While there is heightened interest in tax reform and changes may be on the horizon, the concept of an annual accounting period is unlikely to change. An annual accounting period is the tax year that a taxpayer uses to compute its federal (and, usually, state and local) taxable income. Depending on the type of entity, a taxpayer may have a required tax year prescribed by the Internal Revenue Code, or it may be free to choose any tax year it wishes. A newly formed entity usually adopts a tax year without having to obtain the IRS's approval, but if an entity later wants to use a different tax year, it generally must request the IRS's approval. Thus, when an entity is formed, it is important to give some thought to the tax year it will adopt. This item highlights the accounting period rules and the guidance for changing an accounting period for the most common types of entities and illustrates why adopting a tax year should not be an afterthought.
General requirements of tax years
A tax year may be either a calendar year, which is a period of 12 consecutive months ending on Dec. 31, or a fiscal year, which is either a period of 12 consecutive months ending on the last day of any month other than December, or a 52-53-week tax year. A 52-53-week year is one that varies from 52 to 53 weeks in any particular year, ends always on the same day of the week, and ends either on the date that same weekday last occurs in a calendar month (e.g., the last Friday in December) or on the date that same weekday falls that is nearest to the last day of a calendar month (e.g., the Friday nearest to Dec. 31—note that in this example, some tax years will end in December and some will end in January).
For tax purposes, the correct reference for a 52-53-week tax year is to the end of the year, not the beginning (or first day) of the year; for example, adopting a tax year beginning the first Friday in January is not a proper year. A 52-53-week tax year may be desirable for management purposes, as the fiscal year is broken down into months of four- and five-week blocks that are easily comparable to other quarters and years and make data analysis easier and more accurate. It is common for entities in the retail industry to use a 52-53-week tax year because each month generally has the same number of selling days and weekends from one year to the next and comparisons to prior years are simpler. Fiscal years are recognized by the IRS only if the books of the entity are also maintained on the fiscal year end.
Some types of entities have required years: The tax year of a partnership is determined by reference to the tax years of its partners; the tax year of a controlled foreign corporation (CFC) is determined by reference to the tax year(s) of its U.S. shareholder(s); and the tax year of an S corporation, personal service corporation (PSC), trust (with certain exceptions), or real estate investment trust (REIT) is the calendar year.
Adoption of a tax year
A new entity generally adopts a permissible tax year by filing its first federal income tax return using that tax year; no Form 1128, Application to Adopt, Change, or Retain a Tax Year, needs to be filed. Filing a request for an extension of time to file the federal income tax return, applying for an employer identification number, or paying estimated taxes based on a particular tax year do not effect an adoption of a tax year. As discussed in more detail below, an entity with a required tax year has a limited ability to use a different tax year. A partnership, existing S corporation, or PSC that wants to adopt a tax year other than its required tax year must file a Form 1128 (a corporation electing S status uses Form 2553, Election by a Small Business Corporation) and demonstrate a business purpose to obtain IRS approval before adopting that tax year (the procedures discussed below for changing a tax year apply to these adoptions) or elect to use a different tax year under Sec. 444 (also discussed below). Note that the tax year of a partnership that has a technical termination under Sec. 708(b)(1)(B) ends on the date of the technical termination, and the new partnership then must either adopt its required tax year or request permission to adopt a different tax year. See Sec. 441 and the regulations thereunder for more details on permissible tax years and adopting a tax year.
A partnership, S corporation, or PSC that cannot establish a business purpose sufficient for the IRS to approve a tax year other than the required tax year may want to consider a Sec. 444 election, which generally requires a yearly payment, as further discussed below. A Sec. 444 election may also be available for an existing entity that wishes to change its tax year, but depending on the current tax year used by the entity, the tax years that are available may be further restricted. The tax year that may be selected with a Sec. 444 election is limited to a maximum three-month deferral period from the required tax year; however, if the entity's present tax year results in less than a three-month deferral period, the maximum deferral period is that shorter period.
Example 1: A new S corporation that has a required calendar tax year could make a Sec. 444 election to adopt a September, October, or November tax year. However, an existing S corporation that uses a November tax year could make a Sec. 444 election only to use a November tax year because using a September or October tax year would result in an increase from the present one-month deferral period.
An entity using its required tax year cannot make a Sec. 444 election because the deferral period would increase from the present year, which has no deferral. A partnership or S corporation that makes a Sec. 444 election must pay the value of the tax deferral that the owners receive through the use of a tax year that is different from the required tax year (see Sec. 7519 for further information on the required payment). These payments are refundable deposits that do not earn interest. A PSC that makes a Sec. 444 election must distribute certain amounts to employee-owners by Dec. 31 of each year. Note that a Sec. 444 election generally may not be made by any entity that is part of a tiered structure.
Automatic changes in a tax year
After an entity has adopted a tax year, it must use that year when computing taxable income and filing returns for all subsequent years, unless it obtains approval from the IRS to make a change or the entity is otherwise able to change under the Code or regulations without the IRS's approval. One common change that does not require the IRS's approval occurs when a subsidiary corporation joins an affiliated group filing a consolidated tax return. The subsidiary corporation does not need the IRS's consent to change to its required year—that of its new parent corporation.
An entity that needs to obtain the IRS's approval for a change in its tax year must file an application with the IRS, generally on Form 1128, in accordance with the administrative procedures published by the IRS. Currently, Rev. Procs. 2006-45, 2006-46, and 2002-39 address changes for most types of entities; however, other procedures may apply to specific types of entities not covered in these procedures. An entity must establish a business purpose for using its proposed tax year (changes or adoptions that qualify to use the automatic procedures discussed below are deemed to have established a business purpose) and agree to the IRS's prescribed terms, conditions, and adjustments for putting the change into effect. The remainder of this item discusses the business purpose requirement for nonautomatic changes and the most common terms and conditions imposed by the IRS for a change in tax year.
Rev. Procs. 2006-45 and 2006-46 provide procedures for certain entities to obtain the automatic approval of the IRS for an accounting period change. If an entity cannot use the automatic procedures, it should consider whether to file an application with the IRS National Office under the nonautomatic procedure of Rev. Proc. 2002-39, as discussed below. The two automatic procedures are similar in scope, terms and conditions, and filing requirements but have some differences based on the types of entities covered.
Rev. Proc. 2006-45: Rev. Proc. 2006-45 provides the automatic procedures for a corporation (except an S corporation, which is covered under Rev. Proc. 2006-46) to change its tax year. Certain corporations that have required tax years, such as a CFC and a REIT, can only use this procedure for changing to a required tax year. This procedure also covers certain types of tax-exempt organizations that are not covered by the automatic procedures in Rev. Proc. 85-58.
Any of more than a dozen scope limitations explained in Section 4.02 of Rev. Proc. 2006-45 could prevent a corporation from using the automatic procedures. The first two—a prior change in tax year and interest in a passthrough entity or CFC—are most commonly problematic for corporations.
The first limitation precludes a corporation from using the automatic procedures if it has made a change in its tax year within the most recent 48-month period ending with the last month of the requested tax year. There are some exceptions to this limitation that the IRS will not treat as a prior change in tax year, the most common of which are (1) a prior change by a subsidiary corporation that joined an affiliated group filing a consolidated tax return and changed to its parent's tax year, and (2) a prior change or a current request to change from a 52-53-week tax year to a non-52-53-week tax year referencing the same month, or vice versa. An entity that changed its tax year within the 48-month period and does not meet any of the exceptions may file an application under the nonautomatic procedures, but it must explain the legal basis supporting its requested tax year and the facts supporting the business purpose necessitating another change in tax year.
The second limitation is that the automatic procedure does not apply to a corporation that has an interest in a passthrough entity or CFC. This limitation is designed to prevent a corporation that has a minority interest in a passthrough entity (which includes, among other entities, a partnership, trust, and closely held REIT) or a CFC, which generally has a required tax year, from changing its tax year and increasing the deferral period between the corporation and the passthrough entity or CFC. However, a corporation will not be subject to this limitation if it has a majority interest in a passthrough entity or a CFC that will be required to change to the corporation's new tax year, and the passthrough entity or CFC changes its tax year concurrently with the corporation, regardless of any conflicting testing date provisions in the Code.
There are other exceptions to this limitation, such as where the new tax year would result in a reduction in the deferral period and where the corporation has a de minimis interest in the passthrough entity or CFC. If this limitation prohibits a corporation from using the automatic procedures to change its tax year, it may file an application under the nonautomatic procedures but then may be subject to additional terms and conditions that are designed to neutralize the tax effects of any substantial distortion of income that would result from permitting the corporation to make the requested change.
Rev. Proc. 2006-46: Rev. Proc. 2006-46 provides the automatic procedures for a partnership, S corporation or electing S corporation, PSC, or trust to change its tax year. The automatic procedures apply to an entity that is changing to its required tax year or a 52-53-week year ending with reference to the required tax year, or a partnership, S corporation, or PSC that wants to change to a natural business year by meeting a 25% gross-receipts test set forth in Section 5.07 of Rev. Proc. 2006-46 or a 52-53-week year ending with reference to the natural business year. This test calculates the percentage of the gross receipts from the last two months of the requested tax year divided by the gross receipts from the entire requested tax year. This computation is done for the requested year of change and the two preceding 12-month periods. If the result for all three years is equal to or exceeds 25%, the test is met and the entity has demonstrated a natural business year. However, if any other accounting period produces a higher percentage, then the requested tax year will not qualify as the natural business year. Note that a member of a tiered structure cannot use this test to establish a natural business year under either the automatic or nonautomatic procedures.
The automatic procedures will not apply to a partnership, S corporation, PSC, or trust that is under examination (unless the entity obtains the director's consent to the change) or before an area office or a federal court if the tax year is an issue under consideration, or to a partnership or S corporation if the entity's tax year is an issue under consideration in the examination of a partner or shareholder's federal income tax return, or by an area office or federal court. These same limitations apply under the nonautomatic change procedures, so if any of the limitations apply to an entity, it will not be able to make a change in tax year until the limitation no longer applies. The automatic procedure also does not apply to a change to, or retention of, a natural business year if an entity has made a change in its tax year within the most recent 48-month period ending with the last month of the requested tax year.
Certain types of prior changes are disregarded for purposes of the 48-month prior-change limitation, specifically: a change to a required or ownership tax year; a prior change from a 52-53-week tax year to a non-52-53-week tax year referencing the same month, and vice versa; or a change by an S corporation or PSC that joined an affiliated group filing a consolidated tax return and changed to its parent's tax year. Similar to Rev. Proc. 2006-45, if this limitation prohibits a partnership, S corporation, or PSC from using the automatic procedures to change its tax year, it may file an application under the nonautomatic procedures, but it may be subject to additional terms and conditions that are designed to neutralize the tax effects of any substantial distortion of income that would result from permitting the entity to make the requested change.
Automatic change filing requirements: If an accounting period change qualifies under the automatic procedures of either Rev. Proc. 2006-45 or Rev. Proc. 2006-46, the entity must complete the appropriate sections of the Form 1128 application (or Form 2553, for an electing S corporation, which has different filing requirements) and file the application in two places: The original application should be filed with Entity Control at the IRS service center where the entity files its federal income tax return (or, if the return is e-filed, the service center where a paper copy of the return would be filed), and a copy of the application must be attached to the federal income tax return filed for the short period (which begins on the day following the close of the old tax year and ending on the day the new tax year ends).
The Form 1128 may be filed as early as the day after the end of the short period and must be filed no later than the due date, including extensions, for filing the federal income tax return for the short period. Because all members of an affiliated group filing a consolidated return must use the same tax year, the parent of such an affiliated group will file one application that includes all the group members. No user fee is required for an application filed under the automatic procedures. The IRS service center and the appropriate director have the authority to review an application filed under the automatic procedures, to ensure the application has been filed timely and confirm compliance with the provisions of the revenue procedures.
Nonautomatic changes in a tax year
An entity that cannot file under the automatic procedures must file a Form 1128 under the nonautomatic procedures of Rev. Proc. 2002-39 and establish a business purpose to obtain the approval of the IRS for its requested change of tax year. A partnership, S corporation, or PSC will generally satisfy the business purpose requirement if the requested tax year is the entity's required tax year, ownership tax year, or natural business year.
An entity must establish a business purpose to use a tax year other than its required tax year. A corporation, partnership, S corporation, or PSC may establish a business purpose by requesting to use a natural business year or by establishing a business purpose based on all the facts and circumstances. A corporation (but not a partnership, S corporation, or PSC) will also generally satisfy the business purpose requirement by providing a nontax reason for the requested tax year.
A partnership, S corporation, or PSC demonstrates it has a natural business year under one of three tests set forth in Section 5.03 of Rev. Proc. 2002-39: (1) an annual business cycle test, which demonstrates the entity has a peak and a nonpeak period of business and permits the entity to use a tax year ending at or soon after the close of the highest peak period of business; (2) a seasonal business test, which demonstrates the entity's business is only operational for part of the year and the entity has insignificant gross receipts during the period the business is not operational, and permits the entity to use a tax year ending at or soon after the operations end for the season; or (3) the same 25% gross-receipts test in Rev. Proc. 2006-46, as described above, which permits an entity to use the tax year that meets the highest average at or above 25%.
It has been the author's experience that unless a partnership, S corporation, or PSC squarely fits into one of these tests, it is difficult to obtain permission to use a tax year other than the required tax year. Therefore, an entity that has a required tax year should plan for its desired tax year at the time the entity is formed. It may be difficult, if not impossible, to prospectively change to a tax year other than the required tax year, due to the limited scope of the natural-business-year tests and the limitations on the available tax years under a Sec. 444 election.
As under Rev. Proc. 2006-46, an entity with a required tax year cannot use the nonautomatic procedures if the entity is under examination (unless the entity obtains the appropriate IRS director's consent to the change), is before an area office or a federal court if the tax year is an issue under consideration, or is a partnership or S corporation, if on the date the entity would otherwise file its application, its tax year is an issue under consideration in the examination of a partner's or shareholder's federal income tax return or by an area office or federal court with respect to a partner's or shareholder's federal income tax return.
If an accounting period change must be requested under the nonautomatic procedures, the appropriate sections of the Form 1128 must be completed and the application filed with the IRS National Office between the date following the end of the short period and the due date, not including extension, of the federal income tax return for the short period.
Example 2: A corporation that has a June 30 tax year and wishes to change to a Dec. 31 tax year effective for Dec. 31, 2016, must file the Form 1128 between Jan. 1, 2017, and April 18, 2017.
A user fee must be submitted for the IRS to process the request; the fee is currently $5,800. Similar to an automatic change requested for members of an affiliated group filing a consolidated return, the parent of the affiliated group files one application that includes all the group members and pays one user fee. The IRS National Office will review the entity's request. It may ask for additional information and will issue a letter ruling either approving or denying the request.
An entity should request a conference of right when it files the application so that if the IRS contemplates an adverse response, the entity will have the option to have a conference with the IRS before the letter ruling is issued (see Part III, Section A, question 13, of Form 1128 (Rev. October 2014)). If the entity receives a favorable letter ruling, it must attach a copy of it to the federal income tax return filed for the short period. The appropriate director has the authority to review the letter ruling to confirm the facts and representations that the entity provided were accurate and that it properly implemented the change.
Terms and conditions for a change in tax year
Whether a change in tax year is made under the automatic or nonautomatic procedures, the terms and conditions imposed by the IRS are similar. The main terms and conditions are discussed below. An entity must file a federal income tax return for the first tax year for which the change is effective, which is generally the short period, and continue to file its returns on the new tax year unless it secures approval to make a change. An entity's taxable income for the short period must be annualized and the tax computed as specified in Sec. 443, except for partnerships and S corporations.
An entity must compute its income and keep its books and records (including financial statements and reports to creditors) on the new tax year; however, there is an exclusion to this condition for books and records that are required to be maintained for foreign law purposes on a different tax year end (Rev. Proc. 2006-45, §6.02(3)). Also, a partnership, S corporation, PSC, or trust that changes to its required tax year is not required to conform its financial statements and reports to creditors to the required tax year. Note that the book/tax year-end conformity when making a change in tax year is more restrictive than what is required when a tax year is adopted; when a tax year is adopted, reconciliation between books and tax years is permitted under Regs. Sec. 1.441-1(b)(7).
A corporation or PSC that generates a net operating loss or capital loss in the short period may not carry the loss back but must carry it over, beginning with the first tax year after the short period. Exceptions to this rule permit the loss to be carried back if the loss is either $50,000 or less or it is less than that generated for the full 12-month period beginning with the first day of the short period (and, for a nonautomatic change, the short period is nine months or longer). Any unused general business credit generated in the short period by a corporation or PSC must be carried forward.
Finally, a partnership, S corporation, PSC, or trust that files an application under either the automatic or nonautomatic procedures receives audit protection, meaning that the IRS will not require the entity to change its tax year for any period prior to the short period.
Key long-term planning consideration
As discussed above, when an entity is formed, it is important to consider the tax year it desires to have over the long term, because changing to a different tax year in the future may be difficult, if not impossible. Although a corporation generally has more flexibility in choosing a tax year, in a complex group structure that includes passthrough entities or CFCs, the passthrough entities or CFCs also may be required to change their tax years if they are majority owned by the corporation; or, if they are minority owned by the corporation, the corporation may be subject to additional terms and conditions when making its requested change. It is vital to understand the ownership, structure, and tax year-end consequences before a corporation requests a change in tax year. A corporation also may be able to have different book and tax years when it adopts a tax year, but when it subsequently changes its tax year, book and tax years will have to conform.
An entity with a required tax year, such as a partnership, S corporation, or PSC, has much less flexibility in choosing its tax year, even when adopting one, unless it can demonstrate a natural business year for the requested tax year end. A Sec. 444 election provides a limited selection of tax years that can be used without having to establish a business purpose but comes with a price. Moreover, if an entity adopts a tax year that provides less than the maximum three months of deferral, it will not be allowed to increase that deferral in a later year. Therefore, tax-year planning is important.
Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.