Choice of Tax Year

Your tax year determines the time frame in which your taxable income will be computed. All income received or accrued within a single year is reported on that year's tax return, along with all expenses paid or accrued. The end of the year is the cut-off point for many tax-saving strategies.

In theory, your tax year, which is also known as your accounting period, may be either a calendar year or a fiscal year (a 12-month period that ends on the last day of any month other than December). Whether you knew it or not, you selected your tax year the very first time you filed a tax return as an individual, partnership, or corporation. You must continue to use the same tax year that you used that first time, unless you get IRS permission to change. The default selection is a calendar year.

Limitations on your choice. There are a number of restrictions on the accounting period you can use for tax purposes.

Since a sole proprietorship does not exist apart from its owners (at least in the eyes of the IRS), a sole proprietorship must use the same tax year as the owner. Most sole proprietors use the calendar year as their tax year, since they must continue to use the same tax year that the owner used in his or her initial individual tax return (and since most of us began filing early in life, we used the calendar year for our first tax return). If you want to switch to a fiscal year, you'll need special permission from the IRS.

A partnership or LLC must generally use the same tax year as the majority of its owners. An S corporation or a personal service corporation must generally use a calendar year. Exceptions to these general rules may be made if you can establish to the satisfaction of the IRS that you have a business purpose for using a different tax year.

If you have started a new business that will be operated as a C corporation, it may initially have large expenses or losses. Because of this, if you begin operations during the year (rather than on January 1), it may be helpful to choose a fiscal year that extends beyond the end of the first calendar year so that as much income as possible will be offset by the opening expenses and losses.

Choosing a fiscal year. The tax year you choose may determine the accuracy with which your business's income is matched with the expenses that generate the income. So, in the case of a seasonal business, the accounting period should include the entire season.

Example A ski resort is open only during the months of December through March — the winter resort season. If the books are kept on the basis of a calendar year, the accounting period would split the season, and distortion of income would result. So, what would appear as a profit as of December 31, the close of the calendar year, may turn out to be a loss, or vice versa, when the entire season, December through March, is considered. Moreover, the use of the calendar year would require the operators to take inventories and make other determinations in the middle of the season when they have the least amount of time available. The use of a fiscal year that included the entire season would make it possible to avoid these difficulties.

If the nature of your business is such that the bulk of expenses and receipts for an operating cycle fall in different years, it may be best to select an accounting period that includes both.

Example Let's say that your business incurs most of its expenses in the fall and gets most of its income in the spring. In any one calendar year, expenses and receipts would have little relation to each other. Receipts in 2011, for example, would not be offset by corresponding expenses, because these expenses would have been incurred in 2010. The 2011 receipts would be offset by 2011 expenses, although these expenses would relate to 2012 receipts. A fiscal year starting on July 1, August 1, or September 1 would more accurately reflect income for your natural business year.

Making changes in your accounting period. If you want to switch from a calendar year to a fiscal year (or vice versa), you'll need permission from the IRS. To get permission you must demonstrate to the IRS's satisfaction that you have a valid business purpose other than tax avoidance. In many cases, a seasonal business would be able to show a valid business purpose for using a fiscal year. You can request approval by filing IRS Form 1128, Application to Adopt, Change, or Retain a Tax Year.

Warning Except in unusual cases, once you have received permission to change your tax year, the IRS will not allow you to change it again within 10 years.