Almost all individuals use calendar year accounting for taxes. A tax yeartax yearTwelve month period; for most taxpayers, tax year = calendar year. for an individual other than the calendar is rare since the tax system is set up to accommodate calendar year taxpayers. However, there are no restrictions on an individual taking a tax year other than a calendar year. The choice to file on a fiscal year basis must be made with an initial tax return and books and records must be kept on that basis. An individual may also request a change to a fiscal year with the IRS if certain conditions are met.

Many individual tax returns include income from partnerships, S corporations and personal service corporationspersonal service corporationCorporation whose owners/shareholders provide accounting, actuarial, consulting, legal, or medical services to clients.. The income or loss from partnerships and S corporations is passed through, on Schedule K-1, to the owners and taxed in the owners’ personal tax returns. Partnerships and S corporations are not taxable entities, only reporting entities. Similarly, wages are passed through to doctors, lawyers, accountants, and other professionals from personal service corporations owned by them. Because the pass through of income and loss from partnerships and corporations plays such a large role in the taxation of many individuals, it is important to understand the rules governing the allowed accounting periods for these entities.

Partnerships and corporations had a great deal of freedom in selecting a tax year in the past, but Congress changed the tax laws to prevent an inappropriate deferral of taxable income. For example, if an individual taxpayer has a calendar tax year and receives income from a partnership with a tax year ending September 30, the taxpayer is able to defer three months of partnership income for an indefinite period of time. Therefore, the tax law was changed to include provisions that specify the required tax year for many partnerships and corporations, reducing the opportunities for deferring income.

Generally, a partnership must adopt the same tax year as that of the partners owning a majority interest (greater than 50%) in partnership profits and capital. If a majority of the partners do not have the same tax year, the partnership is required to adopt the tax year of all of its principal partners (partners with at least a 5% interest in profits or capital). If the principal partners have different tax years, the partnership, generally, is required to use the least aggregate deferral method. As a general rule, S corporations, which allow a pass-through of income and loss to individual shareholders in a manner similar to partnerships, must adopt a calendar year under similar rules.

Partnerships and S corporations may elect to adopt a fiscal tax year different from the one prescribed by the rules above, if one of the following conditions is met:

Partnerships and S corporations generally do not pay taxes. The “required tax payment” is essentially a non-interest-earning deposit with the IRS. The amount of the deposit is increased or decreased annually with additional payments or refunds. This adjusted deposit provides the IRS with a cash flow approximately equal to the partners’ or S corporation shareholders’ taxes deferred as a result of using a fiscal year different from the one prescribed by law.

The only business purpose the IRS will recognize for the adoption of a fiscal tax year other than a calendar year for individuals, partnerships, or S corporations is the need to conform to a natural business year, based on the cyclical nature of income or inventory levels. Normally, only seasonal businesses have natural business years.

The deferral period is the period from the end of the partnership’s or S corporation’s fiscal year to the end of the calendar year. The estimated taxes are computed by multiplying the estimated deferral period taxable income by the highest individual tax rate plus one percent, 36% (35% maximum individual tax rate + 1%). To estimate the deferral period taxable income, the taxpayer uses the average monthly income for the immediately preceding fiscal tax year (the base year).

A personal service corporation is a corporation whose shareholder-employees (any employee who owns stock either directly or indirectly) provide personal services, such as medical, accounting, legal, actuarial, or consulting services, for the corporation’s patients or clients. Personal service corporations generally must adopt a calendar year-end. However, they may adopt or retain a fiscal year if one of the requirements discussed above for partnerships and S corporations can be met.

If taxpayers have a short year other than their first or last year of operations, they are required to annualize their taxable income to calculate the tax for the short period. The tax liability is calculated for the annualized period and allocated back to the short period.

The calculation of short year taxable income for individuals requires special adjustments. For example, deductions must be itemized for the short period and the standard deduction is not allowed. Exemptions also must be prorated for the short period. As a general rule, individual taxpayers rarely change tax years.

The cash receipts and disbursements method recognizes income when it is actually or constructively received; deductions are recognized when paid. Accrual basis taxpayers recognize income when earned and deduct expenses when they are incurred. The receipts and payments may be in a different financial reporting period.

Cash basis taxpayers may not use the cash methodcash accounting methodAccounting method in which income and expenses are reported when cash is received or paid; method used by most individual tax payers. for all expenses. Tax provisions require cash basis taxpayers to use the accrual basis for prepayments of interest and rent. Interest and rent expense cannot be deducted when they are prepaid. Conversely, accrual basis taxpayers who receive certain types of prepaid income, such as rent in advance, must generally recognize the income on the cash basis.

The accrual methodaccrual accounting methodAccounting method in which income is reported when earned and expenses are reported when incurred. of accounting requires that income be recognized when (1) all events have occurred, which fix the right to receive the income, and (2) the amount of income can be estimated with reasonable accuracy. An expense is deductible in the year in which all events have occurred that determine a liability exists and the amount can be estimated with reasonable accuracy. Also, “economic performance” must occur before an accrual basis deduction can be claimed. Economic performance means that all activities related to the incurrence of the liability have been performed. For example, economic performance occurs for the purchase of services when the taxpayer uses the services.

A hybrid methodhybrid accounting methodMethod using both cash and accrual accounting. of accounting involves the use of both the cash and accrual methods of accounting. The tax law permits the use of a hybrid method providing the taxpayer’s income is clearly reflected by the method. An example of a hybrid method is the use of the accrual method for cost of products sold by the business and the use of the cash method for income and other expenses. Taxpayers make an election to use an accounting method when they file an initial tax return and use that method. To change methods, taxpayers must obtain permission from the Internal Revenue Service.

The tax law contains certain restrictions on use of the cash method of accounting. Regular corporations, partnerships that have a regular corporation as a partner, and tax-exempt trusts with unrelated business income are generally prohibited from using the cash method. However, this requirement does not apply to farming businesses, qualified personal service corporations, and entities with average annual gross receipts of $5,000,000 or less.