Business tax returns are filed on an annual basis and report income and expenses for a 12-month period. When a business first starts operations, the company’s tax return will normally not include 12 months of operations. For example, if a business opens its doors on May 1, the tax return will only include operations for the period May through December. When the tax return does not include 12 months of operations, it is known as a short year tax return. Businesses may also file a short year tax return if there is a change in the accounting period.
Determine the net income of the business for the short tax year period and the rate of federal tax for the short year net income. This can be done using tax tables for the business’s tax form. IRS Form 1120, 1120-S and 1065 are used for corporations, S-corporations and partnerships, respectively.
Annualize the federal tax. The IRS requires businesses filing short year tax returns to determine the federal tax that would have been due if the business was operating for a full 12-month year. This calculation ensures that a new business is not paying a lower rate of tax than other companies that had a full 12 months of operations. The IRS wants to make sure businesses with similar net profits pay similar rates of tax regardless of how many months the business operated during the year. Multiply the federal tax by 12 and then divide by the number of months in the short tax year. For example, if the company’s short tax year was May 1 through December 31 and federal tax for the short year was $10,000, the annualized federal tax would be $15,000 ($10,000 times 12 divided by 8).
Determine if there is any tax relief available for the payment of annualized federal tax under IRS Section 443(b)(2). IRS Section 443(b)(2) allows the business to reduce the annualized federal tax due if the ratio of the short year federal tax is greater than or equal to the annualized federal tax. To determine if relief is available, divide the annualized federal tax by the annualized taxable income; divide the short year tax by the short year taxable income. Compare the two ratios and determine if the criteria for relief have been met. When a business uses tax software to file tax returns, the software will perform this calculation after the option for a short year tax return is indicated.
Indicate that the tax return is for a short tax year on the business’s tax form. This information is near the top of page 1, under the business’s identifying information. This box is not checked for the following year.
In order for a business to change its accounting period, approval must be granted from the IRS by completing Form 1128. A fee may be required to file this form.
If the business is subject to alternative minimum tax, follow the same steps indicated in the article to determine the annualized alternative minimum tax.
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