649 / What is an individual’s “taxable year”?

The basic period for computing income tax liability is one year, known as the taxable year. The taxable year may be either (a) the calendar year or (b) a fiscal year. A “calendar year” is a period of 12 months ending on December 31. A “fiscal year” is a period of 12 months ending on the last day of a month other than December.¹

Although most taxpayers report tax liability based on a calendar year, a taxpayer may choose to report tax liability based on a fiscal year. However, whichever year is used, it must generally correspond to the taxpayer’s accounting period.² Thus, if the taxpayer’s accounting period is based on a fiscal year, tax liability cannot be determined by the calendar year. But if the taxpayer has no accounting period and does not keep books, a calendar year must be used.³ Once a tax year has been chosen, the taxpayer cannot change from a calendar year to a fiscal year or vice versa without the permission of the Internal Revenue Service.⁴

A principal partner must use the same tax year as the partnership and cannot change to a different tax year unless it establishes to the IRS that there is a business purpose for doing so.⁵ Under certain circumstances, partnerships, S corporations, and personal service corporations must use the calendar year for computing income tax liability.⁶

A short period income tax return must be filed if (1) the taxpayer changes an annual accounting period, or if (2) the taxpayer has been in existence for only part of a taxable year.⁷ For this purpose, a short period is considered a “taxable year.”⁸

For an individual taxpayer, if a short period income tax return is required due to a change in accounting period, the income during the short period must be annualized, and deductions and exemptions prorated.⁹ The computation is as follows:

Step 1: Compute the adjusted gross income for the short tax year. Then subtract actual itemized deductions (do not take the standard deduction).

Step 2: Multiply the dollar amount of the personal exemptions (prior to 2018) by the number of months in the short year and divide that result by 12.

Step 3: Subtract the amount in Step 2 from the amount in Step 1. This is modified taxable income.

Step 4: Multiply modified taxable income (Step 3) by 12 and divide the result by the number of months in the short period. This is the annualized income.

Step 5: Compute the tax on the annualized income (using the tax rate schedule then in effect).

Step 6: Multiply the tax (Step 5) by the number of months in the short period and divide the result by 12. This amount is the tax for the short period.

However, if a short period income tax return is required by a taxpayer who was not in existence for the entire tax year, annualized income is not required.¹⁰

Generally, for the final regulations affecting taxpayers who want to adopt an annual accounting period (under IRC Section 441), or who must receive approval to adopt, change, or retain their annual accounting periods (under IRC Section 442), see Treasury Regulation Sections 1.441-0, 1.441-1, 1.441-2, 1.441-3, 1.441-4; TD 8996.¹¹

More specifically, the rules for establishing a business purpose to justify the use of a taxable year and obtaining approval to adopt, change, or retain an annual accounting period are found in Revenue Procedure 2002-39.¹²

See Revenue Procedure 2003-62¹³ for the exclusive procedures developed in accordance with IRC Section 442 that allow fiscal reporting year individuals (e.g., sole proprietors) to obtain automatic approval to change to calendar year reporting.

The exclusive procedures for (1) certain partnerships, (2) S corporations, (3) electing
S corporations, (4) personal service corporations, and (5) trusts to obtain automatic approval to adopt, change, or retain their annual accounting period are set forth in Revenue Procedure 2006-46.¹⁴