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New rules on accounting-period changes for partnerships and S corporations. (Accounting Methods & Periods).

In addition to updating the rules on accounting-period changes for C corporations, the IRS also recently updated its rules for such changes for partnerships, S corporations and personal services corporations (PSCs). Similar to the C corporation provisions, partnerships, S corporations and PSCs cannot change their accounting periods without the Service's prior approval. Also, similar to the C corporation rules, they must establish and disclose a sufficient business purpose.

Previously, Rev. Proc. 87-32 provided expeditious approval guidelines for these entities. As a practical matter, partnerships and S corporations had difficulty establishing a sufficient business purpose for a tax year other than a calendar year. Rev. Proc. 87-32, however, provided a mechanical test, which, if met, established a "natural business year" year-end other than December. A change to a natural-business year was a sufficient business purpose under this procedure. Under the mechanical test, a taxpayer had to show that:

1. 25% or more of its gross receipts occurred within the last two months of the desired year;

2. It satisfied the 25% calculation for the prior three-year period; and

3. No other two-month period (in all of the above periods) had a higher percentage of gross receipts.

If a taxpayer met these requirements, it could retain a tax year that coincided with its natural-business year or change to a year that coincided with such year, provided the change resulted in a year with less income deferral to the entity's owners than in its present tax year.

Recently issued Rev. Proc. 2002-38 clarifies, modifies, amplifies and supercedes the 1987 procedure. It provides automatic approval procedures for partnerships, S corporations, electing S corporations and PSCs to change their accounting periods. The new procedure expanded the scope of taxpayers eligible for automatic change approval to allow:

1. A partnership, S corporation or PSC to change automatically to a natural-business year that satisfies the 25%-gross-receipts test, regardless of whether such year results in more income deferral than its present tax year;

2. In appropriate circumstances, a partnership, S corporation or PSC to adopt, change to or retain a 52-53-week year, ending with reference to a required, natural-business or ownership year;

3. Any partnership, S corporation or PSC to automatically change from a 52-53-week year to a non-52-53-week year that ends with reference to the same calendar month (and vice versa);

4. A partnership that would be required to change its tax year if it had a minor percentage change in ownership to retain its current year for one year, subject to certain circumstances; and

5. A PSC to automatically change its year even if it makes an S election for the year following the short period.

Similar to C tax years, Rev. Proc. 2002-37 reduces the limit on changes from within six years to the most recent 48 months. It also modifies the net operating loss carryback provisions to prevent a taxpayer from carrying certain capital losses generated in the short period. It provides audit protection for taxpayers that change their accounting period under this procedure. Finally, the new procedure extends the period for filing Form 1128, Application to Adopt, Change, or Retain a Tax Year, to the due date of the taxpayer's return (including extensions) for the first effective year.

If a taxpayer is not eligible for automatic approval for an accounting-period change under either of the automatic procedures, the IRS's prior approval would then be necessary. Rev. Proc. 2002-39 provides procedures for taxpayers seeking such approval, superseding Rev. Procs. 85-16 and 74-33. As a general rule, a taxpayer must establish a sufficient business purpose for a change in accounting period, typically under a facts-and-circumstances test. However, a taxpayer can change to a natural-business, required or ownership tax year even if it cannot meet this test. A taxpayer can determine its natural-business year using an annual-business-cycle, a seasonal-business or the 25%-gross-receipts test.

Under the annual-business-cycle test, the taxpayer's year should end at or "soon after" the end of the highest peak business period. Under the seasonal-business test, the taxpayer's natural business year should end at or soon after the end of the season's operations.

The new procedure provides clarification by including safe-harbor rules for administrative convenience, as well as examples. Under one safe harbor, one month will be considered "soon after" the end of a peak period (for the annual-business-cycle test) or the dose of operations (for the seasonal-business test).

Under a second safe harbor, gross receipts will be "insignificant" for purposes of the seasonal-business test if they are less than 10% of the taxpayer's total gross receipts for the year. In addition, taxpayers in existence for less than three years can satisfy the annual-business-cycle or seasonal-business test by providing reasonable estimates of gross receipts in place of an actual history.

For an accounting-period change under Rev. Proc. 2002-39, the taxpayer must file Form 1128 no later than the due date (including extensions) of the return for the first effective year, pay a user fee and agree to several terms and conditions.

Note: Rev. Proc. 2002-39 contains a provision specifically dealing with a taxpayer's failure to satisfy the natural-business-year test in future years. It provides that if a partnership, S corporation, electing S corporation or PSC changes to a natural-business year, and that year later fails to qualify as a permitted year, the taxpayer must then change to a permitted year. Thus, Rev. Proc. 2002-39 requires annual monitoring of the taxpayer's continued compliance with the natural-business-year requirement. Rev. Proc. 87-32 had no requirement that, for example, the 25% test must be met on an annual basis after the first year. In fact, in Section 11 of the 1987 procedure, taxpayers using a fiscal year on a natural-business-year basis (pursuant to the 25% test) may have to demonstrate periodically the continued existence of such a year.

The annual testing requirement should be of concern to partnerships and S corporations using a natural-business year predicated on having satisfied the 25%-gross-receipts test years ago. If the taxpayer fails the test currently, a year-end change might be necessary. The IRS notes, however, that even if the tax year fails in some later year to qualify as a permitted year under the original test for which it granted approval (e.g., the 25%-gross-receipts test), the taxpayer would not have to change its existing tax year if it can demonstrate that the year is permitted under some other test (e.g., the annual-business-cycle test). In addition, under Rev. Proc. 2002-39, even if the taxpayer fails to satisfy one of the three tests for showing a natural-business year, it must still obtain approval by demonstrating some nontax reason for the change. However, as a practical matter, despite the 25%-gross-receipts test, partnerships and S corporations will continue to have difficulty establishing a sufficient business purpose for a year-end other than December. Note: a Sec. 444 election is otherwise available for a year ending in September, October or November; however, Sec. 444 applies to adoption of an accounting period, not a later change.

The new rules place a significant restriction on a flowthrough entity's ability to retain fiscal tax years predicated on meeting the 25%-gross-receipts test. This might be troublesome if a flowthrough entity adopted or changed a year pursuant to this test many years ago and has not monitored its compliance since. Under the prior procedures, many such taxpayers probably did nothing after they adopted or changed their fiscal year. Now, under Rev. Proc. 2002-39's explicit annual monitoring requirement, they must continue to meet the 25% test each year. If they cannot satisfy this test (e.g., the taxpayer's underlying business model has significantly changed over the years), taxpayers must change to a permitted year, unless they can establish a natural-business year under an alternative test.

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Article Details
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Author:Keller, Brian E.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Sep 1, 2002
Previous Article:Automatic tax-year-change procedures modified for C corporations. (Accounting Methods & Periods).
Next Article:Revised Temp. Regs. may ease anti-Morris Trust rule effects. (Corporations & Shareholders).

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