What Does a Fiscal Year End Mean for Your Business?

A business must establish an annual accounting period, known as a tax year, to report its income and expenses. While many use the calendar year from January 1 to December 31, a fiscal year is a 12-month period ending on the last day of any month except December. This allows a company to align financial reporting with its operational cycle. A variation is the 52-53-week tax year, which always ends on the same day of the week and varies in length. A business adopts its tax year by filing its first income tax return, and those without formal records must use the calendar year.

Establishing a Tax Year for Your Business

The decision to adopt a fiscal year is often driven by the concept of a natural business year. This is the 12-month period where a business experiences a peak in activity followed by a lull, making it a logical point to close the books. For example, a retail business that generates most of its sales during the holiday season might choose a January 31 year-end to include all holiday-related sales and returns in a single reporting period. An agricultural business might align its fiscal year with its harvest season, ensuring the costs of planting are matched with the revenue from that harvest.

The choice of a tax year is governed by IRS rules that differ based on the business’s legal structure. These regulations are designed to prevent the deferral of income for tax avoidance purposes.

Sole Proprietorships

Individuals operating a business as a sole proprietorship use the same tax year as the owner. Since most people file personal taxes on a calendar year basis, their businesses must do the same. The business’s income and expenses are reported on Schedule C, filed with the owner’s Form 1040 tax return. To use a fiscal year, the owner must maintain their personal books on that same basis and receive IRS approval.

Partnerships

A partnership must conform to the tax year of its partners. The entity is required to adopt the tax year of the partners who own a majority interest in its profits and capital. If no majority interest tax year exists, the partnership must adopt the tax year of all its principal partners, defined as those owning 5% or more of profits or capital. If neither condition applies, the partnership defaults to a calendar year.

S Corporations

As a pass-through entity, an S corporation’s profits and losses are passed to its shareholders’ personal returns. For this reason, the IRS requires S corporations to use a calendar year. An S corporation can elect a fiscal year if it establishes a valid business purpose, such as a natural business year. It can also make an election under section 444 of the Internal Revenue Code, which may require the company to make certain tax payments.

C Corporations

C corporations have the most flexibility in choosing a tax year. A new C corporation can adopt either the calendar year or a fiscal year when it files its first federal income tax return, Form 1120. This choice is made on the initial return and does not require separate IRS approval at that time. This allows a C corporation to select a year-end that best aligns with its operational needs without having to meet the stricter requirements imposed on pass-through entities.

Core Accounting Tasks at Fiscal Year End

The end of a fiscal year begins the process of closing the books, which finalizes all financial transactions for the period and prepares for the new year. This procedure involves several tasks to ensure financial statements are accurate according to the accrual basis of accounting. Key tasks include:

• Making adjusting journal entries to account for items not yet recorded in the daily course of business. These entries, such as for accrued expenses or deferred revenues, ensure that revenues and expenses are reported in the period in which they are earned or incurred.
• Conducting a physical inventory count for businesses that sell goods. The physical count is compared to inventory records, and any discrepancies due to loss, theft, or damage must be recorded as an adjustment.
• Reconciling all balance sheet accounts, including bank accounts, accounts receivable, and accounts payable. This involves verifying that the balances in the company’s books match external records like bank statements and vendor invoices.
• Preparing the company’s annual financial statements. The Income Statement summarizes revenues, expenses, and the resulting net income or loss over the fiscal year. The Balance Sheet provides a snapshot of the company’s assets, liabilities, and equity on the final day of the fiscal year.

Filing for a Change in Tax Year

Changing an established tax year is a formal process that requires approval from the IRS. A business must demonstrate a substantial business purpose for the change, such as aligning its tax year with its natural business year, not simply to gain a tax advantage. The request is made using IRS Form 1128, Application to Adopt, Change, or Retain a Tax Year.

Before completing the form, a business must define its current and proposed new tax years and calculate financial figures for the short tax period that will result from the change. The application also requires a detailed statement explaining the business purpose for the new year-end. Some businesses may qualify for an automatic approval process if they meet specific conditions outlined in IRS procedures, which simplifies the application.

For those not qualifying for automatic approval, a ruling request must be submitted, which may involve a user fee. Once completed, Form 1128 is filed with the IRS service center where the business files its tax return. A business must not implement the new tax year until it receives formal approval, which is the final step before the company can operate under its new fiscal year.