payment date, not the work date.

Prepaid expenses. Treasury Regulation 1.263(a)-4(f) has a 12-month rule. You are not required to capitalize an amount paid for a right or benefit that does not extend beyond a set date. That date is the earlier of 12 months after you first realize the benefit, or the end of the tax year after the year you paid. Publication 538 gives two examples. A $3,000 premium for a 36-month policy starting July 1 produces a $500 deduction in the year paid. A $10,000 premium for a 12-month policy is deductible in full in the year paid. The 12-month rule decides whether you must capitalize; an accrual-method business still has to meet economic performance before deducting.

Who cannot use the cash method

Section 448(a) says that for a C corporation, a partnership which has a C corporation as a partner, or a tax shelter, "taxable income shall not be computed under the cash receipts and disbursements method of accounting."

Section 448(b)(3) removes that bar for a corporation or partnership that meets the gross receipts test. The test is met if average annual gross receipts for the three tax years ending with the prior tax year do not exceed the threshold. Revenue Procedure 2025-32, section 3.30, sets the threshold at $32,000,000 for tax years beginning in 2026. The current edition of Publication 538 still prints an older figure, so use the revenue procedure for the number. Tax shelters get no gross receipts exception. Section 448(b)(1) and (b)(2) lift the bar for a farming business and for a qualified personal service corporation regardless of size.

Two rules matter for a company in its first years, both in section 448(c)(3):

  • If the entity was not in existence for the entire three-year period, the test is applied on the basis of the period it was in existence.
  • Gross receipts for a tax year of less than 12 months are annualized: multiply the short period's receipts by 12 and divide by the number of months in the short period. A company formed in October 2026 with a short first year annualizes those first months when it tests itself later.

Sole proprietors and S corporations are not named in section 448(a)(1) or (a)(2). So section 448 does not take the cash method away from them, unless the business is a tax shelter under section 448(d)(3). The Form 1120-S instructions say an S corporation generally cannot use the cash method if it is a tax shelter. Inventory rules still apply. Section 471(c)(3) applies the gross receipts test to a taxpayer that is not a corporation or partnership as if each trade or business were a corporation or partnership.

Inventory and the small business exception

If you produce, purchase, or sell merchandise, Publication 538 says you generally must keep an inventory and use an accrual method for sales and purchases of merchandise. Section 471(c) is the exception. A taxpayer that meets the section 448(c) gross receipts test, other than a tax shelter, is not treated as failing to clearly reflect income if its inventory method does one of two things. The method can treat inventory as non-incidental materials and supplies. Or it can conform to the taxpayer's applicable financial statement, or, if there is none, to its books and records prepared in accordance with its accounting procedures. Publication 538 adds that you can choose not to keep an inventory under this rule, but you must still use a method of accounting for inventory that clearly reflects income.

Deciding for a new company

Your situationWhat the rules allowWhat to watch
Sole proprietor or single-member LLC, services only, no inventoryCash or accrualConstructive receipt: amounts credited to you count even if you leave them in the account
Partnership or multi-member LLC, no C corporation partnerCash or accrual; the Form 1065 instructions say a partnership generally may use the cash method unless it must keep inventories, has a C corporation partner, or is a tax shelterThe gross receipts test matters here only through the inventory rule in the last row
S corporationCash or accrual; section 448(a) does not name S corporationsTax shelter status removes the cash option; inventory rules still apply
C corporation, including an LLC that elected corporate taxCash or accrual while average gross receipts are $32,000,000 or less for tax years beginning in 2026; above that, the cash method is not allowed unless the corporation is a qualified personal service corporation or a farming business (section 448(b)(1) and (b)(2))A short first year is annualized for the test
Any of the above with inventoryCash with section 471(c) inventory treatment if the gross receipts test is met; otherwise an accrual method for inventoryKeep the inventory method consistent with your books or financial statement

In the sources we read, the IRS does not call one method simpler than the other. Publication 538 says that "most individuals and many small businesses" use the cash method, and leaves it there. The practical difference for a first-year company is the December-to-January line shown in the invoice example above. A related decision is who keeps those records: the forms and filings that decide when a small company outgrows do-it-yourself books are covered separately.

The tax shown on that first return also matters the following year. Last year's tax is one of the two figures the estimated tax safe harbor uses. See LLC estimated tax safe harbor in year one.

Changing later: Form 3115

Publication 538 lists "a change from the cash method to an accrual method or vice versa" among the changes that require IRS approval. The request goes on Form 3115. The instructions point to Revenue Procedure 2015-13 for the procedures, and to a separately published list of automatic changes. As of the 2025 Schedule C instructions, that list is Revenue Procedure 2025-23. Later revenue procedures can modify it. If you are eligible for an automatic change you must file under the automatic procedures, and no user fee applies. The original Form 3115 is attached to the timely filed return (including extensions) for the year of change. A signed copy goes to the IRS National Office, at the address in the instructions' Address Chart (the Ogden, Utah address for automatic changes), or by fax. The copy must be sent no earlier than the first day of the year of change, and no later than the date the original is filed.

If the owner lives outside the United States

A domestic single-member LLC wholly owned by a foreign person is a foreign-owned US disregarded entity. The Form 5472 instructions say it has no income tax return filing requirement of its own. But it files a pro forma Form 1120 with Form 5472 attached, by the due date of that Form 1120, including extensions. Only the name and address and items B and E on the first page are completed, so the accounting method box on Schedule K is not part of that filing.

The method question moves to the owner's own return. A nonresident alien individual with effectively connected business income reports it on Schedule C (Form 1040), attached to Form 1040-NR through Schedule 1, line 3. Line F of that Schedule C is where the method is recorded. Your state of formation does not change any of this federal picture. What it does change is the annual state bill, compared in Wyoming vs Delaware LLC: two-year state costs.

FAQ

Do I need IRS permission to use the cash method on my first return? No. Publication 538 says you can choose any permitted method on your first return without approval. Approval is generally needed to change it afterward.

Can I use the cash method if I sell products and keep inventory? If you meet the section 448(c) gross receipts test and are not a tax shelter, section 471(c) lets you treat inventory as non-incidental materials and supplies, or follow your books. The Schedule C instructions say a small business taxpayer is not required to use an accrual method for inventory. Otherwise, sales and purchases of merchandise go on an accrual method.

What is the gross receipts limit for 2026? Average annual gross receipts of $32,000,000 or less for the three prior tax years, from Revenue Procedure 2025-32, section 3.30. Short tax years are annualized, and a company that has not existed for three years uses the period it has existed.

A client paid in January for December work. Which year is it? Under the cash method, the year you received it, so January's year. Under the accrual method, the income belongs to the year your right to the payment became fixed and the amount became determinable. December's year applies if the work was complete and the amount was set.

Sources

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