An S corporation's accounting method can have a big impact on how its revenues and expenses are recorded, as well as the amount of income that flows through to shareholders. Eligible S corporations can file on a cash basis if they have less than $10 million in annual gross receipts. S corporations that hold inventory can only use a cash basis if they have average annual gross receipts of less than $1 million.
S corporations can maintain their accounting records on a cash basis or an accrual basis. Using accrual accounting, the business recognizes revenues and expenses as they occur regardless of whether or not cash is exchanged. Under cash method accounting, the business only records a transaction when cash flows in or out of the business. Since S corporations are pass-through entities, the business income and loss flows through to individual shareholder tax returns. The choice of accounting method can alter net income or loss for the period and the final figure that flows through to shareholder tax returns.
Not every S corporation can file on a cash basis. The IRS only allows S corporations with certain business activities to use the cash accounting method. Typically, businesses that primarily provide a service, fabricate or modify personal property can use the cash method. However, companies involved in mining activities, manufacturing, wholesale trade, retail trade and information industries aren't eligible for the cash method and must instead use accrual accounting.
Beyond having an eligible business, S corporations must also pass a gross receipt test to file on a cash basis. The IRS restricts cash basis accounting to businesses with annual average gross receipts of less than $10 million from the three most recent tax years. If the current shareholders purchased the S corporation within the last three years, they must include the records of their predecessor to the gross receipts. Businesses that haven't been in existence for three years should base the average on gross receipts since inception.
As a general rule, S corporations that hold inventory must use the accrual basis of accounting. However, the IRS makes an exception for small companies. Businesses with less than $1 million in average annual gross receipts may use the cash method. These S corporations should account for inventory as if it were materials and supplies rather than using an inventory valuation method.