Who Must Use Accrual?

Most types of business that have inventory must use the accrual method, at least for sales and for purchases. Inventories are necessary in most marketing, manufacturing, retail, or wholesale businesses.

At the end of 2001, the IRS issued new rules allowing certain small service businesses that also sell related products and have average annual gross receipts under $10 million for the previous three year period to use the cash method of accounting for their income and expenses. The cash method, instead of the accrual method, can be used under the following four safe harbors:

• The taxpayer may use the cash method if its principal business activity is not retailing, wholesaling, manufacturing, mining, publishing or sound recording.
• The taxpayer may use the cash method if its principal business activity is the provision of services, even if the taxpayer is providing property incident to the services.
• The taxpayer may use the cash method if its principal business activity is custom manufacturing as defined in the guidance.
• Regardless of the taxpayer's primary business activity, the taxpayer may use the cash method with respect to any separate and distinct trade or business that satisfies one of the first three safe harbors.

 
There is also another exception for artists, authors, and photographers who sell works that they have created by their own efforts. They are not required to assign their qualified creative expenses to the particular works they have created as "cost of goods sold," which generally means they don't need to keep track of inventory costs. "Qualified creative expenses" do not include expenses related to printing, photographic plates, film, videotape, etc., so if you are involved in mass reproduction or publishing of your own creative work, you'll have to use inventory accounting for that part of your business.
C corporations with average annual cash receipts over $5 million that are not personal service corporations generally must use the accrual method. Other types of entities that must use accrual accounting are partnerships that have one or more C corporations as partners, tax shelters, and charitable trusts having unrelated business taxable income.