IRC 446 and 448: Accounting Methods for Tax
The general rule for methods of accounting, the small business cash-method exception and its gross-receipts test, and changing methods
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
Section 446 is the general rule: taxable income follows the method the taxpayer regularly uses for its books, if it clearly reflects income, and changes need IRS consent. Section 448 bars C corporations, partnerships with C corporation partners, and tax shelters from the cash method unless they meet the small business gross receipts test (US$32 million for 2026).
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What does section 446 require?
Three things. Consistency: use the same method year to year, and the method used for books. Clear reflection of income: the method must not distort income — the IRS can impose a method where the taxpayer's doesn't clearly reflect it. Consent for changes: a taxpayer may not switch methods (cash to accrual, or the treatment of any material item) without filing Form 3115, either under the automatic-consent procedures for common changes or with an advance-consent request for others. The permissible overall methods are the cash receipts and disbursements method, the accrual method, and hybrid methods approved for specific items; special methods exist for long-term contracts, installment sales, and inventories.
Cash or accrual?
| Cash method | Accrual method | |
|---|---|---|
| Income recognized | When actually or constructively received | When the right to it is fixed and the amount determinable (all-events test), subject to the advance-payment deferral |
| Expenses deducted | When paid (with the twelve-month rule for prepayments) | When the liability is fixed and economic performance has occurred |
| Unbilled and uncollected work | Not income | Income when billed or billable |
| Advance payments | Income when received | Deferrable one year to the extent deferred in the books |
| Bad debts | No deduction (income never recognized) | Deductible when worthless |
| Who may use it | Businesses meeting the section 448(c) gross receipts test; individuals; S corporations and partnerships without C corporation partners regardless of size (unless tax shelters) | Anyone; required for those failing the test |
What is the section 448(c) gross receipts test?
A taxpayer meets it for a year if its average annual gross receipts for the three prior tax years do not exceed the inflation-adjusted threshold (set at US$25 million in 2018 and indexed since — US$31 million for 2025 and US$32 million for 2026). Gross receipts of related entities under common control are aggregated. Meeting the test does more than permit the cash method: it exempts the business from the uniform capitalization (inventory cost) rules, lets it treat inventory as non-incidental materials and supplies or follow its book method, exempts it from the percentage-of-completion requirement for long-term contracts, and exempts it from the business interest limitation. A business that grows past the threshold loses all of these in the year it fails and must change methods — the reason the consulting revenue recognition guide calendars the threshold against growth.
What is a tax shelter for this purpose?
Most often, any enterprise (other than a C corporation) in which more than 35 percent of a loss year's losses are allocated to limited partners or limited entrepreneurs who do not actively participate in management — a "syndicate"; the other two categories are enterprises offered in registration-required offerings and tax-avoidance arrangements. A tax shelter cannot use the cash method regardless of size. The definition catches some ordinary partnerships and S corporations in a loss year when passive investors hold more than 35 percent: an LLC with a loss and passive members owning 40 percent is a syndicate for that year and must use accrual. An election exists to test the 35 percent on the prior year's allocations instead of the current year's, which stabilizes the answer.
How do I change methods?
Form 3115. For most changes — cash to accrual or the reverse, inventory methods, depreciation corrections, the advance-payment deferral — the change is under the automatic-consent procedures: the form is attached to the return for the year of change and a copy sent to the IRS, with no user fee. The section 481(a) adjustment captures the cumulative difference between the old and new methods at the start of the year of change — a positive adjustment (income increase) is spread over four years; a negative one is taken entirely in the year of change. A change made without Form 3115 is an impermissible change; the IRS can require the original method for all open years, with the adjustment computed as it chooses.
Worked example
A consulting S corporation with three shareholders has averaged US$4 million of gross receipts and used the cash method. It meets the section 448(c) test (well under the threshold), has no C corporation shareholders, and is not a syndicate — cash method permitted. It adds two passive investors who together hold 40 percent, and the firm has a loss year: with more than 35 percent of the loss allocated to non-managing owners, it is a syndicate for that year and must use accrual — unless it makes the election to test on the prior (profitable) year's allocations, which keeps it on the cash method. Growth alone would not force a change: an S corporation that is not a syndicate may use the cash method at any size. Had it been a C corporation, crossing the threshold would mean Form 3115 under the automatic procedures, a section 481(a) adjustment (unbilled and uncollected receivables less unpaid payables) spread over four years, and the advance-payment deferral elected for milestone deposits.
Frequently asked questions
What is IRC 446?
The general rule for tax accounting methods: compute taxable income under the method regularly used for your books, provided it clearly reflects income, and change methods only with IRS consent (Form 3115).
What is IRC 448?
The section limiting the cash method: C corporations, partnerships with C corporation partners, and tax shelters must use accrual, except that businesses meeting the small business gross receipts test (other than tax shelters) may use the cash method, as may farming businesses and qualified personal service corporations.
What is the small business taxpayer gross receipts test?
Average annual gross receipts for the three prior years at or below the inflation-adjusted threshold (US$32 million for 2026), aggregating related entities. Meeting it permits the cash method and exempts the business from the inventory capitalization, percentage-of-completion, and business interest limitation rules.
How do I change accounting methods?
File Form 3115 — under the automatic-consent procedures for common changes, or with an advance-consent request otherwise — and compute the section 481(a) adjustment, spread over four years if positive.
Official sources
Publication 538 states: “No single accounting method is required of all taxpayers. You must use a system that clearly reflects your income and expenses and you must maintain records that will enable you to file a correct return.” — Internal Revenue Service, Publication 538, Accounting Periods and Methods, https://www.irs.gov/publications/p538
Next step
Fairlight Accounting is a cross-border accounting and tax practice with a U.S. Tax Desk and a Canadian Tax Desk. Our U.S. Tax Desk handles accounting method selection and the gross receipts test, syndicate analysis for partnerships with passive investors, Form 3115 method changes with section 481(a) adjustments, and advance-payment deferral elections. See pricing or book a call.
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