9044 / What is the cash basis method of accounting?

Editor’s Note: The 2017 tax reform legislation provides that the cash method of accounting can be used by taxpayers that satisfy the gross receipts test regardless of whether the purchase, production or sale of merchandise is an income producing factor. The gross receipts test allows taxpayers with annual average gross receipts that do not exceed $31 million (in 2025) for the three prior tax years (the “gross receipts test”) to use the cash method. The $25 million amount is indexed for inflation beginning after 2018 and was $29 million for 2023, $30 million in 2024 and $31 million in 2025.¹

The cash basis method of accounting is the most widely used accounting method for individual taxpayers, and is often used by many business entities, as well.² Cash basis taxpayers recognize all gross income, whether in the form of cash, property or services, in the year that the income is actually or constructively received.³

“Constructive receipt” is considered to have occurred when income is made available to a taxpayer without restrictions.⁴ For example, a cash basis taxpayer cannot avoid reporting income simply because he refused to deposit a check. Conversely, if a taxpayer’s employer provides the taxpayer with a stock bonus, but conditions are imposed so that the bonus is not available to the taxpayer until a future date, the corporation’s reporting such bonus on its books does not constitute constructive receipt on the part of the taxpayer-employee.

Similarly, a taxpayer is entitled to claim any deductions for the year in which the expenses that gave rise to the deduction were actually paid.⁵ There is no “constructive payment” type doctrine that corresponds to the constructive receipt doctrine discussed above, however.⁶

Though a cash basis taxpayer’s receipt of income in the form of cash is simple to recognize, complications may arise when the income is received in the form of non-cash property or a right to receive income based on future services. As such, the IRS has developed the doctrines of “cash equivalence” and “economic benefit” to address the receipt of property and services. When income is received in the form of property, the cash basis taxpayer must include the fair market value of such property in income if rights to the income are (1) freely transferable,
(2) readily marketable and (3) immediately convertible into cash.⁷

On the other hand, if a taxpayer contracts to perform services for a specified amount of income that will be received in installments over the period of service, the taxpayer does not report the value of the installment payments in the year the contract is entered. This is because the taxpayer does not receive a cash equivalent at the time of contracting, but rather obtains only the right to receive such cash payments in the future dependent on performance of the required services.⁸

Under the economic benefit theory, a taxpayer is required to recognize income if an economic benefit has been conferred upon the taxpayer, even if the taxpayer has no ability to currently access the cash or non-cash property providing such benefit.⁹ For the cash basis taxpayer to recognize income under the economic benefit theory, the property must be transferred for the benefit of the taxpayer¹⁰ and confer vested, nonforfeitable rights¹¹ to the taxpayer. For example, a taxpayer was required to recognize income when his employer transferred certain amounts into a trust for his future benefit where the employer’s payment was irrevocable, even though the taxpayer was not currently able to access the funds in the trust.¹² Therefore, unlike the cash equivalence theory, the property that is irrevocably transferred and held for the taxpayer’s benefit does not have to be transferrable by the taxpayer.¹³ The taxpayer is required to include the fair market value of non-cash property, or present value of any cash, that is transferred in income for the year such property or cash is transferred.¹⁴

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Planning Point: Generally speaking, the cash basis method of accounting works best for organizations that prefer simplicity over predictability. Cash basis is like balancing a checkbook; if the money is there, then the money affects the tax obligations. Large and unanticipated increases in revenues can lead to large tax obligations—and potentially large cash outflows—that small business owners may not be prepared for. Quarterly estimated tax payments may be more difficult to predict in a cash basis business with large, infrequent sales.

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