The Hybrid Method of Accounting

The hybrid method is a combination of the cash and accrual methods of accounting. The IRS says, you can generally use any combination of cash, accrual, and special methods of accounting if the combination clearly reflects your income and you use it consistently.

However, the following restrictions apply:

  • If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales ( see "Exceptions" below). Generally, you can use the cash method for all other items of income and expenses.
    • Incidental and non-incidental materials and supplies:
      • For tax purposes, the cost of supplies may be deducted upon purchase as an ordinary and necessary business expense, in the case of incidental materials and supplies, or be capitalized under Regs. Sec. 1.162-3 and expensed as consumed, in the case of nonincidental materials and supplies.
      • More specifically, incidental materials and supplies on hand at the end of the year may be deducted in the year of purchase as long as no record of consumption is kept or no physical inventories are taken, provided the taxpayer's taxable income is clearly reflected by this method.
  • If you use the cash method for reporting your income, you must use the cash method for reporting your expenses.
  • If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.
  • Any combination that includes the cash method is treated as the cash method for purposes of section 448 of the Internal Revenue Code. .

CAUTION! The rules discussed here apply only if they do not conflict with the uniform capitalization rules of section 263A and the mark-to-market rules of section 475.

Exceptions -

The following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise.

  • A qualifying taxpayer under Revenue Procedure 2001-10 on page 272 of Internal Revenue Bulletin 2001-2, available at–02.pdf.
  • A qualifying small business taxpayer under Revenue Procedure 2002-28, on page 815 of Internal Revenue Bulletin 2002-18, available at–18.pdf.
    • Note that Revenue Procedure 2002-28 does not apply to a farming business of a qualifying small business taxpayer. A taxpayer engaged in the trade or business of farming generally is allowed to use the cash method for any farming business (see IRS Pub. 538).

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