style="font-size:15px;"> For a further discussion on tax years and accounting methods, see IRS Publication 538, Accounting Periods and Methods. Inventory rules are discussed in Chapter 4.
Accounting Periods
You account for your income and expenses on an annual basis. This period is called your tax year. There are 2 methods for fixing your tax year: calendar and fiscal. Under the calendar year, you use a 12-month period ending on December 31. Under the fiscal year, you use a 12-month period ending at the end of any month other than December.
You select your tax year when you begin your business. You do not need IRS approval for your tax year; you simply use it to govern when you must file your first return. You use the same tax year thereafter. If you commence your business in the middle of the tax year you have selected, your first tax year will be short.
Example
You start your S corporation in May 2017. It uses a calendar year to report expenses. The corporation will have a short tax year ending December 31, 2017, for its first tax year. Then, for 2018, it will have a full 12-month tax year.
A short tax year may occur in the first or final year of business. For example, if you closed the doors to your business on May 1, 2017, even though you operated on a calendar year. Your final tax year is a short year because it is only 4 months. You do not have to apportion or prorate deductions for this short year merely because the business was not in existence for the entire year. Different rules apply if a short year results from a change in accounting period.
Seasonal businesses should use special care when selecting their tax year. It is often advisable to select a tax year that will include both the period in which most of the expenses as well as most of the income is realized. For example, if a business expects to sell its products primarily in the spring and incurs most of its expenses for these sales in the preceding fall, it may be best to select a fiscal year ending just after the selling season, such as July or August. In this way, the expenses and the income that are related to each other will be reported on the same return.
C corporations, other than personal service corporations (PSCs), can choose a calendar year or a fiscal year, whichever is more advantageous. Other entities, however, cannot simply choose a fiscal year, even though it offers tax advantages to its owners. In general, partnerships, limited liability companies (LLCs), S corporations, and PSCs must use a required year. Since individuals typically use a calendar year, their partnership or LLC must also use a calendar year.
Required year For S corporations, this is a calendar year; for partnerships and LLCs, it is the same year as the tax year of the entity's owners. When owners have different tax years, special rules determine which owner's tax year governs.
The entity can use a fiscal year even though its owners use a calendar year if it can be established to the satisfaction of the IRS that there is a business purpose for the fiscal year. The fact that the use of a fiscal year defers income for its owners is not considered to be a valid business purpose warranting a tax year other than a required tax year.
Business purpose This is shown if the fiscal year is the natural business year of the entity. For a PSC, for example, a fiscal year is treated as a natural business year if 25 % or more of its gross receipts for the 12-month period ending on the last month of the requested tax year are received within the last 2 months of that year.
While the vast majority of small businesses use a calendar year, some companies may use a fiscal year because it is the natural year of the type of business they are in. The end of the fiscal year coincides with the close of the business cycle. For example, a ski shop may close out its year on June 30 after running end-of-season sales. They do not have to use this fiscal year, however, and many such businesses use a calendar year.
If an entity wants to use a fiscal year that is not its natural business year, it can do so by making a Section 444 election. The only acceptable tax years under this election are those ending September 30, October 31, and November 30. Use of these fiscal years means that at most there can be a 3-month deferral for the owners. The election is made by filing Form 8716, Election to Have a Tax Year Other Than a Required Tax Year, by the earlier of the due date of the return for the new tax year (without regard to extensions) or the fifteenth day of the sixth month of the tax year for which the election will be effective.
If the election is made, then partnerships, LLCs, and S corporations must make certain required payments. These essentially are designed to give to the federal government the tax that has been deferred by reason of the special tax year. This payment can be thought of as simply a deposit, since it does not serve to increase the tax that is otherwise due. The payment is calculated using the highest individual income tax rate plus one percentage point. Therefore, the rate for 2017 is 40.6 %. The required payment is made by filing Form 8752, Required Payment or Refund Under Section 7519 for Partnerships and S Corporations, by May 15 of the calendar year following the calendar year in which the election begins. For example, if the election begins on October 1, 2017, the required payment must be made no later than May 15, 2018. In view of the high required payment and the complications involved in making and maintaining a Section 444 election, most of these entities use a calendar year.
Personal service corporations that make a Section 444 election need not make a required payment. Instead, these corporations must make required distributions. They must distribute certain amounts of compensation to employee-owners by December 31 of each year for which an election is in effect. The reason for the required elections is to ensure that amounts will be taxed to owner-employees as soon as possible and will not be deferred simply because the corporation uses a fiscal year. Required distributions are figured on Part I of Schedule H of Form 1120, Section 280H Limitations for a Personal Service Corporation.
Owners in pass-through entities who are on a calendar year report their share of the business's income, deductions, gains, losses, and credits from the entity's tax year that ends in the owners’ tax year.
Example
You are in a partnership that uses a fiscal year ending October 31. The partnership's items for its 2017 fiscal year ending October 31, 2017, are reported on your 2017 return. The portion of the partnership's income and deductions from the period November 1, 2017, through December 31, 2017, are part of its 2018 fiscal year, which will be reported on your 2018 return.
You may have a year that is less than a full tax year. This results most commonly in the year you start or end a business.
Example
You start an LLC on August 1, 2017, and use a calendar year to report your income and expenses. The LLC's first tax year is a short tax year, running from August 1, 2017, through December 31, 2017.
A short tax year can also result when a C corporation that had been reporting on a fiscal year elects S status and adopts a calendar year. The tax year of the C corporation ends on the date the S election becomes effective.
Alternatively, if an S election is terminated within the year or there is a substantial change in ownership (50 % or more), then the corporation can have 2 short tax years in this case.
Example
A C corporation with a fiscal year ending on June 30 elects to become an S corporation and adopts a calendar year. The election is effective on January 1, 2018. The C corporation has a
