Sec. 444 elections for S corporations - should you revoke?

Under pre-1983 law, an S corporation was allowed to select any fiscal year. Because of perceived abuses, current law requires that an S corporation generally be on a calendar year. There are, however, a few exceptions to this general rule.

The first exception is the valid business purpose test. An S corporation may adopt any fiscal year-end if it can establish that there is a business purpose for that fiscal year. If a fiscal year is permitted under the business purpose exception, no deposits are required to maintain a noncalendar year.

There are two other exceptions available, at the corporation's election. First, an S corporation was able to elect to retain the fiscal year it had in 1986. (This election had to be made no later than July 26, 1988.) In addition, an S corporation may elect a fiscal year that does not defer income for the shorter of three months, or the deferral period of the tax year from which the corporation is changing. Thus, a new S corporation may elect a fiscal year ending in September, October or November.

If a fiscal year is elected under these latter exceptions (i.e., an election other than the business purpose exception), the S corporation is required to make interest-free deposits with the IRS per Sec. 7519. The deposits are based on the deferral period, and the tax is calculated at 1% above the highest individual rate.

With the increase in tax rates in 1993, required deposits have increased from 32% to 40.6%. Because of this increase, many S corporations are considering revoking their fiscal year elections and switching to a calendar year-end. This may, however, cost the corporation more tax than it would to retain a fiscal year-end.

There are two major disadvantages to revoking a fiscal year

election. One is the permanent loss of the deferral. The other is that, in the year of revocation, the shareholders must bunch possibly up to 23 months of income, depending on the deferral period. With dependency exemptions and other phase-out rules, this can become quite expensive.

In many cases it may be beneficial to keep a fiscal year-end. One of the determining factors to be considered is how much of the corporation's income is earned during the deferral period. If a large enough percentage of the income is earned during the deferral period, it would cost the corporation more to revoke its fiscal year than it would to make the required deposits.

Example 1: An S corporation with a sole shareholder has a September 30 year-end. The S corporation's yearly income is $200,000, with 50% of that earned during the last three months of the calendar year. If the corporation retains its fiscal year, the tax results are as follows.

Shareholder's tax

on $200,000 $57,305

S corporation's

required deposit 20,300

Total tax $77,605

If the S corporation revoked its fiscal year election, the tax results would be as follows:

Shareholder's tax

on $300,000

($200,000 for the

fiscal year and

$100,000 for the

    last three months)     $95,105
  S corporation's required       0

deposit

Total tax 95,105

The tax savings for retaining a fiscal year-end is $17,500. In this situation, until the percentage of income earned in the deferral period falls below 28%, it would be beneficial to retain a fiscal year.

Even taxpayers in a lower tax bracket may receive a benefit from the retention of a fiscal year election.

Example 2: Assume the same facts as in Example 1, except that the corporation's income is $80,000, with 50% earned in the last three months of the calendar year. Retention of a fiscal year:

Shareholder's tax

    on $80,000               $17,460
  Required deposit             8,120
  Total tax                  $25,580

Revocation of fiscal year:

Shareholder's tax

  on $120,000                $29,505
  Required deposit                 0
  Total tax                  $29,505

The total savings is $3,925. Although this savings is quite a bit smaller than for individuals in higher brackets, there is still a benefit for retaining a fiscal year-end. In addition, the breakeven point in this situation is when income earned during the deferral period falls below 34%. As income falls, the percentage earned in the deferral period must go up in order to make retaining the fiscal year advantageous.

With the increase in the required deposits for S corporations, it may seem too costly to retain a fiscal year-end. However, a careful analysis should be made before deciding to revoke the election and switch to a calendar year.