@Q01 CAN MY BUSINESS ADOPT A FISCAL YEAR FOR INCOME TAX PURPOSES? Selection of a fiscal tax year (as opposed to the calendar year) as your business's accounting period can provide consid- erable tax planning benefits, including increased flexibility. Not surprisingly, the tax law puts quite a few restrictions on your ability to adopt, or switch to, a fiscal tax year. This is particularly true in the case of partnerships, S corp- orations, and C corporations that are "Personal Service Corp- orations." (If you are not sure whether your corporation is a "Personal Service Corporation," exit now and first go through the question and answer session on PSC's--Item #3 on the XPERT consulting menu.) QUESTION: What type legal entity is your business set up as? (1) Sole proprietorship (2) Partnership (3) S corporation (4) C corporation that is a "personal service corporation" (5) C corporation (not a "personal service corporation") @MC\05 01\Q02 02\Q03 03\Q03 04\Q03 05\Q03 @Q02 CONCLUSION: As a sole proprietorship, you do not have a whole lot of leeway in selecting an accounting period for tax purposes. Very few sole proprietors (that is, individ- uals) have fiscal tax years. Unless you are one of the rare breed who already have been properly filing your individual tax returns on a fiscal year basis, you generally will be required to use the calendar year, ending December 31st, as your accounting period for income tax purposes. The rule for individuals is that, no matter how many busi- nesses a taxpayer conducts, he or she may use only one and the same taxable year for all of them. This also means that a sole proprietor must use the same tax year for bus- iness income (on a Schedule C, for example) as for personal income and deductions. A salaried individual who has been filing on a calendar year basis, who goes into business for himself, may not change to a fiscal year without getting IRS approval, which can only be obtained by showing a very good business reason why a fiscal year should be allowed. The IRS will rarely approve such a change to a fiscal year, so, as a practical matter, don't expect to be able to use a fiscal year for your sole proprietorship. (In any event, the tax planning benefits of having a fiscal tax year for your business usually come from having a separate taxable entity, such as a partnership or corporation, that has a fiscal year that DIFFERS from your personal calendar year tax period, thus allowing opportuni- ties for tax planning games and manipulations. That isn't possible for a sole proprietorship, which is not a separate taxable entity, since the only entity is YOU, the individual taxpayer, so there is seldom any great tax benefit to be de- rived from your having a fiscal tax year.) @STOP @Q03 "NEW" TAXPAYERS: A "new" taxpayer is a person or entity that is just becoming subject to any internal revenue tax. This does not necessarily mean a new business, since an old, existing business that has just become a partnership or just been incorporated, for example, will be a "new" taxpayer in its first year as a new entity. Ordinarily, a new taxpayer has somewhat more flexibility in choosing a taxable year than an existing entity. However, a partnership, S corporation or personal service corporation ("PSC") is considerably restricted as to its choice of tax year, except when it applies to the IRS for permission to select a particular taxable year-end for persuasive busi- ness purposes. The IRS is not often persuaded, unfortunately. QUESTION: Is your partnership or corporation a "new" taxpayer at the present time? @YN 01\Q04 02\Q05 @Q04 @BR\04 @Q05 @BR\05 @Q06 CONCLUSIONS: As a newly-formed partnership, your business is quite limited in its choice of taxable year, unless you can establish to the IRS's satisfaction that you have good business reasons for adopting a year-end other than as des- cribed below. However, a partnership may make a "Section 444" election, which will allow it to have a fiscal year (ending only in September, October, or November, generally), provided that the partnership agrees to make tax prepayments that negate any tax deferral benefits the partners would otherwise de- rive from their having a taxable year different than that of the partnership. The required payments, which can be quite complex to calculate, are due on April 15th each year. Otherwise, as a general rule, your partnership will have to adopt as its taxable year a period that coincides with the taxable year of a majority in interest (over 50%) of its partners. If that is not possible, it must select one of the following as its taxable year, attaching a statement to the first tax return (Form 1065) justifying the taxable year used: . A year that is the same as that of ALL of its "principal partners" (partners who have at least a 5% interest in profits or capital of the part- nership); or, if they do not all have the same taxable year, . The calendar year, and a statement showing that all the principal partners are not on the same taxable year. (Unless IRS regulations call for a different taxable year in your situation.) In all other cases, you must attach a copy of the IRS's let- ter approving the partnership's request to use the particu- lar year-end that is being adopted. @STOP @Q07 CONCLUSION: In general, a partnership that already has adop- ted a tax year for prior tax returns cannot now change to a different year without obtaining IRS approval, which usually requires a showing of some important business purpose. Such a change ordinarily WILL NOT be approved if it would result in any of the following: . A deferral of income or a shifting of deductions to ano- ther year that will reduce tax liability (for a partner or partners); or . A net operating loss in the short taxable year that re- sults from the change in year-end (except in certain circumstances). @GOTO\Q12 @Q08 CONCLUSIONS: As a newly-formed S corporation, your business is quite limited in its choice of taxable year. In general, unless you can establish to the IRS's satisfaction that you have good business reasons for adopting a fiscal year, your S corporation will have to adopt a December 31st year-end. However, an S corporation may make a "Section 444" election, which allows it to have a fiscal year (ending only in September, October, or November, generally), provided that the corporation agrees to make tax prepayments that negate any tax deferral benefits the shareholders would otherwise receive from its having a taxable year different than theirs. These required payments, which can be quite complex to cal- culate, are due on April 15th each year. @STOP @Q09 CONCLUSION: In general, an S corporation that already has adopted a tax year for prior tax returns cannot now change to a different year without obtaining IRS approval, which usually requires a showing of some important business pur- pose. Such a change ordinarily WILL NOT be approved if it would result in any of the following: . A deferral of a portion of the corporation's income, or a shifting of a portion of its deductions to ano- ther taxable year in a way that will reduce its tax liability; or . A deferral or a shifting of either income or deduc- tions of another taxpayer, such as a shareholder, in a way that would substantially reduce the sharehol- der's tax liability; or . A net operating loss in the short taxable year that results from the change in year-end (except in cer- tain circumstances). @GOTO\Q12 @Q10 CONCLUSIONS: As a newly-formed personal service corporation ("PSC"), your business is quite limited in its choice of taxable year. Unless you can establish to the IRS's satis- faction that you have good business reasons for adopting a fiscal year, your PSC will generally have to adopt a December 31st year-end. However, a PSC may make a "Section 444" election, which al- lows it to have a fiscal year (ending only in September, October, or November, generally), provided that the corpor- ation agrees not to claim a full deduction for certain other- wise deductible payments to its shareholders during each tax year, unless it meets certain "minimum distribution re- quirements" for payments of compensation, rent, etc. to its shareholders during the year. In effect, if you delay much of your annual compensation from the corporation until after January 1, on a disproportionate basis, in order to obtain a tax deferral, the corporation will not be able to deduct those payments to you during its current tax year, under a complex formula. @STOP @Q11 CONCLUSION: In general, a personal service corporation ("PSC") that already has adopted a tax year for prior tax returns cannot now change to a different year without obtain- ing IRS approval, which usually requires a showing of some important business purpose. Such a change ordinarily WILL NOT be approved if it would result in any of the following: . A deferral of a portion of the corporation's income, or a shifting of a portion of its deductions to ano- ther taxable year in a way that will reduce its tax liability; or . A deferral or a shifting of either income or deduc- tions of another taxpayer, such as a shareholder, in a way that would substantially reduce the sharehol- der's tax liability; or . A net operating loss in the short taxable year that results from the change in year-end (except in cer- tain circumstances). @GOTO\Q12 @Q12 One business reason that may be considered an acceptable basis for a change in taxable year is a shift to a "natural business year." Reasons that usually ARE NOT acceptable to the IRS include: . use of a particular fiscal year for regulatory or for financial accounting purposes; . the fact that your company usually hires staff at a certain time of the year; . use of a particular year for internal administrat- ive purposes, such as promotions, admitting or retiring owners, or setting compensation levels; . convenience of the taxpayer (or its accountants); or . the fact that the business involves use of price lists or model years that change on an annual basis at a particular time. @STOP @Q13 CONCLUSION: A newly-formed C corporation (which is not a personal services corporation) is ordinarily free to choose whatever year-end it desires, without IRS approval. All that is necessary is to file a first corporate tax return (Form 1120) within two months and fifteen days after the end of the fiscal year you wish to choose, indicating what taxable year you have selected. Often, it is useful to select a January 31st fiscal year. In this way, if the corporation pays substantial bonuses to you or other of its employees at year-end, these can be de- layed until the month of January, so that they are deducti- ble (for example) for the corporation's fiscal year ended January 31, 1994, which spans the period from February 1, 1993 to January 31, 1994, but won't be included in employ- ees' taxable income until calendar year 1994, providing an 11-month tax deferral, in effect. But be careful about paying too much of annual compensation to owner-employees as bonuses: The IRS may take the posi- tion that such payments are really more like dividends than compensation, and thus not deductible by the corporation! @STOP @Q14 CONCLUSION: An existing C corporation (which isn't a per- sonal service corporation) may generally change its taxable year without IRS permission, if it has not changed its year- end before in the last ten years. To do so, however, it must meet certain specific requirements for obtaining auto- matic approval from the IRS. To obtain such automatic ap- proval, it must file certain information with the IRS on a timely basis, and state that it meets the following require- ments that are necessary for such automatic approval of the change: . It hasn't changed its taxable year in the last 10 calendar years. . The short taxable year resulting from the change is not one in which it has a net operating loss. . Its annualized taxable income for the short year is 80% or more of the income for the preceding year. . If it has certain types of "special status" (such as being a foreign personal holding company, etc.) for either the short period or the preceding tax year, it must have such status for both such periods. . It must not try to become an S corporation for the taxable year that would immediately follow the short year that results from the change of year-end. Remember that this right to automatic approval of a change in taxable year applies only to certain C corporations, ot- her than PSCs, and does not apply to S corporations or un- incorporated taxpayers. @STOP @HELP @H\01 A "C corporation" is a technical term, but, fortunately, is a relatively easy one to understand. A C corporation is, quite simply, any corporation (other than a not-for-profit one) OTHER THAN an "S corporation" (formerly known as a Subchapter S corporation). Thus if your business is incorporated, unless it is a corporation that has made an election to be taxed as an S corporation, it is considered to be a "C corporation." @H\02 The IRS is very unlikely to grant a re- quest for a change of taxable year to a fiscal year by an individual taxpayer, if it appears that any tax deferral is likely to result (which would be the main reason you would want to change to a fiscal year). @H\03 In other words, is your business entity one that has not yet filed its first tax return, and thus has not yet elected an accounting period.... @H\14 Corporations that are DISCs, or that are partners in a partnership, or that are controlled foreign corporations, or that have made certain elections relating to "possessions tax credits" are not elig- ible to change their accounting period under the automatic approval procedures. @END