Business Entities and Considerations · Business entities

Accounting periods (tax year)

The accounting period rules read as though a business picks its year. For a sole proprietor and a C corporation that is roughly true. For a partnership or an S corporation it is not: the year is dictated by the owners’ years, and the entity’s preferences are irrelevant unless it can prove a business purpose that has nothing to do with deferring tax. The examination tests the dictated cases far more than the free ones, and it tests the one escape hatch — the section 444 election — hardest of all, because that escape hatch has a price questions like to leave out.

The rule

What a taxable year is. the taxable year is the annual accounting period on the basis of which the taxpayer regularly computes income in keeping its books, if that period is a calendar year or a fiscal year; a calendar year is a period of 12 months ending 31 December and a fiscal year a period of 12 months ending on the last day of any other month (IRC § 441(b) to (e))^TY2026

When it is the calendar year by default. the taxable year is the calendar year where the taxpayer keeps no books, has no annual accounting period, or has one that does not qualify as a fiscal year (IRC § 441(g))^TY2026

The 52-53 week alternative. a taxpayer who in keeping its books regularly computes income on an annual period varying from 52 to 53 weeks, always ending on the same day of the week and always either on the last occurrence of that day in a calendar month or on the occurrence nearest the last day of a calendar month, may elect to compute taxable income on that basis (IRC § 441(f)(1))^TY2026

Changing it. a change of annual accounting period makes the new period the taxpayer taxable year only if the change is approved by the Secretary, and a taxpayer to whom IRC § 441(g) applies that adopts an annual accounting period other than a calendar year is treated as having changed its period (IRC § 442)^TY2026

The short period this produces. a return for a period of less than 12 months is required where the taxpayer changes its annual accounting period with the approval of the Secretary — running from the day after the close of the former year to the close of the day before the first day of the new year — and where the taxpayer is in existence during only part of what would otherwise be its taxable year (IRC § 443(a)(1), (2))^TY2026

And how the short period is taxed. on a change of annual accounting period the taxable income for the short period is placed on an annual basis by multiplying modified taxable income by 12 and dividing by the number of months in the short period; the tax is the same part of the tax so computed as the number of months in the short period is of 12 months, subject to the relief computation available on application (IRC § 443(b))^TY2026

A partnership’s required year. a partnership may not have a taxable year other than the majority interest taxable year; failing that, the taxable year of all its principal partners; failing that, the calendar year unless regulations prescribe another period — save where it establishes a business purpose to the satisfaction of the Secretary, and deferral of income to partners is never a business purpose (IRC § 706(b)(1)(B), (C))^TY2026

The tests inside that. the majority interest taxable year is the taxable year which, on each testing day, was the taxable year of one or more partners holding an aggregate interest in partnership profits and capital of more than 50 percent, the testing day being the first day of the partnership taxable year or such representative period as the Secretary prescribes. A principal partner is one holding an interest of 5 percent or more in profits or capital, and a partnership required to change under this rule need not change again for either of the 2 following years (IRC § 706(b)(3), (4))^TY2026

An S corporation’s permitted year. the taxable year of an S corporation must be a permitted year: a year ending 31 December, or any other accounting period for which the corporation establishes a business purpose to the satisfaction of the Secretary — and deferral of income to shareholders is not a business purpose (IRC § 1378)^TY2026

The election out. a partnership, S corporation or personal service corporation may elect a taxable year other than the required year only if the deferral period of the year elected is not longer than 3 months; where the entity is changing its taxable year, only if that deferral period is not longer than the shorter of 3 months or the deferral period of the year being changed (IRC § 444(b)(1), (2))^TY2026

What a deferral period is. the deferral period of a taxable year is the months between the beginning of that year and the close of the first required taxable year ending within it (IRC § 444(b)(4))^TY2026

What the election costs. an entity making the election must, if a partnership or S corporation, make the required payments under IRC § 7519, and if a personal service corporation, be subject to the deduction limitations of IRC § 280H. The election remains in effect until the entity changes its taxable year or otherwise terminates it (IRC § 444(c), (d)(2))^TY2026

Establishing a natural business year. a natural business year is established by the 25-percent gross receipts test: gross receipts from sales and services for the last 2 months of the 12-month period ending with the last month of the requested year, divided by gross receipts for that whole 12-month period, must equal or exceed 25 percent — and the same computation must do so for each of the two preceding 12-month periods ending with that month. The requested year does not qualify if any other annual accounting period produces a higher average of its three percentages, and a taxpayer without a 47-month history of gross receipts cannot establish a natural business year at all^TY2026

When business purpose is taken as shown. the business purpose requirement is generally satisfied, without adjustments to neutralise tax consequences, where the requested annual accounting period coincides with the taxpayer required taxable year, ownership taxable year or natural business year^TY2026

No going back. unless specifically authorised by the Commissioner, a taxpayer may not request or otherwise make a retroactive change in annual accounting period, whether or not the change is to a required taxable year^TY2026

Current figures

How it works in practice

Work a partnership’s required year in the statutory order and stop at the first test that produces an answer. Is there a taxable year that, on the testing day, was the year of partners holding more than half of profits and capital in aggregate? If so, that is the year, and nothing else is considered. If not, do all the principal partners — those meeting the statutory threshold of profits or capital (IRC § 706(b)(3)) — share a year? If so, that is the year. If neither, the calendar year. Only after all three have failed does business purpose come into it.

Two details in that sequence trip people. The majority interest test is aggregate, not individual: three partners with a fifth each who all use a June year make a June majority interest year between them, even though no one of them holds a majority. And the test is on profits and capital, so a partner holding most of the profits but only a sliver of the capital does not carry the year alone.

A partnership forced to change its year by the majority interest rule cannot be forced to change again for either of the following two years (IRC § 706(b)(4)(B)), so a partnership whose ownership is in flux does not churn its accounting period annually.

The section 444 election buys deferral and charges rent on it. The deferral period is the gap between the start of the elected year and the close of the first required year ending within it, so a partnership with a required calendar year that elects a 30 September year has the maximum three-month deferral period; a 31 October year gives two months, a 30 November year one. The cap is on the elected year, not on the amount of income involved.

For an entity changing its year the cap tightens to the shorter of three months and the deferral period of the year being changed, and that second limb defeats most elections in practice. An entity already on its required year has a deferral period of zero, so there is nothing to elect. That is the ordinary case, not a technicality: the correct advice to a calendar-year partnership that would like a September year is that section 444 does not reach it.

The rent is a required payment for a partnership or S corporation, recomputed annually and approximating the tax value of the deferral (IRC § 7519(a)), and for a personal service corporation a limit on the deduction for amounts paid to employee-owners rather than a demand for money (IRC § 280H(a)). Either way the deferral is not free, and an election that looks attractive in year one is a permanent annual computation.

The natural business year suits an entity whose seasonality genuinely justifies a non-calendar year, and the 25-percent test is stricter than it is usually described. It is not enough that the last two months of the requested year produced a quarter of receipts once. The test must be met in each of three consecutive 12-month periods; no other candidate year may produce a higher average of its three percentages; and an entity without 47 months of receipts history cannot use the route at all.

Scenarios

How this has changed

The structural change here is old but its consequences are still mis-taught. Before 1986 partnerships and S corporations chose their years freely, and the standard planning move was a January year end for an entity whose owners were on calendar years, deferring eleven months of income at every level. The required year rules closed that, and section 444 was enacted as the transitional concession — which is why it is capped at three months and why it carries the IRC § 7519 required payment. Reading it as a remnant of the old regime, bought and paid for, explains every one of its limits.

The three-month cap has never moved, and the section 444 election has not been broadened since. What has changed around it is the approval machinery: automatic approval procedures for adopting, changing and retaining a year now cover most ordinary situations, so the practical question is usually which revenue procedure applies rather than whether a ruling is needed.

The 25-percent gross receipts test itself is stable, and the comparison requirement — that no other candidate year produce a higher average — is the part most often omitted from summaries. Any description of the natural business year as a single-year, single-period calculation is describing the test incompletely rather than describing an earlier version of it.

Exam focus

Two shapes account for most questions. First, a partnership with stated ownership percentages and stated partner year ends, where the answer is the required year: run the majority interest test on aggregate profits and capital, then principal partners, then the calendar year. Second, a section 444 question, where the answer is nearly always either “three months” or “no election is available because the deferral period would be zero” — and which of those two it is depends on whether the entity is on its required year already.

Where a question gives gross receipts figures and asks about a natural business year, do the arithmetic but read the options for one that raises the three-consecutive-periods requirement. Where a question gives a business reason for a year end, check whether the reason is really about deferral; if it is, no business purpose has been shown.

Check yourself

1. A partnership has four equal partners, each with 25 percent of profits and capital. Three use a calendar year and one uses a year ending 31 August. What is the partnership’s required year?

Answer: the calendar year. The three calendar-year partners hold an aggregate 75 percent of profits and capital, which is more than half, so the majority interest taxable year under IRC § 706(b)(4)(A)(i) is the calendar year. The test is aggregate, so it does not matter that no single partner holds a majority.

2. An S corporation on a calendar year, which is its required year, wishes to make a section 444 election for a year ending 30 September. May it?

Answer: no. This would be a change of taxable year, so IRC § 444(b)(2) caps the deferral period of the elected year at the shorter of three months and the deferral period of the year being changed. The calendar year is the required year, so its deferral period is zero, and no other year has a deferral period of zero. The election is unavailable.

3. A partnership with a required calendar year makes a section 444 election for a year ending 30 September. What is the deferral period, and what does the election cost?

Answer: three months, and the required payments under IRC § 7519. The deferral period is the months between the beginning of the elected year — 1 October — and the close of the first required year ending within it, 31 December, which is three months and therefore the statutory maximum. Under IRC § 444(c)(1) a partnership making the election must make the IRC § 7519 payments for as long as it stands.

4. A business whose receipts are heavily concentrated in November and December wants a year ending 31 December on the natural business year route. It has been trading for 30 months. May it establish one?

Answer: no. Rev. Proc. 2006-46 requires 47 months of gross receipts history — 36 months to run the test across three consecutive 12-month periods, plus 11 more to compare the requested year against every other candidate year. A business with 30 months of history cannot establish a natural business year under the revenue procedure whatever its seasonality.

5. A calendar-year corporation obtains approval to change to a year ending 30 September, effective for the year beginning 1 October 2026. What return is required, and how is its tax computed?

Answer: a short period return for 1 January to 30 September 2026, with the income annualised. Under IRC § 443(a)(1) the short period runs from the day after the close of the former year to the day before the first day of the new one. Under IRC § 443(b)(1) modified taxable income for the nine-month period is multiplied by 12 and divided by 9, tax is computed on that annualised figure, and the short-period tax is nine-twelfths of it.