Who Cannot Use the Cash Method of Accounting?

Choosing an accounting method affects how a business reports income and expenses. The cash method, which records transactions when money changes hands, is simple but not available to all businesses due to regulatory restrictions.

Certain entities must use the accrual method because of their size, structure, or industry. Understanding these limitations helps businesses comply with tax laws and avoid penalties.

Large Corporate Entities

C corporations with average annual gross receipts exceeding $29 million over the prior three years cannot use the cash method. This threshold, adjusted for inflation, is set by the IRS under Section 448 of the Internal Revenue Code. Larger corporations typically have complex financial activities, making the accrual method a more accurate representation of their financial position.

The accrual method records income when earned and expenses when incurred, regardless of cash flow. This prevents corporations from manipulating taxable income by delaying receipts or accelerating payments. For example, a corporation using the cash method could defer income by postponing customer payments until the next tax year, reducing its current tax liability. The accrual method eliminates this possibility by requiring revenue recognition when a service is performed or a product is delivered.

Publicly traded companies must also follow Generally Accepted Accounting Principles (GAAP), which mandate the accrual method. This ensures financial statements provide a consistent and transparent view of a company’s financial health for investors and regulators. Corporations with significant accounts receivable or payable benefit from accrual accounting, as it aligns reported earnings with actual business activity rather than cash flow timing.

Partnerships With a Corporate Partner

If a partnership includes a C corporation as a partner and has gross receipts exceeding $29 million, it cannot use the cash method. This rule, under Section 448 of the Internal Revenue Code, prevents businesses from structuring themselves as partnerships to bypass accounting requirements while still benefiting from corporate financial scale.

This ensures larger business structures follow standardized financial reporting, particularly when the partnership’s earnings significantly contribute to the corporate partner’s taxable income. If the cash method were allowed, income recognition could be manipulated by delaying taxable revenue or accelerating deductions. The IRS requires accrual accounting to align income and expense recognition with actual business activity rather than cash movement.

A common example is large law or accounting firms operating as partnerships with corporate partners. If a law firm’s gross receipts exceed the threshold, it must use the accrual method, even if most partners are individuals or non-corporate entities. This affects financial planning, as income must be recognized when earned rather than when received, potentially altering tax liabilities and cash flow management.

Inventory-Focused Operations

Businesses that maintain inventory as a core part of their operations generally cannot use the cash method. Inventory directly impacts taxable income, and the cash method does not accurately reflect financial performance for businesses that buy, store, and sell goods over time. These companies must use an inventory accounting system that aligns with accrual-based principles, ensuring income and expenses are matched in the same period.

Under IRS regulations, businesses with inventory must account for it in a way that clearly reflects income. This means applying the accrual method, where inventory purchases are recorded as assets until the goods are sold, at which point they become part of the cost of goods sold (COGS). If a retailer or manufacturer used the cash method, they could manipulate taxable income by purchasing large amounts of inventory at year-end, deducting the cost immediately, and deferring revenue recognition until the following year. This would distort financial reporting and reduce tax liabilities in ways that do not reflect actual profitability.

The Tax Cuts and Jobs Act (TCJA) introduced some flexibility by allowing businesses with average annual gross receipts under $29 million to use the cash method even if they have inventory. However, these businesses must still treat inventory as non-incidental materials and supplies, meaning deductions can only be taken when the items are sold or used. This simplifies record-keeping for smaller businesses while maintaining financial accuracy. Larger companies, particularly in retail, wholesale, and manufacturing, must continue using accrual-based inventory accounting methods such as FIFO (First-In, First-Out) or LIFO (Last-In, First-Out), depending on their financial strategy and tax planning.

Tax Shelter Organizations

Entities classified as tax shelters cannot use the cash method due to their potential for income distortion and tax avoidance. The IRS defines a tax shelter under Section 6662(d)(2)(C)(ii) as any entity where more than 35% of losses are allocated to limited partners or passive investors. These organizations often engage in transactions designed to generate tax benefits rather than economic profit, making accrual accounting necessary to ensure proper income recognition and prevent artificial deferrals.

Real estate investment partnerships, syndicated leasing arrangements, and certain structured finance vehicles frequently fall into this category. These entities may leverage depreciation, interest deductions, and deferred income strategies to minimize taxable income for investors. If they were allowed to use the cash method, they could further manipulate tax liabilities by timing income and expenses in a way that does not reflect economic activity. The accrual method mitigates this issue by requiring revenue recognition when it is earned, regardless of payment timing, and ensuring that expenses are only deducted when incurred.

Entities Exceeding Regulatory Thresholds

Certain businesses lose eligibility for the cash method by surpassing regulatory financial limits. These thresholds, primarily based on gross receipts, ensure larger businesses maintain financial transparency and consistency in reporting. The IRS enforces these limits to prevent businesses from using the cash method in ways that misrepresent taxable income.

The most relevant threshold is the $29 million average annual gross receipts test under Section 448(c). If a company’s gross receipts exceed this limit over a three-year period, it must switch to the accrual method starting in the following tax year. This transition requires businesses to recognize income and expenses when they occur rather than when cash is exchanged.

For example, a growing construction firm that previously relied on the cash method may need to adjust its financial planning once it surpasses the threshold, particularly in managing accounts receivable and payable. Businesses that temporarily exceed the limit may still be required to use the accrual method for at least one tax year before requalifying for the cash method if their receipts drop below the threshold again.