Establishing a Business Purpose With IRS Notice 87 16
Explore the IRS framework that allows S corps and partnerships to adopt a fiscal tax year by demonstrating a legitimate, non-tax business purpose.
IRS guidance allows certain businesses to use a fiscal tax year instead of a calendar year if they can establish a valid business purpose. Following the Tax Reform Act of 1986, which mandated that entities like S corporations, partnerships, and personal service corporations generally use a calendar year, the IRS outlined pathways to justify a different year-end. While initial guidance was provided in notices like IRS Notice 87-16, the rules have since been updated and are now primarily found in formal revenue procedures. The core principle is the “natural business year,” which allows a business to align its tax reporting with its operational cycle.
The Natural Business Year 25-Percent Test
A primary method to establish a business purpose for a fiscal year is proving the entity has a “natural business year.” This concept applies to businesses with distinct peak and off-peak seasons. To qualify automatically, the IRS uses the 25-percent test, a calculation proving the requested fiscal year-end matches the end of a business cycle.
The calculation analyzes gross receipts for the three most recent 12-month periods ending with the proposed fiscal year. For each of those three years, the gross receipts from the final two months are divided by the total gross receipts for that 12-month period.
The resulting percentage for each of the three years must be 25% or greater. If multiple year-ends meet the test, only the one producing the highest average of the three percentages qualifies as the natural business year. For example, a landscaping company wanting a November 30 fiscal year-end must show its receipts from October and November are at least 25% of its total receipts for the year.
This test provides an objective measure, removing subjectivity from the approval process. If a business satisfies this requirement, it is deemed to have a valid business purpose and qualifies for automatic approval.
Alternative Methods for Establishing a Business Purpose
If a business does not meet the 25-percent test, alternative paths exist to justify a fiscal tax year. These methods accommodate entities whose business purpose is valid but not reflected by a gross receipts calculation.
Ownership Tax Year
The ownership tax year test is an alternative for S corporations and partnerships. This method allows the entity to adopt the same tax year as the partners or shareholders who collectively own more than 50 percent of the stock or capital and profits. This test simplifies tax administration by conforming the entity’s tax year to that of its majority owners.
Facts and Circumstances
If neither the 25-percent nor the ownership tax year test is met, a business can request a fiscal year based on “facts and circumstances.” This requires the taxpayer to present a non-tax business reason for the desired year-end. The business must prove to the IRS that its rationale is sound and based on its operational reality.
Valid reasons might include aligning the tax year with a natural cycle that fails the 25-percent test or conforming to the requirements of a franchisor. The IRS states that reasons of convenience, like simplifying bookkeeping, are not valid business purposes. Approval is granted only in what the IRS calls “rare and unusual circumstances,” which indicates a high threshold for success.
Filing Procedures for a Tax Year Change
To request a change in its tax year, a business must file Form 1128, “Application to Adopt, Change, or Retain a Tax Year.”
The applicant must provide its name, employer identification number (EIN), and its current and requested tax years. The filer must also cite the authority for the request, indicating if it is for automatic approval, like the 25-percent test, or a ruling based on facts and circumstances.
The filing deadline for Form 1128 differs based on the request type. For automatic approval requests, the form is due by the due date of the tax return for the short period created by the change, including extensions. For ruling requests, the deadline is the due date of the return for the first effective year, not including extensions.
A user fee is required for ruling requests and must be paid through Pay.gov. After submission, the IRS will review the application and issue a letter either approving or denying the requested tax year change.