A cash basis taxpayer can have inventory. Under Internal Revenue Code Section 471(c), any business whose average annual gross receipts over the prior three years stay at or below the inflation-adjusted threshold — $31 million for 2025 — can skip traditional inventory accounting and stay on the cash method.1Internal Revenue Service. Rev. Proc. 2024-40 Most small and mid-sized retailers, manufacturers, and wholesalers sit well below that ceiling, so the simpler cash method is available to far more inventory-carrying businesses than owners often assume.
Who Qualifies and Who Doesn’t
Section 448(a) restricts the cash method for three categories of taxpayers: C corporations, partnerships that have a C corporation as a partner, and tax shelters.2Office of the Law Revision Counsel. 26 U.S. Code 448 – Limitation on Use of Cash Method of Accounting Sole proprietors, single-member LLCs, and S corporations aren’t on that list, so the Section 448 restriction never applies to them in the first place.
C corporations and affected partnerships aren’t shut out either. The exception in Section 448(b)(3) lets any entity that passes the gross receipts test use the cash method for that year. Section 471(c) then uses the same test to decide whether traditional inventory accounting is required.
One group gets no relief regardless of size: tax shelters. Section 448(a)(3) bars any tax shelter from the cash method, and Section 471(c) specifically excludes tax shelters prohibited under that provision.3Office of the Law Revision Counsel. 26 U.S. Code 471 – General Rule for Inventories The IRS defines a tax shelter broadly enough to catch certain partnerships (called “syndicates”) that allocate more than 35 percent of their losses to limited partners or limited entrepreneurs.4Federal Register. Small Business Taxpayer Exceptions Under Sections 263A, 448, 460, and 471
How the Gross Receipts Test Works
You average gross receipts over the three tax years ending before the current year. If that average is $31 million or less (the 2025 figure), you qualify.1Internal Revenue Service. Rev. Proc. 2024-40 The IRS adjusts the ceiling for inflation each year, so check the most recent revenue procedure for the exact number in your tax year. Gross receipts include total sales (net of returns and allowances) plus amounts received for services.
The three-year lookback smooths out volatility so a single unusual year doesn’t flip your accounting method. If the business hasn’t existed for three full years, you average over the years it has existed.
Aggregation of Related Entities
Splitting one business into several smaller ones won’t get you under the threshold. Section 448(c)(2) requires you to combine gross receipts across related entities — parent companies and subsidiaries, businesses under common control, and affiliated service groups all count together.5Internal Revenue Service. FAQs Regarding the Aggregation Rules Under Section 448(c)(2) that Apply to the Section 163(j) Small Business Exemption
Sole Proprietors and Individuals
For taxpayers that aren’t corporations or partnerships, Section 471(c)(3) applies the gross receipts test as if each trade or business were a separate corporation or partnership.3Office of the Law Revision Counsel. 26 U.S. Code 471 – General Rule for Inventories A sole proprietor running a retail shop measures that shop on its own. Multiple businesses are measured independently.
Two Ways to Handle Inventory Under the Cash Method
Once you qualify, Section 471(c) gives you two simplified paths. The choice hinges on whether you prepare an applicable financial statement (an audited statement, a filing with a federal agency such as the SEC, or certain other certified statements).6Internal Revenue Service. Publication 538, Accounting Periods and Methods
Non-Incidental Materials and Supplies
Under this approach, you reclassify inventory items as non-incidental materials and supplies. You deduct their cost when the items are sold or used, not when purchased. The math looks like a simplified cost of goods sold: beginning inventory, plus purchases paid during the year, minus ending inventory equals the deductible amount for the year.6Internal Revenue Service. Publication 538, Accounting Periods and Methods Unsold goods at year-end carry forward and are deducted in the year they’re eventually sold.
The Financial Statement Method
If you already prepare an applicable financial statement, you can account for inventory on your tax return the same way it appears on that statement.6Internal Revenue Service. Publication 538, Accounting Periods and Methods For businesses that already produce audited or certified financials for lenders or investors, this eliminates a separate tax-specific inventory calculation.
A Related Benefit: UNICAP Exemption
The same test that unlocks cash-method inventory also exempts you from the Uniform Capitalization rules under Section 263A. Qualifying businesses aren’t required to capitalize indirect production costs such as utilities, rent, or equipment depreciation into inventory.4Federal Register. Small Business Taxpayer Exceptions Under Sections 263A, 448, 460, and 471 Growing past the gross receipts threshold costs you both benefits at once.
The De Minimis Safe Harbor Doesn’t Cover Merchandise
Some owners assume they can expense low-cost inventory items under the de minimis safe harbor that permits immediate deduction of tangible property costing $2,500 or less per item (or $5,000 with an applicable financial statement). It doesn’t work that way. The regulations exclude amounts paid for property that is or is intended to be included in inventory. The safe harbor covers tools, office furniture, and minor equipment, not the goods you plan to sell.
Recordkeeping Still Applies
Simplified inventory doesn’t mean skipping documentation. The IRS expects records showing what you paid and confirming the payment was for inventory. Cancelled checks, credit card receipts, cash register tapes, and supplier invoices all qualify.7Internal Revenue Service. Publication 583, Starting a Business and Keeping Records You still have to value your inventory at year-end, so some form of physical count or perpetual inventory system stays necessary.
Schedule C filers complete Part III (Cost of Goods Sold) using their simplified figures.7Internal Revenue Service. Publication 583, Starting a Business and Keeping Records Lighter than full accrual inventory work, but not zero.
Switching From Accrual to Cash
A business already using accrual that now qualifies files Form 3115 (Application for Change in Accounting Method) to switch. For small business taxpayers meeting the gross receipts test, this is an automatic change, so the IRS doesn’t have to approve it before you implement it. You attach the original Form 3115 to your timely filed return (including extensions) for the year of change and send a signed copy to the IRS National Office.8Internal Revenue Service. Instructions for Form 3115
New businesses that qualify from day one skip Form 3115 entirely. They adopt the cash method on their first tax return.
Designated Change Numbers
Form 3115 requires the correct Designated Change Number (DCN). The two most relevant here are:
- DCN 233, for switching to the overall cash method as a small business taxpayer under Section 446.
- DCN 235, for changing inventory accounting to treat inventory as non-incidental materials and supplies under Section 471(c).
Making both changes at once can require filing for each on the same Form 3115. The Form 3115 instructions list additional DCNs (260 and 261) for variations of the inventory method change.8Internal Revenue Service. Instructions for Form 3115
The Section 481(a) Adjustment
Changing methods triggers a one-time adjustment under Section 481(a) so income and deductions aren’t counted twice or missed entirely.9Office of the Law Revision Counsel. 26 USC 481 – Adjustments Required by Changes in Method of Accounting The direction of the adjustment sets the timing:
- A negative adjustment, common when moving from accrual to cash, is deducted entirely in the year of change. This happens when the business had already paid tax on accrued income it hadn’t collected. For a business with large receivables, that one-time deduction can be sizable.
- A positive adjustment is spread over four years — the year of change plus three more.
The four-year spread for positive adjustments rewards voluntary compliance. The IRS is much less generous when it forces the change on you.
What Happens if You Use the Wrong Method
A business that claims cash-method treatment without actually qualifying faces an involuntary accounting method change on examination. Any positive Section 481(a) adjustment is generally taken into account entirely in the year of change, with no four-year spread.10Internal Revenue Service. Changes in Accounting Methods For a business with substantial receivables, the compressed timeline can produce a large tax bill in a single year.
Beyond the accelerated adjustment, the IRS will make collateral adjustments to all open tax years under examination to reflect the correct method.10Internal Revenue Service. Changes in Accounting Methods Interest runs on underpayments, and accuracy-related penalties may apply if the IRS finds the wrong method was used without reasonable cause. A voluntary Form 3115 filing is free and relatively painless; an audit-driven correction can cost multiples of the tax itself once interest and penalties stack up.
When You Outgrow the Threshold
Eligibility is tested each year. If your three-year average climbs above the inflation-adjusted ceiling, you lose the simplified inventory rules and, for restricted entity types, the cash method itself. The transition back to accrual is its own change in accounting method: another Form 3115, another Section 481(a) adjustment. Track your rolling three-year average annually so the switch doesn’t catch you off guard. One strong year won’t immediately disqualify you, but two or three years of growth above the threshold will.