Rev. Rul. 77-264

Advice has been requested whether, under the circumstances described below, the taxpayer, an individual, will be considered to have ceased to engage in a particular trade or business for purposes of Rev. Proc. 70-27, 1970-2 C.B. 509, relating to procedures to be used for obtaining consent to a change in accounting practice or method.

The taxpayer was an individual operating a retail store as a sole proprietorship. The taxpayer engaged in no other trade or business. The taxpayer has been on the cash receipts and disbursements method of accounting and has filed Federal income tax returns on a calendar year basis. In 1971, the taxpayer sought permission for a change in accounting method from the cash receipts and disbursements method to the accrual method of accounting. In accordance with Rev. Proc. 70-27, the taxpayer filed an Application for Change in Accounting Method (Form 3115) with the Commissioner of Internal Revenue. The taxpayer's request for a change in accounting method received favorable consideration based on the condition that the taxpayer would take the necessary resulting adjustment under section 481 of the Internal Revenue Code of 1954 into account ratably over a period of 10 taxable years. The resulting adjustment under section 481 was an increase in income of 30,000x dollars of which the taxpayer included in income 3,000x dollars in each of taxable years 1971, 1972, and 1973, leaving the balance of the adjustment at the end of 1973 at 21,000x dollars.

One of the conditions prescribed by the Commissioner and agreed to by the taxpayer in 1971 in changing the method of accounting was that if the taxpayer ceased to engage in the trade or business at any time prior to the expiration of the 10-year period, the taxpayer would take into account for Federal income tax purposes, for the year in which the taxpayer ceased to engage in the trade or business, the balance of the adjustments determined under section 481 of the Code, not previously taken into account in computing taxable income.

The taxpayer ceased to operate as a sole proprietorship and immediately incorporated the entire business on July 1, 1974.

The specific question is whether the taxpayer ceased to engage in the trade or business upon incorporation of the business and, therefore, was required to include in the 1974 Federal income tax return the balance of the adjustment not previously accounted for (21,000x dollars).

Rev. Rul. 66-206, 1966-2 C.B. 206, holds that an individual taxpayer, operating a retail store as a sole proprietorship, does not cease to engage in that trade or business when the taxpayer sells a share in the proprietorship and continues to be actively engaged in the management of the business that is operated as a partnership. The taxpayer in that Revenue Ruling was required to continue to take into account, in computing taxable income, adjustments that had previously been required under section 481(a) of the Code.

In the instant case, the taxpayer incorporated the business and ceased to operate as a sole proprietorship. The taxpayer became an employee of the corporation. An employee is engaged in a trade or business separate and distinct from the trade or business of such employee's corporation. Fischer v. United States, 490 F.2d 218 (7th Cir. 1973).

Accordingly, for purposes of Rev. Proc. 70-27, upon incorporation of the sole proprietorship the taxpayer ceased to be engaged in that particular trade or business. Therefore, the balance of the adjustment determined under section 481(a) of the Code to the extent not previously taken into account must be taken into account in computing taxable income in 1974 in accordance with the conditions agreed to by the taxpayer under Rev. Proc. 70-27.

Rev. Rul. 66-206 is distinguished.