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All enterprises must keep their books based on accounting periods, called tax years. For individuals, the tax year is the same as the good old calendar year starting on January 1 and ending on December 31. Most small businesses are required to use the calendar year, too.
Some enterprises may choose an alternative tax-reporting period called a fiscal year. This is defined as any one-year period that does not end on December 31. Individual taxpayers are never allowed to report on a fiscal year basis.
A business notifies the IRS of its accounting period by checking the designated box on its annual tax return form. Once chosen, the accounting period usually cannot be changed without written approval from the IRS.
Regardless of which accounting tax year is used, a business' payroll taxes must be reported on a calendar year basis.
Calendar Year Period
Sole proprietors, partnerships, limited liability companies, S corporations and personal service corporations must report as calendar-year entities unless they can convince the IRS they qualify for an exception.
Fiscal Year Period
Small enterprises may legally use a fiscal year instead of a calendar tax year. A fiscal year is a one-year period ending on the last day of any month except December. However, the fiscal year is not favored by the tax code for small businesses, except for C corporations. Other entities can use a fiscal year only by showing the IRS a business reason for it, such as a cyclical or seasonal business—for instance, farming.
For IRS permission, file Form 8716, Election to Have a Tax Year Other Than a Required Tax Year. Consult a tax pro first to see if using a fiscal year really makes sense.
Short Tax Years
A short tax year occurs when a business starts up during a calendar year on any day but January 1. For instance, if Sandra's Sunshades opens on July 15 and uses a calendar tax year reporting period, her first tax year is only five and a half months and ends on December 31. Likewise, a short year occurs if Sandra closes her doors at any time other than the year end. A short tax year requires Sandra to prorate certain tax deductions, such as depreciation of assets, to match the short period in that first or last year of operation.
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