Most mature businesses operate on the accrual basis of accounting, and they should. Accrual basis accounting provides the clearest picture of a company's current financial health and also offers a preview of the assets and liabilities that are ready to be converted into cash. But what does this mean for tax reporting? Are we handcuffed to an accrual basis? Is there another option? 

You might be surprised to hear that many companies report income on a cash basis for tax purposes, while maintaining accrual basis financials for their internal operations and decision-making. Overall, if your business regularly carries high accounts receivable and prepaid expenses compared to your payables and accrued liabilities, switching to a cash basis for tax reporting could significantly defer your tax burden. Here's how to determine if this strategy makes sense for your business. 

How Cash Basis Can Reduce Your Tax Liability 

Cash basis accounting can defer significant taxable income by delaying when you report revenue until payment is received. This becomes especially powerful when your business regularly carries more in accounts receivable and prepaid expenses than you owe in accounts payable and accrued liabilities, creating a net deferral effect that reduces your income tax burden. 

Here's how the two methods differ: 

• Cash basis: Income is reported when you receive payment, and expenses are deducted when you pay them. That invoice you sent in December? If the customer pays in January, it's next year's income for tax purposes. 
• Accrual basis: Income and expenses are recorded when earned or incurred, regardless of when cash changes hands. That December invoice becomes taxable income immediately, even if you're still waiting for payment. 

The rule of thumb?

If your receivables and prepaid expenses consistently exceed your payables and accrued liabilities, you have a net deferral opportunity. Cash basis lets you push income into future tax years while still deducting current expenses, often resulting in meaningful tax savings. 

This strategy works particularly well for service businesses, consultants, and companies with longer payment cycles who typically have substantial accounts receivable but fewer outstanding payables. 

IRS Eligibility Requirements for Cash Basis 

Not every business can make this switch. The IRS has specific rules about who qualifies for cash basis accounting. The good news is that most small to mid-sized businesses are eligible and can take advantage of this tax strategy. Here are the key eligibility requirements: 

• Gross receipts test: Your business must have average annual gross receipts of around $30 million or less over the past three years. This threshold covers a majority of businesses outside of large corporations. 
• Entity restrictions: C corporations and partnerships with C corporation partners face additional limitations, but most LLCs, S corporations, and sole proprietorships qualify without issue. 
• Inventory considerations: If your business carries significant inventory, special rules may apply that could limit the benefits of cash basis accounting. 

Making the Election 

Switching to cash basis requires filing Form 3115 (Application for Change in Accounting Method) with your tax return. Once approved, you'll need to make a Section 481(a) adjustment to prevent income or expenses from being doubled or omitted during the transition. Common Section 481(a) adjustments include: 

• Accounts receivable: Outstanding invoices get removed from taxable income in the transition year 
• Prepaid expenses: Already-paid items (like insurance or rent) get deducted again under the cash basis 
• Accounts payable: Unpaid bills that were already deducted must be added back to income 
• Accrued liabilities: Similar to payables - previously deducted amounts get reversed 

The timing matters, too. You typically need to file this election with your current year's return, so planning is essential to capture the tax benefits starting with your next filing. 

What Should I Consider Before Switching Methods? 

Making the switch to a cash basis for taxes doesn't mean overhauling your entire accounting system. Many businesses find the dual approach gives them the best of both worlds, better tax positioning and reliable financial reporting. 

Here's what you need to know: 

• Keep your books on accrual: Your internal financial statements can remain on an accrual basis while you file taxes using a cash basis. This gives you accurate financial reporting for business decisions while capturing tax advantages. 
• Not all cash activity affects taxes: Understanding what counts as taxable income versus regular cash flow is crucial. Loan proceeds, owner contributions, and equipment sales aren't taxable income, just like loan payments, capital purchases, and owner distributions aren't deductible expenses. 
• Cash flow vs. tax planning: Accrual accounting still provides the clearest picture of your true financial position, showing who owes you money and what you owe others. This remains essential for managing cash flow and making strategic business decisions. Tax Planning, on the other hand, will need more analysis during year-end because cash basis income is typically more volatile than accrual basis.
   

Making the Right Choice for Your Business 

The decision to switch from accrual to cash basis isn't one-size-fits-all, but the math often makes it clear. If you're consistently carrying more money in receivables and prepaids than you owe in payables and accruals, a cash basis likely offers meaningful tax deferrals. 

When it comes time to evaluate, you should:

• Run the numbers: Calculate your typical year-end balances for accounts receivable and prepaid expenses versus accounts payable and accrued liabilities. A consistent pattern of higher receivables indicates potential tax savings. 
• Consider your business cycle: Companies with seasonal revenue, long collection periods, or significant year-end billings often see the biggest benefits from cash basis reporting. 
• Factor in growth plans: If you're rapidly expanding, the administrative complexity of dual-method accounting might outweigh the tax benefits. Conversely, stable businesses with predictable patterns often find the switch very worthwhile. 
  
  

Lutz Can Help You Navigate Cash vs. Accrual Decisions 

Our accounting experts at Lutz help businesses evaluate these decisions strategically, considering both immediate tax impact and long-term business goals. We'll walk you through the eligibility requirements, quantify potential savings, and handle the technical filing requirements. Have questions? Contact us to learn more.