PARTNERSHIP MUST ACCELERATE PORTION OF UNAMORTIZED SEC. 481 ADJUSTMENT WHEN ONE OF TWO PARTNERSHIP BUSINESSES IS INCORPORATED

Rev. Rul. 85-134

ISSUE

When one of the two trades or businesses of a partnership is incorporated, is the partnership (PRS) required to accelerate the portion of an unamortized adjustment under section 481(a) of the Internal Revenue Code applicable to that trade or business?

FACTS

PRS commenced business in 1965 and established two separate businesses, a "professional" business and a "technical" business. As a result of expansion, PRS's accounts receivable and liabilities increased and PRS determined that the cash receipts and disbursements method of accounting no longer properly reflected its activities. Therefore, PRS applied for and received permission to change its method of accounting for federal income tax purposes to an accrual method for its tax year ended March 31, 1980. The ruling letter issued by the Internal Revenue Service stated that the adjustment required under section 481(a) of the Code would be taken into account over a 10-year period beginning with the year of the change. The ruling also stated that if PRS ceased to be engaged in a trade or business with respect to which the change applied, the unamoritized section 481(a) adjustment with respect to that trade or business would be taken into account in the year it ceased to be engaged in that particular trade or business. On April 1, 1982, the professional business of PRS was incorporated.

LAW AND ANALYSIS

Section 446(e) of the Code requires a taxpayer to secure the consent of the Commissioner before changing a method of accounting. Section 1.446-1(e)(3)(i) of the Income Tax REgulations states that in order to secure the consent of the Commissioner, the taxpayer must agree to the terms, conditions, and adjustments under which the change will be effected.

Section 481(a) of the Code provides that in computing a taxpayer's taxable income for the tax year for which there has been a change in the method of accounting initiated by the taxpayer, there shall be taken into account those adjustments that are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted.

Rev. Rul. 77-264, 1977-2 C.B. 187, describes a situation in which the sole proprietor of a retail store obtained permission to effect a change in method of accounting, agreeing to take into account ratably over a 10-year period the adjustments required under section 481(a) of the Code and to include in income the balance of the adjustment determined under section 481(a) upon ceasing to engage in the trade or business. Three years later the sole proprietor incorporated the business. Rev. Rul. 77-264 holds that the taxpayer is no longer engaged in that particular trade or business and, therefore, the balance of the adjustment determined under section 481(a), to the extent not previously taken into account, must be taken into account in computing taxable income in the tax year in which the taxpayer ceased to engage in that particular trade or business.

Rev. Rul. 80-39, 1980-1 C.B. 112, describes a domestic corporation that carries out its business operations through several divisions. Each division is in a different trade or business, and each keeps a complete and separate set of books and records. The corporation seeks permission to change its method of accounting for the trade or business conducted by one of the divisions. Rev. Rul. 80-39 holds that, in granting a change in method of accounting, the Service will impose a condition that requires any balance of a section 481(a) adjustment applicable to the trade or business conducted by that division to be reported in the tax year in which the corporation ceases to engage in that trade or business.

Before April 1, 1982, PRS had two separate businesses. The ruling letter granting PRS permission to change to an accrual method of accounting provides that, "in the event your partnership ceases to engage in a trade or business with respect to which the change applies at any time prior to the expiration of the 10-year period, the balance of the adjustment with respect to that trade or business not previously taken into account in computing ordinary income shall be taken into account in such year." By incorporating the professional business on April 1, 1982, PRS ceased to engage in that particular trade or business as of that date. See Rev. Rul. 77-264 and Shore v. Commissioner, 69 T.C. 689 (1978), affd., 631 F.2d 624 (9th Cir. 1980). A portion of section 481(a) adjustment resulting from the earlier change in method of accounting by PRS from the cash method to the accrual method is attributable to the professional business. To allow PRS to continue to report the section 481(a) adjustment applicable to the professional business over years subsequent to the time PRS ceases to engage in that particular trade or business would distort the income of PRS during the remaining adjustment period. See Rev. Rul. 80-39 and Section 5.09(2) of Rev. Proc. 84-74, 1984-2 C.B. 736.

HOLDING

PRS is required to accelerate the portion of the unamortized adjustment under section 481(a) of the Code applicable to the trade or business incorporated.

EFFECT ON OTHER DOCUMENTS

Rev. Ruls. 77-264 and 80-39 are amplified.