Choosing a Tax Year for Your Business

The IRS requires taxpayers to figure income on the basis of a tax year. A tax year generally covers a period of twelve consecutive months.

There are two kinds of tax years:

  • Calendar year
  • Fiscal year

Calendar Year

A calendar year is twelve consecutive months that begins on January 1 and ends on December 31.

Fiscal Year

A fiscal year is twelve consecutive months that ends on the last day of any month except December. A fiscal year may include a 52-53-week tax year.

You must use the same tax year for both your business and nonbusiness income. For example, if you report your business income on a fiscal year, you must report your nonbusiness income on a fiscal year.

When You Must Use a Calendar Year

You must use a calendar year if:

  • You keep no books.
  • You have no annual accounting period.
  • Your present tax year does not qualify as a fiscal year.
  • A provision in the Internal Revenue Code or income tax regulations require you to use a calendar year.

Required Tax Year

A required tax year is a tax year that is required under the Internal Revenue Code and income tax regulations. Partnerships, S corporations, and personal service corporations (PSC) must use a required year.

If an entity receives IRS approval to use another permitted year or if it makes an election under Section 444, then it does not have to use the required tax year.

A permitted tax year is any of the following:

  • A Calendar year
  • A tax year elected under section 444
  • A 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444.
  • Any other tax year for which the corporation establishes a business purpose.

Section 444

A partnership or an S corporation that makes a section 444 election must make certain required payments and a PSC must make certain distributions.

Here's what IRC Section 444(1) says:

In General. - Except as provided in paragraphs (2) and (3), an election may be made under subsection (a) only if the deferral period of the taxable year elected is not longer than 3 months.

If the partnership, S corporation, or PSC is adopting or changing to a tax year other than its required year, the deferral period is:

  • The number of months from the end of the new tax year to the end of the required tax year.

The IRS will allow a section 444 election only if the deferral period of the new tax year is less than the shorter of:

  • Three months, or
  • The deferral period of the tax year being changed.

For example, say you go into business August 2013 as an S corporation. The required year for an S corporation is a calendar year (twelve months ended December 31). You decide to make a Section 444 election to use a fiscal year with the fiscal year ending September 30. The deferral period is three months (October 1 through December 31).

Taxes for the three months Oct, Nov, and Dec. of 2013 will be applicable to fiscal year ended September 30, 2014.

Partnerships

IRS rules say a partnership must conform its tax year to the tax year of its partners unless any of the following apply:

  • The partnership makes a section 444 election
  • The partnership elects to use a 52-53-week tax year that ends with reference to either its required tax year or a tax year elected under section 444.
  • The partnership can establish a business purpose for a different tax year. (This is the tax year immediately preceding the year for which the partnership, S corporation, or PSC wishes to make the section 444 election.)

If the partnership, S corporation, or PSC’s tax year is the same as its required tax year, the deferral period is zero.

Example 1:

  • BD Partnership uses a calendar year, which is also its required tax year.
  • BD cannot make a section 444 election because the deferral period is zero.

Example 2:

  • E, a newly formed partnership, began operations on December 1, 2013.
  • E is owned by calendar year partners.
  • E wants to make a section 444 election to adopt a September 30 tax year.
  • E’s deferral period for the tax year beginning December 1, 2013 is 3 months, the number of months between September 30 and December 31.

Section 444 Election:

A partnership, can elect under section 444 to use a tax year other than its required tax year. Certain restrictions apply to the election.

The section 444 election does not apply to any partnership that establishes a business purpose for a different period.

The following are the required tax year rules for a partnership:

  • If one or more partners having the same tax year own a majority interest (more than 50%) in partner-ship profits and capital, the partnership must use the tax year of those partners.
  • If there is no majority interest tax year, the partner-ship must use the tax year of all its principal partners. A principal partner is one who has a 5% or more interest in the profits or capital of the partnership.
  • If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use a tax year that results in the least aggregate deferral of income to the partners (see Pub 538 page 5).

S corporation

All S corporations, regardless of when they became an S corporation, must use a permitted tax year.

A permitted tax year is any of the following:

  • A Calendar year
  • A tax year elected under section 444
  • A 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444.
  • Any other tax year for which the corporation establishes a business purpose.

Form 2553 and Form 1128:

Note that if you're filing Form 2553 to elect S corporation tax treatment for your LLC or C corporation, and you want to use a tax year other than a calendar year, you must request IRS approval using Form 2553 instead of filing Form 1128.

  • See the instructions to Form 1128.
  • See Revenue Procedure 2006-46 for automatic approval requests.
  • See Revenue Procedure 2002-39 or its successor for ruling requests.

The section 444 election does not apply to any S corporation that establishes a business purpose for a different period.

Personal Service Corporation

A PSC must use a calendar tax year unless any of the following apply:

  • The corporation makes an election under section 444. See Section 444 Election, below for details.
  • The corporation elects to use a 52-53-week tax year ending with reference to the calendar year or a tax year elected under section 444.
  • The corporation establishes a business purpose for a fiscal year.

See the Instructions for Form 1120 for general information about PSCs.

For information on adopting or changing tax years for PSCs, see the Instructions for Form 1128.

See Revenue Procedure 2006-46 for automatic approval requests and Revenue Procedure 2002-39 or its successor for ruling requests.

The section 444 election does not apply to any PSC that establishes a business purpose for a different period.

Corporation

Unlike partnerships, limited liability companies, and S corporations, which must use a required tax year, regular C corporations (not personal service corporations) may choose to use a fiscal year or calendar year, whichever is determined to be more advantageous.

How to Make a Section 444 Election

A partnership, S corporation, and personal service corporation can make a Section 444 election to use a tax year other than the required tax year.

File Form 8716, Election To Have a Tax Year Other Than a Required Tax Year with the Internal Revenue Service Center where the entity will file its tax return.

Form 8716 must be filed by the earlier of:

  • The due date (not including extensions) of the income tax return for the tax year resulting from the section 444 election, or
  • The 15th day of the 6th month of the tax year for which the election will be effective. For this purpose, count the month in which the tax year begins, even if it begins after the first day of that month.
  • Attach a copy of Form 8716 to Form 1065, Form 1120S, or Form 1120 for the first tax year for which the election is made.

Extension of Time for Filing:

There's are automatic twelve-month extension to make the election. See the instruction on Form 8716.

Termination of Section 444 Election:

The Section 444 election remains in effect until it is terminated, for example, if the entity liquidates or the entity changes to its required year.

Once the election is terminated, another Section 444 election cannot be made for any tax year.

Fiscal Year

A fiscal year is twelve consecutive months that ends on the last day of any month except December. A fiscal year may include a 52-53-week tax year.

Why You May Want to Choose a Fiscal Year

You may have a compelling business reason to use a fiscal year instead of a calendar year.

For example, say your revenue and expense patterns suggest that ending your tax year on June 30th (fiscal year-end) would make more sense than ending it on December 31st (calendar year-end).

  • You start your business July 1, 2013.
  • In your type of business, the biggest selling months are March, April, May, and June.
  • Therefore, you figure about 80% of your annual revenues can be expected during those four months in 2014.
  • However, during September, October, November, and December of 2013 you incur about 70% of the annual expenses to generate those 2014 revenues.

You decide to elect a fiscal year for reporting your taxes and keeping your books. Your fiscal year will run from July 1 to June 30th. (A calendar year would end December 31st.)

The results:

By choosing a fiscal year ending June 30, 2014, revenues expenses will be more precisely matched within the 12-month period. As a result, the income statement prepared as of June 30, 2014 will reflect a more accurate presentation of net income.

On the other hand, had you chosen a calendar year, and closed your books on December 31st, this would have resulted in a matching of only 20% of annual revenues earned through December 31st with 70% of annual expenses incurred through December 31st.

Since this is a seasonal business where 80% of revenues are generated during March, April, May, and June while 70% of the expenses to produce those revenues are incurred September, October, November, and December of the prior year, it makes sense to elect a fiscal year for tax-reporting and financial reporting.

Inventory Considerations

Something else to consider is inventory levels. Since most of your sales occur March through June, your inventory levels will be at their lowest point in June. Less stuff to count means time and money saved when taking a physical inventory at the end of your fiscal year.

How to Change Your Tax Year

Form 1128 Application To Adopt, Change, or Retain a Tax Year is used to request IRS approval to change your tax year. If you qualify for an automatic approval request, a user fee is not required.

If you're filing Form 2553 to elect S corporation tax treatment, also use Form 2553 to elect a tax-year change if you want to elect a fiscal year.

An individual must generally adopt a calendar year. However, an individual can adopt a fiscal provided he/she maintains his books and records on that basis.

A partnership, S corporation, and Personal Service Corporation establishes the business purpose for a tax year by filing Form 1128.

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