When a taxpayer wants to change their accounting period, they generally need the permission of the IRS to do so. The request needs to show the IRS that there is a substantial business purpose for the change and that any tax cost that will be assumed by the IRS will be insignificant.
Requesting a Change of Accounting Period
If a business feels the need to request a change of accounting period, they should do so by filing Form 1128 (Application to Adopt, Change, or Retain a Tax Year) on or before the 15th day of the third calendar month following the end of the short tax year.
Once the IRS has processed Form 1128 requesting a change of accounting period, they will respond to the business using Form 5654 (Notification of Action on Application for Change in Accounting Period). This form is used to indicate to the taxpayer a list of conditions that need to be met prior to the IRS giving final approval of the change of accounting period.
Distortion of Income
The IRS is always concerned of a taxpayer changing their accounting period in order to distort their income. The IRS will generally ask for an agreement between the taxpayer in order to agree on terms, conditions, and adjustments that are necessary in order to correctly implement the change.
The IRS generally considers the following to be distortions of income:
1. Deferring a substantial portion of income, or shifting a substantial portion of deductions, from one year to another so as to reduce their overall tax liability
2. Causing a similar deferral as listed in point one in the case of a related taxpayer, such as a partner, beneficiary, or a shareholder in an S corporation
3. Creating a short period in which there is either a net operating loss, or, in the case of an S corporation, amounts treated as long term capital gain
The IRS is very strict about their policy to avoid the above income distortion practices. It is very important that you analyze your individual situation to make sure you are not in violation of any of the points above.
Approval of Change of Accounting Period
If the IRS approves an application for a change of accounting period, the taxpayer is required to file a tax return for the short period caused by the change. It is important to understand that there are special rules that need to be followed when calculating a short period tax return and therefore you must do your research before attempting it yourself.