Accounting Methods

An accounting method is a set of rules used to determine when and how income and expenditures are reported. The method of accounting used must be reconcilable with the partnership’s books and records. In all cases, the method used must clearly reflect income. Generally, the following rules apply. For more information, see Pub. 538, Accounting Periods and Methods.

Permissible overall methods of accounting include:

• Cash,

• Accrual, or

• Any other method authorized by the Internal Revenue Code (the Code).

Generally, a partnership may use the cash method of accounting unless it’s required to maintain inventories, has a C corporation as a partner, or is a tax shelter (as defined in section 448(d)(3)). However, for tax years beginning after 2017, any partnership qualifying as a small business taxpayer (defined below) may use the cash method.

Tax shelter election. A taxpayer that is a tax shelter, as defined in section 448(d)(3), isn’t permitted to use the cash method pursuant to section 448(a)(3), and is also not permitted to use the small business taxpayer exemptions contained in sections 163(j)(3) (limitation on business interest), 263A(i) (uniform capitalization), 460(e)(1)(B) (percentage of completion method), and 471(c) (general inventory method). Under section 448(d)(3), a taxpayer that is a syndicate is considered a tax shelter. For purposes of section 448(d)(3), a syndicate is a partnership or other entity (other than a C corporation) if more than 35% of the losses of such entity during the tax year are allocated to limited partners or limited entrepreneurs.

The final regulations under section 448 permit a taxpayer to make an annual election to use its allocations made in the immediately preceding tax year, instead of using the current tax year’s allocation, to determine whether the taxpayer is a syndicate under section 448(d)(3) for the current tax year. The election is made on the timely filed original return (including extensions) for the tax year for which it’s made. The election is valid only for the tax year for which it’s made and, once made, can’t be revoked. See Regulations section 1.448-2(b)(2)(iii)(B) (2) for guidance on the time and manner of making the annual election and effective dates.

Small business taxpayer. For tax years beginning after 2017, a small business taxpayer (defined below) can adopt or change its accounting method to account for inventories (a) in the same manner as materials and supplies that are nonincidental; or (b) to conform to the taxpayer’s treatment of inventories in an applicable financial statement (as defined in section 451(b)(3)), or, if the taxpayer doesn’t have an applicable financial statement, the method of accounting used in the taxpayer’s books and records prepared in accordance with the taxpayer’s accounting procedures. See section 471(c)(1), and Change in accounting method, later.

For tax years beginning after 2017, a small business taxpayer can adopt or change its accounting method to not capitalize costs to property produced or acquired for resale under section 263A. See section 263A(i), and Change in accounting method and Limitations on Deductions, later.

Small business taxpayer defined. For 2025, a small business taxpayer is a taxpayer that (a) has average annual gross receipts of $31 million or less for the prior 3 tax years, and (b) isn’t a tax shelter (as defined in section 448(d)(3)).

Accrual method. Generally, under the accrual method, an amount is includible in income when:

1. All the events have occurred that fix the right to receive income, which is the earliest date:

a. Payment is earned through the required performance,

b. Payment is due to the taxpayer,

c. Payment is received by the taxpayer,

d. When title passes, or

e. When the income is reported as revenue in an

applicable financial statement (AFS); and

2. When the amount can be determined with reasonable accuracy.

Instructions for Form 1065 (2025) 7

See Regulations sections 1.451-1(a) and -3(c) for details. Generally, an accrual-basis taxpayer can deduct accrued expenses in the tax year in which:

• All events that establish the liability have occurred,

• The amount of the liability can be figured with reasonable accuracy, and

• Economic performance takes place with respect to the expense.

For property and service liabilities, for example, economic performance occurs as the property or service is provided. There are special economic performance rules for certain items, including recurring expenses. See section 461(h) and the related regulations for the rules for determining when economic performance takes place.

Nonaccrual-experience method. Accrual method partnerships aren’t required to accrue certain amounts to be received from the performance of services that, on the basis of their experience, won’t be collected if:

• The services are in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; or

• The partnership’s average annual gross receipts don’t exceed $31 million for all prior tax years. For more details, see section 448(d)(5).

This provision doesn’t apply to any amount if interest is required to be paid on the amount or if there’s any penalty for failure to timely pay the amount. For information, see section 448(d)(5) and Regulations section 1.448-2. For reporting requirements, see the instructions for line 1a, later.

Percentage of completion method. Long-term contracts (except for certain real property construction contracts) must generally be accounted for using the percentage of completion method described in section 460. See section 460 and the underlying regulations for rules on long-term contracts.

Mark-to-market accounting method. Dealers in securities must use the mark-to-market accounting method described in section 475. Under this method, any security that is inventory to the dealer must be included in inventory at its fair market value (FMV). Any security that isn’t inventory and that is held at the close of the tax year is treated as sold at its FMV on the last business day of the tax year, and any gain or loss must be taken into account for the tax year. The gain or loss taken into account is generally treated as ordinary gain or loss. For details, including exceptions, see section 475 and the related regulations, and Rev. Rul. 97-39, 1997-39 I.R.B. 4.

Dealers in commodities and traders in securities and commodities can elect to use the mark-to-market accounting method. To make the election, the partnership must file a statement describing the election, the first tax year the election is to be effective, and, in the case of an election for traders in securities or commodities, the trade or business for which the election is made. Except for new taxpayers, the statement must be filed by the due date (not including extensions) of the return for the tax year immediately preceding the election year and attached to that return or, if applicable, to a request for an extension of time to file that return. For more details, see Rev. Proc. 99-17, 1999-7 I.R.B. 52; Rev. Proc. 2025-23, 2025-24 I.R.B. 1476; and sections 475(e) and (f).

Change in accounting method. Generally, the partnership must get IRS consent to change its method of accounting used to report income or expense (for income or expense as a whole or for any material item). To do so, the partnership must generally file Form 3115, Application for Change in Accounting Method, during the tax year for which the change is requested. See the Instructions for Form 3115 and Pub. 538 for more information and exceptions.

Section 481(a) adjustment. The partnership may have to make an adjustment to prevent amounts of income or expenses from being omitted or duplicated. This is called a section 481(a) adjustment. The section 481(a) adjustment period is generally 1 year for a net negative adjustment and 4 years for a net positive adjustment. However, in some instances, a partnership can elect to modify the section 481(a) adjustment period. The partnership must complete the appropriate lines of Form 3115 to make the election. See the Instructions for Form 3115.

Include any net positive section 481(a) adjustment on page 1 of Form 1065, line 7. If the net section 481(a) adjustment is negative, report it on page 1, line 21.

There are some instances when the partnership can obtain automatic consent from the IRS to change to certain accounting methods. See the Instructions for Form 3115.