Anti-abuse rules of sec. 444.

Temporary regulations under Sec. 444 provide rules for partnerships, S corporations and personal service corporations (PSCs) that attempt to avoid the limitations of Sec. 444. The regulations provide two anti-abuse provisions. The first deals with predecessor entities. Temp. Regs. Sec. 1.444-1T(b)(5)(iii) must be considered when a partnership, S corporation or PSC transfers assets to a related party; it will apply when the principal purpose of the transfer is to create a deferral period greater than the deferral period of the predecessor, or to make a Sec. 444 election following the termination of the predecessor entity's Sec. 444 election. The deferral period is defined as the months between the end of an entity's year and December 31. If a partnership, S corporation or PSC makes a predecessor transfer for one of these two reasons, the new entity will not be able to make a valid Sec. 444 election.

The regulations apply to entities changing their tax year by making a Sec. 444 election. Sec. 444 limits changes in tax years to the shorter of three months or the deferral period of the tax year being changed.

Example 1: Partnership AB has historically used the calendar year. AB's required tax year is the calendar year. Under Sec. 444, AB has no deferral period since it uses a calendar year. AB would therefore be precluded from changing to a different tax year since a change is limited to three months or the entity's deferral period (in this case, zero).

Temp. Regs. Sec. 1.444-1T(b)(5) is designed to prevent partnerships, S corporations and PSCs from avoiding the deferral period limitation. In addition, the regulation prevents entities that terminated a prior Sec. 444 election from making a new election.

Example 2: Assume that P1 is a partnership that has used the calendar year. P1 wishes to make a Sec. 444 election to change to an October year-end for the tax year beginning Jan. 1, 1994. P1 cannot make a Sec. 444 election, however, since P1 current deferral period is limited to zero. Further, P1 transfers its assets to newly formed partnership P2. If not for Temp. Regs. Sec. 1.444-1T(b)(5)(iii), P2 could make a Sec. 444 election to use a tax year with a deferral period of three months or less (i.e., September 30, October 31 or November 30). However, the regulation grants the IRS authority to void such election, since P2 f or all intents and purposes is a contribution of P1.

Temp. Regs. Sec. 1.444-1T(b)(5)(iii) can apply not only to transfers by the original entity, but can also apply to situations such as a liquidation and creation of a new partnership. Unfortunately, the regulations do not provide much, if any, guidance as to the extent of their application.

The regulations, when literally interpreted, do eliminate the only method available for avoiding both the deferral period limitation and prior termination rule. Entities or owners of entities must be aware that asset transfers to new entities could fall within the reach of the anti-abuse provisions, thereby resulting in the termination of what was believed to be a valid election.

The second abuse provision deals with the use of tiered structures. The basic rules of Sec. 444 do not allow a partnership, S corporation or PSC that is a part of a tiered structure to make a Sec. 444 election. Generally a partnership, S corporation or PSC (a deferral entity) is a member of a tiered structure if it owns an interest in another deferral entity or a deferral entity owns an interest in such entity. The term "deferral entity" also includes nongrantor trusts. Temp. Regs. Sec. 1.4X4-2T(b)(3) attempts to prevent entities from organizing structures intended to create or continue deferral tax benefits that would normally be eliminated under Sec. 444.

A partnership, S corporation or PSC is considered a member of a tiered structure if it, or related taxpayers, have organized or reorganized their ownership structure or operations for the principal purpose of obtaining a significant unintended tax benefit from making or continuing a Sec. 444 election. A significant unintended benefit results if a taxpayer obtains a significant deferral of income.

Example 3: X is a calendar-year partnership that owns a 50% interest in partnership Z, which has a June 30 year-end. The other 50% is owned by the same individuals who own X. This structure provides a vehicle for obtaining a significant tax deferral on a portion of the 50% income from Z.

Temp. Regs. Sec. 1.444-2T(b)(3) is intended to eliminate the ability of structuring groups of entities such as X and Z, which provide a potential deferral benefit. While the regulations restrict the use of tiered structures, they do allow for de minimis ownership in or by deferral entities. The de minimis rules are divided into an upstream rule and a downstream rule. The downstream de minimis rule allows a partnership, S corporation or PSC to own an interest in a deferral entity if the entity's income does not exceed 5% of its adjusted taxable income or not more than 2% of its gross income.

The testing period for the determination of taxable and gross income is the period ending immediately prior to the tax year the entity desires to make or continue a Sec. 444 election.

The upstream de minimis rule provides that a deferral entity can own 5% or less of an interest in the current profits of a partnership or stock of an S corporation or PSC.

The regulations also provide an exception for entities that are members of a tiered structure when all entities in the structure have the same tax year. When all entities have the same tax year, the anti-abuse rules of Temp. Regs. Sec. 1.444-2T(b)(3) do not apply. While the regulations do not provide a great deal of guidance in determining if an entity derives an unintended tax benefit, they do provide significant reason for caution when considering a Sec. 444 election for members of a tiered structure and when assets are transferred to a predecessor entity. Familiarity with the anti-abuse provisions will help prevent having an entity unknowingly terminate or fail to qualify for a Sec. 444 election.

From Joseph F. Pigga, CPA, Parente, Randolph, Orlando, Carey & Associates, Wilkes-Barre, Penn.