How to Change an Accounting Period for Tax Purposes

An accounting period is the regular interval a business uses to track its financial activity. For federal tax purposes, this is called a tax year. The most common tax year is the calendar year, which runs from January 1 to December 31, but some entities use a fiscal year, which is a 12-month period ending on the last day of any month except December. Businesses or individuals may seek to change their tax year for a variety of reasons, such as aligning with a natural business cycle or conforming to the tax year of a parent company.

Determining if IRS Approval is Required

A taxpayer wanting to change their annual accounting period must secure approval from the IRS. However, some circumstances allow for an automatic change without prior consent. The IRS provides automatic approval procedures for certain taxpayers who meet specific conditions, which simplifies the process.

For many corporations, an automatic change is possible if they meet a specific set of conditions. A requirement is that the corporation has not changed its tax year within the previous 48 months, but other terms and conditions must also be met. Another common scenario for automatic approval is an individual changing from a fiscal year to a calendar year. Newly married individuals who wish to adopt the tax year of their spouse to file a joint return can also change their accounting period without needing to formally apply for permission.

Formal approval is required when the proposed change could lead to a significant distortion of income. This includes changes that defer a substantial portion of income or shift a large number of deductions from one year to another, thereby reducing the tax liability. A change that creates a short tax period with a substantial net operating loss also requires IRS permission. If your situation does not fall under one of the automatic approval procedures, you must file a formal application.

Required Information and Documentation for a Change

When formal IRS approval is necessary, the document required is Form 1128, Application to Adopt, Change, or Retain a Tax Year. Gathering the necessary information before you begin ensures the application is complete and can be processed without delay. You will need your legal name, address, and Employer Identification Number (EIN) or Social Security Number.

You must state your present tax year and the requested new tax year on the form. A component of the application is the statement of business purpose. The IRS requires a non-tax reason for the change; a request will not be approved if the primary motivation is to achieve a preferential tax status. Examples of valid business purposes include changing to a natural business year that aligns with a peak sales season or conforming to the tax year of a newly consolidated parent company.

For ruling requests that require a user fee, payment must be made electronically through the Pay.gov website before you file. A copy of the payment receipt must be included with your Form 1128 application. Automatic approval requests do not require a user fee. You should consult the latest Form 1128 instructions on irs.gov to confirm the current fee amount and payment procedure.

The Filing Process for Form 1128

Once Form 1128 is complete, it must be mailed as it cannot be filed electronically. The mailing address depends on the type of request. For example, ruling requests are sent to the IRS National Office in Washington, D.C., while automatic approval requests are filed at the service center where the taxpayer’s income tax return is filed. It is important to use the precise address listed in the most current Form 1128 instructions to ensure proper delivery.

The filing deadline for Form 1128 differs based on the type of request. For a ruling request, the form is due by the due date of the tax return for the short period, not including any extensions. For an automatic approval request, the form must be filed by the due date of the short period tax return, but this deadline includes extensions.

After mailing the application, the IRS will generally notify you of its decision within 90 days. The notification will be in writing and will either approve or deny the request. If approved, the letter will outline the terms and conditions that you must follow to finalize the change.

Filing the Short Period Tax Return

An approved change in an accounting period creates a “short tax period.” This is a tax year of less than 12 months that begins the day after the old tax year closes and ends on the day before the new tax year begins. For instance, if a business changes from a calendar year ending December 31 to a fiscal year ending June 30, a short period return is required for the period from January 1 to June 30. This short period return is a filing requirement separate from the application process.

The tax for this short period cannot be calculated simply by applying tax rates to the income earned. Instead, the law requires that the income for the short period be annualized. This process projects what the income would have been for a full 12-month period, ensuring the tax paid is proportional to a full year’s earnings and that the taxpayer benefits from a full year of graduated tax rates and deductions.

The annualization calculation is a multi-step process:

• Determine the taxable income for the short tax period.
• Multiply this short-period income by 12.
• Divide that result by the number of months in the short period to arrive at the annualized income.
• Calculate the tax on this annualized figure using the applicable tax rates.

Once the tax on the annualized income is figured, one final step is required. This calculated tax must be prorated back to the short period. This is done by multiplying the full year’s tax amount by the number of months in the short period and then dividing by 12. The resulting figure is the actual tax liability for the short period return. The due date for this return is the 15th day of the third or fourth month following the close of the period, depending on the business structure.