What Is the Gross Receipts Test for Small Businesses?

The gross receipts test is a threshold used by the Internal Revenue Service (IRS) to determine if a business qualifies as a “small business taxpayer.” This classification allows businesses to use several simplified tax accounting methods, which can reduce administrative burdens and offer more favorable tax outcomes. Passing the test provides alternatives to otherwise mandatory accounting rules and can impact how a company reports income, manages inventory, and deducts expenses.

Determining Applicability

A business must first determine if it is eligible to use the gross receipts test. For taxable years beginning in 2025, a business qualifies as a small business taxpayer if its average annual gross receipts for the three preceding tax years are $31 million or less.

This test is an annual determination, meaning a business must re-evaluate its status each year. A company could fail the test in one year but qualify in the next, or vice-versa, depending on its revenue fluctuations. This annual assessment is a component of tax planning, as eligibility for simplified accounting methods can change from year to year.

A significant exception prohibits certain businesses from using this test, regardless of their revenue. Under Internal Revenue Code (IRC) Section 448, entities classified as “tax shelters” are ineligible. The definition of a tax shelter can include partnerships or S corporations, defined as “syndicates,” where more than 35% of the entity’s losses for the year are allocated to limited partners or limited entrepreneurs—individuals who do not actively participate in management.

This rule means that a legitimate business that experiences an unusual loss could be classified as a tax shelter if it allocates too much of that loss to passive investors. Therefore, any business with passive investors must carefully monitor its loss allocations to avoid being disqualified from the benefits available to small business taxpayers.

Calculating Average Annual Gross Receipts

The foundational step is to determine the business’s gross receipts for the three taxable years immediately preceding the current one. For example, to determine eligibility for the 2025 tax year, a business would sum its gross receipts from 2022, 2023, and 2024, and then divide that total by three.

The IRS defines “gross receipts” comprehensively for this test. The term includes total sales, net of returns and allowances, and all amounts received for services. It also encompasses income from investments and other incidental sources, such as interest, dividends, rents, and royalties. However, sales taxes collected from customers and remitted to a taxing authority are excluded.

Special rules apply to businesses that have not been in existence for the full three-year look-back period. In such cases, the average is based on the number of years the business has existed. If a business has a short taxable year, its gross receipts for that period must be annualized by multiplying the short-period gross receipts by 12 and then dividing the result by the number of months in that short period.

The aggregation rules require that businesses under common control be treated as a single entity for the purpose of the gross receipts test. This prevents a larger enterprise from splitting into smaller entities to meet the threshold. Common control groups include parent-subsidiary relationships, where one business owns more than 50% of another, and brother-sister groups, where five or fewer individuals, estates, or trusts own a controlling interest in multiple businesses. The gross receipts of all entities within the controlled group must be combined before applying the test.

Tax Accounting Method Qualifications

Meeting the gross receipts test provides access to several simplifications in tax accounting. The benefits affect the overall method of accounting and specific rules for inventory, cost capitalization, and interest deductions.

Cash Method of Accounting

One of the most significant benefits is the ability to use the cash method of accounting. The tax code prohibits C corporations and partnerships with a C corporation partner from using the cash method, requiring them to use the more complex accrual method. Businesses that pass the gross receipts test are exempt from this requirement and can use the cash method, which allows for the recognition of income when it is received and expenses when they are paid.

UNICAP Rules

Qualifying small businesses are also exempt from the Uniform Capitalization (UNICAP) rules under IRC Section 263A. UNICAP requires businesses to capitalize certain direct and indirect costs associated with producing property or acquiring property for resale, rather than expensing them immediately. The exemption allows small businesses to avoid these intricate calculations, simplifying their accounting for inventory and self-constructed assets.

Business Interest Expense Limitation

Another advantage is an exemption from the business interest expense limitation under IRC Section 163(j). This rule limits a business’s deduction for net business interest expense to 30% of its adjusted taxable income (ATI). Small businesses that meet the gross receipts test are not subject to this limitation, allowing them to deduct their full business interest expense.

Inventories

Passing the test simplifies inventory accounting. Under IRC Section 471, businesses with inventory are required to use an accrual method for purchases and sales. Qualifying small businesses, however, can choose to treat their inventory as non-incidental materials and supplies, allowing them to deduct the cost of inventory items in the year they are used or consumed rather than when they are sold.