The tax year is the basic unit of time in which income is totaled and taxed [IRC §441 (a)]. The taxable year is an important component in determining the tax that an individual or business must pay, since tax rates change from year to year and because most taxes on earned income are progressive. Most people and businesses use the calendar year to report their income. However, for some businesses, it is more natural to use the fiscal year, which is a taxable year that ends on a month other than December. However, S corporations and personal service corporations cannot use the fiscal year unless the choice serves a valid business purpose. When the tax code dictates the choice of tax year, it is known as a required year. Partnerships and limited liability companies must use the tax year that the owners use. Since most people use the calendar year, most partnerships and limited liability companies also use the calendar year. If the partners use different tax years, then there are a set of rules that determine which tax year must be used. As with S corporations, partnerships and LLCs can use the fiscal year if it serves a business purpose.
However, a fiscal year that ends in September, October, or November can be chosen, under IRC § 444, even if it does not serve a business purpose, by filing Form 8716, Election to Have a Tax Year Other Than a Required Tax Year, which must be filed by the earlier of the due date of the return without extensions or by the 15th day of the six-month of the new tax year. The business entity may have to make a required payment as a deposit for taxes that would otherwise be deferred by the election, or, if a personal service corporation, then a required distribution must be made before the end of the calendar year to the shareholders, so that the tax on the distribution is not deferred.
Businesses generally select a tax year that coincides with their accounting period, and the accounting period is generally selected based on the business's economic cycle, so that the end of the period is soon after the busiest season for the business. So, for instance, most retailers select a fiscal year that ends on January 31, since Christmas time is the busiest season for them and they need some time to collect the information necessary to report their taxes. A business can also use what is called a 52-53 week year, where the year could be either be 52 or 53 weeks so that it ends on the same day of the week each year. Most regular corporations choose a tax year based on their accounting period, but pass-through entities are restricted in choosing a fiscal year unless there is a strong economic reason for doing so.
Most tax years consist of 12 months, but a short tax year can result because the business began after the start of the tax year or ended before the end of the tax year. A short tax year can also result because of a change in the tax year, such as when a C corporation that adopted a fiscal year converts to an S corporation, which must use a calendar year. However, if an unincorporated entity converts to a C corporation, which must be done before electing S corporation status, and then elects the S corporation status on its 1st day of business under a state's formless conversion statute or check-the-box rules, then there is no short year for the C corporation if the election is valid.
Changing the tax year for a business requires the approval of the IRS, which is obtained by filing Form 1128, Application to Adopt, Change, or Retain a Tax Year. The IRS may grant the request automatically or it may request more information about the business purpose of the request.
Taxable Years for Partnerships
Pass-through entities are business entities that do not pay tax; instead, income, losses, deductions, and other tax items pass-through to the owners of the business entity. The owners then determine their own taxable income based on the tax items passed through to them. The types of pass-through entities include partnerships, limited liability companies, and S corporations. However, S corporations must use a calendar year unless a business purpose can be established for using a fiscal year. Since most limited liability companies are taxed as partnerships, the remaining discussion will concern the selection of the tax year for a partnership.
One tax rule that restricts the use of the fiscal year requires that the tax year of the entity must be the same as those of the owners. Since most people use a calendar year, this compels most entities to use a calendar year also. An exception applies if the entity has a natural business year, which is defined as a fiscal year in which the entity earns at least 25% of its income in the final 2 months.
The choice of fiscal year is restricted for pass-through entities because the owners report their income from the entity when the taxable year for the entity ends. For instance, if the owners were free to choose a fiscal year for the entity while they use a calendar year, then they could choose a fiscal year to end on January 31, thus allowing them to report the first 11 months of income from the partnership in their later calendar year. For instance, suppose ABC partnership earns $300,000 for the fiscal year ending January 31, 2020. Because the 3 partners only have to report their $100,000 share in the year in which the entity's fiscal year ends, they would report their $100,000 on their 2021 returns and would not have to pay the tax until their tax filing date in April, 2021. Thus, 11 months of income from the partnership is deferred for at least a full year. Of course, the payment of estimated taxes reduces the advantage of this tax strategy, but it could still be used to defer income if the partnership is growing rapidly, since the payment of estimated taxes can be based on the previous year.
If a partnership does not have a business purpose for a fiscal year, then there is several other tax rules regarding what tax year partnership may use. A partnership must conform to the majority interest taxable year if a group of partners who use the same tax year also owns 50% or more of the capital and profits of the partnership. So if Doris and Edward of DEF partnership owns 60% of the profit interest in the partnership and both have a tax year that ends on March 31, then the partnership must also use a fiscal year ending on March 31.
If the majority interest taxable year is not applicable, then the principal partnership taxable year rule may apply if the principal partners, who each own at least 5% of the capital or profits of the partnership, have the same tax year, in which case, the partnership must have the same tax year as the principal partners.
If none of the above rules apply, then the least-aggregate-deferral-of-income method must be used, in which the tax year for the partnership must be chosen so that the deferral of income is a minimum. This method is calculated by the following procedure:
- choose a tax year that coincides with the tax year of 1 partner;
- calculate the deferral of income by multiplying the number of months for the deferral for each partner by that partner's profit percentage;
- add the percentages;
- repeat the entire procedure for the tax year of each partner.
The tax year for the partnership must be the tax year that yields the lowest deferral.
Example: Choosing a Tax Year for a Partnership Using the Least Aggregate Deferral of Income Method
John Anderson, Bill Bentley, and Jim Calvin form the ABC Partnership, which does not have a business purpose for using a particular tax year. Anderson uses a calendar year but Bentley uses a fiscal year ending in March, and Calvin uses a fiscal year ending in August. The majority interest taxable year rule does not apply because (1) each partner uses a different tax year and (2) none of the partners owns more than 50% of the partnership. Because of reason #1, the principal partnership taxable year rule also does not apply. Therefore, the least aggregate deferral of income method must be used.
Profit percentages: Anderson, 20%; Bentley, 40%; Calvin, 40%.
|Profit %||Deferral Months |
|Fiscal Year Ending in March|
|Fiscal Year Ending in August|
Using Bentley's fiscal year yields the least aggregate deferral of income for all the partners, because 3.4 < 3.6 < 5.2. Therefore, ABC Partnership must use the fiscal year ending on March 31.