You must pay your income, Social Security, and Medicare taxes one year at a time. Correspondingly, you also keep your tax records on an annual basis. This yearly period is your tax year.
As a taxpayer, you must consistently maintain your books and records and report your income and expenses using your tax year.
The tax year is automatically chosen when you file your first tax return for your business. After this, permission from the IRS is required to change the type of tax year you decide upon.
There are two different types of tax years:
The calendar year is twelve consecutive months beginning on January 1 and ending on December 31.
Virtually all individual taxpayers who don’t have a business must use the calendar year as their tax year. The only exception is if you keep your books and records on a fiscal year basis—this is very rare.
Any business can use the calendar year as its tax year. And the vast majority of small businesses do so.
The IRS requires sole proprietors to use the calendar year. This alignment makes sense because when you’re a sole proprietor, you personally own your business. So, your business tax year should be the same as your personal tax year, which is ordinarily a calendar year.
Single-member limited liability companies are usually taxed the same as sole proprietorships, so they also use the calendar year.
If your sole proprietor or single-member LLC business grows and you become a partnership, multi-member LLC or corporation, you must continue to use the calendar year unless you obtain permission from the IRS to use a fiscal year.
Partnerships, multi-member limited liability companies, S corporations, and personal service corporations are also required to use the calendar year as their tax years.
However, a few exceptions permit some of these entities to use a fiscal year. But you have to ask the IRS for permission. If you have a good reason, then file IRS Form 1128, Application To Adopt, Change, or Retain a Tax Year.
You may have to pay a fee. Keep in mind that this is a complex form; you’ll probably need a tax pro to help you file it.
The IRS prefers that you use a calendar year. And for most small businesses it’s a good idea because it’s the most straightforward tax year to use.
A fiscal year is any tax year other than a calendar year. Typically, it is twelve consecutive months ending on the last day of any month except December 31st.
However, a fiscal year does not have to end on the last day of the month. In this event, it varies from 52 to 53 weeks.
Larger businesses organized as regular C corporations have more leeway in choosing their tax year than most others. They commonly use a fiscal year instead of the calendar year as their tax year.
For example, the fiscal year for many C corporations ends in March, June, or September. Such corporations typically choose to use fiscal years for accounting convenience.
Using a fiscal tax year rather than the calendar year complicates bookkeeping and taxes. For instance, your tax return will not be due on April 15. If you elect a fiscal year, you must file your tax return by the 15th day of the fourth month after the close of your fiscal year. To demonstrate, if your fiscal year ends on June 30, you have until October 15 to file your return.
One good reason to use a fiscal year is that your business is seasonal. If you have a seasonal business, using the calendar year might split your selling season into two tax years.
To illustrate, if you earn most of your income in the spring and incur most of your expenses in the fall, a tax year ending in July or August might be better than a calendar tax year ending in December. This way, the income and expenses on each tax return will be more closely related.
Businesses that rely on holiday sales that spill into the new year can also benefit from using a fiscal year ending January 31 or even later than a calendar year ending December 31.
If you contract quite a bit with the federal government, you might choose a fiscal year ending September 30. This coincides with the federal government’s fiscal year.
Also, if you’re in an industry where most businesses use a fiscal year, you may want to do the same.
A short tax year is a tax year that lasts twelve months. You’ll typically have a short tax year the year you start or end your business. You can also have a short tax year if you change from a calendar year to a fiscal year, or vice versa.
You must file a tax return for a short tax year. It’s important to realize if you start your business on April 1 and use the calendar year, you must file a return for April 1 through December 31. For details on how to figure your taxes for a short tax year, see IRS Publication 538, Accounting Periods and Methods.