by George G. Jones and Mark A. Luscombe
The Internal Revenue Service recently announced an opportunity for some partners and S corporation shareholders to spread out income that is realized in any short year generated by certain accounting year changes by their S corporation or partnership. Unfortunately, this opportunity — in the form of Revenue Procedure 2003-79 — allows the S corp or partnership a relatively short window of time within which to act.
Analysis of who benefits and what steps should be taken to maximize these benefits becomes especially appropriate as the end of the year approaches. Given that the most frequent year to which switching will be permitted under the new Rev. Proc. will be the regular calendar year, Dec. 31, 2003, becomes a pivotal date.
Rev. Proc. 2002-38 details the automatic approval procedures for partnerships, S corps, electing S corps, and personal service corps to change accounting periods. Pass-through entities complying with all the specified requirements will be deemed to have established a business purpose and the change would be automatically approved by the IRS. Taxpayers ineligible for automatic approval must request approval under Rev. Proc. 2002-39.
After the S corp or partnership changes its tax year under Rev. Proc. 2002-38 or Rev. Proc. 2002-39, a short tax year usually arises. This is the period between the close of the old accounting period and the commencement of the new accounting period.
As a result, a partner or shareholder in an S corp may have pass-through income from more than one tax year compressed into a single tax year. Rev. Proc. 2003-79 attempts to ease this burden by permitting income from the short tax year to be reported pro rata over four years.
Example: An S corp decided to switch this past October, under Rev. Proc. 2002-38, from a tax year ending March 31 to a year ending December 31. Each calendar-year shareholder will have pass-through net income of $70,000 in calendar year 2003 for the past March 1, 2002, to Feb. 28, 2003, tax year, and $60,000 for the March 1, 2003, to Dec. 31, 2003, short tax year (and annualized as required under Section 443 regulations).
Each shareholder may elect to spread his $60,000 short-year income over calendar year 2003, 2004, 2005 and 2006, pro rata $15,000 for each year.
Although the decision to change an accounting period is made at the entity level, each partner or S corporation separately decides whether or not to take the four-year spread on their share of the short year’s income.
Partners and S shareholders may elect the four-year spread if a short year exists because the partnership or S corp changes its annual accounting period for one of two reasons:
● A tax year that no longer qualifies as a natural business year, or,
● In the case of an S corp, a change in ownership year has taken place.
Both reasons rely on terms defined by the approval procedures under Rev. Procs. 2002-38 and 39.
The four-year spread applies to most tax year changes made under either Rev. Proc. 2003-38 or 39. Most partnerships and S corporations that established non-calendar fiscal years under loose interpretations of the natural business year prevalent in past years are no longer able to pass the more stringent test under the revenue procedures.
For a natural business year to exist (which would allow the taxpayer to keep its present accounting period), the pass-through entity must pass a “25 percent gross receipts test.” That test generally requires a substantial amount of the annual income to be earned during the later portion of the fiscal year. Unless a natural business year other than the calendar year is evident, a partnership or S corporation will need to switch to a required tax year that generally conforms to the tax year of its owners.
The IRS is only making the income spread effective for short tax years ending on or after May 10, 2002 (the release date of Rev. Proc. 2002-38 and Rev. Proc. 2002-39), and before June 1, 2004. The IRS appears convinced that many S corps and partnerships continue to use impermissible years. It apparently blames its previous silence at least in part for this noncompliance and hopes that by offering the four-year spread on the income, it will lessen some of the unanticipated costs of compliance.
But in setting the June 1, 2004, deadline for the end of short tax years, the IRS also is sending a clear message that taxpayers should wake up now and make the switch while there is an incentive to do so, or be relegated to the “regular” rules, which may include penalties.
Whether or not an entity is changing a tax year under the automatic or the approval-only procedure, it must timely file Form 1128, Application to Adopt, Change, or Retain a Tax Year. That deadline is the due date of the taxpayer’s federal income tax return (including extensions) for the first effective year, but no earlier than the day following the end of the first effective tax year.
The first effective tax year is the short period required to effect the change — beginning with the day following the close of the old tax year and ending with the day preceding the first day of the new tax year.
Regulations under Section 443 provide that, in general, a return for a short period resulting from a change of annual accounting period “shall be filed and the tax paid within the time prescribed for filing a return for a taxable year of 12 months ending on the last day of the short period.”
Unless specifically authorized, a taxpayer may not make a retroactive change in the annual accounting period, wheth-er or not the change is to a required tax year.
However, since the end of the short year need not be determined until Form 1128 is filed, ending the taxpayer’s year on Dec. 31, 2003, does not require action by that date. It does require action, however, before the date that the return for that year, including extensions, is due. For S corporations, the end date for a short year ending on December 31 is September 15. For partnerships, it’s October 15.
Nevertheless, partnerships and S corporations may want to act sooner. Once the taxpayer is under examination (or the partner or S owner is under audit for the tax year issue), consent must be obtained to change tax years, even to a required year. Further, once the shareholder or partner files her own personal return for 2003, the four-year spread can no longer be chosen.
The deadline for electing the four-year spread is not the same as the deadline for determining the short tax year. To elect to spread income over four years, taxpayers must:
● Report 25 percent of the total amount of income that will be included in income over four years on a timely return (or, under pre-Nov. 24, 2003, circumstances noted below, an amended return); and,
● Complete Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, and attach it to a timely return or amended return.
If a taxpayer elects the spread, 25 percent of income is reported on a timely original return for the tax year covering the year in which the short tax year ends. (Income may be reported (and the election therefore made) on an amended return only if filed on or before April 12, 2004, and if the original return had been timely filed prior to Nov. 24, 2003.)
Following the deadline schedule, therefore, an individual partner or S shareholder may make the election for a short year that ends on Dec. 31, 2003, no later than their extended deadline of Oct. 15, 2004, as long as the S corporation has filed an extension by Sept. 15, 2004, or the partnership by Oct. 15, 2004.
Should the four-year spread be elected?
For most partners and S shareholders, a switch from a natural business year that is no longer applicable will require a change to a calendar year. Unless the IRS extends the June 1, 2004, deadline to Dec. 31, 2004, for the applicable short year end date, the “real” deadline moves up to Dec. 31, 2003, for most entities.
That being the case, the decision to elect the four-year spread will depend on the amount of 2003 taxable income otherwise anticipated by the shareholder or partner, as well as predictions of how even income will remain for the 2004 to 2006 period.
Generally, the four-year spread will be advantageous, which, in turn, means that partnerships and S corporations that are not on calendar years should take a close look at their situations at this time. It is better to switch their tax years now, while the four-year spread is available, rather than delay and face penalties for the use of an impermissible year in the future.
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