If you own a small business, you have a choice of how to pay tax on business income - accrual or cash. Accrual is where the big boys play (revenue over $30mm) as it's more accurate. But for tax purposes, an accrual basis tax return isn’t entirely accrual.

Buried in the code are a handful of transaction types that ignore your method of accounting and behave like cash no matter what. Miss them and you either overpay by leaving deductions on the table, or underpay and hope and pray the IRS doesn't notice.

A quick refresher first.

Cash vs. Accrual Primer

Cash method: Income when cash is received. 🏦 Deductions when cash is paid. Simple. Favors the taxpayer in most cases.

Accrual method: Income when "earned." 🫳 Deductions when the expense is incurred and economic performance has occurred. More complex. Generally worse for the taxpayer as accrual often accelerates income faster than deductions.

2017 tax reform raised the gross receipts threshold so that businesses under about $30MM (indexed annually) can elect cash method even if their books are on accrual.

If you qualify for cash and aren’t using it, you may be overpaying tax. (Worth noting some small businesses aren't eligible for cash even at low levels of income - like those with a high % of passive investors).

The Twist

Accrual has two hurdles for recognizing a transaction:

1. All Events Test. All events have occurred that fix the right to income or the liability.
2. Economic Performance. The underlying economic activity has happened.

These tests usually line up with when you’d expect. But the code has carved out several exceptions that override accrual treatment and force cash-basis-like timing.

Here are five ✋ I see most often.

1. Prepaid Rent (Income)

A tenant pays January rent on December 28th. That cash is income to the landlord on December 28th. Period. Your method doesn’t matter. Whether the rent is technically “earned” doesn’t matter.

On accrual books, that prepayment sits as a liability on the balance sheet. For tax, it’s income the moment the cash hits your account.

Prepaid rent is one of the most common accrual-to-tax differences on rental properties - and we often see it missed.

2. Accrued Bonuses: The 2.5 Month Rule & S-Corp Carveout

This one trips up more business owners than any other item on the list.

December 20th. You decide to pay your team $100,000 in year-end bonuses. You accrue the liability on 12/31 and plan to cut checks on March 1st.

You’d think you get the deduction in the year accrued. You do, but only if the cash goes out within 2.5 months of year-end.

For calendar year taxpayers, that deadline is March 15th. Miss it and you lose the deduction in the accrual year. You’ll pick it up whenever you finally pay. 📅

There’s a separate landmine under §267 for bonuses to owners. If you own more than 50% of a C-Corp, or any percentage of an S-Corp, the 2.5 month rule doesn’t apply at all. You can only deduct the bonus when the owner recognizes it as income (cash).

If you’re an S-Corp owner trying to accrue a bonus to yourself, don’t bother. It’s cash all the way.

3. Nonrefundable Deposits

Collect a $10,000 nonrefundable deposit for a future service and that’s taxable income on the day it arrives. Cash or accrual.

The Indianapolis Power & Light case from the Supreme Court set the standard. If the customer has no right to get the money back, you have “complete dominion” over the cash, and it’s income. Whether you’ve performed the service is irrelevant for tax.

Refundable deposits are different. Those are liabilities until earned.

This catches deposit-heavy businesses off guard all the time. Event venues. Custom manufacturers. Contractors with nonrefundable booking fees. If it's nonrefundable, it's taxable - leaving GAAP experts in shambles.

4. Prepaid Interest

You can’t deduct interest before it’s technically incurred, even on cash basis. §461(g) requires prepaid interest to be amortized over the period to which it relates.

Prepay a full year of interest in December to stuff a deduction in and the IRS says no. The interest gets spread over the 12 months it covers.

One exception: points on a primary home mortgage are deductible when paid. But that’s individual, not business.

5. Related Party Accruals

I've seen this game try to be played a lot. "I'll just book an accrual over here and since the other entity is cash basis, I can game the system a year." Negative ghost rider.

If an accrual-basis business owes a payment to a cash-basis related party (a partner, a family member, a related entity), the accrual business cannot deduct the expense until the cash-basis party recognizes it as income.

Example: your accrual-basis operating company accrues $50k of rent due to your cash-basis real estate LLC that owns the building you operate out of. On 12/31, you accrue the expense on the OpCo side. No deduction until the cash moves and the real estate LLC picks it up as income.

The rule exists to prevent timing arbitrage between related parties. It's also why reconciling intercompany accounts is a critical tax exercise to complete.

Why This Matters

If you’re mostly accrual, you need to know which accounts in your chart of accounts are cash-basis in disguise. Missing them creates three bad outcomes:

• Overpaying tax when you leave deductions on the table (timely-paid bonuses)
• Underpaying tax when you don’t pick up income on time (prepaid rent, nonrefundable deposits)
• IRS matching notices that turn into audits when your books don’t reconcile to your return

Your method of accounting is a strategic lever. Get the exceptions right and you control when tax gets paid.

🫡

Meme Cleanser 🧼

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