A company reports its taxable income to the IRS based on a tax year, which is determined at the time a company files its first tax return. This determination must be made by the due date when an entity’s tax return is due following the end of the tax year. For a C corporation or S corporation, the due date is the 15th day of the third month following the end of the tax year, while the due date for individuals, participants in a partnership, and shareholders in an “S” corporation is the 15th day of the fourth month after the end of the tax year.
The Default Tax Year
The default period to use for a tax year is the calendar year, which is January 1 through December 31. Unless special permission is given, the calendar year must be used as the tax year for a sole proprietorship, a shareholder in an S corporation, or a personal service corporation. A personal service corporation is a C corporation, primarily performs personal services (as defined by compensation costs for personal services activities being at least 50% of all compensation costs), and the owners are primarily owners who not only perform much of the services work, but who also own more than 10% of the company’s stock. Personal services include activities in the areas of consulting, performing arts, actuarial work, accounting, architecture, health and veterinary services, law, and engineering.
Setting the Partnership Tax Year
The rule for setting the tax year of a partnership is more complex; if one or multiple partners having the same tax year own a majority interest in the partnership, then the partnership must use their tax year; if there is no single tax year used by the majority partners, then the partnership must use the tax year of all its principal partners (those with a stake of at least 5%); if the partners do not share the same tax year, then the tax year used must be the one that results in the smallest amount of deferred partner income. This is calculated by determining the number of months remaining in each partner’s tax year (using as the basis of calculation the earliest tax year end amongst the partners), and multiplying this amount by the percentage share in partnership earnings for each partner. Then add up this calculation for all partners, and determine the tax year-end that will result in the smallest possible number. The result will generally be the earliest tax year-end amongst the partners that follows the existing partnership year-end.
Setting the Calendar Year as the Tax Year
The use of the calendar year as the tax year is also required if one does not keep sufficiently accurate tax–related records, use an annual accounting period, or if one’s present tax year does not qualify as a fiscal year (which the IRS defines as 12 consecutive months ending on the last day of any month except December).
Setting the 52-to-53 Week Year as the Tax Year
It is also possible to file for a 52-to-53 week tax year, as long as the fiscal year is maintained on the same basis. The 52-to-53 week year always ends on the same day of the week, which one can select. This can result in tax years that end on days other than the last day of the month. In order to file for this type of tax year with the IRS, one should include a statement with the first annual tax return that notes the month and day of the week on which its tax year will always end, and the date on which the tax year ends. It is possible to change to a 52-to-53 week tax year without IRS approval, as long as the new tax year still falls within the same month under which an entity currently has its tax year end, and a statement announcing the change is attached to the tax return for the year in which the change takes place.
The 52-53 week tax year presents a problem for the IRS, since it is more difficult to determine the exact date on which changes to its tax rules will apply to any entity that uses it. To standardize the date of the tax year end for these entities, the IRS assumes that a 52-to-53 week tax year begins on the first day of the calendar month closest to the first day of its tax year, and ends on the last day of the calendar month closest to the last day of its tax year.
Changing the Tax Year
A company can apply to the IRS to have its tax year changed if there is a valid business purpose for doing so. When reviewing an application for this change, the IRS is primarily concerned with any possible distortion of income that will have an impact on taxable income. For example, a cause for concern would be shifting revenues into the following tax year, as would be the case if a company switched to a tax year that ended just prior to the main part of its selling season, thereby shifting much of its revenue (and taxable income) to a future period. To use the same example, this might also cause a major net operating loss during the short tax year that would result from the change, since much of the revenue would be removed from the year. In cases such as this, the IRS would not be inclined to approve a change in the tax year. If the IRS sees that the change will result in a neutral or positive change in reported income, then it will more favorably review any business reasons for supporting the change, such as timing the year-end to correspond with the conclusion of most business activities for the year (such as the use of January as a year-end for many retailing firms). Thus, the prime consideration for the IRS when reviewing a proposed change of tax year will always be its potential impact on tax receipts.
The one case in which the IRS will automatically approve a change in the tax year is the 25% test. Under this test, a company calculates the proportion of total sales for the last two months of the proposed tax year as compared to total revenues for the entire year. If this proportion is 25% or greater for all of the last three years, then the IRS will grant a change in the tax year to the requested year-end date. If a company does not yet have at least 47 months of reportable revenues upon which to base the calculation, then it cannot use this approach to apply for a change in its tax year.
A tax year must fall under the rules just stated, or else it is considered to be improper, and must be changed with IRS approval. For example, if a company were founded on the 13th day of the month, and the owner assumes that the fiscal and tax year will end exactly one year from that point (on the 12th day of the same month in the next year), this is an improper tax year, because it does not end on the last day of the month, nor does it fall under the rules governing a 52-to-53 week year. In such cases, a company must file an amended income tax return that is based on the calendar year and then get IRS approval to change to a tax year other than the calendar year (if the calendar year is not considered appropriate for some reason).
When a company either changes to a new tax year or is just starting operations, it is quite likely that it will initially have a short tax year. If so, it must report taxable income for that short period beginning on the first day after the end of the old tax year (or the start date of the organization, if it is a new one) and ending on the day before the first day of the new tax year. The key issue when reporting taxable income for a short tax year is that the amount subject to tax is not the reported net income for the short year, but rather the annualized amount. The annualized figure is used because it may place the company in a higher tax bracket. For example, if the Hawser Company has a short tax year of six months and has taxable income for that period of $50,000, it must first annualize the $50,000, bringing full-year taxable income to $100,000. The tax percentage is higher on $100,000 than on $50,000, resulting in a tax of $22,500 on the annualized figure. The Hawser Company then pays only that portion of the tax that would have accrued during its short tax year, which is ½ of the $22,500 annualized tax, or $11,250.
The tax calculation method for a short tax year can cause problems for those organizations that have highly seasonal revenue patterns, since they may have a very high level of income only during a few months of the year, and losses during the remaining months. If the short tax year falls into this high-revenue period, the company will find that by annualizing its income as per the tax rules, it will fall into a much higher tax bracket than would normally be the case, and pay considerably more taxes. This issue can be addressed in the following year by filing for a rebate. However, in case an uncomfortable cash shortfall occurs that may not be alleviated for some months, one should be aware of this problem in advance and attempt to plan the timing of the short tax year around it.
If a company wishes to change its tax year, it must obtain approval (with a few exceptions) from the IRS. To do so, complete and mail IRS form 1128 by the 15th day of the second calendar month following the close of the short tax year. Do not actually change tax years until formal approval from the IRS has been received.