Why keep my books on an accrual basis but pay taxes on a cash basis?

Many small business owners are surprised to learn that they can keep their books using one accounting method and file their taxes using another. It may seem strange, but it’s actually a powerful strategy that helps you run your business more effectively while staying tax efficient. 

Using accrual or modified accrual accounting for your books gives you a clearer view of your business’s financial health. Using cash basis accounting for taxes can reduce your liability by making sure you only pay taxes on income you’ve actually received. And the IRS allows this for many businesses. 

This setup isn’t confusing or shady—it’s smart. Here’s how it works and why it might be the right approach for your business. 

What’s the difference between accrual and cash basis accounting? 

The main difference comes down to timing—when you record income and expenses. 

Accrual basis accounting records income when it’s earned and expenses when they’re incurred. It doesn’t matter when the cash comes in or goes out. It’s about when the work happens. 

Cash basis accounting only records income when you receive payment and only records expenses when you actually pay the bill. It’s based on what’s happening in your bank account, not what’s been invoiced or billed. 

Here’s a quick example. You send an invoice for $10,000 in December. Your client pays it in February. 

Under accrual accounting, that $10,000 counts as December income. Under cash accounting, it counts in February. 

This difference matters, especially at year-end when your financial reports and your tax return might be telling two different stories. 

Here is a quick chart for comparison: 

Why would a business choose accrual for internal books? 

Accrual or modified accrual gives you a better way to manage your business. It helps you understand what you’ve really earned, what you owe, and whether your operations are truly profitable—even if the money hasn’t landed in your account yet. 

Here’s why many small businesses use accrual or modified accrual accounting internally: 

• You can track profitability more accurately. Revenue is matched to expenses, so you can see if a particular job, month, or client is truly profitable. 
  
• It supports better planning. You can forecast revenue and expenses more realistically, which helps with cash flow management. 
  
• It looks more professional. Lenders, investors, and even some customers may ask for accrual-based financial statements to evaluate your stability. 

Modified accrual adds some flexibility. For example, you may only track receivables and payables for large transactions or adjust for things like payroll liabilities or inventory without going full accrual. 

Why file taxes on a cash basis? 

Cash basis tax filing has one major advantage: you don’t pay taxes on income until you’ve received it. That’s especially helpful if your clients pay slowly or you bill at the end of the year. 

Here’s why many small businesses choose the cash method for taxes: 

• It’s simple. You only count what’s actually happened in your bank account.
  
• It’s fair. You’re not taxed on invoices you haven’t been paid for yet. 
  
• It’s flexible. You can manage the timing of income and expenses to smooth out your tax obligations. 

A business might look wildly profitable in December on its accrual books, but if no one’s paid their invoices yet, using the cash method for taxes lets you avoid paying tax on that income prematurely. 

Can you really use accrual for your books and cash for your taxes? 

Yes. Many businesses do exactly that. There’s no rule saying your management accounting and your tax accounting have to match—at least not for most small businesses. 

Here’s how it works in practice: 

• You track your business using accrual or modified accrual accounting throughout the year, which gives you insight into operations and financial performance.
  
• At tax time, your CPA performs an accrual-to-cash conversion. They adjust your year-end financials to reflect only income received and expenses paid. 

That final set of numbers is what gets reported to the IRS. 

You don’t need to file anything special with the IRS to do this, unless you’re officially changing your tax method. If you’ve already elected cash basis for taxes, you can continue using accrual internally without issue. 

Who qualifies to use the cash method for taxes? 

The IRS allows many small businesses to use the cash method. To qualify: 

• Your average gross receipts over the past three years must be under $27 million 
  
• You can’t be a C corporation (or a partnership with a C corp as a partner) 
  
• You can’t be considered a tax shelter 
  
• You must not hold inventory in a way that requires accrual reporting (although these rules have been relaxed in recent years) 

If you’re a service-based business, freelancer, consultant, or even a contractor who bills for labor and services, you likely qualify. 

How does the accrual-to-cash conversion work? 

At year-end, your CPA will make several adjustments to convert your accrual books to cash basis for tax reporting. These adjustments include: 

• Removing any income that’s been invoiced but not collected 
  
• Reversing any expenses that have been recorded but not paid 
  
• Adjusting inventory, prepaids, or payroll liabilities as needed 
  
• Reconciling your books to match actual cash movement 
  

This ensures you’re only taxed on cash you’ve actually received and only deduct expenses you’ve actually paid. 

Why not just use cash for everything? 

It’s tempting—but you lose important insights. 

Cash accounting doesn’t show you: 

• What revenue you’ve earned but haven’t collected 
• What expenses are coming due 
• Whether specific jobs or time periods were actually profitable 
• What your financials look like in the real world (not just in your bank account) 

If you’re growing, trying to secure financing, or just want to make informed decisions, accrual gives you the visibility you need. 

Are there any downsides to this strategy? 

While this setup is great for many businesses, there are a few things to watch out for: 

• You need a CPA or bookkeeper who understands how to convert between methods accurately 
• You must keep good records of your receivables, payables, and timing differences 
• It can get tricky if your business grows beyond the eligibility limits for cash basis tax filing 

It’s also important to keep your internal books clean. Don’t mix accrual and cash thinking in the same file. Pick one for management (usually accrual or modified accrual) and let your tax professional handle the conversion at year-end. 

Can you switch tax methods later? 

Yes, but it requires IRS approval. To change your official tax accounting method (from accrual to cash or vice versa), you must file Form 3115 and receive consent. 

But if you’re already using the cash method for taxes, and you simply want to switch your internal books to accrual for better insights—you can do that anytime. There’s no need to file anything, as long as your taxes remain consistent. 

Why this matters for small businesses 

Here’s the bottom line: accrual or modified accrual accounting gives you the best lens into your business. You see what’s really happening—what you’ve earned, what you owe, and how each part of the business is performing. 

Cash basis tax filing, on the other hand, gives you control. You avoid taxes on income you haven’t collected and can manage the timing of deductions and income recognition. 

The combination of the two lets you: 

• Run your business strategically 
• File taxes efficiently 
• Avoid surprises 
• Keep more cash in your business 

This isn’t a workaround or a loophole—it’s just smart financial strategy. 

Here is a quick chart for reference: 

The bottom line

Using accrual or modified accrual accounting for your books and cash basis for taxes gives you the best of both worlds. It’s not overly complicated when set up correctly, and it positions you to make better decisions while keeping more cash in your business. 

If you’re unsure whether you qualify or how to structure it, work with a CPA who understands how to implement this system cleanly. It’s one of the smartest and simplest things you can do to run your business better and manage your taxes wisely. 

Need help? That’s what we’re here for. Let’s talk.