S Corporation Tax Year Rules

The use of a fiscal year defers reporting of the S corporation’s passthrough income to the shareholders and facilitates year-end tax planning. The shareholders can determine their income from the S corporation before their individual calendar tax year ends. This allows them to prepare for the effects of passthrough from the S corporation and implement any appropriate tax planning strategies before the end of their tax years. Further, a fiscal year may result in the deferral of income.

Using a Permitted Year

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) ends on December 31 or (2) is any other accounting period for which the corporation establishes a business purpose to the satisfaction of the IRS.

A business-purpose fiscal year may be automatically established if it is:

1. A natural business year because it meets a 25% mechanical test;
2. 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; or
3. A certain 52-53-week year.

If the requested business-purpose tax year cannot be established under the automatic approval provisions, it must be established based on facts and circumstances. As an alternative to using a calendar year or a business-purpose fiscal year, the corporation may elect a fiscal year if it meets the requirements of Sec. 444.

Choosing a Fiscal Year When the Corporation Elects S Status

When a corporation elects S status by filing a properly completed Form 2553, Election by a Small Business Corporation (Under Section 1362 of the Internal Revenue Code), it simultaneously applies for a tax year. The entry of a month and day in the “selected tax year” space provided on Form 2553 is a formal request for a specific year that ends on the last day of that month.

A company electing to be an S corporation can:

1. Use a calendar year;
2. Make the Sec. 444 election and use an acceptable fiscal year;
3. Apply for a fiscal year that will be approved automatically; or
4. Apply for a business-purpose fiscal year established by facts and circumstances.

When a C corporation elects S status, the S corporation’s first tax year begins on the first day following the calendar or fiscal tax year of the electing C corporation.

Changing the Year of an Existing S Corporation

An existing S corporation may change its tax year to (1) a calendar year; (2) an allowable Sec. 444 fiscal year; (3) a year that coincides with the tax year used by shareholders holding more than 50% of the corporation’s stock, a certain 52-53- week year, or a business-purpose year that will be automatically approved; or (4) a business-purpose year that requires IRS approval.

An existing S corporation generally uses Form 1128, Application to Adopt, Change, or Retain a Tax Year, to apply for a change in a permitted fiscal year. However, Form 8716, Election to Have a Tax Year Other Than a Required Tax Year, is used to apply for a change under Sec. 444.

Using a Fiscal Year by Making the Sec. 444 Election

An alternative to using a permitted year is provided by two Code sections dealing with fiscal years—Secs. 444 and 7519. Sec. 444 allows an S corporation to elect to use a fiscal year if it meets certain criteria. Sec. 7519 states that the entity must make required payments if it elects a fiscal year under Sec. 444. The required payments are intended to approximate the amount of tax that would be paid by the shareholder if the corporation changed to a calendar year. Thus, in most cases, the payments offset the income tax deferral provided by the fiscal year.

If an S corporation makes the Sec. 444 election, there are restrictions on the fiscal years that it can choose. S corporations making the Sec. 444 election are limited to year ends of September 30, October 31, or November 30. Furthermore, an S corporation generally must make a required payment in each year for which the Sec. 444 election is effective (Sec. 7519). Required payments are cumulative, however, and no payments are due until the cumulative required payments exceed $500.

The Sec. 444 election remains in effect until terminated—for example, when the corporation changes to a calendar year. If the S corporation terminates its Sec. 444 election, it cannot make the election again.

Using a Fiscal Year Under the Grandfather Rules

An S corporation that used a fiscal year for the year that began in 1986 can continue using that fiscal year if it made the Sec. 444 election by July 26, 1988. Also, an S corporation that received IRS permission to use a fiscal year on or after July 1, 1974, can retain that fiscal year if the fiscal year did not end on September 30, October 31, or November 30. The S corporation does not have to make a Sec. 444 election.

Obtaining Automatic Approval of Fiscal Year

The automatic approval provisions allow an S corporation to elect a fiscal year using simplified procedures. Automatically approved fiscal years are considered to have a business purpose. Thus, they are not subject to Sec. 444, and the S corporation does not have to make required payments. The IRS will automatically approve a tax year when the S corporation is (Rev. Proc. 2006-46):

1. Adopting, changing to, or retaining a calendar year;
2. Adopting, retaining, or changing to a fiscal year that is considered a natural business year because it meets an objective 25% test;
3. Adopting, retaining, or changing to an ownership tax year because it is the same as the fiscal year used by shareholders who own more than half its shares; or
4. Changing to a certain 52-53-week year.

Using a Business-Purpose Tax Year Established by Facts and Circumstances

Rev. Proc. 2002-39 and Rev. Rul. 87-57 contain the IRS position on granting business- purpose fiscal years established by facts and circumstances. Apparently, obtaining a year that requires IRS approval will be very difficult. Rev. Proc. 2002-39 states that the IRS will grant a taxpayer permission to adopt, change, or retain a fiscal year under the facts-and-circumstances test only in “rare and unusual circumstances.” Nevertheless, the practitioner may encounter an existing or newly electing S corporation operating under extraordinary circumstances that warrant applying for a business-purpose fiscal year.

The IRS assesses a user fee when an S corporation applies for a business-purpose fiscal year established by facts and circumstances, but not when an S corporation applies for an automatically approved year or a fiscal year under Sec. 444.

Changing Fiscal Year End Following Termination of S Status

S corporations generally must use a calendar year under Sec. 1378 or a September, October, or November fiscal year under Sec. 444. C corporations are not restricted to such required years. C corporations (except personal service corporations) can generally use any fiscal year end. Thus, a corporation may want to change its tax year following a voluntary or involuntary termination of S status.

This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 22d Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, and James A. Keller, published by Practitioners Publishing Company, Ft. Worth, TX, 2008 ((800) 323-8724; ppc.thomson.com).

EditorNotes

Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA