IRS Policy Change Threatens Certain Fiscal-Year Partnerships

by the AICPA Tax Divisions Tax Accounting Technical Resource Panel

Rev. Procs. 2002-37, 2002-38 and 2002-39 provided new rules for automatic approval of accounting period adoptions and changes (see Brooks, Tax Clinic, New Procedures for Changing Accounting Periods, TTA, August 2002, p. 488). Since publication of these procedures, a potentially troubling aspect of the new rules has emergedRev. Proc. 2002-38 toughened the rules for fiscal-year partnerships. If the new rules are enforced, partners of these partnerships face a one-time inclusion of more than 12 months of partnership income. (S corporation shareholders will encounter similar results.)

The policy change in Rev. Proc. 2002-38 (effective for the first tax year of a partnership ending on or after May 10, 2002) involves the 25%-gross-receipts test, a safe harbor for establishing (and maintaining) a fiscal year. Following enactment of the Tax Reform Act of 1986 (which mandated conformity of partnership years with their partners years (generally, a calendar year)), Rev. Proc. 87-32 permitted the use of a fiscal year if it represented the entitys natural business year.

In defining a natural business year, Rev. Proc. 87-32 had provided a safe harbor for partnerships with at least 25% of their gross receipts occurring in the final two months of the desired fiscal year. Section 11 of the procedure indicated that the IRS would monitor compliance, noting that taxpayers using a fiscal year on the basis of a natural business year [i.e., the 25%-gross-receipts test]may be required periodically to demonstrate the continued existence of such a year. (Emphasis added.)

Rev. Proc. 2002-38 changed the rules from merely monitoring compliance periodically to requiring compliance annually, stating in Section 6.05 that a partnership that fails the 25%-gross-receipts test is using an impermissible annual accounting period and should change to a permitted taxable year. The requisite change to a calendar year has severe consequences for partners in a partnership forced to give up its fiscal year.

Example: XYZ Partnership has a tax year ending May 31, 2002; its partners are on a calendar year. Rev. Proc. 2002-38 forces XYZ to change to a calendar year. The partners 2002 returns must include 19 months of partnership income: 12 months of income for the year ended May 31, 2002 and seven months of income for the short period ended Dec. 31, 2002.

In a letter to Treasury and the Service dated Dec. 17, 2002, the AICPA Tax Divisions Tax Accounting Technical Resource Panel called attention to this harsh consequence; it requested relief in the form of a four-year spread of the additional income resulting from the involuntary change in year-ends.