A natural business year is a 12-month accounting period that ends when a company’s operations hit their lowest point, usually just after peak season when inventory has moved and receivables have been collected. The IRS lets certain businesses use a natural business year 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, this is one of the few routes out of the default calendar year.
The 25% Gross Receipts Test
The IRS decides whether you have a natural business year using an objective formula set out in Revenue Procedure 2006-46. Take your gross receipts from sales and services for a full 12-month period ending on the fiscal year-end you want, then calculate what percentage of those receipts fell in the final two months. If that percentage is 25% or higher, you pass for that period.1Internal Revenue Service. Rev. Proc. 2006-46
One pass isn’t enough. You run the same calculation for the two preceding 12-month periods, and all three must independently clear 25%. A ski resort that pulls 40% of its annual revenue in March and April would need to show that pattern held for three straight years to qualify for an April 30 year-end.1Internal Revenue Service. Rev. Proc. 2006-46
There’s a comparison requirement that catches people off guard. You also have to check whether any other potential year-end produces a higher average across those three periods. If your proposed September 30 year-end averages 28% but an October 31 year-end averages 31%, September doesn’t qualify. The IRS wants your fiscal year landing at the true low point, not just a low point.1Internal Revenue Service. Rev. Proc. 2006-46
Because you need three full 12-month periods for the requested year-end plus another 11 months of data to compare against other potential year-ends, the IRS requires at least 47 months of gross receipts history before you can establish a natural business year under this procedure. A company that’s been operating for two or three years simply doesn’t have the record to apply.1Internal Revenue Service. Rev. Proc. 2006-46
Who Actually Needs a Natural Business Year
The concept matters most for entities that would otherwise be locked into a calendar year. Where your business falls determines whether the 25% test is worth running.
S corporations must use a calendar year unless they can justify something else. 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.2eCFR. 26 CFR 1.1378-1 – Taxable Year of S Corporation Passing the 25% gross receipts test is the standard way to establish that business purpose. The restriction exists to prevent income deferral: a January 31 year-end would let shareholders push nearly a full year of pass-through income into a later personal return.
Partnerships follow a cascading set of default rules. The partnership first uses the majority interest taxable year — the tax year used by partners holding more than 50% of profits and capital. If no majority exists, the partnership defaults to the year used by all principal partners (those with 5% or more). Failing that, it uses the calendar year.3Office of the Law Revision Counsel. 26 U.S. Code 706 – Taxable Years of Partner and Partnership A partnership that wants something different from this waterfall needs either a natural business year or a Section 444 election.
Personal service corporations in fields like 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 deferring income to shareholders does not count as a valid business purpose, so the natural business year test is the primary route for a PSC seeking a non-calendar year.4Office of the Law Revision Counsel. 26 U.S. Code 441 – Period for Computation of Taxable Income
Two entity types rarely need the test. C corporations can adopt any fiscal year-end when they file their first tax return, with no business purpose required. Sole proprietors are effectively tied to the calendar year because the business income flows onto the owner’s personal return, and nearly all individuals file on a calendar year.5Internal Revenue Service. Tax Years
Why It’s Worth Doing
The immediate payoff is operational. When your year-end lands at the slow point in your cycle, inventory levels are at their lowest, so physical counts go faster and don’t pull staff away during peak season. Receivable balances are smaller, which means fewer outstanding items to reconcile.
Financial statements prepared at a natural year-end tend to show a truer picture of profitability. They capture a complete revenue cycle from ramp-up through peak and back down, instead of slicing the cycle at an arbitrary date. Lenders and investors generally find these statements easier to read because the balance sheet shows the business in its most liquid state, with cash collected and inventory depleted.
There’s a scheduling benefit too. A fiscal year-end away from December 31 means you’re not competing with every calendar-year filer for your accountant’s attention during the January-through-April rush. Tax planning gets more room, and decisions feel less rushed.
What to Do If You Can’t Pass the Test
If your receipts don’t hit 25% in the right pattern but you still want a non-calendar year, Section 444 is the fallback. Partnerships, S corporations, and personal service corporations can elect a fiscal year under this provision, but the chosen year-end can’t create a deferral period longer than three months. In practice, if your required year is the calendar year, you could elect September 30 or October 31, but not June 30.6Office of the Law Revision Counsel. 26 U.S. Code 444 – Election of Taxable Year Other Than Required Taxable Year
The election carries strings. Partnerships and S corporations have to file Form 8752 every year and make a required payment under Section 7519 that approximates the tax benefit of the deferral. The payment is a non-deductible deposit, not a tax, and it’s refunded when the election ends or the entity liquidates.7Internal Revenue Service. Instructions for Form 8752 Personal service corporations face a different mechanism: minimum distribution rules under Section 280H that limit the compensation deduction if employee-owners aren’t paid enough during the deferral period.8Office 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
For an entity that genuinely has a natural business year, passing the 25% test is cleaner because it avoids the annual deposit and the distribution rules entirely.
How to Make the Change
If you pass the 25% test, you file Form 1128 under the automatic approval provisions of Revenue Procedure 2006-46. The form is due by the due date (including extensions) of the federal income tax return for the short period required to complete the change, and a copy gets attached to that short-period return.9Internal Revenue Service. Instructions for Form 1128
The short period is the transitional stub between your old year-end and the new one. It starts the day after your old tax year closes and ends the day before your new tax year begins.9Internal Revenue Service. Instructions for Form 1128 A company switching from December 31 to September 30 would file a return covering January 1 through September 30 and pay tax on the income earned in that window.
A couple of filing exceptions are worth knowing. A corporation electing S status and wanting a non-calendar year uses Form 2553 instead of Form 1128.2eCFR. 26 CFR 1.1378-1 – Taxable Year of S Corporation Entities making a Section 444 election file Form 8716.9Internal Revenue Service. Instructions for Form 1128
If you can’t pass the 25% test and don’t want to use Section 444, Form 1128 still exists, but as a ruling request. The deadline is stricter — the form must be filed by the original due date of the return for the first effective year, without extensions — and the IRS charges a user fee with no guarantee of approval.9Internal Revenue Service. Instructions for Form 1128 For most small businesses, the realistic choice is between passing the test and making a Section 444 election.