IRS Publication 538 sets out the federal rules for two things every return depends on: your accounting period, meaning the 12-month window you use to measure income, and your accounting method, meaning the timing rules that decide when income and expenses count. For most individuals the defaults settle both questions — a January-through-December calendar year and the cash method — but businesses face real choices, and picking wrong or switching without IRS approval can create years of problems.
Choosing a Tax Year
Your tax year is the annual period you use to figure taxable income. Three options exist.
- A calendar year runs January 1 through December 31. This is the default for individuals, sole proprietors, and any business that does not keep a formal set of books.
- A fiscal year is any 12 consecutive months ending on the last day of a month other than December. Using one requires books and records that track income and expenses over the same 12-month cycle.
- A 52/53-week year is a fiscal-year variation that always ends on the same day of the week, either the last time that day falls in a given calendar month or the nearest occurrence to month-end. Retailers and other weekly-cycle businesses often prefer it.
You lock in your tax year when you file your first return. After that, changing it requires IRS approval.1Internal Revenue Service. Tax Years
Required Tax Years for Certain Entities
Some businesses do not get a free choice. A partnership must generally use the tax year of its majority-interest partners. If no single year covers more than 50 percent of partnership interests, the partnership uses the tax year shared by all of its principal partners. When that test also fails, the partnership must pick the year producing the least overall deferral of income for its partners.2eCFR. 26 CFR 1.706-1 – Taxable Years of Partner and Partnership
S corporations and personal service corporations are generally required to use a calendar year. Any of these entities can elect a different tax year under Section 444, as long as the elected year creates no more than three months of income deferral compared with the required year. The trade-off is real. S corporations and partnerships that make the election must make annual “required payments” to the IRS under Section 7519, and personal service corporations become subject to limits on the compensation they can deduct during the deferral period.3Office of the Law Revision Counsel. 26 USC 444 – Election of Taxable Year Other Than Required Taxable Year
Short Tax Years
A short tax year is any period shorter than 12 months. Two situations create one: a new business that starts mid-year, and an existing business that gets IRS approval to change its tax year. You still file a return covering the shortened period.1Internal Revenue Service. Tax Years
Tax on a short year is not just a prorated full-year calculation. In many cases the IRS requires you to annualize income first, then prorate the resulting tax back to the short period. The mechanics vary, so check the Form 1128 instructions or Publication 538 before filing.
The Cash Method
The cash method is the simplest approach and the one most individuals use. You report income when you actually or constructively receive it, and you deduct expenses when you pay them. Finish a project in December but the client’s check does not arrive until January? That income belongs on next year’s return.
The key wrinkle is constructive receipt. Income counts as received when it is credited to your account or otherwise made available to you without restriction, even if you haven’t physically collected the money.4Internal Revenue Service. IRS Publication 538 – Accounting Periods and Methods Bank interest posted to your account on December 31 is taxable that year whether you withdraw it or not. A customer’s check sitting in your mailbox counts as received even if you don’t open the envelope. The test is whether you had control, not whether you used it.
The Accrual Method
Under the accrual method, income hits your books when you earn it and expenses count when you owe them, regardless of when cash changes hands. Income is earned once two things are true: your right to the payment is fixed, and the amount can be determined with reasonable accuracy. Expenses work in reverse — you deduct once the liability is established and the amount can be pinned down.
The method matters most for businesses carrying significant receivables and payables, because revenue gets reported when billed and expenses get deducted when incurred, not when cash arrives or leaves.
The Hybrid Method
The tax code allows a combination of cash and accrual as long as the mix clearly reflects income and you apply it consistently. The most common setup is accrual for inventory purchases and sales with the cash method for everything else. A taxpayer running more than one business can even use a different method for each, provided the books stand on their own.5Office of the Law Revision Counsel. 26 USC 446 – General Rule for Methods of Accounting
Who Must Use Accrual
Three categories of taxpayers are barred from the cash method: C corporations, partnerships with a C corporation partner, and tax shelters.6Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting Historically, businesses where inventory was a significant income-producing factor also had to use accrual for purchases and sales.7eCFR. 26 CFR 1.471-1 – Need for Inventories
The Tax Cuts and Jobs Act of 2017 carved out a major exception for small businesses, and the threshold rises with inflation each year. Tax shelters, however, remain locked into accrual with no exception available.
The Small Business Taxpayer Exception
If your average annual gross receipts over the prior three tax years stay at or below an inflation-adjusted ceiling, you qualify as a small business taxpayer. For tax years beginning in 2025, that ceiling is $31 million.8Internal Revenue Service. Revenue Procedure 2024-40 For 2026 it rises to $32 million.6Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting
Qualifying businesses gain several advantages. C corporations and partnerships with C corporation partners can use the cash method. Inventory can be treated as non-incidental materials and supplies, deductible in the year the items are either paid for or used up, whichever comes later. Direct labor and overhead can be deducted as incurred rather than capitalized into inventory. The exception also relieves qualifying businesses from the uniform capitalization rules under Section 263A and relaxes the percentage-of-completion requirement for certain long-term contracts.
The test is applied each year. If your three-year average creeps above the threshold, you lose the exception starting the following tax year and must switch to whatever method the law otherwise requires. That switch is itself a change in accounting method, with all the procedural requirements that follow.
The “Clearly Reflect Income” Standard
Every accounting method must clearly reflect income. That phrase runs through the tax code and gives the IRS broad authority. If the agency concludes your method distorts income, it can require you to change to one it considers more accurate. No showing of fraud or negligence is required — only that the results fail to match economic reality.5Office of the Law Revision Counsel. 26 USC 446 – General Rule for Methods of Accounting
A method that consistently shifts income into later years or pulls deductions into earlier ones is the pattern that draws scrutiny. You do not need to pick the method producing the highest tax bill, but whatever you pick has to give a fair picture of what you earned and spent.
Changing Your Accounting Method
Switching methods requires IRS consent. You request it by filing Form 3115, Application for Change in Accounting Method.9Internal Revenue Service. About Form 3115, Application for Change in Accounting Method The process splits into two tracks.
Automatic Consent Changes
Many common changes qualify for automatic consent under a published IRS revenue procedure (currently Rev. Proc. 2024-23, as updated). If the change is on the list, you file Form 3115 with your return for the year of change and send a copy to the IRS. No user fee, no waiting for a ruling. The automatic list covers hundreds of specific changes, including switching to the cash method under the small business exception and adopting the non-incidental materials and supplies treatment for inventory.
Non-Automatic Consent Changes
Changes not on the automatic list require Form 3115 to be filed with the IRS National Office before your return is due, plus a user fee: $13,225 for requests filed in 2026.10Internal Revenue Service. Internal Revenue Bulletin 2025-1 A separate Form 3115 and separate fee are required for each business and each requested change, so costs stack up for taxpayers with multiple entities.11Internal Revenue Service. Instructions for Form 3115
The Section 481(a) Adjustment
When you change methods, some items could easily fall through the cracks or get counted twice. The Section 481(a) adjustment prevents both. It captures the cumulative difference between what you reported under the old method and what you would have reported under the new one, then folds that difference into taxable income.12Office of the Law Revision Counsel. 26 USC 481 – Adjustments Required by Changes in Method of Accounting
A positive adjustment, meaning one that increases taxable income, is generally spread evenly over four tax years starting with the year of change. A negative adjustment is taken entirely in the year of change. The asymmetry is intentional: the IRS is more generous when the adjustment lowers tax and more cautious when it raises revenue previously deferred.
Changing Your Tax Year
Switching your accounting period, say from a fiscal year ending in June to a calendar year, requires Form 1128, Application to Adopt, Change, or Retain a Tax Year.13Internal Revenue Service. About Form 1128, Application to Adopt, Change or Retain a Tax Year Partnerships, S corporations, and personal service corporations may also need Form 1128 when first adopting a tax year, depending on the facts.
A change in tax year creates a short period covering the gap between your old year-end and the new one, and you file a short-period return for those months. The special annualization rules for that return can produce a higher effective rate than a normal 12-month calculation.
What Happens If You Change Without Permission
The IRS treats unauthorized changes seriously. Section 446(e) requires the Commissioner’s consent before you change your method. Skip that step and the IRS can force you back to your old method, even if the method you switched to was technically correct. The agency can make that adjustment in the year of the unauthorized change, or, if the statute of limitations has closed on that year, in the earliest year still open for assessment.14Internal Revenue Service. 4.11.6 Changes in Accounting Methods
Failing to request consent is also not a shield against penalties. You cannot argue that because the IRS never approved your change, it somehow cannot penalize you for the resulting errors on your return.5Office of the Law Revision Counsel. 26 USC 446 – General Rule for Methods of Accounting A $13,225 user fee looks modest next to the prospect of several years’ worth of returns being recalculated by an examiner who is not inclined to give you the benefit of the doubt.