Identifying the final C corporation and initial S corporation tax years

Determining allowable tax years

The decision to file an S election requires consideration of the tax year to be used by the S corporation. At the time Form 2553, Election by a Small Business Corporation, is filed, the corporation must designate its selected accounting period. In general, an electing S corporation has three choices with respect to its accounting period:

1. Conform to the Dec. 31 calendar year, as required by Sec. 1378;
2. Apply for a permitted fiscal year end based on the IRS’s approval of a business purpose; or
3. Elect under Sec. 444 to use a fiscal year ending on the last day of either September, October, or November and become subject to the annual tax deposit requirement under Sec. 7519.

Determining when the initial S corporation year begins

Newly formed corporation electing S status

A newly formed corporation’s first S year begins on the date the S election is effective (i.e., the earliest date on which the corporation has shareholders, acquires assets, or begins doing business).

C corporation electing S status

The first S year of a C corporation electing S status begins the first day following the calendar or fiscal tax year of the electing C corporation. If a C corporation uses, for example, a June 30 fiscal year and elects S status, the first S year will normally begin July 1. If the S corporation uses a calendar year, its first year will begin on July 1 and end on Dec. 31.

Limited options do exist, however, for electing S status at the close of a short C year. A newly formed corporation can begin operating as a C corporation, then close the C year to file a timely S election. Also, an existing C corporation that meets certain requirements can automatically change its tax year to a calendar year (or other permitted year), then elect S status effective for the tax year immediately following the C corporation’s short period (Rev. Proc. 2006–45).

Closing the C year of a newly formed corporation to file a timely S election

When a practitioner encounters a newly formed corporation after the two–month–and–15–day deadline for submission of an S election has passed, a possible remedy (other than seeking relief through the IRS) may be filing an initial short–period C corporation return to start a new tax year for which a timely S election can be filed.

Example 1. Filing a timely S election by closing the C year of a newly formed corporation:Z was incorporated and began business operations on Jan. 2. The shareholders anticipate initial losses and are generally aware that the filing of an S election will allow a passthrough loss that can be deducted on their personal income tax returns. However, they did not visit with their tax practitioner until March 26, which is 10 days past the deadline for the filing of the Form 2553. How might the practitioner salvage this situation by use of a short–period C return?

The corporation can establish a C corporation tax year ending Jan. 31, so its first tax year will begin on Jan. 2 and end Jan. 31. If it then elects S status and uses a calendar year, the S corporation’s first tax year will begin on Feb. 1 and end Dec. 31. Such short years are allowable when both the C corporation and the S corporation are in existence only part of their respective first tax years (see Sec. 443(a)(2)).

A new C corporation is not restricted in its choice of a fiscal year. Thus, by filing an initial short–period C corporation tax return for the period Jan. 2–Jan. 31, Z can establish a new fiscal year beginning Feb. 1, for which a timely S election can now be made. If there is insufficient time to compile the data to prepare the one–month initial short–period return, a timely extension request filed by May 15 would serve to fix the Jan. 31 fiscal year end. The S election in this situation would be due April 15 and would establish the end of the corporation’s first S tax year as Dec. 31. In this manner, the tax planner will have limited the initial losses trapped in the C corporation to only a one–month period.

Planning tip: Rather than having Z file a short–period C corporation return, the practitioner might suggest that the corporation apply for relief from filing a late election under Rev. Proc. 2013–30. If such relief is granted, Z will become an S corporation on Jan. 2, the date the corporation was formed and began business operations. The corporation is required to show that there was reasonable cause for the late filing and must meet the other requirements of the applicable revenue procedure. No user fee is required.

Warning: Operating as a C corporation, even for a short time, subjects the S corporation to the built–in gains (BIG) tax rules. The BIG tax can cause double–taxation on assets acquired during the C period. Inventory and cash–basis receivables can generate enough potential BIG tax to render electing S status impractical. Furthermore, if the S corporation has accumulated earnings and profits generated during the C period, the Sec. 1375 excess net passive income tax rules may apply.

Changing fiscal year end of an existing C corporation before electing S status

A corporation generally must obtain IRS approval before changing its tax year by showing a business purpose for the change (Sec. 442). However, Rev. Proc. 2006–45 allows a C corporation to change its tax year to a calendar year (or other year that S corporations are permitted to use) without obtaining prior IRS approval if it meets all of the following requirements:

• The corporation has not changed its tax year at any time within the last 48 months ending with the calendar year that includes the beginning of the short period required to effect the change. (A corporation that has been in existence less than 48 months qualifies if it has not previously changed its tax year.) Certain exceptions apply to this requirement.
• The corporation is not a member of certain partnerships or a beneficiary of certain trusts or estates as of the end of the short period.
• The corporation does not attempt to make an S corporation election for the tax year immediately following the short period, unless the C corporation’s year change is to a permitted S corporation year. For this purpose, a permitted S corporation year includes a calendar year, a natural business year, an ownership tax year, or a tax year permitted under Sec. 444.
• The corporation is not a personal service corporation, as defined in Sec. 441(i).
• The corporation is not an entity that is specifically prohibited from using the revenue procedure (e.g., foreign sales corporations, certain tax-exempt organizations, and certain cooperative associations).

To change to an automatically approved tax year under Rev. Proc. 2006–45, the C corporation must also file Form 1128, Application to Adopt, Change, or Retain a Tax Year, on or before the time (including extensions) for filing the return for the resulting short period. The form must be signed by a corporate officer and submitted to the director, IRS Center, Attention: ENTITY CONTROL, where the corporate federal income tax return is filed. The company should type or print the statement “FILED UNDER REV. PROC. 2006–45” across the top of page 1 of the form.

No user fee is required when a Form 1128 is submitted under Rev. Proc. ٢٠٠٦-٤٥.

Example 2. Changing the fiscal year end of an existing C corporation before electing S status:N, a C corporation, has used a tax year ending Sept. 30 since it incorporated 11 years ago. The shareholders want the corporation to elect S status and change to a calendar year. They ask their practitioner if the corporation can elect S status effective Jan. 1, 2026, and file a short C corporation return for Oct. 1 through Dec. 31, 2025. Can N change to a Dec. 31 tax year without IRS approval?

The practitioner advises the shareholders that the S year must be effective on the day following the last day of the C corporation’s tax year. Thus, the S election would normally be effective on Oct. 1, 2025, if the S election is filed any time from Oct. 1, 2024 (i.e., the beginning of the C corporation’s tax year), through Dec. 15, 2025 (i.e., the 15th day of the third month of the new tax year). Under the general rule, the final C corporation return will be for the 12–month period ending Sept. 30, 2025. The S corporation’s first tax return will cover Oct. 1, 2025, through Dec. 31, 2025. The second S corporation return will be for the 2026 calendar year.

The practitioner determines that N can change its tax year beginning Oct. 1, 2025, to a Dec. 31 tax year because it meets all the requirements of Rev. Proc. 2006–45. The change requires N to file a Form 1128 as well as a short–period C corporation return for Oct. 1 through Dec. 31, 2025. In computing the tax due with this short–period return, N is required to annualize its taxable income. The S corporation’s first tax return will be for the 2026 calendar year.

Form 1128 must be filed by the due date of the short–period return (April 15, 2026) if N does not file an extension request. If a six–month extension is requested, Form 1128 must be filed by Oct. 15, 2026, the extended due date for the short–period tax return.

Contributor

Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. This case study has been adapted from
Checkpoint Tax Planning and Advisory Guide’s S Corporations topic. Published by Thomson Reuters, Frisco, Texas, 2026 (800-431-9025; tax.thomsonreuters.com).