Personal Service Corporations

Transcription

1 T20 2/ Personal Service Corporations TABLE OF CONTENTS KEY ISSUE DESCRIPTION PAGE Introduction A Defining a PSC for Tax Year Purposes Calendar-year Requirement Use of Week Year Minimum Distribution Requirements for PSCs Using a Fiscal Year B Defining a PSC for Accounting Method and Tax Rate Purposes Function and Ownership Tests Qualification Not Always Clear Consulting Services Accounting and Engineering Services Defining a Health Field for PSC Purposes Performing Arts Services Qualified PSC Can Generally Use the Cash Method of Accounting Qualified PSC Is Taxed at a Flat 35% Rate Avoiding the 35% Tax Rate Compensation to Shareholders Must Be Reasonable Accumulated Earnings Tax Exemption IncludingaPSCinanAffiliatedGroup C Completing Form 1120 for a PSC Identifying a PSC on Form Reporting Rules for PSCs D Distinguishing PSCs from Professional Corporations ILLUSTRATION 1-1 Quick Reference Table for PSC Rules Introduction Many individuals in the business of performing personal services have chosen to operate their business in corporate form, either individually or as small groups of individuals in the same business or profession. The IRS and Congress believed that many such decisions are made to gain certain tax advantages, such as the graduated corporate tax rate, the ability to deduct business expenses that would otherwise be subject to the limitations on miscellaneous itemized deductions, or the use of corporate retirement and fringe benefit plans. Therefore, Introduction

2 1-2 T20 2/18 Congress enacted significant legislation to limit these advantages. The designation of certain corporations as personal service corporations (PSCs) is one of these limiting factors. Neither Congress nor the Treasury has provided a single controlling definition of a PSC, and numerous references to PSCs are found in the Code and regulations (see Table T805). However, many of these do not contain a definition, but rather a cross-reference to other Code sections and regulations. The multiple definitions result in some entities being affected by all of the provisions dealing with PSCs while others are affected by only some of them. In other words, a corporation may be classified as a PSC under one section of the Code, but fall outside the definition under other sections. See Illustration 1-1 for a quick reference table of the PSC rules. This chapter focuses on the definitions of a PSC under IRC Sec. 441(i), relating to the corporation s ability to use a fiscal year (see Key Issue 1A), and IRC Sec. 448(d)(2). Qualifying as a PSC under IRC Sec. 448(d)(2) can be both good and bad such a PSC can generally use the cash method of accounting, but is not entitled to use the corporate graduated tax rates and is instead taxed at a flat 35% rate (see Key Issue 1B). Throughout the chapter, a PSC as defined under IRC Sec. 441(i) will be called a PSC, and a PSC, as defined in IRC Sec. 448(d)(2) will be called a qualified PSC. Note: The IRS Business Consultants Audit Technique Guide contains a section on determining if a corporation meets the definition of a qualified PSC in light of a corporation s desire to qualify as a PSC in order to use the cash method of accounting, or not being considered a PSC in order to use the graduated tax rates. The guide can be accessed at by searching for business consultants audit techniques guide. When preparing Form 1120 (U.S. Corporation Income Tax Return), it is important for the practitioner to examine the various definitions of a PSC and determine which ones affect that client. A practitioner preparing the tax return for the corporation of a professional such as a physician or attorney should not assume that all of the provisions relating to a PSC apply. Misclassification of a corporation under these varying definitions can result in substantial tax problems. See Key Issue 1C for more on identifying the corporation as a PSC on Form Observation: A completely different definition applies to PSCs subject to the passive activity loss (PAL) rules. For this purpose, a PSC is defined as a corporation whose principal activity for the prior tax year is the performance of personal services substantially performed by employee-owners owning any of the corporation s stock on the last day of the prior year [IRC Sec. 469(j)(2)]. IRC Sec. 469(a) limits the deductibility of net passive losses of certain closely held C corporations. For these corporations, losses from a passive activity can be used only to offset passive activity income. Any disallowed loss is suspended and carried forward indefinitely until passive income can be offset against generated passive income, or a passive activity with current or suspended losses is sold in a taxable transaction [IRC Secs. 469(b) and 469(g)]. See Chapter 8 for a discussion of the passive activity loss rules as they pertain to PSCs. All states have professional association or corporation acts authorizing certain professionals to practice in corporate form. Key Issue 1D describes the differences between PSCs and professional corporations. See Checklist C304 for a summary of the steps in determining whether a corporation is a PSC. Table T809 addresses additional issues related to PSCs, such as reasonable compensation and passive activity losses. References Rev. Procs , CB 815; , CB 859; , IRB; and , IRB Rev. Rul , CB 61. Alron Engineering & Testing Corp., TC Memo (2000). Applied Research Associates and Affiliate, 143 TC No. 17 (2014). Brinks Gilson & Lione A Professional Corp. v. Comm., TC Memo (2016). Eure, W.W., M.D., TC Memo (2007). Grutman-Mazler Engineering, Inc., TC Memo (2008). Kraatz & Craig Surveying, Inc., 134 TC 167 (2010). Pediatric Surgical Associates, P.C., TC Memo (2001). Rainbow Tax Service, Inc., 128 TC 42 (2007). Reza Zia-Ahmadi, et ux. v. Comm., TC Summary Opinion (2017). Introduction

3 T20 2/ It is taxed at a flat rate of 35% on all of its taxable income [IRC Sec. 11(b)(2)]. Law Change Alert: The 2017 Tax Cuts & Jobs Act (TCJA) eliminates the corporate graduated tax rates, and imposes a flat rate of 21%, down from a maximum rate of 35%. While the law indicates that the change is effective for tax years beginning after December 31, 2017, fiscal-year corporations with tax years that begin after that date will have the benefit of a blended rate under existing IRC Sec. 15. IRC Sec. 15(a) provides that if there is a change in the rate of tax imposed, and the tax year includes the effective date of the change (unless that date is the first day of the tax year), then two tentative taxes are computed by applyingtheratefortheperiodbeforetheeffectivedateofthechange,andtheratefortheperiodonandaftersuch date, to the taxable income for the entire year. The tax for this straddle year then is the sum of the prorated tax by the number of days in each period over the number of days in the entire year. Caution: Taxpayers should monitor the IRS for the issuance of expected regulations or other guidance that impacts the new tax law. Function and Ownership Tests A corporation must meet both a function and an ownership test to be a qualified PSC for cash method purposes [IRC Sec. 448(d)(2); Temp. Reg T(e)]: 1. Substantially all (95% or more) of the time spent by employees must be devoted to the performance of services in the fields of health (including veterinarians), law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts, or consulting. 2. Substantially all of the value of the corporation s stock (95% or more) must be held (directly or indirectly) at all times during the tax year by current or retired employees who perform(ed) the services, or by their estates or beneficiaries (but only for a two-year period). This definition is the one that controls for notification to the IRS on line 2 of Schedule J, Form 1120 (Tax Computation and Payment) of a corporation s status as a qualified PSC. (See Key Issue 1C.) See Checklist C304 for a summary of the steps in determining whether a corporation is a PSC. Example 1B-1 Meeting the ownership and function tests. Assume the same facts as in Example 1A-1. Bildrite does not meet the ownership test because Jack Moore holdslessthan95%ofitsstock;therefore,bildriteisnotaqualified PSC. Bildrite will pay tax at the regular corporate rates and will have to use the accrual method of accounting unless it meets other exceptions. Variation: Assume instead that Jack Moore owns 100% of the stock. Bildrite now meets the ownership test because Moore provides architectural services and owns 95% or more of the stock. If Bildrite also meets the function test, then it will be a qualified PSC. Bildrite will need to determine if substantially all of its services involve the performance of services in the architectural field. To do this, Bildrite will need to analyze how much time its employees spent building homes, and how much time its architect spent providing architectural services, to determine whether 95% or more of itsservicesareinthearchitecturalfield. Qualification Not Always Clear In many situations, it may not be clear if an entity meets the definition of a qualified PSC. In such cases, the practitioner will have to exercise professional judgment. The determination should only be made, on an annual basis, after a careful review of the examples provided in Temp. Reg T(e) and other IRS guidance. The following example is based on facts in Alron Engineering & Testing Corp. and illustrates the importance of analyzing a corporation s activities before deciding it is a PSC. Example 1B-2 Testing for qualified PSC status by examining the corporation s activities. ABC, Inc. is a C corporation that conducts geotechnical testing and provides engineering services. Approximately 20% of ABC professional services were spent in the area of geotechnical testing and the remaining 80% were spent in providing customary engineering services. Bill Smith owns 100% of ABC stock. Smith is an engineer and works full-time for ABC. ABC s average annual gross receipts are $5.5 million. The Section 448(d)(2) definition of a PSC requires that substantially all (defined as 95% or more) of a taxpayer s activities must be devoted to certain professions, one of which is the field of engineering. (See Key Issue 1B

4 1-6 T20 2/18 Function and Ownership Tests earlier in this key issue.) Therefore, if ABC spends at least 95% of its time performing engineering services it will be considered a PSC and will pay tax at a flat rate of 35%. The main question, then, is whether geotechnical testing is considered to be in the field of engineering. In Alron Engineering & Testing Corp., the court held that geotechnical testing services are not within the field of engineering, nor are they incident to engineering. Such services are not dependent upon the corporation s ability to provide engineering services. Since over 5% of ABC s activities were spent in a field not considered to be engineering services, ABC is not a qualified PSC and will pay tax at the normal corporate tax rates. In Reza Zia-Ahmadi, the IRS argued that an ultrasound company was a PSC and used a 35% tax rate to recalculate its liabilities. The company claimed that it was not a PSC because its employees were not required to be licensed as health care professionals in the state, did not provide direct treatment services to patients, and did not make health care decisions. The Tax Court disagreed, holding that ultrasound services fall within the health profession. Consulting Services Consulting includes the provision of advice and counsel, but does not include sales or brokerage services, or economically similar services [Temp. Reg T(e)(4)(iv)]. For example, assume that a company helps clients determine their data processing needs. It is engaged in consulting services if it does not provide additional services distinct from its recommendations. If the company orders data processing equipment for the client and is compensated based on the equipment orders, it is engaged in sales, not consulting. A corporation that provided educational training courses and educational materials to computer users was not performing consulting services, nor was another corporation that provided lobbying to influence the outcome of legislation or administrative actions (Ltr. Ruls and ). In both rulings, the services did not involve giving advice to clients. On the other hand, graphic design, lighting design, marketing consulting, and merchandising services came within the definition of consulting, because they involved providing advice and counsel to clients, and not sales, brokerage, or economically similar services (Ltr. Rul ). Accounting and Engineering Services In Ron Lykins, Inc., the IRS found that a corporation owned by a CPA should be characterized as a PSC. Lykins, Inc. focused on tax preparation and advice and operated as a C corporation. The practice expanded to providing financial and investment advice on a commission basis. Lykins formed a single-member LLC (Lykins Financial) to separate those services from the tax preparation services. The two businesses filed separate income tax returns. The employees salaries of both firms, as well as the related payroll taxes and benefits, were paid by the tax preparation corporation. The IRS concluded that Lykins, Inc. was a PSC since Lykins clearly met the ownership test and was an employee who performed more than de minimis accounting services for the corporation. The IRS also found that Lykins, Inc. met the 95% function test because employees who generated commission income were employees of Lykins Financial at that time rather than of Lykins, Inc. The court, however, by applying common law principles based on control, found that the employees were considered to be employees of Lykins, Inc. at all times. Even though some spent time working on Lykins Financial activities, they remained under the control of Lykins, Inc. A breakdown of Lykins, Inc. employees hours showed that only 80.53% were spent on accounting services. Therefore, the 95% function test was not met and Lykins, Inc. should not be characterized as a PSC. Many professional corporations perform certain types of work that are not considered services provided in one of the specified fields. If it can be shown that these unrelated services constitute more than 5% of the overall services provided by the corporation, it will not meet the definitionof a qualified PSC. For instance, in Ltr. Rul , the IRS ruled a full-service business valuation firm was not engaged in performing services in the field of consulting because none of the examples in Temp. Reg T specifically identify such services as being subject to the PSC rules. However, in Rainbow Tax Services, tax return preparation and bookkeeping services were found to be analogous to accounting services and therefore subject to the PSC rules of IRC Secs. 448(d)(2) and 11(b)(2). In Grutman-Mazler Engineering, the taxpayer argued that services performed by its planning department did not constitute engineering services, thus at least 95% of the services performed by its employees were not performed in the field of engineering. However, the court found that the planning department activities, which included submitting designs, plans, tentative tract maps, grading plans, and other engineering reports, fell within the applicable state law s definition of civil engineering. The fact that some of the planning department s subordinate Key Issue 1B

5 T20 2/ employees did not hold engineering licenses did not preclude them from performing engineering services. As a result, the corporation was a qualified PSC and subject to the 35% flat tax rate. Another case also illustrates the point that individuals engaged in the specified professional activities do not need to be licensed in that particular field. In Kraatz & Craig Surveying, none of the corporation s employees were licensed engineers. However, surveying services performed by the land surveying corporation were considered services performed within the field of engineering under IRC Sec. 448(d)(2) even though it didn t perform any services required to be performed by licensed engineers under state law. The Tax Court found the corporation was a PSC, stating that surveying was traditionally regarded as within the field of engineering. The Court stated that the issue was one to be decided by the facts and circumstances rather than by state licensing laws. Defining a Health Field for PSC Purposes According to IRC Sec. 448(d)(2), for a corporation to be a qualified PSC, substantially all of its activities must involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (i.e., the function test). Temp. Reg T(e)(4)(ii) states that the performance of services in the health field means medical services provided by physicians, nurses, dentists, and other similar health-care professionals. The definition of PSC under IRC Sec. 441(i) (relating to the use of fiscal years) also refers to Temp. Reg T(e)(4)(ii) [Reg (d)]. A Tax Court case illustrates the broad definition of health services for purposes of IRC Sec. 448(d)(2) (Eure, W.W.). In this case, a physician owned 100% of a radiation therapy corporation and argued that its activities as a facility rather than a person precluded it from being subject to the 35% flat tax rate. However, the court held that the taxpayer met the definition of a qualified PSC because it was a corporation with its employees spending 95% or more of their time in the performance of direct or incidental health related services. The facility argument was disproved by the fact that the employees were treating patients health care needs, and the fact that over 5% of employees services might have been spent in operating and maintaining radiation equipment did not matter because those activities were incidental to the therapy services. The IRS has ruled that performance of services in the field of health also includes services provided by veterinarians (Rev. Rul ). The IRS has also ruled that a corporation that provided emergency medical ambulance service was a PSC because its technicians devoted substantially all of their time to providing medical services (Ltr. Rul ). Similarly, a corporation that provided physical therapy services to its clients, with all clients obtained through physician referral or prescription, was a PSC subject to the top corporate tax rate (Ltr. Rul ). Performing Arts Services One of the fields listed in Reg T(e)(4) that would be considered an activity constituting a personal service activity is the field of performing arts. The performance of services in the field of the performing arts means the provision of services by actors, actresses, singers, musicians, entertainers, and similar artists in their capacity as performing artists. However, Reg T(e)(4)(iii) specifically excludes activities in the following cases: 1. Persons who themselves are not performing artists (e.g., persons who may manage or promote those artists, and other persons in a trade or business that relates to the performing arts). 2. Persons who broadcast or otherwise disseminate the performances of those artists to members of the public (e.g., employees of a radio station that broadcasts the performances of musicians and singers). 3. Athletes. Qualified PSC Can Generally Use the Cash Method of Accounting A qualified PSC can generally use the cash method of accounting regardless of the amount of its gross receipts [IRC Sec. 448(b)(2)]. (This allows PSCs in the business of rendering professional services to use the cash method, even if their gross receipts exceed the $5 million threshold under IRC Sec. 448.) Even so, the qualified PSC rules do not affect the requirement that the corporation must use an accounting method that clearly reflects income. Therefore, a PSC that maintains inventory must use an accounting method that correctly accounts for its sales and purchases. This may require the use of the accrual method in certain instances. Some practitioners have construed the PSC statutory cash method privilege as implying that every corporation conducting services in one of the licensed professions (health, law, engineering, accounting, architecture, and Key Issue 1B

6 1-8 T20 2/18 actuarial science) is always entitled to the cash method. However, the Section 448 rules do not apply to the general requirements of Reg (c)(2), which hold that an accrual method must be used with regard to the purchase and sale of inventory [Temp. Reg T(c)]. Nevertheless, C corporations with a principal business activity of professional services and with gross receipts equal to or less than $5 million should qualify for the cash method under the $10 million privilege of Rev. Procs , , and This means that a C corporation with over $5 million of average annual gross receipts could be forced to the accrual method if its activities begin to involve the sale of goods and it fails to meet the qualified PSC definition. See Chapter 3 for additional information on accounting methods. For the proper accounting methods to use when inventory is present and the gross receipts exceptions to the accrual method, see Key Issues 3B and 3D. Qualified PSC Is Taxed at a Flat 35% Rate A qualified PSC is taxed at a flat 35% [IRC Sec. 11(b)(2)]. Thus, it cannot use the graduated tax rates available to regular C corporations. Practice Tip: A frequent aggressive strategy for clients facing the 35% PSC tax rate is to assure that taxable income is reduced to zero each year-end. This requires careful tax planning for cash method corporations literally on the last day of the year. However, a more conservative approach provides the investors with some return on their invested capital. Practitioners should work with their clients throughout the year to determine the targeted taxable income considering the number and contribution of employees, market compensation rates, amount of invested capital, and the appropriate return on invested capital. A plan to achieve the targeted taxable income should be implemented. A PSC planning for low taxable income should be advised to forgo making any charitable contributions. Corporate charitable contributions are limited to 10% of taxable income and, consequently, with low taxable income planned for each year, charitable contribution deductions may be greatly reduced. Rather, the corporation s shareholders should personally make all charitable contributions. Also, a PSC that annually targets low taxable income will find that its ability to claim Section 179 depreciation deductions for equipment additions. Under IRC Sec. 179(b)(3), the deduction is limited to the taxable income of the entity for the tax year. Finally, any PSC should consider the risk of excess compensation to shareholders in their tax planning. Reasonable compensation to shareholders is discussed later in this Key Issue. Avoiding the 35% Tax Rate A corporation may wish to fail either the function or the ownership test discussed earlier to avoid the 35% tax rate imposed by IRC Sec. 11(b)(2). One method of failing the ownership test is illustrated in Temp. Reg T(e)(5), Ex. 6. Since the family attribution rules of IRC Sec. 318 are not considered when applying the function and ownership tests of IRC Sec. 448(d)(2), the 95% ownership test would not be met if more than 5% of the corporation s stock were transferred to a nonemployee spouse or child of the taxpayer. However, such transfer of ownership must not occur solely by operation of community property laws. Also, the professional corporation laws of most states require all shareholders of a professional corporation to be licensed professionals in that field of business. Thus, the transfer of stock to an unlicensed spouse or child may not be allowed under state law. Furthermore, the person receiving the stock must be the true owner of the shares, rather than merely holding legal title. (See FSA ) Warning: The definitions in IRC Secs. 441(i) and 448(d)(2) cannot be substituted for each other. Thus, a corporation meeting the Section 448(d)(2) definition of a qualified PSC cannot avoid the imposition of the flat 35% tax rate by saying it does not meet the Section 441(i) definition of a PSC (Ltr. Rul ). In addition, the definition of a qualified PSC is exactly the same for both the requirement to use the 35% flat tax rate and the ability to use the cash method of accounting. A larger corporation using the cash method of accounting should take this into consideration before arguing that it is not a qualified PSC for purposes of the 35% tax rate. The required change to the accrual method of accounting may be more costly in the long run than the higher tax rate. Compensation to Shareholders Must Be Reasonable Few qualified PSCs will want to accumulate income in the corporation and pay tax at a flat 35% rate. Some corporations use a technique called income stripping to remove income from the corporation so that, by the last day of the tax year, little or no income remains. This is sometimes done by paying large year-end bonuses, management fees, or directors fees. However, large year-end distributions, even in the form of compensation, may look to the IRS like earnings distributions (rather than compensation for services) and could result in Key Issue 1B

7 T20 2/ Tax Years TABLE OF CONTENTS KEY ISSUE DESCRIPTION PAGE Introduction A Selecting and Adopting a Tax Year Selecting an Acceptable Tax Year Specific Instructions for Period Covered Tax Year Affects Available Tax Provisions B Requesting Approval for a Change in Tax Year Changes Not Qualifying for Automatic Change Procedures Required Agreements and Adjustments C Automatic Approval for a Tax Year Change Automatic Method Change Eligibility Using Automatic Approval Procedures D Short Tax Years and Annualization of Short-period Income Short Tax Years Annualization of Short-period Income Annualizing Income under the General Rule and Exception Methods Filing for Refund under Exception Method Other Considerations When Annualizing Income E Tax Year of Corporation Joining a Consolidated Group F Business Purpose Fiscal and Calendar Years for PSCs Calendar Year Generally Required Fiscal Year Based on Establishing Natural Business Year Fiscal Year Based on Facts and Circumstances Back-up Section 444 Election G PSC Election of a Tax Year Other than a Required Year (Section 444 Election) Tiered Structures Making the Election Making a Back-up Election Terminating the Election H Minimum Distribution Requirement for PSCs Making the Section 444 Election Determining Whether Requirements Have Been Met Table of Contents

8 2-2 T20 2/18 ILLUSTRATION Calculating the Limitation on the Deduction Worksheet for Annualization of Income Computing Minimum Distribution Requirement (Form 1120, Schedule H) Introduction IRC Sec. 441(b) provides that the term taxable year generally means the taxpayer s annual accounting period, whether a calendar or fiscal year, or, if applicable, the taxpayer s required tax year. C corporations are generally allowed to use any tax year. However, personal service corporations (PSCs) are normally required to file on a calendar-year basis [IRC Sec. 441(i)]. An exception to this rule exists if the PSC can establish a business reason for a fiscal year or makes an election under IRC Sec. 444 and agrees to certain conditions that may limit its deduction for amounts paid to employee-owners. (See Chapter 1 for a further discussion of PSCs.) The IRS has imposed specific procedures and requirements under IRC Secs. 441 and 442 for adopting or changing year-ends. Most tax years consist of 12 months or weeks; however, a corporation can have a short tax year (a year of less than 12 months) in its initial or final tax year or if it changes its tax year. This chapter addresses the requirements necessary to establish a tax year and the procedures for adopting or changing tax years. References Rev. Procs , CB 643; , CB 1046; , CB 856; , CB 1050; , CB 851; , CB 859; and , CB 818. Rev. Ruls , CB 297; , CB 205; and 87-57, CB 117. Politte, M.D., Lenard L., Inc., 101 TC 359 (1993), taxpayer appeal dismissed 42 F.3d 1395 (8th Cir. 1994). KEY ISSUE 2A Selecting and Adopting a Tax Year. All business entities must establish an annual period as a tax year. Technically, this is done by (1) maintaining books and records on that period, and (2) filing the initial tax return based on that period. The tax year does not have to be the same for tax and financial reporting purposes it need only coincide with records that reflect income adequately and clearly on an annual basis [Reg (b)(7)]. Thus, a reconciliation of data prepared on a calendar-year basis for financial reporting to a fiscal-year basis for tax reporting are books and records that support the use of a fiscal year for tax purposes. A taxpayer without books and records must use a calendar year for tax reporting [IRC Sec. 441(g)]. Selecting an Acceptable Tax Year New corporations may normally select one of the following types of tax years: (1) calendar year, (2) fiscal year, or (3) week year [IRC Sec. 441(b) and (f)]. As noted in Key Issue 2F, new personal service corporations (PSCs) are generally limited to a calendar year unless they elect a fiscal year [IRC Secs. 441(i) and 444]. When a corporation is included in a consolidated return as a member of an affiliated group, it must have the same tax year as its parent [Reg (a)]. Generally, a new corporation may adopt a calendar year or fiscal year as its tax year, as long as it coincides with the taxpayer s books and records [IRC Sec. 441(a)]. Except in the case of a week year (i.e., a year that always ends on the same day of the week, such as the last Friday of December), a fiscal year must end on the last day of a month [IRC Sec. 441(e)]. A corporation must adopt a tax year by the due date (not including extensions) of the return for the corporation s first tax year [Reg (c)(1)]. The filing of Form 7004 (Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns) or Form SS-4 (Application for Employer Identification Number), or the payment of estimated taxes for a particular tax year, do not constitute an adoption of that tax year. It is important to choose the desired fiscal year in the first tax return. The failure to properly elect a fiscal Introduction

9 T20 2/ year would give the corporation a calendar year by default. Furthermore, a later change of tax year (presumably) could be made only with IRS approval. The initial return cannot include more than 12 months but may include less, resulting in a short year [IRC Sec. 441(b); Reg (a)(2)]. Specific Instructions for Period Covered Practitioners should use the 2017 Form 1120 for calendar year 2017 and fiscal years that begin in 2017 and end in For a fiscal or short tax year return, fill in the tax year space at the top of the Form The 2017 Form 1120 can also be used if the (1) corporation has a tax year of less than 12 months that begins and ends in 2018, and (2) 2018 Form 1120 is not available at the time the corporation is required to file its return. In the latter case, the corporation must show its 2018 tax year on the 2017 Form 1120 and take into account any tax law changes that are effective for tax years beginning after December 31, Tax Year Affects Available Tax Provisions The available tax provisions may be based on a calendar year or the business s tax year. Two good examples are bonus depreciation, which is based on a calendar year, and Section 179 expensing, where the deduction limits are based on the corporation s tax year. Assume, for example, that 50% bonus depreciation is available in Year 1 and 25% bonus deprecation is available in Year 2, while the Section 179 limits are $100,000 for tax years beginning in Year 1 but only $50,000 for tax years beginning in Year 2. Fiscal-year corporations could place qualifying assets in service after December 31 of Year 1 and still get a $100,000 Section 179 deduction, as long as they did so by the end of the fiscal year ending in Year 2. But to claim 50% bonus depreciation, they would have to place the assets in service by December 31 of Year 1. (See Key Issue 14I for the actual Section 179 limits.) Practitioners must carefully consider the effective dates of various tax provisions. Some tax provisions may expire, and some may be extended by Congress and reinstated retroactively. In addition, some changes in the law or procedural rules may pertain to a particular date rather than a tax year. The bottom line is that a practitioner cannot assume that the same effective dates will apply to all the tax provisions being considered for a particular year. Law Change Alert: The 2017 Tax Cuts & Jobs Act (TCJA) eliminates the corporate graduated tax rates, and imposes a flat rate of 21%, down from a maximum rate of 35%. While the law indicates that the change is effective for tax years beginning after December 31, 2017, fiscal-year corporations with tax years that begin after that date will have the benefit of a blended rate under existing IRC Sec. 15. IRC Sec. 15(a) provides that if there is a change in the rate of tax imposed, and the tax year includes the effective date of the change (unless that date is the first day of the tax year), then two tentative taxes are computed by applyingtheratefortheperiodbeforetheeffectivedateofthechange,andtheratefortheperiodonandaftersuch date, to the taxable income for the entire year. The tax for this straddle year then is the sum of the prorated tax by the number of days in each period over the number of days in the entire year. Caution: Taxpayers should monitor the IRS for the issuance of expected regulations or other guidance that impacts the new tax law. KEY ISSUE 2B Requesting Approval for a Change in Tax Year. A different corporate tax year may be desirable because circumstances have changed or perhaps the initial tax year was not well chosen. For discussion of the relevant considerations, see Chapter 5 of PPC s Tax Planning Guide Closely Held Corporations. The time and manner of filing an application to adopt, change, or retain an annual accounting period is not covered under the regulations [Reg (b)(3)]. Instead, the following revenue procedures have been issued: Rev. Proc addresses changing a business year if the automatic approval procedures do not apply see the following discussion in this key issue. Rev. Proc covers automatic approval for a year-end change see Key Issue 2C. Rev. Proc discusses automatic approval procedures for personal service corporations (PSCs) see Key Issue 2G as well as partnerships and S corporations. Key Issue 2B

10 2-4 T20 2/18 Generally, prior IRS approval is required to change the tax year of a C corporation (IRC Sec. 442). However, if certain conditions are met, a change in tax year may qualify for automatic approval. See Key Issue 2C for a discussion concerning the situations that qualify for automatic approval. Changes Not Qualifying for Automatic Change Procedures A change in year-end generally will be allowed only when the corporation establishes a substantial business purpose for the change. Rev. Proc sets forth procedures and clarifies terms, provides safe harbor rules, and provides examples for the annual business cycle and the seasonal business cycle tests that are used to show substantial business purpose. Also, the revenue procedure notes that taxpayers not in existence for three tax years can satisfy the annual business cycle and seasonal business tests by providing information other than prior year s gross receipts. In addition, taxpayers (other than taxpayers with a required tax year) that demonstrate nontax reasons and accept additional terms and conditions that eliminate substantial income distortion may obtain approval to change their tax year-end. Application for permission to change an accounting period must be submitted on Form 1128 (Application To Adopt, Change, or Retain a Tax Year). Form 1128 must be filed no earlier than the day following the end of the first effective tax year and no later than the due date of the return (not including extensions) of the tax return for the first effective tax year (Rev. Proc , Sec. 6.02). The first effective tax year would normally be the short year resulting from the requested change. According to Sec of Rev. Proc , corporations wanting to establish a natural business year under the annual business cycle or seasonal business tests must provide gross receipts from sales or services and approximate inventory costs (when applicable) for each month in the requested short period and for each month of the preceding three tax years. Corporations wanting to establish a natural business year under the 25% gross receipts test must supply gross receipts for the most recent 47 months for themselves or any predecessor. If the taxpayer cannot file under the automatic approval rules, the Form 1128 is considered a ruling request and must be filed, along with the appropriate user fee, with the National Office at the appropriate address listed in the instructions to the most recent Form See Chapter 5 of PPC s Tax Planning Guide Closely Held Corporations for a discussion of meeting the business purpose tests as well as tax planning ideas related to both automatic and nonautomatic changes to a tax year. Required Agreements and Adjustments A corporation seeking a change in tax year must agree to terms, conditions, and adjustments necessary to prevent a substantial distortion of income [Reg (b)(2) and (3)]. Examples of items that substantially distort income include deferring a substantial portion of income to a future year, shifting of a substantial portion of deductions from one year to another, or creating a short period in which there is a substantial amount of income to offset an expiring net operating loss (NOL) or credit. Rev. Proc modified the rules pertaining to NOLs provided in Rev. Proc An NOL in the short period required to effect a change in tax year-end cannot be carried back, but must be carried forward under IRC Sec. 172, beginning with the first tax year after the short period. However, the short period NOL must be carried back or over in accordance with IRC Sec. 172 if it is either (1) $50,000 or less, or (2) less than the NOL generated for the full 12-month period beginning with the first day of the short period. The taxpayer must wait until this 12-month period has expired to determine whether it qualifies for the exception. KEY ISSUE 2C Automatic Approval for a Tax Year Change. Generally, a corporation must establish a business purpose to change its tax year (see Key Issue 2B). This key issue discusses how a corporation can obtain automatic approval to change its tax year without having to establish a business purpose. Rev. Proc (as modified by Rev. Proc ) provides exclusive procedures for changing C corporation year-ends without IRS approval. This procedure generally is referred to as automatic approval. Chapter 5 in PPC s Tax Planning Guide Closely Held Corporations discusses this procedure in more detail. Key Issue 2C

11 T20 2/ Tax year changes that do not have to meet a business purpose test and that receive automatic approval if the corporation meets certain conditions include the following: 1. Corporations changing to or retaining a natural business year that satisfies a 25% gross receipts test. 2. Corporations changing to or from a week tax year to or from a year ending with reference to the same calendar month. 3. Corporations joining a consolidated group see Key Issue 2E. 4. Personal service corporations (PSCs) changing to a required tax year, or changing to or retaining a natural business year or a week tax year Key Issue 2F. Automatic Method Change Eligibility In order to use the automatic change procedures, the corporation must not fall into one of the disallowed categories listed in Rev. Proc , Sec Some of the most commonly encountered categories are as follows: 1. The corporation must not have changed its tax year at any time within the last 48 months ending with the calendar year that includes the beginning of the short period required to effect the change. (Presumably, a corporation in existence less than 48 months qualifies if it has not previously changed its tax year.) 2. The corporation must not be an S corporation. 3. The corporation has not attempted to make an S corporation election for the tax year immediately following the short period, unless the change is to a permitted S corporation year. 4. The corporation must not be a personal service corporation (PSC), as defined in IRC Sec. 441(i). However, a C corporation that becomes a PSC must change its tax year to a permitted year (e.g., a calendar year), and this change is automatically approved. (See Rev. Proc ) 5. The corporation must not have an interest in a pass-through entity or a controlled foreign corporation at the end of the first effective year. However, certain interests are allowed [see Rev. Proc , Section 4.02(2)]. 6. The corporation is not a member seeking to exit a consolidated group or requesting to change to a week year that is different from the tax year of the consolidated group (see Rev. Proc , which modifies Rev. Proc on this issue). Rev. Proc , Sec. 4.02, should be closely examined before requesting a change in tax years. Example 2C-1 Changing a tax year with automatic consent. Bass Corporation has had a June 30 year-end since it was incorporated 10 years ago. Bass is considering changing to a calendar year to allow more efficient reconciliations and comparisons of its results to its two brother-sister corporations. The change will result in a six-month short period ending December 31. Bass qualifies under Rev. Proc for automatic consent to change its tax year because of the following: 1. Bass has not changed its tax year within the past 48 months. 2. Bass will not be a member of a partnership or the beneficiary of a pass-through entity as of the end of the short period. 3. Bass is not one of the other shareholders or entities prohibited from using this revenue procedure by Rev. Proc , Section Bass will comply with the conditions under Rev. Proc , Secs and 6. Rev. Proc also allows certain corporations to obtain automatic approval to change their tax years under IRC Sec This procedure applies to corporations wanting to change to or from a week tax year to or from a year ending with reference to the same calendar month. When a corporation wants to change to or from a Key Issue 2C

12 2-6 T20 2/ week year and also wants to change the month with reference to which the tax year ends, it must obtain prior approval from the IRS by filing Form 1128 (Application to Adopt, Change, or Retain a Tax Year). Using Automatic Approval Procedures A corporation using the automatic approval procedures must meet certain filing requirements as outlined in the following example (see Section 7.02 of Rev. Proc ). Example 2C-2 Using automatic approval procedures. JTG Corp. satisfies the 25% gross receipts test and wants to change its year-end from January 31 to March 31 under the automatic approval procedures. The practitioner has determined that the corporation satisfies the eligibility requirements and will comply with the conditions listed in Rev. Proc A corporation that wants to change its tax year using the procedures of Rev. Proc must file Form 1128 (Application To Adopt, Change, or Retain a Tax Year) with the Internal Revenue Service Center, Attention: ENTITY CONTROL, where the corporation files its federal income tax return. Copies of Form 1128 need not be sent to the National Office. A copy of Form 1128 must also be attached to the federal income tax return for the short period required to effect the change. The Form 1128 must be filed on or before the due date (including extensions) for filing the return for the short period required to effect the change. The top of the first page of Form 1128 should be labeled FILED UNDER REV. PROC The Form 1128 must be signed by an authorized officer of the corporation. No user fee is required for an application filed under Rev. Proc If the request for change is denied, the IRS will return the Form 1128 with an explanation (see Sec. 8, Rev. Proc ). KEY ISSUE 2D Short Tax Years and Annualization of Short-period Income. Short Tax Years Corporations are required to file tax returns for periods of less than 12 months in the following instances: 1. Initial Returns. A corporation must file a return for the short period beginning with the date of incorporation and ending with the close of its initial tax year. 2. Final Returns. A return must be filed for the short period beginning with the first day of the corporation s final tax year and ending with the date of termination or dissolution. If the corporation is dissolved, its existence for tax purposes terminates when it ceases to do business and distributes its assets. A corporation may cease to exist for tax purposes even though it has not formally been dissolved for state law purposes. In such cases, the corporation s annual accounting period ends on the date it ceases to have existence for tax purposes. A final tax return is due on the 15th day of the fourth month following the month of termination. 3. Change of Accounting Period. When a corporation changes its year-end, a tax return must be filed for the period beginning on the day after the close of its old tax year and ending at the close of the day before the first day of the new tax year [IRC Sec. 443(a)(1)]. An exception applies to changes to or from a week tax year. If the short period resulting from the change has either less than seven days or more than 358 days, a short-period return is not required for a change to or from a week tax year [Reg (a)(1)]. For a discussion of the rules for filing a short-period return when joining a consolidated group, see Key Issue 2E. Annualization of Short-period Income Taxable income must be placed on an annual basis when the short year is caused by a change in the accounting period. This annualization of income estimates what the income would be for a full year, calculates tax on that amount, and prorates the tax based on the months in the short year [IRC Sec. 443(b)(1)]. Annualization of short-period taxable income is not required if the short period arises from an initial or final return. Example 2D-1 Income required to be annualized. Smallcorp wants to change from a fiscal year ending August 31 to a calendar year ending December 31 effective in The corporation is a general partner in a partnership reporting on a calendar-year basis. Key Issue 2D

13 T20 2/ Notes: a b $1,000,000 [$500,000 ($500,000 + $400,000)] = percentage complete (55.555%) using the cost-to-cost method. Costs include direct and indirect costs. Example 3C-2 Using the simplified cost-to-cost method for income recognition. Stained Glass Inc. (SGI) is a building contractor that started one contract with a value of $500,000 in As of December 31, 2017, SGI had incurred the following costs: Year to Date Estimated Total Costs Direct labor $ 50,000 $ 100,000 Direct materials 200, ,000 Depreciation/amortization 25,000 40,000 $ 275,000 $ 390,000 Using the simplified cost-to-cost method, this contract is % complete ($275,000 $390,000) as of the end of the year. Therefore, SGI recognizes $352,564 ($500, %) of revenue in Note: A taxpayer may elect to delay the application of the PCM until the tax year it has incurred at least 10% of the estimated total allocable contract costs [IRC Sec. 460(b)(5)(B)]. The election is binding for all long-term contracts entered into during and after the election year [IRC Sec. 460(b)(5)(C)]. See Practice Aid O112 for a summary of the construction contractor accounting method gross receipts tests. Look-back Computation The PCM entails estimates of contract costs and price. Consequently, once the contract is completed and final amounts are determined, the taxpayer must recalculate the income for each prior year the contract was in progress (look-back method). The taxpayer must then recalculate the tax that would have been paid had the correct income been used originally. Interest is computed and paid by the taxpayer on the hypothetical tax underpayment or by the IRS on an overpayment [IRC Sec. 460(b)(2); Reg ]. Interest due to the IRS or to be refunded to the taxpayer under the look-back method is calculated and reported on Form 8697 (Interest Computation Under the Look-Back Method for Completed Long-Term Contracts). If interest is due to the IRS, Form 8697 is filed with the taxpayer s income tax return. If an interest refund is due to the taxpayer, Form 8697 is filed separately from the tax return. Any interest paid or refund received is deductible as interest expense, or taxable as interest income, under the taxpayer s normal method of accounting [Reg (f)(2)(ii)]. The look-back method makes no attempt to adjust for any differences in tax rates between the tax years involved. Because only interest is charged or paid at the end of the contract, no additional taxes are due [Reg (a)(1)]. This means taxpayers who allocate more than the proper portion of a contract s income to a low marginal tax rate year and, therefore, less to a higher tax rate year, derive an unintended benefit from their misestimates during the life of the contract. Accordingly, taxpayers are still expected to properly estimate total contract price and costs when reporting income under the PCM for each year of the contract. The look-back method does not apply to a contract for which the PCM is required if it is completed within a two-year period, and has a gross price not exceeding the lesser of (1) $1 million, or (2) 1% of the taxpayer s average gross receipts for the three tax years preceding the tax year in which the contract is completed. Example 3C-3 Determining whether the look-back rule applies. Whitestone, Inc. is a C corporation that does not meet the small contractor exception of IRC Sec. 460(e) and so uses the PCM. Whitestone s average annual gross receipts for the past three years are $10,600,000. Key Issue 3C