Can You Switch From Accrual to Cash Method of Accounting for the IRS?

When you report taxes for your first year in business, you must select your method of accounting from the options "Cash," "Accrual" or "Other," and you must use the same method of accounting in subsequent years. If you selected "Accrual" in your first year and want to change to "Cash" in a later year, request permission from the IRS by filing Form 3115. It may grant permission, but only if you meet specific requirements.

According to IRS instructions for Schedule C, if you use the accrual method, you must report income when it is earned and deduct expenses when they are incurred, even if they are not paid during the tax year. Simply put, you may include accounts receivable as income for the year, even if you will not actually receive them until the next year. You may also include expenses such as credit card debt, even if you will not pay them until the following year.

According to IRS instructions for Schedule C, if you select the cash method, you must "show all items of taxable income actually or constructively received during the year in cash, property or services." You may not include income or expenses that will be settled in the next year. In many circumstances, you may not use the cash method if you maintain an inventory of goods to sell or if your gross income exceeds $5 million during the tax year.

Because accounting methods entail extensive details, make sure you're sure you want to change to the cash method before you fill out Form 3115 so you won't have to make another change later. IRS Publication 538 offers extensive information about the cash, accrual and "other" accounting method choices. Download Publication 538 from IRS.gov before you attempt the change. If it doesn't answer your questions, seek advice from an accountant.

Once you are sure you want to change from accrual to cash, download the instruction booklet for Form 3115 to see if your business qualifies for an automatic change. This basically allows you to use the cash method while waiting for IRS approval of your request. If you don't meet the conditions for the automatic change, you must file a standard change and wait for approval. Form 3115 includes an extensive questionnaire that helps you find out if you can qualify, based on the nature of your business activity.