Tax Accounting Methods, Timing, and Inventories
Overall methods
IRC §446 permits the cash receipts and disbursements method, the accrual method, or a hybrid, if the method clearly reflects income. A change in method requires IRS consent under §446(e), generally via Form 3115. Cash-method taxpayers report income when actually or constructively received and deduct when paid, but cannot deduct before economic performance if the expense is a capital item or otherwise deferred. Constructive receipt occurs when income is available without restriction.
Accrual and timing
Accrual-method taxpayers report income when all events have occurred that fix the right to receive it and the amount can be determined with reasonable accuracy. Deductions require the all-events test plus economic performance under §461(h): the liability is fixed, the amount is determinable, and economic performance has occurred. Recurring items may be deducted if performance occurs within 8.5 months after year-end. Related-party expenses under §267 and deferred compensation under §404 have special timing rules.
Inventories and capitalization
Section 471 requires inventories when needed to clearly determine income. Permissible methods include specific identification, FIFO, LIFO, and average cost. LIFO requires conformity with financial statements. Lower of cost or market is available except with LIFO. Section 263A requires capitalization of direct and indirect costs, including mixed service costs, for producers and resellers. Small business taxpayers under the gross receipts threshold may use the cash method, treat inventories as non-incidental materials and supplies, and avoid §263A.
Worked example
An accrual-method calendar-year repair shop receives a $12,000 invoice on December 28, 2024, for repairs performed December 29; it pays on January 10, 2025. The expense is deductible in 2024 because the liability is fixed, the amount is determinable, and economic performance (the repairs) occurred before year-end. A cash-method taxpayer would deduct it in 2025, when paid. If the repairs were a capital improvement, both methods would capitalize and recover the cost through depreciation.
Traps
- Deducting a prepaid expense that benefits a later year without the 12-month rule.
- Using the cash method when the business is a C corporation or tax shelter outside the small-business exception.
- Forgetting economic performance for accrual deductions.
- Changing an accounting method without filing Form 3115.
- Treating inventory as a current deduction.