Picking a tax year for partnership is tougher than it sounds
By Cora M. Barnhart • Bankrate.com

Oct. 7, 1999 -- So you thought that getting your partners to agree on a wallpaper pattern for your front lobby was tough? Hope you've already determined your partnership's tax year.

Partners, like other business owners, have to base taxable income on an annual accounting period called a tax year. However, the IRS imposes constraints on the tax year that partners can select. As this tax tip explains, most partnerships must use what is referred to as "a required tax year." This involves determining whether you have a majority interest or principal partners. If you determine that your partnership has neither of these, this tip will guide you through the tricky procedure of choosing a tax year based on "least aggregate deferral of income."

A taxpayer who files a first tax return based on the calendar year can get stuck with it. If the taxpayer later begins a business as a sole proprietor, becomes a partner in a partnership, or becomes a shareholder in an S corporation, the taxpayer must continue to use the calendar year -- unless the IRS approves a change.

On the other hand, if you select an accounting period of 12 consecutive months ending on the last day of any month other than December, the tax year you've chosen is a fiscal year. A 52-53 week tax year is a fiscal year that varies from 52 to 53 weeks. Once a business owner selects a fiscal year, that owner must maintain books and records and report income and expenses using the same tax year each time.

If you are a business owner who has decided to use a fiscal year, you can elect to use a 52-53 week tax year as long as you report your records, income and expenses along those lines. Your tax year will be 52 or 53 weeks long and will always end on the same day of the week. (There might be 53 because some years have, for example, 53 Fridays in them.) This same day of the week will either be the one that last occurs in a particular month or is closest to the last day of a particular calendar month.

To help befuddled partners, the IRS provides rules to help partnerships determine their required tax year. First, the partnership needs to see if it has a majority interest tax year. If a partnership already has one or more partners who follow the same tax year and their share of partnership profits exceed 50 percent (a majority interest), the partnership simply uses the tax year of those partners.

That's great if the big shots in your business all follow the same tax year, but what happens in a situation where there isn't a clearly defined majority interest? The IRS says the partnership needs to identify its principal partners and use their tax year. The IRS defines a principal partner as one who has a 5 percent or more share of the partnership.

Finding the year that defers the least income
What if it just isn't your day and your principal partners don't follow the same tax year? The IRS has a solution for you, too -- but it's a three-step doozy.

This strategy involves finding the tax year that results in the least aggregate deferral of income to the partners.

Step 1: Select one partner's tax year. Now figure the number of months of deferral for each partner using that tax year. This means that you have to count the months from the end of that tax year forward to the end of every other partner's tax year. In other words, starting at the end of each partner's tax year, how many months do you count going back through the year before you get to the end of the partner's tax year you are considering? (See the example below.)

Step 2: Multiply each partner's months of deferral figured in Step 1 by that partner's interest in the partnership profits for the year used in Step 1.

Step 3: Add the amounts in Step 2 to get the total deferral for the tax year used in Step 1.

Now, 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 number in step (3) above is the tax year that must be used by the partnership. According to the IRS, "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 qualifying years is the partnership's existing tax year, the partnership must continue to use that tax year.

Are you confused? Working through the following example will help you think about how to set up this process for your own partnership.

Example: Suppose that Tom and Jerry each hold a 50 percent share in a partnership. Tom uses a calendar year, so his year ends Dec. 31. Jerry follows a fiscal year ending Nov. 30.

Start with Step 1 and select a partner's tax year. Let's start with Tom's tax year, which ends on Dec. 31. Now figure the number of months of deferral for each partner using that tax year. For Tom, since this is his tax year, there are no months of deferral. However, in Jerry's case, if we start with Nov. 30 and count backward, it is 11 months until we hit the end of Tom's tax year.

Second, multiply each partner's months of deferral figured in Step 1 by that partner's share of the business. Tom has a 50 percent share and 0 months deferral, so this product is zero. Jerry has a 50 percent share and 11 months' deferral, so this product is 5.5. Now, we add the amounts from Step 2 (0 + 5.5 = 5.5) to get the total deferral for Tom's tax year. This amount is also 5.5.

How does this compare to aggregate income deferred using Jerry's tax year? Repeat the process used above, but start by using Jerry's tax year, which ends on Nov. 30. Now figure the number of months of deferral for each partner using that tax year. For Tom, if we start with Dec. 31 and count backward, it is one month until we hit the end of Jerry's tax year, Nov. 30. For Jerry, since this is his tax year, there are no months of deferral.

Second, we have to multiply each partner's months of deferral figured in Step 1 by that partner's share of the business. Tom has a 50 percent share and one month deferral, so this product is 0.5. Jerry has a 50 percent share and zero months' deferral, so this product is 0. Now, we add the amounts from step (2) (0.5 + 0 = 0.5) to get the total deferral for Jerry's tax year. This amount is 0.5.

In this particular situation, the partnership must change its tax year to a fiscal year ending Nov. 30. The reason? Following the steps described above, this year results in a smaller aggregate deferral of income (0.5) than using the calendar year (5.5).

Picking out wallpaper never looked so easy, did it?

-- Posted Oct. 7, 1999