Partnerships, S Corporations, and Personal Service Corporations

Generally, partnerships, S corporations, and personal service corporations must use a required tax year. The entity does not have to use the required tax year if it establishes a business purpose for a different tax year or makes an election under section 444. These issues are discussed later.

Partnership

A partnership must conform its tax year to its partners' tax years unless the partnership can establish a business purpose for a different period or it makes a section 444 election. The rules for the required tax year for partnerships are as follows.

1. If one or more partners having the same tax year own a majority interest (more than 50%) in partnership profits and capital, the partnership must use the tax year of those partners.
2. If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. A principal partner is one who has a 5% or more interest in the profits or capital of the partnership.
3. If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use a tax year that results in the least aggregate deferral of income to the partners.

If a partnership changes to a required tax year because of these rules, no formal application for a change in tax year is needed. Any partnership that changes to a required tax year must notify the IRS by writing at the top of the first page of its tax return for its first required tax year, FILED UNDER SECTION 806 OF THE TAX REFORM ACT OF 1986.

Least aggregate deferral of income.   The tax year that results in the least aggregate deferral of income is determined as follows.

1. Figure the number of months of deferral for each partner using one partner's tax year. Find the months of deferral by counting the months from the end of that tax year forward to the end of each other partner's tax year.
2. Multiply each partner's months of deferral figured in step (1) by that partner's share of interest in the partnership profits for the year used in step (1).
3. Add the amounts in step (2) to get the aggregate (total) deferral for the tax year used in step (1).
4. Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years.

The partner's tax year that results in the lowest aggregate (total) number is the tax year that must be used by the partnership. If more than one year qualifies as the tax year that has the least aggregate deferral of income, the partnership can choose any year that qualifies. However, if one of the tax years that qualifies is the partnership's existing tax year, the partnership must retain that tax year.

Example.   A and B each have a 50% interest in partnership P, which uses a fiscal year ending June 30. A uses the calendar year and B uses a fiscal year ending November 30. P must change its tax year to a fiscal year ending November 30 because this results in the least aggregate deferral of income to the partners, as shown in the following table.

			Months	Interest
Year End	Year	Profits	of	×
12/31:	End	Interest	Deferral	Deferral
A	12/31	0.5	-0-	-0-
B	11/30	0.5	11	5.5
Total Deferral				5.5
			Months	Interest
Year End	Year	Profits	of	×
11/30:	End	Interest	Deferral	Deferral
A	12/31	0.5	1	0.5
B	11/30	0.5	-0-	-0-
Total Deferral				0.5

When determination is made.   The determination of the tax year with the least aggregate deferral of income must generally be made at the beginning of the partnership's current tax year. However, the IRS can require the partnership to use another day or period that will more accurately reflect the ownership of the partnership. This could occur, for example, if a partnership interest was transferred for the purpose of qualifying for a particular tax year.

Short period return.   When a partnership changes its tax year, a short period return must be filed. The short period return covers the months between the end of the partnership's prior tax year and the beginning of its new tax year.

If a partnership changes to the tax year resulting in the least aggregate deferral of income, it must attach a statement to the short period return showing the computations used to determine that tax year. The short period return must indicate at the top of page 1, FILED UNDER SECTION 1.706-1T.

More information.   For more information on partnerships, see Publication 541.

S Corporation

If it meets the requirements, a small business corporation can elect to be an S corporation. All S corporations, regardless of when they became an S corporation, must use a permitted tax year. A permitted tax year is the calendar year or any other tax year for which the corporation establishes a business purpose. For information on S corporations, see the instructions for Form 1120-S.

Personal Service Corporation

A personal service corporation must use a calendar tax year unless it can establish a business purpose for a different period or it makes a section 444 election, discussed later. A corporation is a personal service corporation if all the following conditions are met.

1. The corporation is a C corporation.
2. The corporation's principal activity during the testing period, defined later, is the performance of personal services.
3. Employee-owners of the corporation perform a substantial part of the services during the testing period.
4. Employee-owners own more than 10% of the corporation's stock on the last day of the testing period.

Principal activity.   The principal activity of a corporation is considered to be the performance of personal services if, during the testing period, the corporation's compensation costs for personal service activities are more than 50% of its total compensation costs.

Testing period.   Generally, the testing period for a tax year is the prior tax year.

Example.   Corporation A has been in existence since 1980. It has always used a January 31 fiscal year for its accounting period. To determine whether A is a personal service corporation for its tax year beginning February 1, 2001, the testing period is A's tax year ending January 31, 2001.

New corporations.   The testing period for the first tax year of a new corporation starts with the first day of the tax year and ends on the earlier of the following dates.

1. The last day of its tax year.
2. The last day of the calendar year in which the tax year begins.

Example.   B Corporation's first tax year begins June 1, 2001. B wants to use a September 30 fiscal year for its accounting period. B's testing period for its first tax year is from June 1, 2001, through September 30, 2001. If B wants to use a March 31 fiscal year, the testing period is from June 1, 2001, through December 31, 2001.

Performance of personal services.   Any activity that involves the performance of services in the fields of health, veterinary services, law, engineering, architecture, accounting, actuarial science, performing arts, or certain consulting services is considered the performance of personal services.

Employee-owner.   An employee-owner of a corporation is a person who:

1. Is an employee of the corporation on any day of the testing period, and
2. Owns any outstanding stock of the corporation on any day of the testing period.

Independent contractor.   A person who owns any outstanding stock of the corporation and who performs personal services for or on behalf of the corporation is treated as an employee of the corporation. This rule applies even if the legal form of the person's relationship to the corporation is such that the person would be considered an independent contractor for other purposes.

More information.   For more information on the tax year of a personal service corporation, see section 1.441-4T of the regulations.

Section 444 Election

A partnership, S corporation, or personal service corporation can elect under section 444 to use a tax year other than its required tax year. Certain restrictions apply to the election. In addition, a partnership or S corporation may have to make a payment for the deferral period. See Required payment for partnership or S corporation, later. The section 444 election does not apply to any partnership, S corporation, or personal service corporation that establishes a business purpose for a different period, explained later.

A partnership, S corporation, or personal service corporation can make a section 444 election if it meets all the following requirements.

1. It is not a member of a tiered structure (defined in section 1.444-2T of the regulations).
2. It has not previously had a section 444 election in effect.
3. It elects a year that meets the deferral period requirement.

Deferral period.   The determination of the deferral period depends on whether the partnership, S corporation, or personal service corporation is retaining its tax year or adopting or changing its tax year with a section 444 election.

Retaining tax year.   Generally, a partnership, S corporation, or personal service corporation can make a section 444 election to retain its tax year only if the deferral period of the new tax year is 3 months or less. This deferral period is the number of months between the beginning of the retained year and the close of the first required tax year.

Adopting or changing tax year.   If the partnership, S corporation, or personal service corporation is changing to a tax year other than its required year, the deferral period is the number of months from the end of the new tax year to the end of the required tax year. The IRS will allow a section 444 election only if the deferral period of the new tax year is less than the shorter of:

1. Three months, or
2. The deferral period of the tax year being changed. This is the tax year immediately preceding the year for which the partnership, S corporation, or personal service corporation wishes to make the section 444 election.

If the partnership, S corporation, or personal service corporation's tax year is the same as its required tax year, the deferral period is zero.

Example 1.   BD Partnership uses a calendar year, which is also its required tax year. BD cannot make a section 444 election because the deferral period is zero.

Example 2.   E, a newly formed partnership, began operations on December 1, 2000. E is owned by calendar year partners. E wants to make a section 444 election to adopt a September 30 tax year. E's deferral period for the tax year beginning December 1, 2000, is 3 months, the number of months between September 30 and December 31.

Making the election.   You make a section 444 election by filing Form 8716, Election To Have a Tax Year Other Than a Required Tax Year, with the Internal Revenue Service Center where the entity will file its tax return. Form 8716 must be filed by the earlier of:

1. The due date (not including extensions) of the income tax return for the tax year resulting from the section 444 election, or
2. The 15th day of the 6th month of the tax year for which the election will be effective. For this purpose, count the month in which the tax year begins, even if it begins after the first day of that month.

Attach a copy of Form 8716 to Form 1065 or the appropriate Form 1120 for the first tax year for which the election is made.

Example 1.   AB, a partnership, begins operations on September 11, 2001, and is qualified to make a section 444 election to use a September 30 tax year for its tax year beginning September 11, 2001. AB must file Form 8716 by January 15, 2002, which is the due date of the partnership's tax return for the period from September 11, 2001, to September 30, 2001.

Example 2.   The facts are the same as Example 1 except that AB begins operations on October 21, 2001. AB must file Form 8716 by March 15, 2002, the 15th day of the 6th month of the tax year for which the election will first be effective.

Example 3.   B is a corporation that first becomes a personal service corporation for its tax year beginning September 1, 2001. B qualifies to make a section 444 election to use a September 30 tax year for its tax year beginning September 1, 2001. B must file Form 8716 by December 17, 2001, the due date of the income tax return for the short period from September 1, 2001, to September 30, 2001.

Extension of time for filing.   There is an automatic extension of 12 months to make this election. See the form instructions for more information.

Effect of election.   A partnership or an S corporation that makes a section 444 election must make certain required payments and a personal service corporation must make certain distributions. These are discussed later.

Ending the election.   The section 444 election remains in effect until it is terminated. If the election is terminated, another section 444 election cannot be made for any tax year.

The election ends when the partnership, S corporation, or personal service corporation does any of the following.

1. Changes its tax year to a required tax year.
2. Liquidates.
3. Willfully fails to comply with the required payments or distributions.
4. Becomes a member of a tiered structure.

The election will also end if either of the following events occur.

1. An S corporation's S election is terminated. However, if the S corporation immediately becomes a personal service corporation, the personal service corporation can continue the section 444 election of the S corporation.
2. A personal service corporation ceases to be a personal service corporation. If the personal service corporation elects to be an S corporation, the S corporation can continue the election of the personal service corporation.

Required payment for partnership or S corporation.   A partnership or an S corporation must make a required payment for any tax year:

1. The section 444 election is in effect.
2. The required payment for that year (or any preceding tax year) is more than $500.

This payment represents the value of the tax deferral the owners receive by using a tax year different from the required tax year.

Form 8752,   Required Payment or Refund Under Section 7519, must be filed each year the section 444 election is in effect, even if no payment is due. If the required payment is more than $500 (or the required payment for any prior year was more than $500), the payment must be made when Form 8752 is filed. If the required payment is $500 or less and no payment was required in a prior year, Form 8752 must be filed showing a zero amount.

Form 8752 must be filed and the required payment made (or zero amount reported) by May 15 of the calendar year following the calendar year in which the applicable election year begins. Any tax year a section 444 election is in effect, including the first year, is called an applicable election year. For example, if a partnership's applicable election year begins July 1, 2001, Form 8752 must be filed by May 15, 2002.

Required distribution for personal service corporation.   A personal service corporation with a section 444 election in effect must distribute certain amounts to employee-owners by December 31 of each applicable year. If it fails to make these distributions, it may be required to defer certain deductions for amounts paid to owner-employees. The amount deferred is treated as paid or incurred in the following tax year.

For information on the minimum distribution, see the instructions for Part I of Schedule H (Form 1120), Section 280H Limitations for a Personal Service Corporation (PSC).

Back-up election.   A partnership, S corporation, or personal service corporation can file a back-up section 444 election if it requests (or plans to request) permission to use a business purpose tax year, discussed later. If the request is denied, the back-up section 444 election must be activated (if the partnership, S corporation, or personal service corporation otherwise qualifies).

Making election.   The general rules for making a section 444 election, as discussed earlier, apply. When filing Form 8716, type or print BACK-UP ELECTION at the top of the form. However, if Form 8716 is filed on or after the date Form 1128 is filed, type or print FORM 1128 BACK-UP ELECTION at the top of Form 8716.

Activating election.   A partnership or S corporation activates its back-up election by filing the return required, making the required payment with Form 8752, and printing at the top of the form, ACTIVATING BACK-UP ELECTION. The due date for filing Form 8752 and making the payment is the later of the following dates.

1. May 15 of the calendar year following the calendar year in which the applicable election year begins.
2. 60 days after the partnership or S corporation has been notified by the IRS that the business year request has been denied.

A personal service corporation activates its back-up election by filing Form 8716 with its original or amended income tax return for the tax year in which the election is first effective and printing on the top of the income tax return, ACTIVATING BACK-UP ELECTION.

Business Purpose Tax Year

A business purpose tax year is an accounting period that has a substantial business purpose for its existence. See Natural Business Year, later. In considering whether there is a business purpose for a tax year, significant weight is given to tax factors. A prime consideration is whether the change would create a substantial distortion of income. The following are examples of income distortion.

1. Deferring substantial income or shifting substantial deductions from one year to another to significantly reduce tax liability.
2. Causing a similar deferral or shifting for any other person, such as a partner or shareholder.
3. Creating a short period in which there is a substantial net operating loss.

The following nontax factors, based on the convenience of the taxpayer, are generally not sufficient to establish a business purpose for a particular tax year.

1. Using a particular year for regulatory or financial accounting purposes especially if the change is not based on the taxpayer's own facts and circumstances.
2. Using a particular hiring pattern, such as typically hiring staff during certain times of the year.
3. Using a particular year for administrative purposes, such as:
   1. Admission or retirement of partners or shareholders.
   2. Promotion of staff.
   3. Compensation or retirement arrangements with staff, partners, or shareholders.
4. Using a price list, model year, or other item that changes on an annual basis.
5. Deferring income to partners or shareholders.

For examples of situations in which a business purpose is not shown as well as examples in which a substantial business purpose has been established, see Revenue Ruling 87-57, in Cumulative Bulletin 1987-2.

Natural business year.   One nontax factor that may be sufficient to establish a business purpose for a tax year is an annual cycle of business activity, called a natural business year. A natural business year exists when a business has a peak and a nonpeak period. The natural business year is considered to end at or soon after the end of the peak period. A business whose income is steady from month to month all year would not have a natural business year.

A natural business year is considered a substantial business purpose for an entity changing its accounting period. The IRS will ordinarily approve this change unless it results in a substantial distortion of income or other tax advantage.

Automatic approval.   The IRS provides a procedure for a partnership, an S corporation, or a personal service corporation to retain or automatically change to a natural business year as determined by the 25% test, discussed next. It also allows an S corporation to adopt, retain, or change to a fiscal year that satisfies the ownership tax year test, discussed later. For more information, see Revenue Procedure 87-32, in Cumulative Bulletin 1987-2.

25% test.   The natural business year is determined by applying the 25% test to the method of accounting used for the tax return for each year involved. To figure the 25% test, take the following steps.

1. Total the gross sales and services receipts for the most recent 12-month period that includes the last month of the requested fiscal year. Figure this for the 12-month period that ends before the filing of the request. Also total the gross sales and services receipts for the last 2 months of that 12-month period.
2. Determine the percentage of the receipts for the 2-month period by dividing the total of the last 2-month period by the total for the entire 12-month period. Carry the percentage to two decimal places.
3. Figure the percentage following steps (1) and (2) for the two 12-month periods just preceding the 12-month period used in (1).

If the percentage determined for each of the three years equals or exceeds 25%, the requested fiscal year is the natural business year.

Special rules.   If the partnership, S corporation, or personal service corporation qualifies for more than one natural business year, the fiscal year producing the highest average of the three percentages is the natural business year.

If the partnership, S corporation, or personal service corporation does not have at least 47 months of gross receipts (which may include a predecessor organization's gross receipts), it cannot use this automatic procedure to obtain permission to use a fiscal year.

If the requested tax year is a 52-53 week tax year, the calendar month ending nearest the last day of the 52-53 week tax year is treated as the last month of the requested tax year for purposes of computing the 25% test.

Ownership tax year test.   An S corporation or corporation electing to be an S corporation qualifies for automatic approval if it meets the ownership tax year test. The test is met if the corporation is adopting, retaining, or changing to a tax year and shareholders holding more than 50% of its issued and outstanding shares of stock on the first day of the requested tax year have, or are all changing to, the same tax year. Shareholders desiring to change to the same tax year should follow section 1.442-1(b)(1) of the regulations when requesting permission. If, on the first day of any tax year, the S corporation no longer meets the ownership tax year test, the corporation must change its tax year to a permitted year.

Filing information.   To get automatic approval, a partnership, S corporation, or corporation electing to be an S corporation must file a tax return for the short period. The short period tax return must be filed by the due date, including extensions.

Form 1128 must be filed by the 15th day of the second calendar month following the close of the short period with the director of the Internal Revenue Service Center where the entity files its tax return. The envelope should be marked Attention: ENTITY CONTROL. Type or print FILED UNDER REV. PROC. 87-32 at the top of Form 1128.

In some cases, a late-filed Form 1128 may be accepted. However, applications the IRS receives more than 90 days after the due date will not be approved except in very unusual and compelling circumstances. A corporation that elects to be an S corporation and requests to adopt, retain, or change its tax year must file Form 2553, Election by a Small Business Corporation. The form must be filed when the election request is made. (In certain cases, an extension of time can be granted for filing Form 2553.) The user fee is not due with the form. The IRS will notify you when the fee is due. See User Fees, earlier.

For more information on these tax year requirements, see Revenue Procedure 87-32 and Revenue Ruling 87-57 in Cumulative Bulletin 1987-2.

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