Intro to Corporate Taxes:

Picking a Tax Year for a Partnership

A tax year is an accounting method used to determine the amount to be reported for income and expenses plus record keeping. Picking a tax year to use in a partnership can be really hard especially if you have multiple partners. Every partnership must conform to the partners tax year as a required tax year for their partnership. The partner’s tax year is determined by their regular tax year as a taxpayer or if they had already chosen a fiscal year before entering into a partnership. According to the IRS the only exceptions are:

If a partnership provides an acceptable business purpose for having a tax year different from the existing required tax year, the different tax year can be used. The deferral of income to the partners is not considered to be a business purpose.
Partnerships can elect under section 444 of the Internal Revenue Code to use a tax year different from both the required tax year and any business purpose tax year. Certain restrictions do apply to this election. In addition, the electing partnership may be required to make a payment representing the value of the extra tax deferral to the partners.

There are a few rules to follow when you are determining your required tax year:

If a partner or group of partners owns more than 50% interest in the company, which makes it a majority interest in the capital and partnership profits, the required tax year will be the tax year of this partner or group of partners. The tax year cannot be changed for the next two years. This should also be determined on the first day of the partnership.
If there is no majority interest tax year then you use the tax year of all the principal partners who have a more than 5% interest in the capital and partnership profits.
If there is no majority interest tax year and the principal partners don’t have the same tax year then you have to use the tax year that has the least aggregate deferral of income to it’s partners.

This is a method that IRS recommends after everything fails. Basically you collect all the different tax years of the partners. For e.g., one partner might use Dec. 31st, but someone else might use March 31st or May 31st. You now pick one partner, Joe with a tax year ending March 31st. And now you use everyone else’s tax year to determine the difference in the months with Joe’s. For e.g., Mike’s tax year ends on Nov. 30. For our example we will suppose that there are only two partners, Joe and Mike. They both own 50% of stock in the company. Now you count forward from the end of Joe’s tax year to the end of Mike’s tax year. Joe’s tax year ends on March 31st. So you start counting from April, May, June, July, August, September, October, and November. Now you count the month listed above and you get 8. You multiply .50 (50%) by 8, which equals 4.0. This is the aggregate deferral for Mike. You do the same thing using Mike’s tax year and counting forward to the end of Joe’s tax year. This time you get 4 (December, January, February, and March). You multiply .50 by 4, which equals 2.0. This is the aggregate deferral for Joe. The least aggregate deferral belongs to Joe, so the partnership will use his tax year ending on March 31st and beginning on April 1st.

All of this is not as simple as it sounds but we hope that we have made the process easier for you. If a partnership changes it’s tax year in the middle of a previous tax year that they were using then they have to file a short term period return. This is usually the form 1065.