The Taxable Year
Learn about the concept of the taxable year and how it often, but not always, coincides with the calendar year.
In this lesson, we'll study the taxable year. We'll learn about the difference between transactional and annual accounting, how the federal tax system adopts annual accounting, and how annual accounting gives rise to the bedrock principle that each taxable year exists by itself. Finally, we'll briefly survey the taxable years available to taxpayers.
For any system of taxation to be viable, taxpayers must be required to account for taxable events and pay tax on them at designated times. To that end, the two prevailing systems of tax accounting are transactional and annual accounting. See Myron C. Grauer, The Supreme Court's Approach to Annual and Transactional Accounting for Income Taxes: A Common Law Malfunction in a Statutory System?, 21 Ga. L. Rev. 329, 329-30 (Fall 1986) (hereinafter Grauer).
In pure transactional accounting, a taxpayer accounts for and pays tax on a given transaction only once it is complete, whether the transaction is brief or spans many years. At that point, the taxpayer will balance expenditures against gains to determine whether the transaction as a whole produced a net profit or loss. If the transaction yielded a net profit, then the taxpayer will report and pay tax on the profit. If the transaction produced a loss, then there'll be no tax on it, and the taxpayer may be able to deduct the loss against net gains from other completed transactions. See id. at 330-31 (internal cites omitted).
Annual accounting, on the other hand, revolves around the concept of a taxable year. For each taxable year, the taxpayer must add up all taxable gains during the year and subtract, from that sum, all deductible costs during the year. This computation includes taxable events arising from both complete and incomplete transactions. Events occurring in prior or later years are generally ignored, unless the tax laws require otherwise. If the year produces a net taxable gain, then the taxpayer must pay tax for the year. If not, then there's no tax liability for the year. Put another way, in annual accounting, each taxable year exists by itself. Id. at 330-31 (internal cites omitted).
Let's use an example to illustrate. Suppose a taxpayer enters a four-year contract with a customer. In year one, the taxpayer spends $100,000 to carry out the contract but receives only $50,000 from the customer.
In year two, just like in year one, the taxpayer spends $100,000 to carry out the contract but receives only $50,000 from the customer.
Year three is different. Here, the taxpayer spends $50,000 to carry out the contract and receives $150,000 from the customer.
In year four, the year the contract ends, the taxpayer spends $200,000 to fulfill the contract. However, the taxpayer receives only $100,000 from the customer.
In a system of transactional accounting, the taxpayer wouldn't report the contract for tax purposes until year four, when the contract ended. The contract as a whole produced a net loss of $100,000 over the four-year period, accounting for the $50,000 loss in both year one and two, the $100,000 profit in year three, and the $100,000 loss in year four. Thus, in transactional accounting, the taxpayer would owe no tax on the overall contract.
The outcome is very different in annual accounting. Here, we have to look at income and deductions year by year, because in annual accounting, each taxable year exists by itself.
In year one, the taxpayer suffered a net loss of $50,000 on the contract. Thus, she'd owe no tax on the contract for that year. If she had income from other sources that year, she might be able to deduct the loss against that income.
The same goes for year two, because year two played out identically to year one.
In year three, though, the taxpayer realized a net gain on the contract of $100,000. Thus, for year three, the taxpayer must report and pay taxes on that amount. Of course, if the taxpayer made deductible expenditures during year three, she may be able to offset those against the gain for that year.
In year four, the taxpayer suffered a loss of $100,000 on the contract. Thus, for year four, she wouldn't have any tax liability on the contract, and she might be able to deduct the loss against other income from year four.
The federal income-tax system adopts annual accounting, not transactional accounting. See 26 U.S.C. § 441(a). Thus, in federal tax, each taxable year exists by itself. Taxable gains and deductible expenses are accounted for in the tax return for the taxable year in which they occur, generally without paying any mind to the aggregate impact of transactions spanning multiple taxable years. See Grauer, 21 Ga. L. Rev. at 329; Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931).
As we'll see later, in many discrete instances, Congress has allowed events in one taxable year to affect tax liability for other taxable years. This allowance helps mitigate the potential unfairness of a pure annual accounting system. Nevertheless, it remains a bedrock principle that liability for each taxable year is computed separately from every other taxable year.
For lots of taxpayers, the default taxable year is the calendar year, defined as the twelve-month period ending on December 31st. See 26 U.S.C. § 441(b)-(d), (g); 26 C.F.R. § 1.441–1(b)(4). Many taxpayers instead adopt a fiscal year. A fiscal year is a twelve-month period ending on the last day of any month except December. 26 U.S.C. § 441(b)(1), (e).
A short period is a taxable year spanning less than twelve months' time. Id. at § 443(a). Generally, a taxpayer will file a tax return for a short period in one of two instances. First, the taxpayer has changed her taxable year, for instance, from the calendar year to a fiscal year. Id. at § 443(a)(1). Changing one's taxable year requires approval from the Internal Revenue Service, which can be difficult to obtain. See 26 C.F.R. § 1.442–1(a)(2), (b)(2).
Second, the taxpayer hasn't existed for the entirety of what would otherwise be the applicable taxable year. 26 U.S.C. § 443(a)(2). This case could apply to a business entity that came into existence or was dissolved during the year, or an individual who died during the year. Though many believe in an afterlife, death is when an individual ceases to exist for tax purposes. See 26 C.F.R. § 1.443–1(a)(2).
Finally, some taxpayers may elect to adopt a special fifty-two-to-fifty-three-week taxable year, to comport with their own distinct accounting practices. See 26 U.S.C. § 441(f)(1).