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Fiscal tax year elections should be reconsidered.

Certain partnerships and S corporations that elected to retain their fiscal year-ends (FYEs) under Sec. 444 may want to consider terminating such elections and adopting required year-ends in 1993. By doing so, cash flow savings may be realized by the entities and their owners, especially when the entity's income is decreasing or a substantial portion of its taxable income is earned during the latter pa.rt of the fiscal year.

Effective for tax years beginning after 1986, the Tax Reform Act of 1986 (TRA) generally requires partnerships and S corporations to conform their tax years to the tax years of their owners (i.e., generally the calendar year). However, Sec. 444 generally allows such entities to adopt, change to or retain an FYE, provided the partnership or S corporation makes a "required payment" under Sec. 7519 with the IRS.

The required payment is equal to the excess of (1) the amount computed by multiplying the entity's "net base year income" by the highest individual tax rate plus one percentage point over (2) the amount of the required payment for the preceding year. The "net base year income" is generally (1) the entity's income for the preceding year multiplied by the "deferral ratio" (the number of months in the deferral period for such preceding year to the number of months in the tax year) plus (2) any excess of (i) the deferral ratio multiplied by the aggregate amount of payments (e.g., taxable wages or interest paid to partners or S shareholders) made during the preceding year over (ii) the total amount of such payments made during the deferral period.

Although the TRA sought to eliminate the tax deferral available to a partner or shareholder as a result of a fiscal year, Sec. 444 still provided partners or shareholders an opportunity to effectively defer a portion of the tax on their distributive share of net income earned by an entity in the deferral period (i.e., the period between the beginning of the fiscal tax year elected and the close of the required tax year), provided the entity's taxable income is increasing each year or a substantial portion of the entity's taxable income is earned during the deferral period. Because the "required payment" is based on the prior year's taxable income multiplied by the deferral ratio, the entity's required payment would be less than the deferral of tax.

Conversely, there are two situations in which a Sec. 444 election may result in a required payment greater than the tax deferral: (1) when the electing entity's net income is decreasing or (2) when a substantial portion of the electing entity's taxable income is earned after the deferral period (i.e., the entity earns most of its income in the latter part of its fiscal year).

An entity with decreasing taxable income would realize a cash flow savings from terminating its Sec. 444 election because required payment would be greater than the tax deferral. See Example 1 at right.

As Example 1 illustrates, if S's taxable income decreases in FYE June 30, 1994, the entity would realize a net cash flow savings of $16 by terminating its fiscal year election and adopting a December 31 year-end. This is primarily because the actual tax due on the short period income of $16 is less than the entity's required payment of $32 had the entity maintained its Sec. 444 election. However, this cash flow savings would be eliminated after one year, since a portion of the required payment would have been refunded in the succeeding year to reflect the lower net base year income.

Example 1: Fiscal Year Election Comparison

S corporation S, with a Sec. 444 election to retain a June 30 fiscal year, has taxable income to decreases to $200 for the fiscal year ending June 30, 1993, and expects taxable income to decrease i searned evenly in both fiscal years). S's required payment on deposit to the IRS is $28, and its shareholders' marginal Federal tax rate for 1993 is 31%.

The chart below is a comparison of S's cash flow applicable to the FYE June 30, 1993 and the short period July 1 through Dec. 31, 1993 (SYE) for required payments and/or distributions to the shareholders to cover their individual 1993 tax liabilities with and without the fiscal yeat election in effect:
 With Without
 election election
Tax on FYE 6/30/93
 net income ($200 x 31%) $62 $62
Tax on SYE 12/31/93
 net income ($50 x 31%) N/A 16
1993 tax liability 62 78
Required payment
 (($200 x 6/12 x 31%) - $28) 4
Refund of prior year
 required payment (28)
Net cash required $66 $50

Remember that the lower the taxable income in the short period, the greater the cash flow savings. Moreover, if the Sec. 444 election was terminated and S incurred a net operating loss in the short period ending Dec. 31, 1993, the loss would be available to the shareholder to offset taxable income from FYE June 30, 1993.

A similar result occurs when a substantial portion of the electing entity's taxable income is earned after the deferral period (i.e., in the latter part of its fiscal year). See Example 2 on page 436.

Example 2: Fiscal Year Election - Taxable Income

Earned After Deferral Period

Partnership P, with a fiscal year-end of June 30,has taxable income of #300 for both FYE June 30, 1993. In both years $50 is earned in the first six months of the fiscal year and the balance of $250 is earned in the last six months of the fiscal year.P's required payment on deposit to the IRS is $48 and its partners' marginal Federal tax rate for 1993 is 31%.

Because the entity earns most of its income after the deferral period (i.e., January June), its required payment is greater than the actual deferral of tax:
 With Without
 election election
Tax on FYE 6/30/93 income
 ($300 x 31%) $93 $93
Tax on SYE 12/31/93 income
 ($50 x 31%) N/A 16
1993 tax liability 93 109
Required payment
 (($300 x 6/12 x 32%) - $48) 0
Refund of prior payment (48)
Net cash required $93 $ 61

As illustrated in Example 2, a $32 cash flow savings is achieved by terminating the Sec. 444 election. This is because the required payment calculation assumes that taxable income is earned ratably throughout the tax year; that is, taxable income for the prior fiscal year is multiplied by the deferral ratio to obtain net base year income. Since P earns a substantial portion of its income after the deferral period, the required payment, which is based on taxable income of $150 ($300 X 6/12), is greater than the actual income deferral of $50. Thus, by terminating the Sec. 444 election, a significant cash flow savings can be achieved. Unlike Example 1, however, the cash flow savings would be "permanent" to the extent income remains constant or decreases in the deferral period (i.e., July to December) from year to year.

Note: Cash flow savings may be achieved by terminating a Sec. 444 election in 1993 to the extent Federal individual tax rates are higher in 1994.

These examples do not consider the effects on the owners' tax liabilities as a result of terminating the fiscal year election, including accelerating net income into the short period, particularly on estimated tax payments and state income taxes. In addition, the limitations on personal exemptions and itemized deductions; the various floors on itemized deductions; or other limitations due to adjusted gross income or taxable income (such as the $25,000 rental real estate allowance, IRAs and charitable contributions) were not considered. Any analysis of the effect of terminating a fiscal year election should take these items into account, as well as consider the time value of money, any administrative costs (e.g., additional tax returns or audit for the short period) and any other factors that may exist in any given situation.

It is important to note that once an entity changes to its required year-end, it generally cannot adopt a different year-end under Sec. 444 in the future should such an election be desirable.

If an electing entity can establish a business purpose for retaining a fiscal year to the Service's satisfaction, the entity could terminate its fiscal year election and obtain a refund of its required payment while still retaining the desired fiscal year-end. (See Rev. Proc. 87-32 and Rev. Rul. 87-57.)

An electing entity can terminate its fiscal year election by adopting a required year-end. This is done by filing the return or an extension request by the original due date of the short period return (i.e., March 15 for S corporations and April 15 for partnerships with a required tax year of December 31). The entity should type " SECTION 444 ELECTION TERMINATED" on the first page of its short period return.

The electing entity is eligible for a refund of the entire amount of the required payment on termination of its fiscal year election. The refund is payable on the later of (1) April 15 of the calendar year following the calendar year in which the election ends or (2) 90 days from the date the refund claim is filed with the IRS. Accordingly, in order to take maximum benefit of the refund period, the refund claim should be filed no later than January 15. A claim for refund of the prior year's required payment is made by filing Form 8752, Required Payment or Refund Under Section 7519. No interest will be paid on the amount refunded.

Partnerships and S corporations with fiscal year elections currently in effect should review such elections to determine if cash flow tax savings can be obtained by terminating the election and adopting a required tax year.
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Article Details
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Author:Morrow, Gregory E.
Publication:The Tax Adviser
Date:Jul 1, 1993
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