When Is Accrual Accounting Required for Tax Purposes?

Accrual accounting is required for tax purposes when a business is a C corporation, a partnership that has a C corporation as a partner, or a tax shelter — unless it qualifies for an exception. The main exception is the gross receipts test: for tax years beginning in 2026, a business whose average annual gross receipts over the prior three years do not exceed $32 million can generally use the cash method instead.¹ A separate rule pulls in businesses that sell physical goods, though the same threshold offers relief there too.

Which Businesses Are Required To Use Accrual

Section 448 of the Internal Revenue Code names three categories of taxpayers that cannot use the cash method:

C corporations
Partnerships with a C corporation as a partner
Tax shelters

C corporations and partnerships with a C corporation partner can escape the mandate by passing the gross receipts test or qualifying for one of the statutory carve-outs described below. Tax shelters get no such relief; they must use accrual regardless of size.²³

Notably absent: S corporations, sole proprietorships, and single-member LLCs treated as disregarded entities. Section 448(a) does not cover them, so they can use the cash method at any revenue level, provided they are not classified as a tax shelter and clear the inventory rules discussed below. An S corporation with $100 million in receipts can still file on a cash basis.

The Gross Receipts Test

The gross receipts test is the primary way a C corporation or a partnership with a C corporation partner stays on the cash method. A business passes if its average annual gross receipts over the three tax years preceding the current year do not exceed the inflation-adjusted threshold. For tax years beginning in 2026, that threshold is $32 million.¹

The base figure in the statute is $25 million, adjusted annually for inflation and rounded to the nearest million. It was $30 million for 2024, $31 million for 2025, and $32 million for 2026.⁴ The line keeps moving up, so a business pushed into accrual a few years ago may now qualify to switch back.

The three-year averaging smooths one-time spikes. A C corporation with prior-year receipts of $28 million, $35 million, and $30 million averages $31 million — under the 2026 ceiling. Once the average tips over, the business must switch to accrual for the following year.²

A few mechanics matter. A business that hasn’t existed for three full years uses whatever shorter period it has. Any short tax year is annualized: multiply gross receipts by 12 and divide by the number of months. Gross receipts are reduced by returns and allowances.

Related Entities Get Combined

Splitting operations across multiple entities does not let owners keep each one individually under $32 million. Section 448(c)(2) requires related entities under common control to combine their gross receipts against the threshold.²

Aggregation kicks in when entities are treated as a single employer under the controlled group rules of Sections 52(a) and 52(b), or the affiliated service group rules of Sections 414(m) and 414(o). That catches parent-subsidiary chains, brother-sister corporate groups with common controlling owners, and service organizations that regularly work for each other. If the combined average exceeds the threshold, every entity in the group must use accrual, even the ones that would pass on their own.

This is where growing businesses often get tripped up. A founder running two C corporations with $18 million each in receipts might assume both qualify for cash treatment. Combined, their $36 million average pushes both over the $32 million line.

Businesses That Sell Physical Goods

Separate from the entity-type rules, businesses that produce, purchase, or sell merchandise face an inventory accounting requirement under Section 471. When physical goods are an income-producing factor, the IRS requires inventories at the beginning and end of each tax year so cost of goods sold lines up against revenue.⁵ Maintaining inventories this way effectively forces at least a partial accrual method for purchases and sales, even if the rest of the books stay on cash.

The same gross receipts test rescues small goods sellers. A business under the $32 million threshold for 2026 can skip the traditional inventory rules entirely. Section 471(c) lets qualifying small businesses treat inventory as non-incidental materials and supplies, meaning inventory costs are deducted when the items are used or sold rather than tracked through opening and closing inventory balances.⁵ Tax shelters do not qualify for this relief.⁶

Many small retailers and manufacturers use a hybrid setup: accrual accounting for purchases and sales of goods, and cash accounting for everything else. If you sell products and your gross receipts stay under the threshold, you have real flexibility in how inventory costs get handled.

Exceptions Beyond the Gross Receipts Test

Two carve-outs let some businesses stay on cash even when they would otherwise fail the standard tests.

Qualified Personal Service Corporations

A qualified personal service corporation, or PSC, can use the cash method regardless of gross receipts. Two tests apply. First, substantially all of its activities must involve performing services in one of these fields: health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. Second, substantially all of the corporation’s stock by value must be held by employees who perform those services, retired employees who formerly performed them, their estates, or people who acquired stock through the death of such an employee (for the two-year period after the death).²

Stock held indirectly through partnerships, S corporations, or other qualified PSCs also counts toward the ownership test.

Farming Businesses

Farming has overlapping rules. Section 448(b)(1) broadly exempts farming businesses from the Section 448 prohibition, so a farming C corporation or farming partnership with a C corporation partner isn’t automatically pushed into accrual the way other C corporations are.²

Section 447 then imposes its own accrual requirement on farming C corporations and partnerships with a C corporation partner. A farming corporation escapes Section 447 if it is an S corporation or if it meets the same Section 448(c) gross receipts test — $32 million for 2026.⁷ A small farming C corporation under the threshold can use cash; a larger one above it must use accrual.

Section 447 also carves out nurseries, sod farms, and operations involving raising or harvesting trees other than fruit and nut trees. These businesses are not subject to the farming accrual mandate regardless of size.⁷

Switching From Cash to Accrual

A business that needs to switch methods, in either direction, files Form 3115, Application for Change in Accounting Method.⁸ You cannot simply start using a different method on next year’s return.

Most switches triggered by the gross receipts test or the inventory rules qualify for the automatic consent procedure. You attach Form 3115 to your timely filed return for the year of the change. No separate ruling request, no waiting for IRS approval. Changes that don’t qualify for automatic consent go through advance consent, where you submit the form to the IRS National Office and wait for a specific approval before making the switch.

The main complication is the Section 481(a) adjustment. Switching from cash to accrual means outstanding invoices you’ve sent (accounts receivable) and bills you owe (accounts payable) suddenly need to appear on your books. Without an adjustment, that income would either get counted twice or drop out entirely. The Section 481(a) adjustment captures the transitional items in one calculation.⁹

If the adjustment increases taxable income, which is the usual outcome moving from cash to accrual because previously unrecorded receivables get recognized, the IRS allows the increase to be spread over four tax years under its standard automatic consent procedures rather than absorbed in year one. If the adjustment decreases income, you take the full benefit in the year of change.¹⁰ The four-year spread can meaningfully soften the cash-flow impact when receivable balances are large at the time of conversion.

What Happens If You Use the Wrong Method

Using an impermissible method can result in underpaying tax for the years reported incorrectly, plus penalties and interest. During an audit, the IRS will recompute income for the affected years under accrual accounting and assess any additional tax owed.

The Section 6662 accuracy-related penalty adds 20% to the resulting underpayment when the IRS finds negligence, a failure to follow rules or regulations, or a substantial understatement of income tax.¹¹ Using an impermissible accounting method can fall under the negligence category if the IRS views it as a failure to exercise ordinary care. Interest on the underpayment runs from the original due date of the return until the balance is paid.¹²

In practice, the IRS is more likely to push for a prospective method change through Form 3115 than to unwind years of returns. The longer you operate under the wrong method, though, the larger the Section 481(a) adjustment becomes when the correction happens. A large adjustment compressed into fewer years hurts more than one spread voluntarily over four. Filing Form 3115 on your own terms, before the IRS forces the change, gives you the most favorable transition.

1
Internal Revenue Service. Rev. Proc. 2025-32
2
Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting
3
eCFR. 26 CFR 1.448-2 – Limitation on the Use of the Cash Receipts and Disbursements Method of Accounting
4
Internal Revenue Service. Rev. Proc. 2024-40
5
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
6
eCFR. 26 CFR 1.471-1 – Need for Inventories
7
Office of the Law Revision Counsel. 26 U.S. Code 447 – Method of Accounting for Corporations Engaged in Farming
8
Internal Revenue Service. About Form 3115
9
Office of the Law Revision Counsel. 26 USC 481 – Adjustments Required by Changes in Method of Accounting
10
eCFR. 26 CFR 1.481-1 – Adjustments in General
11
Office of the Law Revision Counsel. 26 U.S. Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments
12
Internal Revenue Service. Return Related Penalties