Small Business Series: When You Can’t Use Cash Basis Accounting

As a US business owner, understanding the rules around accounting for tax purposes is essential. While cash basis accounting is a common method used by many small businesses, there are certain situations in which it cannot be used.

The Internal Revenue Service (IRS) has strict rules around which businesses can use cash basis accounting. In general, businesses can use cash basis accounting for tax purposes if they meet one of the following criteria:

1. Average annual gross receipts of $25 million or less for the three prior tax years.

2. Qualifying small business taxpayer with average annual gross receipts of $26 million or less for the three prior tax years.

3. Qualifying farming business that meets specific criteria related to the production or cultivation of crops, livestock, or fish.

If a business exceeds these thresholds, it generally must use accrual basis accounting for tax purposes. Under the accrual basis method, income is recognized when earned and expenses are recognized when incurred, regardless of when cash is received or paid.

There are a few other situations in which a business cannot use cash basis accounting, even if it meets the above criteria. These include:

1. Inventory Sales: If a business sells inventory, it must use accrual accounting to report the cost of goods sold. This is because inventory is considered an asset that must be tracked and valued at the end of each accounting period.

2. Long-term contracts: If a business has long-term contracts that span more than one accounting period, it must use accrual accounting to report income and expenses related to those contracts. This is because the income and expenses related to long-term contracts are not earned or incurred until the work is completed.

3. C Corporations: C corporations with average annual gross receipts of more than $5 million for the three prior tax years must use accrual accounting for tax purposes. This is because C corporations are subject to different tax rules than other types of businesses, and the IRS requires them to use accrual accounting to ensure that they are reporting income and expenses accurately.

While cash basis accounting can be a simpler method of accounting for small businesses, there are situations in which it cannot be used for tax purposes. Businesses that exceed the gross receipts thresholds, sell inventory, have long-term contracts, or are C corporations with average annual gross receipts of more than $5 million must use accrual accounting. It's important to consult with a tax professional to determine which accounting method is best for your specific business needs.