SERVICE ISSUES GUIDANCE RELATING TO CHANGES OF ACCOUNTING PERIOD BY PARTNERSHIPS, S CORPORATIONS AND PERSONAL SERVICE CORPORATIONS.

Rev. Rul. 87-57

ISSUE

In the situations described below, has a partnership, an S Corporation, or a personal service corporation established, to the satisfaction of the Secretary, a business purpose for adopting, retaining, or changing its tax year?

FACTS

In each of these situations, the taxpayer is a partnership, an S corporation, or a personal service corporation. In addition, in each instance the owners of the taxpayer have tax years that differ from the tax year requested by the taxpayer. The requested tax year is not a "grandfathered fiscal year" within the meaning of section 5.01(2) of Rev. proc. 87- 32 page ___ this Bulletin.

SITUATION 1. The taxpayer desires to use a January 31 tax year. The taxpayer's reason for the requested tax year is that that year corresponds to the natural business year for the taxpayer's type of business as suggested by the Natural Business Year Committee of the American Institute of Certified Public Accountants (AICPA) in an official release published in 100 Journal Of Accountancy 59 (December 1955). In addition, the taxpayer is using a January 31 fiscal year for financial reporting purposes.

SITUATION 2. The taxpayer desires to use a September 30 tax year. The taxpayer's reasons for the requested tax year are that the taxpayer's accountant is extremely busy during the first six months of the year and that, if the taxpayer were to have a September 30 tax year, the taxpayer would receive a reduced charge for the accountant's services.

SITUATION 3. The taxpayer desires to retain its November 30 tax year. The taxpayer's reasons for the requested tax year are that the taxpayer has used a November 30 tax year since the inception of its business 15 years ago and that, if the taxpayer is required to change its tax year, it would lose its recordkeeping consistency and thus would suffer a financial hardship in changing the records to another year.

SITUATION 4. The taxpayer desires to use a tax year ending September 30. The taxpayer's reason for the requested tax year is that the taxpayer desires to issue timely tax information (for example, Schedules K-1, Form 1065 Partner's Share of Income, Credits, Deductions, Etc.) to its owners to facilitate the filing of timely returns by its owners.

SITUATION 5. The taxpayer desires to use a November 30 tax year. The taxpayer can establish a natural business year ending on January 31 under section 4.01(1) of Rev. Proc. 87-32. If the taxpayer had not satisfied the natural business year test for January 31, it would have met the natural business year test for November 30.

SITUATION 6. The taxpayer desires to use a June 30 tax year. The taxpayer's reason for the requested tax year is that it coincides with the taxpayer's natural business year. For this taxpayer, June 30 is not a "natural business year," within the meaning of section 4.01(1) of Rev. Proc. 87-32. This failure to satisfy section 4.01(1) of Rev. Proc. 87-32 is caused by unusual gross receipts figures for several months during the 47-month period (36-month period for requested tax year plus additional 11-month period for comparing requested tax year with other potential tax years) covered by the test. The figures for those months were unusual because a labor strike closed the taxpayer's business during a period that included its normal peak season. The taxpayer has data for the most recent five years demonstrating that the requested tax year would have satisfied the definition of a natural business year within the meaning of section 4.01(1) of Rev. Proc. 87-32, if the strike had not occurred.

SITUATION 7. The taxpayer desires to use a May 31 tax year. The taxpayer's reason for the requested tax year is that due to weather conditions the business is operational only during the period of September 1 through May 31. For the 10 years it has been in business, the taxpayer has had insignificant gross receipts for the period June 1 through August 31. The facility used by the taxpayer is not used for any other purpose during the three months of insignificant gross receipts. This taxpayer does not have a "natural business year," within the meaning of section 4.01(1) of Rev. Proc. 87-32.

SITUATION 8. The taxpayer desires to continue to use a March 31 tax year. The taxpayer changed its method of accounting to the accrual method for the tax year ended March 31, 1987. The taxpayer's reason for the requested tax year is that it coincides with the taxpayer's natural business year. For this taxpayer, March 31 is not a "natural business year," within the meaning of section 4.01(1) of Rev. Proc. 87-32. The 25-percent test in section 4.01(1) of Rev. Proc. 87-32 requires the taxpayer to compute the gross receipts on the basis of the method of accounting used to file its return for each year of the test. Therefore, the taxpayer must compute gross receipts on the cash method of accounting for tax years prior to the tax year ended March 31, 1987. The taxpayer has audited financial statements that were prepared on the basis of an accrual method that is acceptable for tax purposes. The taxpayer's gross receipts based on the accrual method would satisfy the 25-percent test for a tax year ending March 31.

LAW AND ANALYSIS

Section 441(b)(1) of the Internal Revenue Code provides that the term "taxable year" generally means the taxpayer's annual accounting period, if it is a calendar year or a fiscal year. Section 441(c) provides that the term "annual accounting period" means the annual period on the basis of which the taxpayer regularly computes its income in keeping its books. Section 441(d) defines the term "calendar year" as a period of 12 months ending on December 31. Section 441(e) defines the term "fiscal year" as a period of 12 months ending on the last day of any month other than December or a 52-53 week period as described in section 441(f). See also sections 1.441-1 and 1.441-2 of the Income Tax Regulations.

Section 441(i) of the Code, as added by section 806(c) of the Tax Reform Act of 1986 (the Act), 1983-3 (Vol. 1) C.B. __,* provides that the tax year of any personal service corporation shall be the calendar year unless the corporation establishes, to the satisfaction of the Secretary, a business purpose for having a different period for its tax year. Any deferral of income to shareholders is not to be treated as a business purpose.

Section 706(b)(1)(B) of the Code, as added by section 806(a) of the Act, requires that, except as provided in section 706(b)(1)(C), a partnership shall not have a tax year other than:

(i) the tax year of one or more of its partners that have an aggregate interest in partnership profits and capital of greater than 50 percent;

(ii) if there is no tax year described in (i), the tax year of all the principal partners of the partnership; or

(iii) if there is no tax year described in (i) or (ii), the calendar year unless the Secretary by regulations prescribes another period.

Section 706(b)(1)(C) provides that a partnership may have a tax year not described in section 706(b)(1)(B) if it establishes, to the satisfaction of the Secretary, a business purpose therefor. Any deferral of income to partners is not to be treated as a business purpose.

Section 706(b)(3) of the Code provides that a principal partner is a partner having an interest of 5 percent or more in the partnership's profits or capital.

Section 1378(a) of the Code, as amended by section 806(b) of the Act, provides that the tax year of an S corporation shall be a "permitted year." Section 1378(b) defines the term "permitted year" as a tax year which (1) is a year ending December 31, or (2) is any other accounting period for which the corporation establishes a business purpose to the satisfaction of the Secretary. Any deferral of income to shareholders is not to be treated as a business purpose.

Prior to the Act, Rev. proc. 74-33, 1974-2 C.B. 489, set forth the factors considered in determining if a "natural business year" existed for purposes of granting a request for a change in accounting period. The Conference Report for the Act, 2 H.R. Rep. No. 99-841 (Conf. Rep.), 99th Cong., 2d Sess. II-319 (1986), states that the conferees intend that any partnership that received permission under the provisions of Rev. Proc. 74-33 to use a fiscal tax year (other than a tax year that resulted in a three-month-or-less deferral of income) will be allowed to continue to use such tax year without obtaining the approval of the Secretary. Similarly, any S corporation that received permission to use a fiscal tax year (other than a tax year that resulted in a three-month-or-less deferral of income) which permission was granted on or after the effective date of Rev. Proc. 74-33 will be allowed to continue to use such tax year without obtaining the approval of the Secretary. See Rev. Proc. 87-32 , which defines the term "grandfathered fiscal year" to include tax years for which a taxpayer received the permission described in the Conference Report. None of the taxpayers in the factual situations here is requesting to retain a grandfathered fiscal year.

With respect to the establishment of a business purpose for the use of a tax year, the Conference Report states that the Secretary may prescribe tests to be used to establish the existence of a business purpose if, in the discretion of the Secretary, such tests are desirable and expedient towards the efficient administration of the tax laws. Rev. Proc. 87-32 sets forth a mechanical natural business year test and an ownership tax year test that, if either is satisfied, establish, to the satisfaction of the Secretary, a business purpose (as described in sections 441(i), 706(b)(1)(C), and 1378(b)(2)) for a taxpayer to retain, and in limited situations, adopt or change to a tax year.

A taxpayer that cannot satisfy any of the tests set forth in Rev. Proc. 87-32 must establish a business purpose based on consideration of all the facts and circumstances, including the tax consequences. The tax consequences to be considered include: (1) deferring a substantial portion of a taxpayer's income or shifting a substantial portion of a taxpayer's deductions from one year to another to reduce substantially a taxpayer's tax liability; (2) causing a similar deferral or shift in the case of any other person, such as a partner, a beneficiary, or a shareholder in an S corporation; and (3) creating a short period in which there is a substantial net operating loss.

The Conference Report lists various nontax factors that will ordinarily not be sufficient to establish that the business purpose requirement for a particular tax year has been met. These factors are: (1) the use of a particular year for regulatory or financial accounting purposes; (2) the hiring patterns of a particular business -- for example, the fact that a firm typically hires staff during certain times of the year; (3) the use of a particular year for administrative purposes, such as the admission or retirement of partners or shareholders, promotion of staff, and compensation or retirement arrangements with staff, partners, or shareholders; and (4) the fact that a particular business involves the use of price lists, a model year, or other items that change on an annual basis.

Both tax factors and nontax factors must be considered for purposes of determining whether a taxpayer has established a business purpose for the requested tax year. In this context, the Conference Report demonstrates the significant weight that must be assigned to tax factors. The four nontax factors that the report identifies as ordinarily insufficient all involve issues of convenience for the taxpayer. Accordingly, if a requested tax year creates deferral or distortion, the taxpayer's nontax factors must demonstrate compelling reasons for the requested tax year.

The taxpayer in each of the eight situations must establish, to the satisfaction of the Secretary, a business purpose for the use of the requested tax year. Each taxpayer has nontax, business reasons for the use of the requested tax year. However, because the requested tax year is different from the tax year of the taxpayer's owners, the taxpayer's use of the requested tax year would inherently create deferral or distortion. Under these circumstances, the taxpayer can establish, to the satisfaction of the Secretary, a business purpose for the requested tax year only if the nontax reasons for the use of that year are compelling.

The taxpayer's reason for the requested tax year in SITUATION 1 is that the requested tax year is the natural business year suggested by the Natural Business Year Committee of the AICPA and the taxpayer uses the requested tax year for financial statement purposes. As stated in the Conference Report, the use of a particular year for financial accounting purposes is not sufficient to establish that the business purpose requirement for that year has been met. In addition, the natural business year suggested by the AICPA is not based upon the taxpayer's own facts and circumstances.

In SITUATIONS 2-4, the taxpayers' reasons for the requested tax years are to take advantage of an accountant's reduced rate (SITUATION 2), to have recordkeeping consistency (SITUATION 3), and to issue timely tax information forms to partners (SITUATION 4). The reasons given in these three situations are ones of convenience to the taxpayers. Although the reasons are not among those specifically enumerated in the Conference Report, they are very similar to the convenience reasons listed there as being insufficient to establish that the business purpose requirement for a requested tax year has been met.

The taxpayer's reason in SITUATION 5 is that the requested November 30 tax year would be a natural business year but for the fact that the January 31 year produces a higher percentage under the 25-percent test of Rev. Proc. 87-32. Because a November 30 fiscal year satisfies the 25-percent test and results in less deferral to the shareholders than January 31, the Commissioner, in his discretion, considers it desirable and expedient for the efficient administration of the tax laws for this taxpayer to use November 30 as its tax year. Accordingly, the taxpayer has established a business purpose for using the requested tax year. See 2 H.R. Rep. No. 99-841 at II-319.

The taxpayer's reasons in SITUATION 6 are that the requested tax year coincides with the taxpayer's natural business year and that, if the strike had not occurred the requested year would have been a natural business year according to the test set forth in Rev. Proc. 87-32. The taxpayer's failure to establish a natural business year under the 25-percent test is due to unusual circumstances that occurred during the test period and that were beyond the taxpayer's control. The historical data support the taxpayer's contention that, in the absence of these unusual circumstances, the requested year would have qualified as the taxpayer's natural business year. Thus, the Commissioner is satisfied that the taxpayer has established a business purpose for the requested tax year.

The taxpayer's reason in SITUATION 7 is that the requested May 31 tax year coincides with the time the taxpayer has closed down operations for the past 10 years. That closing is not within the taxpayer's control. Accordingly, the taxpayer has established a business purpose for using the requested tax year.

The taxpayer's reason in SITUATION 8 is that the requested March 31 tax year coincides with the taxpayer's natural business year and that, if the taxpayer had used the accrual method of accounting, the requested year would have been a natural business year according to the test set forth in Rev. Proc. 87-32. The taxpayer has changed its method of accounting to the accrual method. Therefore, it is reasonable for the Commissioner, to allow the taxpayer to use a March 31 tax year if the accrual method, which will be used for all future tax years, would establish a natural business year ending on March 31.

HOLDING

Each taxpayer in SITUATIONS 1 - 4 has failed to establish, to the satisfaction of the Secretary, a business purpose for the use of its requested tax year. Each taxpayer in SITUATIONS 5 - 8 has established, to the satisfaction of the Secretary, a business purpose for the use of its requested tax year.