While there is heightened interest in tax reform and changes may be on the horizon, the concept of an annual accounting period is unlikely to change. An annual accounting period is the tax year that a taxpayer uses to compute its federal (and, usually, state and local) taxable income. Depending on the type of entity, a taxpayer may have a required tax year prescribed by the Internal Revenue Code, or it may be free to choose any tax year it wishes. A newly formed entity usually adopts a tax year without having to obtain the IRS's approval, but if an entity later wants to use a different tax year, it generally must request the IRS's approval. Thus, when an entity is formed, it is important to give some thought to the tax year it will adopt. This item highlights the accounting period rules and the guidance for changing an accounting period for the most common types of entities and illustrates why adopting a tax year should not be an afterthought.
General requirements of tax years
A tax year may be either a calendar year, which is a period of 12 consecutive months ending on Dec. 31, or a fiscal year, which is either a period of 12 consecutive months ending on the last day of any month other than December, or a 52-53-week tax year. A 52-53-week year is one that varies from 52 to 53 weeks in any particular year, ends always on the same day of the week, and ends either on the date that same weekday last occurs in a calendar month (e.g., the last Friday in December) or on the date that same weekday falls that is nearest to the last day of a calendar month (e.g., the Friday nearest to Dec. 31--note that in this example, some tax years will end in December and some will end in January).
For tax purposes, the correct reference for a 52-53-week tax year is to the end oi the year, not the beginning (or first day) of the year; for example, adopting a tax year beginning the first Friday in January is not a proper year. A 52-53-week tax year may be desirable for management purposes, as the fiscal year is broken down into months of four- and five-week blocks that are easily comparable to other quarters and years and make data analysis easier and more accurate. It is common for entities in the retail industry to use a 52-53-week tax year because each month generally has the same number of selling days and weekends from one year to the next and comparisons to prior years are simpler. Fiscal years are recognized by the IRS only if the books of the entity are also maintained on the fiscal year end.
Some types of entities have required years: The tax year of a partnership is determined by reference to the tax years of its partners; the tax year of a controlled foreign corporation (CFC) is determined by reference to the tax year(s) of its U.S. shareholder(s); and the tax year of an S corporation, personal service corporation (PSC), trust (with certain exceptions), or real estate investment trust (REIT) is the calendar year.
Adoption of a tax year
A new entity generally adopts a permissible tax year by filing its first federal income tax return using that tax year; no Form 1128, Application to Adopt, Change, or Retain a Tax Year, needs to be filed. Filing a request for an extension of time to file the federal income tax return, applying for an employer identification number, or paying estimated taxes based on a particular tax year do not effect an adoption of a tax year. As discussed in more detail below, an entity with a required tax year has a limited ability to use a different tax year. A partnership, existing S corporation, or PSC that wants to adopt a tax year other than its required tax year must file a Form 1128 (a corporation electing S status uses Form 2553, Election by a Small Business Corporation) and demonstrate a business purpose to obtain IRS approval before adopting that tax year (the procedures discussed below for changing a tax year apply to these adoptions) or elect to use a different tax year under Sec. 444 (also discussed below). Note that the tax year of a partnership that has a technical termination under Sec. 708(b)(1) (B) ends on the date of the technical termination, and the new partnership then must either adopt its required tax year or request permission to adopt a different tax year. See Sec. 441 and the regulations thereunder for more details on permissible tax years and adopting a tax year.
A partnership, S corporation, or PSC that cannot establish a business purpose sufficient for the IRS to approve a tax year other than the required tax year may want to consider a Sec. 444 election, which generally requires a yearly payment, as further discussed below. A Sec. 444 election may also be available for an existing entity that wishes to change its tax year, but depending on the current tax year used by the entity, the tax years that are available may be further restricted. The tax year that may be selected with a Sec. 444 election is limited to a maximum three-month deferral period from the required tax year; however, if the entity's present tax year results in less than a three-month deferral period, the maximum deferral period is that shorter period.
Example 1: A new S...