{"id":2022,"date":"2015-08-15T05:30:27","date_gmt":"2015-08-15T12:30:27","guid":{"rendered":"http:\/\/evergreensmallbusiness.com\/?p=2022"},"modified":"2018-02-26T11:25:59","modified_gmt":"2018-02-26T19:25:59","slug":"form-3115-for-a-cash-to-accrual-method-accounting-changes","status":"publish","type":"post","link":"https:\/\/evergreensmallbusiness.com\/form-3115-for-a-cash-to-accrual-method-accounting-changes\/","title":{"rendered":"Form 3115 for a Cash to Accrual Method Accounting Change"},"content":{"rendered":"
\"Picture<\/a>
You may need to switch from cash basis to accrual basis accounting if your business grows big enough.<\/figcaption><\/figure>\n

Most small businesses use cash-basis accounting for their operations.<\/p>\n

And that makes sense. First of all, cash-basis accounting makes a firm\u2019s bookkeeping easy because it simply counts income when a firm receives cash and (generally) counts expenses when a firm disburses cash.<\/p>\n

Second, though tax law prefers accrual-basis accounting (and in fact requires accrual-basis accounting in some situations, as discussed in later paragraphs) a special dispensation for small businesses, Rev. Proc . 2001-10<\/a>, says small businesses with less than $1,000,000 in average annual gross receipts can use cash basis accounting in spite of its flaws.<\/p>\n

Note:<\/strong> Even a business with less than $1,000,000 in revenues must delay expensing inventory purchases until the later of the date the inventory is sold or the date the inventory is paid for.<\/p>\n

However, if you\u2019re a business owner, you need to be aware of the reality that in a variety of situations, U.S. tax laws, treasury regulations, and related rules require a small business to use accrual basis accounting for a simple reason: Accrual-basis accounting provides for better measurement of profits and so a fairer calculation of taxes.<\/p>\n

Accordingly, in this post, I\u2019m going to talk about two things: First, when a cash-basis small business taxpayer needs to switch<\/em> from cash-basis accounting to accrual-basis accounting. Second, the general process you step through\u00a0to prepare\u00a0Form 3115 for a cash to accrual accounting method change\u2014which is how you report this change to the IRS.<\/p>\n

Switch if You Answer Any Question \u201cYes\u201d<\/h2>\n

Okay, this is all pretty byzantine, but probably the easiest way to determine if and when you need to switch is by asking and answering a series of questions. If you can answer any of the following questions \u201cyes,\u201d then you need to switch from cash-basis to either a hybrid of cash-basis and accrual-basis accounting or full-on accrual-basis accounting.<\/p>\n

Are You a C Corporation with Average Annual Revenues Over $1,000,000 But Not Over or Equal to $5,000,000?<\/h3>\n

If you operate as a \u201cC\u201d corporation but not as a \u201cpersonal service corporation\u201d and your operation has generated more than $1,000,000 a year, but not more than $5,000,000, in revenues on average over the last three years, tax law (specifically IRC Sec. 448<\/a>, and the related Treasury Regs at 1.448<\/a>) say you can\u2019t necessarily\u00a0use 100% cash-basis accounting.<\/p>\n

Note:<\/strong> A personal service corporation is a \u201cC\u201d corporation that sells personal services provided by the corporation\u2019s shareholder-employees. For example, a professional services firm of lawyers, consultants or physicians if operated as a \u201cC\u201d corporation and owned by the lawyers, consultants or physicians may be treated as a personal service corporation.<\/p>\n

Now if you\u2019re totally a service business and you don\u2019t sell inventory, sure, you can use cash basis accounting.<\/p>\n

But if you have inventory, you do need to at least account for your revenue and inventory using accrual accounting once you trip over the $1,000,000 in revenue threshold.<\/p>\n

People often call this mixed approach \u201chybrid\u201d accounting because you use accrual accounting for your revenues and for your inventory and cost of goods sold but then cash accounting for pretty much everything else.<\/p>\n

Note what this means, though: If you\u2019re a \u201cC\u201d corporation currently using cash accounting and you trip over other $1,000,000 threshold and you sell inventory, you probably need to change either to hybrid or accrual accounting.<\/p>\n

Are You an C Corporation with Average Annual Revenues Over $5,000,000?<\/h3>\n

If you operate as a \u201cC\u201d corporation (but not as a \u201cpersonal service corporation\u201d) and your operation has generated more than $5,000,000 a year in revenues on average over the last three years, tax law says you need to change your accounting method from cash to accrual method.<\/p>\n

Note:<\/strong> This \u201cC\u201d corporation category includes any corporation that hasn\u2019t made a Subchapter S election, including real estate investment trusts and nonprofit corporations that operate as exempt organizations.<\/p>\n

Are You a Partnership with a C Corporation Partner and Average Annual Revenues Over $5,000,000?<\/h3>\n

A partnership with a C corporation partner must also use accrual method accounting if the annual average revenues over the last three years exceed $5 million.<\/p>\n

Are You a Partnership, Sole Proprietorship, or S Corporation?<\/h3>\n

I already mentioned the $5,000,000 threshold which applies to \u201cC\u201d corporations. But a similar, though higher, $10,00,000 threshold applies to sole proprietors, \u201cS\u201d corporations, partnerships without \u201cC\u201d corporation partners, and qualified personal service corporations if taxpayers are principally service businesses or<\/em> are custom fabricators or<\/em>\u00a0are not<\/em> included in the NAICS codes for mining (NAICS codes 211 through 212), manufacturing (NAICS codes 31 through 33), wholesaling (NAICS code 42), retailing (NAICS codes 44 and 45)\u00a0or information business (NAICS codes 5111 and 5122).<\/p>\n

For businesses in these categories, as per Rev. Proc. 2002-28<\/a>, the firm may generally use cash-basis accounting. But do note that if you have inventory\u2014and you probably don\u2019t if you qualify per the terms of Rev. Proc. 2002-28\u2014you need to use accrual-style accounting for those inventory and cost of goods sold items. (For example, you might use the nonincidental materials and supplies rule, which essentially says the business can’t expense inventory until the later of the the point the inventory is sold or the point the inventory is paid for.)<\/p>\n

If you\u2019re operating a partnership, sole proprietorship,\u00a0S corporation or qualified personal service corporation and you don\u2019t qualify per Rev. Proc. 2002-28 to use cash basis accounting, you\u00a0are required to use accrual basis accounting. And note what this essentially says is if you\u2019ve got inventory in your business and you\u2019re generating more than $1,000,000 in revenue, yup, you need to use accrual basis accounting.<\/p>\n

\n

\"Picture<\/a>Tip:<\/strong> Just in case you are operating an S corporation, can I mention something sort of off topic but also possibly helpful?<\/p>\n

We’ve got a great 50pp monograph which outlines the rules for setting S corporation shareholder-employee salaries. If you or your clients wrestle with this issue, you would probably find the monograph very helpful.<\/p>\n

More information is available here “Setting Low Salaries for S Corporations<\/a>“.<\/p>\n

\n

Farming Corporations<\/h3>\n

Farming corporations need to know about a couple of other rules.<\/p>\n

C corporations operating farms generally need to accrual accounting if average annual gross receipts exceed $1,000,000. But there is an exception to this general rule. If the C corporation qualifies as a family farm corporation, the corporation doesn\u2019t have to use accrual accounting unless the average annual gross receipts (based on the last three years) exceed $25,000,000.<\/p>\n

Note:<\/strong> A family farm corporation is one where the members of family own at least 50% of the corporation\u2019s stock.<\/p>\n

Preparing 3115 to Report Change from Cash to Accrual<\/h2>\n

If you have been using cash basis accounting or hybrid accounting and need to change to full accrual accounting, you should do that. It\u2019s the law, after all.<\/p>\n

But you need to do more than simply begin using accrual accounting on your tax returns. Specifically, you need to calculate any adjustment required to make sure that income or deductions don\u2019t drop between the cracks due to the switch (this is called a Sec. 481 adjustment). And you need to explicitly document and describe the accounting method change and the Sec. 481 adjustment amount using Form 3115.<\/p>\n

You first file one copy of the 3115 form with the IRS\u2019s National Office (typically) and then after that you attach another copy of the Form 3115 to your tax return. You may in certain situations also need to provide copies of the 3115 to other IRS employees or workgroups, as explained in the relevant revenue procedures.<\/p>\n

This blog post has gone on way too long\u2014and we may publish an monograph with sample forms and full-blown instructions if people show interest. So I won\u2019t say much more. But let me make two other points about Form 3115 and the Sec. 481 adjustment.<\/p>\n

First about the Form 3115 you file to request permission to change your accounting from cash to accrual: You requesting permission to make this change\u2014a change required by tax law\u2014seems crazy, I know. But you need to follow the prescribed procedure so you don\u2019t inadvertently let income or deductions drop between the cracks\u2014and so you gain some special benefits afforded to\u00a0people who \u201cplay by the rules.\u201d<\/p>\n

Second, note that normally with cash-basis accounting, a firm delays reporting income and therefore delays paying taxes on the delayed income. What this means is that this \u201cwould have been reported earlier\u201d income drops between the cracks when you switch from cash accounting to accrual accounting. And\u00a0 because the IRS is full of pretty smart accountants and tax lawyers,\u00a0they of course<\/em> watch carefully for this. Further, what your Form 3115 with its Sec. 481 adjustment does is report this amount.<\/p>\n

Note:<\/strong> If the adjustment is a bump in taxable income, you typically get to split the amount over four years to soften the burden\u2014this is actually one of the benefits you gain when you \u201cplay by the rules.\u201d\u00a0If the adjustment is a cut in taxable income, you can report the entire adjustment at once.<\/p>\n

P.S. Interested in more articles like this? You can subscribe to the email newsletter version of the blog post by clicking the green Follow button that appears below.<\/p>\n","protected":false},"excerpt":{"rendered":"

Most small businesses use cash-basis accounting for their operations. And that makes sense. First of all, cash-basis accounting makes a firm\u2019s bookkeeping easy because it simply counts income when a firm receives cash and (generally) counts expenses when a firm disburses cash. 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