What Is a Natural Business Year? 25% Test and Section 444

A natural business year is a 12-month accounting period that ends when your business hits its lowest operational point, typically right after peak season, once inventory has been sold down and receivables have been collected. The IRS lets certain pass-through entities use one as their fiscal year for tax purposes, but only if they can prove the pattern with a specific mathematical test. For S corporations, partnerships, and personal service corporations, it’s one of the few paths out of the default calendar year.

The 25% Gross Receipts Test

The IRS uses a formula called the 25% gross receipts test, laid out in Revenue Procedure 2006-46. Take your gross receipts from sales and services for a full 12-month period ending on your proposed fiscal year-end, then calculate what percentage of those receipts fell in the last two months. If that percentage is 25% or higher, you pass for that period.¹

One pass isn’t enough. You have to run the same calculation for the two preceding 12-month periods, and all three must independently clear 25%. A ski resort earning 40% of its annual revenue in March and April, for example, would need to show that pattern held for three consecutive years to qualify for an April 30 year-end.¹

The Comparison Requirement

There’s a second check that catches people off guard. Even if your proposed year-end passes 25% three times over, you still have to test it against every other potential year-end. If your September 30 year-end averages 28% across the three periods, but an October 31 year-end averages 31%, September doesn’t qualify. The fiscal year has to land at the true low point of your cycle, not just a low point.¹

How Much History You Need

Because you need three full 12-month periods for the proposed year-end, plus an additional 11 months to compare against alternative year-ends, the IRS requires at least 47 months of gross receipts data before you can establish a natural business year under this procedure. A business two or three years into operations simply doesn’t have enough history to qualify yet.¹

Which Businesses Actually Need to Pass the Test

The 25% test matters for entities that would otherwise be forced onto a calendar year. If your entity type has flexibility already, you can skip it.

C corporations have the most freedom. They can adopt any fiscal year-end when filing their first tax return without demonstrating a business purpose or passing any test.² Because C corporations pay their own taxes, there’s no shareholder-level deferral for the IRS to worry about.

S corporations are the classic case. The regulations define a “permitted year” as the calendar year, a year elected under Section 444, or a year for which the corporation establishes a business purpose to the IRS’s satisfaction.³ Passing the 25% test is the standard way to establish that business purpose.

Partnerships default to the year used by partners holding more than 50% of profits and capital, and if that fails, the year used by all 5%-or-more partners, and if that fails, the calendar year.⁴ A partnership that wants a different year-end needs either a natural business year or a Section 444 election.

Personal service corporations, which include firms in law, accounting, consulting, and health care, must use a calendar year unless they establish a business purpose or make a Section 444 election. The statute explicitly says that deferring income to shareholders does not count as a business purpose, so the 25% test is essentially the only route to a non-calendar year on the merits.⁵

Sole proprietors typically can’t use this route. Since business income flows onto the owner’s personal return, the business uses whatever year the owner filed on to begin with, and nearly all individuals are on a calendar year.²

Why It’s Worth the Effort

The most immediate payoff is operational. When your year-end sits at the slowest point of your cycle, inventory is at its lowest. Physical counts go faster and don’t pull staff away during peak season. Receivables are smaller, so there are fewer outstanding items to reconcile.

Financial statements also tell a more honest story. They capture a complete revenue cycle from ramp-up through peak and back down, rather than slicing the cycle at an arbitrary point. Lenders and investors tend to find these statements more useful, because the balance sheet shows the business in its most liquid state.

There’s a scheduling benefit too. When your fiscal year doesn’t end December 31, you’re not competing with every calendar-year business for your accountant’s attention during the January-through-April crunch.

Changing Your Tax Year to a Natural Business Year

If you qualify under the 25% test, the change goes through an automatic consent procedure. No private letter ruling, no user fee, no IRS agent reviewing your file.

You file Form 1128 by the due date (including extensions) of the federal income tax return for the short period required to complete the change, and you attach a copy of the form to that short-period return.⁶

The short period is the gap between your old year-end and your new one. It runs from the day after your old tax year closes to the day before your new tax year begins.⁶ Switching from December 31 to September 30, for instance, produces a short period running January 1 through September 30. You file a return for that stub period and pay tax on the income earned in it.

Two exceptions worth knowing. A corporation electing S status that wants a non-calendar year handles the request on Form 2553 rather than Form 1128.³ And an entity making a Section 444 election files Form 8716 instead.⁶

If you can’t pass the 25% test and still want IRS approval for a specific fiscal year on business-purpose grounds, Form 1128 becomes a ruling request rather than an automatic filing. The deadline tightens: the form must be in by the due date of the return for the first effective year, not including extensions. The IRS charges a user fee, and approval isn’t guaranteed.⁶

If You Can’t Pass the Test: Section 444

Businesses that can’t clear the 25% threshold but still want off the calendar year have a fallback. Partnerships, S corporations, and personal service corporations can elect a fiscal year under Section 444, but the year-end can’t create a deferral period longer than three months. If your required year is the calendar year, that means September 30, October 31, or November 30 are on the table; June 30 is not.⁷

The trade-off is money on deposit with the IRS. Partnerships and S corporations that make the election file Form 8752 annually and pay an amount calculated under Section 7519. The formula multiplies net base year income by a deferral ratio, then applies the highest individual income tax rate plus one percentage point.⁸ The payment isn’t a tax. It’s a non-deductible deposit refunded when the election ends or the entity liquidates.⁹

Personal service corporations face a different consequence. Instead of the required payment, they’re subject to minimum distribution rules under Section 280H: if the PSC doesn’t pay enough compensation to its employee-owners during the deferral period, it loses its deduction for a portion of those payments.¹⁰

A Section 444 election terminates automatically if the entity switches back to its required year, changes to another permitted year, or is penalized for willful noncompliance with its payment or distribution obligations. On termination, the entity files a final Form 8752 to claim its refund.⁹

1
Internal Revenue Service. Rev. Proc. 2006-46
2
Internal Revenue Service. Tax Years
3
eCFR. 26 CFR 1.1378-1 – Taxable Year of S Corporation
4
Office of the Law Revision Counsel. 26 U.S. Code 706 – Taxable Years of Partner and Partnership
5
Office of the Law Revision Counsel. 26 U.S. Code 441 – Period for Computation of Taxable Income
6
Internal Revenue Service. Instructions for Form 1128
7
Office of the Law Revision Counsel. 26 U.S. Code 444 – Election of Taxable Year Other Than Required Taxable Year
8
Office of the Law Revision Counsel. 26 U.S. Code 7519 – Required Payments for Entities Electing Not To Have Required Taxable Year
9
Internal Revenue Service. Instructions for Form 8752
10
Office of the Law Revision Counsel. 26 U.S. Code 280H – Limitation on Certain Amounts Paid to Employee-Owners by Personal Service Corporations Electing Alternative Taxable Years