Which accounting method should your business be using for tax purposes? Many business owners are surprised to learn that they have a choice. True, certain businesses are required to use the accrual method, but you’d be surprised how many businesses are eligible for the cash method. If you have the option to use either accounting method, it pays to consider whether switching methods would lower your tax bill.
Here’s a closer look at which businesses are eligible to choose either the accrual or cash method — and the relative advantages and disadvantages of each. Keep in mind that cash and accrual are the two primary tax accounting methods, but they’re not the only ones. Some businesses may qualify for a different method, such as a hybrid of the cash and accrual methods.
Cash method availability
Generally, a business is permitted to use the cash method of accounting for tax purposes unless it’s 1) expressly prohibited from using the cash method, or 2) expressly required to use the accrual method. Businesses prohibited from using the cash method include C corporations and partnerships with a C corporation partner, unless one of the following exceptions applies:
- The business’s average annual gross receipts for the previous three tax years are $5 million or less.
- The business is a qualified personal service corporation. This includes law, accounting, consulting, engineering and architecture firms — and certain other service providers — whose stock is substantially owned by current or retired employees or their estates.
Special rules apply to farming businesses, and tax shelters are always prohibited from using the cash method.
The following types of businesses generally are required to use the accrual method:
- Businesses with income from long-term contracts (such as construction firms and manufacturers), which generally must use the percentage-of-completion method.
- Businesses with inventories, with certain exceptions. (See “A note on inventories.”)