Question

When creating a business, the owners must decide on what taxable year to give the business.

What choices of taxable years are available for "C" corporations, "S" corporations and partnerships?

What impact does the choice of taxable year have on the taxation of the owners?

Answer 1

Taxable Year of a business

Tax year affects your taxable income. All the income received or accrued within a single year is reported on that year's tax return, along with all the expenses paid or accrued, and the end of the year is the cut-off point for many tax-saving strategies. How to account for your income and expenses is one of the first decisions you must make when you start your business

A tax year is the designation of a year used by the IRS for tax purposes. The IRS says,

A “tax year” is an annual accounting period for keeping records and reporting income and expenses.

For tax year purposes, the IRS says you can use either of these two years as your business tax year:

• A calendar year - January 1 to December 31
• Your company's fiscal year.
• If your fiscal year ends on December 31, you're using a calendar year as your business tax year.

Your business fiscal year is almost always your tax year, but it doesn't have to be. A corporation with a March 31 fiscal year end may also file a corporate income tax return, effective March 31.

"C" corporations

A separate legal entity created by a state filing. The C-corporations, also called the "regular" corporation, is subject to corporate income tax. Income earned by a C corporation is normally taxed at the corporate level using the corporate income tax rates.

Businesses that operate as C corporations have substantial flexibility when selecting a tax year. Once selected, a tax year generally must be maintained until the business is required or elects (with IRS permission, if necessary) to change it.

There are two types of tax years:

a. Calendar Tax Year. A calendar tax year is a period of 12 consecutive months beginning January 1st and ending December 31st.

b. Fiscal Tax Year. A fiscal tax year is a period of 12 consecutive months ending on the last day of any month other than December, or a 52–53 week period that ends on a specific day of the week occurring either in the last week or nearest the last day of a specific month.

A business that operates as a C corporation establishes an annual period as its calendar or fiscal tax year by (a) maintaining books and records on the same basis, and (b) filing the initial tax return based on that period. If books and records are not maintained to establish a fiscal year, the corporation will use a calendar tax year. A C corporation must adopt a tax year by the due date (not including extensions) of the return for the corporation’s first tax year. The initial return cannot include more than 12 months, but may include fewer, resulting in a short year.

A 52–53 week fiscal tax year is an annual period that varies from 52 to 53 weeks. Any new eligible C corporation that maintains its books and records on a 52–53 week year-end can adopt a 52–53 week year for tax purposes. The tax year always ends on the same day of the week, and always ends—

A. on whatever date that day of the week last occurs in a calendar month

B. on whatever date that day of the week falls nearest to the last day of the calendar month

"S" corporations

A separate legal entity created by a state filing. The S corporation is a corporation that has filed a special election with the IRS to be treated like a partnership (or LLC) for tax purposes. Therefore, S-Corporations are not subject to corporate tax rates and are exempt from federal income taxes except for certain capital gains and passive income, according to the IRS.

Instead, S-Corporations pass-through profits (or net losses) to shareholders. The business profits are taxed at individual tax rates on each shareholder's Form 1040. The pass-through nature of the income means the corporation's profits are taxed only once—at the shareholder level.

S-Corporations, like C-Corporations, can decide to retain their net profits as operating capital. However, all profits are considered as if they were distributed to shareholders. Therefore, an S-Corporation shareholder might be taxed on income never received because it was retained by the business.

The S corporation tax-year rules, similar to those governing partnerships, state that an S corporation must use a permitted year. Under Sec. 1378(b), a permitted year is a tax year that

1. A tax year ending December 31.
2. Any other accounting period for which the corporation establishes a business purpose to the satisfaction of the IRS.
3. An ownership tax year - because it coincides with the tax year used by shareholders holding more than 50% of the corporation’s stock on the first day of the requested tax year
4. A tax year elected under section 444 - As an alternative to using a calendar year or a business-purpose fiscal year, the corporation may elect a fiscal year
5. A 52-53-week tax year ending
6. Any other tax year (including a 52-53-week tax year) for which the corporation establishes a business purpose.

Partnerships

Partnership is the relation between two or more persons who have agreed to share profit/loss of the business carries on by all or any one of them acting for all. A partnership determines its tax year as if it were a taxpayer. However, there are limits on the year it can choose. In general, a partnership must use its required tax year. Generally it uses the partner’s tax year as taxable year of the business.

Choices of Tax Year:

A partnership generally must conform its tax year to its partners' tax years. The rules for determining the required tax year are as follows.

Majority interest tax year: If one or more partners having the same tax year own an interest in partnership profits and capital of more than 50% (a majority interest), the partnership must use the tax year of those partners.

Testing day: The partnership determines if there is a majority interest tax year on the testing day, which is usually the first day of the partnership's current tax year.

Change in tax year: If a partnership's majority interest tax year changes, it will not be required to change to another tax year for 2 years following the year of change.

Principal partner: If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. A principal partner is one who has a 5% or more interest in the profits or capital of the partnership.

Least aggregate deferral of income: If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use a tax year that results in the least aggregate deferral of income to the partners.

Calculation of Least aggregate deferral of income:

1. Figure the number of months of deferral for each partner using one partner's tax year. Count the months from the end of that tax year forward to the end of each other partner's tax year.
2. Multiply each partner's months of deferral figured in step (1) by that partner's interest in the partnership profits for the year used in step (1).
3. Add the amounts in step (2) to get the aggregate (total) deferral for the tax year used in step (1).
4. Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years.

The partner's tax year that results in the lowest number in step (3) above is the tax year that must be used by the partnership. If more than one year qualifies as the tax year that has the least aggregate deferral of income, the partnership can choose any year that qualifies. However, if one of the years that qualify is the partnership's existing tax year, the partnership must retain that tax year.

Special de minimis rule: If the tax year that results in the least aggregate deferral produces an aggregate deferral that is less than 0.5 when compared to the aggregate deferral of the current tax year, the partnership's current tax year is treated as the tax year with the least aggregate deferral.

Exceptions to Tax Year

There are two exceptions to the tax year rule.

1. Business purpose tax year: If a partnership establishes an acceptable business purpose for having a tax year different from its required tax year, the different tax year can be used. The deferral of income to the partners is not considered a business purpose.
2. Section 444 elections: Partnerships can elect under section 444 of the Internal Revenue Code to use a tax year different from both the required tax year and any business purpose tax year. Certain restrictions apply to this election. In addition, the electing partnership may be required to make a payment representing the value of the extra tax deferral to the partners.