One of the most important decisions in partnership taxation is determining the taxable year. Unlike individuals, who almost always file on a calendar year, partnerships face statutory limits designed to prevent deferral of income. The Internal Revenue Code and accompanying regulations set out a hierarchy of rules under IRC §706(b) to ensure that a partnership’s year aligns with that of its partners.

What’s the Difference Between a Calendar Year and a Fiscal Year?

A calendar year runs from January 1 to December 31, which is the default reporting period for most individuals. An alternative, sometimes called a fiscal year, ends on the last day of any month other than December. For example, a partnership might prefer a June 30 year-end if its operations are highly seasonal.

Example:
Imagine a farming partnership whose business cycle does not line up with the calendar year. The partnership incurs substantial expenses late in the year—such as soil preparation, fertilizer, irrigation maintenance, and labor costs—in November and December to prepare fields for the next planting season. However, the related crop is not harvested and sold until February and March of the following year.

If the partnership must use a calendar year ending December 31, these end-of-year expenses are deducted in Year 1, while the corresponding harvest revenue is not reported until Year 2. The calendar year thus splits a single economic cycle into two different tax years:

• Year 1 shows unusually low or negative income (because it contains the costs but not the revenue), while
• Year 2 shows unusually high income (because it contains the revenue but not the associated costs).

This misalignment does not change the total profit over time, but it does distort the reported annual income and creates a mismatch between revenue and the expenses that produced it..

By contrast, if the partnership were permitted to use a fiscal year ending June 30, the entire farming cycle would fall within one taxable year. The fall planting expenses and the spring harvest revenue would be reported in the same 12-month period. This alignment provides a more accurate matching of revenue and related costs, reflecting the true economics of the farming business rather than the arbitrary cutoff of December 31.

The IRS allows fiscal years only when specific statutory rules are satisfied, so most partnerships are required to use the calendar year unless an exception applies.

Can a Partnership Pick Any Taxable Year It Wants?

No. Partnerships cannot freely choose any year-end they like. Under §706(b)(1)(B)(i), the first test requires a partnership to adopt the “majority interest taxable year.” That means the taxable year of the partner or group of partners who together own more than 50% of profits and capital.

Example: A partnership has three partners with ownership percentages of 40%, 30%, and 30%. The first two use the calendar year. Together they hold 70%, so the partnership must adopt the calendar year—even if the third partner prefers a June 30 fiscal year.

What Happens If No Majority of Partners Share the Same Year?

If no single group of partners with more than 50% ownership shares the same taxable year, the Code turns to the “principal partner” test. Under Treas. Reg. §1.706-1(b)(2)(i)(B), a principal partner is anyone with at least a five percent interest. If all principal partners share the same taxable year, the partnership must adopt it.

Example: Consider a partnership with four equal partners, each holding 25%. None holds a majority, but if all four use a fiscal year ending June 30, the partnership must also use June 30.

What If the Principal Partners All Use Different Years?

In that case, the “least aggregate deferral” test applies. This test, found in Treas. Reg. §1.706-1(b)(2)(i)(C), requires looking at the deferral period each partner would experience under each possible taxable year and then selecting the year that minimizes the total.

Example: Suppose a partnership has three equal partners. One uses the calendar year, one uses a June 30 fiscal year, and one uses a September 30 fiscal year.

• If the partnership chose a calendar year, the June 30 partner would defer six months of income and the September 30 partner would defer nine months—for a total of fifteen months of deferral.
• If the partnership chose June 30, the calendar-year partner would defer six months and the September 30 partner would defer three—for a total of nine months.
• If the partnership chose September 30, the calendar-year partner would defer nine months and the June 30 partner would defer three—for a total of twelve months.

Because nine months is the least aggregate deferral, the partnership must adopt the June 30 fiscal year.

Is There Any Flexibility to Use a Different Year?

Yes, but only in limited circumstances. Under Treas. Reg. §1.706-1(b)(2)(ii), a partnership may adopt a different taxable year if it can demonstrate a substantial business purpose. For instance, a farming partnership may argue that a year ending after harvest better reflects its income cycle. However, the IRS interprets this exception narrowly and usually requires a formal request on Form 1128.

What Does This Mean in Practice?

For most partnerships, especially those made up of individuals, the answer will be simple: the calendar year will control. But where ownership is split among institutional or fiscal-year partners, or where seasonal business cycles provide a strong case for a business-purpose exception, the outcome can shift. The overall structure of the rules shows that Congress and the IRS are determined to prevent manipulation—partnerships cannot simply select a fiscal year that allows partners to defer reporting income.