Adopting, retaining and changing accounting periods.
Required Tax Years under Current Law
Sec. 441(b) provides generally that a taxpayer's tax year must coincide with its annual accounting period if the year is a calendar or a fiscal year, or with the calendar year, if the taxpayer was to maintain no books or have no annual accounting period or an annual accounting period that would not qualify as a fiscal year. Under Sec. 441(e), a fiscal year is a 12-month period, ending on the last day of any month except December 31, or a 52-to-53-week year for which the taxpayer elected to determine taxable income.
Under Sec. 441(i)(2), a PSC's required tax year is the calendar year, unless the corporation establishes, with IRS approval, a business purpose for maintaining a different tax year. Under Sec. 706(b)(1)(B), the majority interest's tax year, the principal partner's tax year or the calendar year, determine a partnership's tax year unless regulations provide otherwise. Under Sec. 706(b)(1)(C), a partnership might also maintain a different tax year if it establishes a business purpose for such year and obtains IRS approval. Sec. 1378 requires an S corporation to maintain as its tax year the calendar year ending on December 31 of each year, or any other accounting period for which the corporation established a business purpose with IRS approval.
While PSCs, partnerships and S corporations are subject to different tax-year requirements, each can establish a business purpose for maintaining a tax year different from that otherwise required. Regs. Sec. 1.442-1(b) and Rev. Procs. 85-16, 74-33 and 87-32 provide guidance for establishing such business purpose.
Current Rules for Changing Accounting Periods
Taxpayers wishing to change to a tax year based on business purpose, but not qualifying under Rev. Proc. 87-32 for automatic approval of such change, must request prior approval under Regs. Sec. 1.442-1(b)(1). Taxpayers must file an application on Form 1128, Application to Adopt, Change, or Retain a TaxYear. They must file Form 1128 by the 15th day of the second month following the close of the short period resulting from the change. Under Regs. Sec. 1.442-1(b)(1), the Service will grant approval if the taxpayer establishes a substantial business purpose, and the IRS agrees to the terms, conditions and adjustments of the change. In determining whether the taxpayer established a substantial business purpose for the change, the Service will consider all facts and circumstances, including the tax consequences of such change. The IRS might set forth other conditions, preventing substantial distortion of income as a result.
Rev. Proc. 85-16 provides the approval procedure for taxpayers requesting a change in annual accounting period when they incur a short-period net operating loss (NOL) resulting from the change. If the Service were to approve the request for a change in the annual period in which a short-period NOL occurred, the taxpayer would deduct the NOL ratably over a six-year period, beginning with the first tax year following the short period, unless the NOL were $10,000 or less, or resulted from a short period of nine months or longer and were less than the NOL for a full 12-month period, beginning with the first day of the short period.
Under Rev. Proc. 74-33, taxpayers requesting a change in accounting period by establishing a business purpose may do so by requesting to change to an accounting period that coincides with their natural business year. The IRS generally approves a change to a natural business year provided substantial distortion of income does not result from the change. While Rev. Proc. 74-33 offers procedures for prior approval to change, partnerships, S corporations and PSCs are eligible under Rev. Proc. 87-32 for automatic approval.
Automatic Approval of Accounting-Period Changes
Rev. Proc. 87-32 provides automatic approval for partnerships, S corporations or PSCs electing to retain or change their natural business year as their tax year, if such year were to result in less of an income deferral than for their current tax year. Under Rev. Proc. 87-32, a taxpayer determines its natural business year by performing the "25% test," which requires the taxpayer to determine the percentage of gross receipts received from sales and services in the last two months of the most recent 12-month period, ending with the last month of the tax year in which the taxpayer requested the change. The taxpayer must complete this computation for the three most recent 12-month periods. If each test result is greater than or equal to 25%, the fiscal year tested would be the taxpayer's natural business year. If more than one 12-month period meets this test, the period resulting in the greatest average percentage would be the taxpayer's natural business year. To establish a natural business year under Rev. Proc. 87-32, the taxpayer must have gross receipts for at least 47 months prior, to compare the requested tax year with other possible tax years. Under current law, a taxpayer may obtain automatic approval for a change to its natural business year, if such year were to result in less deferral of income to its owners than the taxpayer's current tax year.
Proposed Regulations and Revenue Procedures
Under Notice 2001-34, taxpayers can establish a business purpose, under Sec. 442 and Prop. Regs. Sec. 1.4421(b), when requesting consent to adopt, change or retain their annual accounting period. The proposed regulations provide that taxpayers must still request prior approval of a change in accounting period by filing Form 1128. However, Form 1128 is due no later than the 15th day of the third month following the end of the short period. Also, under a proposed revenue procedure, the Service would no longer consider the distortion of income resulting from a taxpayer's request to change its annual accounting period on the basis of its business purpose. Under Notice 2001-34, however, there are additional conditions when a change results in substantial distortion of income, such as a significant short-period NOL resulting from the change.
Under Notice 2001-35, partnerships, S corporations or PSCs establishing a business purpose for their requested fiscal years generally receive automatic approval of the change under the proposed revenue procedure, which reduces the time between automatic changes in accounting periods from six years to four. A taxpayer requesting to change its tax year to its natural business year would establish a business purpose without consideration of income deferral. Under the proposed revenue procedure, taxpayers may establish a natural business year using one of three tests.
First, a taxpayer may establish a natural business year if it meets the annual-business-cycle test. The taxpayer must show that its gross receipts from sales and services for the short period and the three prior years suggest peak and nonpeak business periods. Such taxpayer's natural business year ends at the close of its peak season. Second, a taxpayer may establish a natural business year if the business's operations are limited to only a part of the year, and the gross receipts for the period in which the business is not operational are insignificant. Under this scenario, the taxpayer's natural business year would end at the close of its operational season. Finally, Notice 2001-35 also allows taxpayers to use the 25% test to establish a natural business year. Notice 2001-35 applies the same rules to the 25% test as Rev. Proc. 87-32; however, income deferral is no longer a factor in establishing a taxpayer's business purpose when the taxpayer makes this determination through the establishment of a natural business year.
The proposed revenue procedure provides special rules for computing the 25% test. To determine gross receipts for this test for any tax year, the taxpayer computes its gross receipts using the accounting method it used to compute its Federal taxable income, including in gross receipts its share of income from any passthrough entity in ,the month that the entity's tax year ends. This could be significant for taxpayers reporting on a fiscal year with significant investments in passthrough entities with calendar years.
Notice 2001-35 clarifies the requirements for maintaining a natural business year based on the 25% test. Under Rev. Proc. 87-32, the Service would issue the regulations if it deemed them necessary to revise the 25% test, or to provide requirements for the taxpayer to demonstrate periodically continued existence of the natural business year. Under Section 6.05 of Notice 2001-35, a partnership, S corporation or PSC that retains a natural business year that no longer qualifies as a permissible tax year, is using an impermissible tax year and should change to a permissible year. Taxpayers must determine on an annual basis the natural business year, based on the 25% test (as outlined in the revenue procedure). IRS representatives have indicated that this is not a change in current law. However, the language of the proposed revenue procedure is much stronger than that of Rev. Proc. 87-32, clarifying the requirement to monitor the existence of a taxpayer's natural business year.
Notices 2001-34 and 2001-35 are effective for adoptions, changes or retentions of tax periods ending on or after June 4, 2001. For taxpayers whose deadlines for filing Form 1128 have not yet expired, they may elect early application of the procedure. Taxpayers whose applications are pending with the IRS National Office as of June 4, 2001 may notify the office that they wish to use the proposed revenue procedure by the later of the due date of the application as provided under the current law, or the date on which the IRS issues the letter ruling granting or denying the request. Comments on both the proposed revenue procedure and the proposed regulations may be submitted by Sept. 11, 2001.
FROM STEPHANIE L. BEATTIE, CPA, OAK BROOK, IL
Editor: Frank J. O'Connell, Jr., CPA, J.D. Crowe Chizek Oak Brook, IL
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|Author:||O'Connell, Frank J., Jr.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 2001|
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