Certain Partners and S Corp. Shareholders Can Spread Income from Short Tax Year

Rev. Proc. 2003-79 provides procedures for qualifying partners and S corporation shareholders to elect to take into account ratably over four tax years their share of income from a partnership or S corporation attributable to a short tax year ending after May 9, 2002, but before June 1, 2004. The short tax year must result from a change in tax year because the (1) partnerships or S corporations tax year no longer qualifies as a natural business year or (2) S corporations tax year no longer qualifies as the ownership tax year.

Background

Generally, Rev. Proc. 2002-38 grants a partnership or S corporation automatic consent to change to a natural business year or (for S corporations) to an ownership tax year. However, if a tax year no longer qualifies as a permitted tax year (e.g., ownership of the S corporation changes or the business changes such that the tax year no longer satisfies the natural-business-year requirements), the taxpayer is using an impermissible annual accounting period and should change to a permitted tax year; see Rev. Proc. 2002-38, Sections 6.05 and 6.06, and Rev. Proc. 2002-39, Section 5.04 (which provide procedures for nonautomatic accounting-period changes).

As a result of a change to a permitted tax year, a partner or S shareholder may be required to include in gross income in a single tax year income and expense items from more than one partnership or S tax year. To mitigate the potentially unfavorable consequences of a change to a permitted year, Rev. Proc. 2003-79 allows eligible partners and S shareholders to elect to spread their share of income from the resulting short tax year ratably over four tax years.

Rev. Proc. 2003-79

The procedure applies to a partner or S shareholder, if the partnerships or S corporations change in tax year is solely the result of either:

1. The current tax year no longer qualifying as a natural business year under Rev. Proc. 2002-38 or 2002-39 (whichever is applicable); or

2. In the case of an S corporation, its current tax year no longer qualifying as an ownership tax year because a tax-exempt owner is disregarded under Rev. Proc. 2002-38, Section 5.06.

To be eligible for the spread period under Rev. Proc. 2003-79, the short tax year must end after May 9, 2002, but before June 1, 2004. As a consequence of the change in tax year to a permitted year, income and expense items (as defined in Temp. Regs. Sec. 1.702-3T(b)) from more than one partnership or S tax year would, but for Rev. Proc. 2003-79, be includible in the shareholders or partners taxable income in a single tax year.

The four-year spread period under Rev. Proc. 2003-79 applies only if the partners or S shareholders share of income items exceeds its share of expense items attributable to the partnership or S short tax year.

A partner or S shareholder qualifying under Rev. Proc. 2003-79 may elect the four-year spread by:

•  Reflecting 25% of its allocable or distributive share of income and expense items on either (1) a timely filed original Federal return for the partners or S shareholders tax year that ends with or within the required short tax year or (2) an appropriate amended Federal return filed before April 13, 2004, if the partner or S corporation timely filed the original return before Nov. 24, 2003; and

• Attaching to the original or amended return for the tax year with or within which the partnerships or S corporations short tax year ends, and to the Federal income tax returns for each tax year of the spread period, completed Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, containing as an explanation in Part III, Election under Rev. Proc. 2003-79 to apply a ratable four-year spread of the share of income attributable to a change in annual accounting period.

Implications

Under Rev. Proc. 2002-38, a partnership or S corporation that no longer satisfies the 25% gross receipts test for a natural business year or, in the case of an S corporation, that no longer satisfies the ownership test, is using an impermissible annual accounting period. This was a significant change from Rev. Proc. 87-32, which merely indicated that taxpayers may be required to demonstrate the continued existence of a natural business year. The required change in tax years as a result of this provision could, as discussed above, result in the inclusion of more than 12 months of partnership or S income by a partner or shareholder in a single tax year.

Commentators suggested that the Service provide the same remedy Congress set forth when it changed the annual accounting period rules to provide required tax years for partnerships and S corporations; see Section 806(e) of the Tax Reform Act of 1986. Congress provided a four-year spread of a partnerships or S corporations income in excess of expenses for the short tax year resulting from the required change in annual accounting period.

The Service, in Rev. Proc. 2003-79, has provided similar relief for taxpayers affected by certain changes made under Rev. Proc. 2002-38. Eligible partners and S shareholders should take advantage of the favorable spread period offered under Rev. Proc. 2002-79. A reduction in a partners or S shareholders allocable or distributive share of income may result in additional deductions (due to a lower adjusted gross income) or possibly, lower marginal tax rates.

From Diane Herndon, Washington, DC