A newly formed partnership must adopt its required tax year-end and decide whether it in- tends to use either the cash or accrual method as its overall method of accounting. As dis- cussed in the Business Income, Deductions, and Accounting Methods chapter, an entity’s tax
LO 20-3
34§742.
year-end determines the cutoff date for including income and deductions in a particular re- turn, and its overall accounting method determines when income and deductions are recog- nized for tax purposes. Partnerships must frequently make other tax-related elections as well.
Tax Elections
New partnerships determine their accounting periods and make tax elections, including the election of overall accounting method, the election to expense a portion of organizational ex- penses and start-up costs, and the election to expense tangible personal property. Who for- mally makes all these elections? In theory, either the partnership or the partners themselves could do so. With just a few exceptions, the partnership tax rules rely on the entity theory of partnership taxation and make the partnership responsible for tax elections.35 In many in- stances, the partnership does so in conjunction with filing its annual tax return. For example, it selects an accounting method and determines whether to elect to amortize organizational expenses or start-up costs by simply applying its elections in calculating ordinary business income on its first return. The partnership makes other tax elections by filing a separate docu- ment with the IRS, such as Form 3115 when it elects to change an accounting method.
How will CCS elect its overall accounting method after it begins operations?
Answer: Nicole, Sarah, and Chanzz Inc. may jointly decide on an overall accounting method or, in their LLC operating agreement, they may appoint one of the members to be responsible for making this and other tax elections. Once they have made this decision, CCS makes the election by simply using the chosen accounting method when preparing its first return.
Example 20-12
THE KEY FACTS Partnership Accounting:
Tax Elections, Accounting Periods,
and Methods
• Partnerships are respon- sible for making most tax elections.
• A partnership’s taxable year is the majority interest taxable year, the common taxable year of the principal partners, or the taxable year providing the least aggregate defer- ral to the partners.
• Partnerships are generally eligible to use the cash method unless they have average gross receipts over the three prior years of greater than $25 million and have corporate partners.
Partner’s 12/31 Tax Year-End
Partnership’s 1/31 Tax Year-End
12/31 12/31
Year 1 Year 2
2/1 12/31 1/31
1/1 11 Months
11 Months Year 2
EXHIBIT 20-4 Partner Defers 11 Months of Income for One Year
Accounting Periods
Required Year-Ends Because partners include their share of partnership income or loss in their taxable year ending with the partnership taxable year, or within which the partnership taxable year falls, any partnership tax year other than that of the partners will result in some degree of tax deferral for some or all of the partners.36 Exhibit 20-4 reflects the tax deferral a partner with a calendar year-end would receive if the corresponding partnership had a January 31 year-end.
Because the partner reports the partnership’s year 1 income earned from February 1 until January 31 in the partner’s second calendar year (the year within which the partnership’s January 31 year-end falls), the partner defers reporting for one year the
35§703(b). Certain elections are made at the partner level.
36§706(a).
11 months of income she was allocated from February 1 through December 31 of her first calendar year.
The government’s desire to reduce the aggregate tax deferral of partners (the sum of the deferrals for each individual partner) provides the underlying rationale behind the rules requiring certain partnership taxable year-ends. Partnerships are generally required to use one of three possible tax year-ends.37 As illustrated in Exhibit 20-5, they must fol- low a series of steps to determine the appropriate year-end.
Partnership uses majority interest taxable year.
Partnership uses the principal partners’
taxable year.
Is there a majority interest
tax year? No No
principalDo partners have the
same tax year-end?
Partnership uses tax year with least aggregate deferral.
Yes Yes
EXHIBIT 20-5 Steps to Determine a Partnership’s Year-End
The first potential required tax year is the majority interest taxable year, the tax- able year of one or more partners who together own more than 50 percent of the capital and profits interests in the partnership.38 However, there may not be a majority interest taxable year when several partners have different year-ends. For example, if a partnership has two partners with 50 percent capital and profits interests and each has a different tax year, there will be no majority interest taxable year. In that case, the partnership next applies the principal partners test to determine its year-end.
Under the principal partners test, the required tax year is the taxable year the prin- cipal partners all have in common. For this purpose, principal partners are those who have 5 percent or more interest in the partnership profits and capital.39 Consider a part- nership with two calendar-year partners, each with a 20 percent capital and profits inter- est, and 30 additional fiscal year-end partners, each with less than a 5 percent capital and profits interest. In this scenario, the required taxable year of the partnership is a calendar year corresponding with the taxable year of the partnership’s only two principal partners.
If, as in the earlier example, the partnership had two 50 percent capital and profits part- ners with different tax years, it would then use the tax year providing the “least aggregate deferral” to the partners, unless it is eligible to elect an alternative year-end.40
The tax year with the least aggregate deferral is the one among the tax years of the partners that provides the partner group as a whole with the smallest amount of aggregate tax deferral. Under this approach, the total tax deferral is measured under each potential tax year mathematically by weighting each partner’s months of deferral under the poten- tial tax year by each partner’s profits percentage and then summing the weighted months of deferral for all the partners.
37Under certain circumstances, other alternative taxable years may be available to partnerships. See Rev.
Proc. 2002-38, 2002-1 CB 1037 and §444 for additional information concerning these options.
38§706(b)(1)(B)(i).
39§706(b)(3).
40Reg. §1.706-1(b)(3).
Example 20-13
When CCS began operating in 2017, it had two calendar year-end members, Nicole and Sarah, and one member with a June 30 year-end, Chanzz Inc. What tax year-end must CCS use for 2017?
Answer: CCS was required to use the calendar year as its taxable year unless it was eligible for an alternative year-end. Although Chanzz Inc. had a June 30 taxable year, Nicole and Sarah both had calendar year-ends. Because Nicole and Sarah each initially own 33.33 percent of the capital and profits of CCS, and together they own greater than 50 percent of the profits and capital of CCS, the calendar year is the required taxable year for CCS because it is the majority interest taxable year.
What if: Assume CCS initially began operating with three members: Nicole, a calendar year-end member with a 20 percent profits and capital interest; Chanzz Inc., a June 30 year-end member with a 40 percent profits and capital interest; and Telle Inc., a September 30 year-end member with a 40 percent profits and capital interest. What tax year-end must CCS use for 2017?
Answer: CCS would be required to use a June 30 year-end unless it was eligible for an alternative year-end. CCS does not have a majority interest taxable year because no partner or group of partners with the same year-end owns more than 50 percent of the profits and capital interests in CCS. Also, because all three principal partners in CCS have different year-ends, the principal partner test is not met. As a result, CCS must decide which of three potential year-ends, June 30, September 30, or December 31, will provide its members the least aggregate deferral. The table below illustrates the required computations:
Possible Year-Ends 12/31 Year-End 6/30 Year-End 9/30 Year-End Months Months Months
Tax Deferral* % × Deferral* % × Deferral* % × Members % Year (MD) (MD) (MD) (MD) (MD) (MD)
Nicole 20 12/31 0 0 6 1.2 3 .6
Chanzz Inc. 40 6/30 6 2.4 0 0 9 3.6
Telle Inc. 40 9/30 9 3.6 3 1.2 0 0
Total aggregate
deferral 6 2.4 4.2
*Months deferral equals number of months between the proposed year-end and partner’s year-end.
June 30 is the required taxable year-end because it provides members with the least aggregate tax deferral (2.4 is less than 6 and 4.2).
Accounting Methods
Although partnerships may use the accrual method freely, they may not use the cash method under certain conditions because it facilitates the deferral of income and ac- celeration of deductions. For example, partnerships with C corporation partners are generally not eligible to use the cash method41 unless their average annual gross re- ceipts for the three prior taxable years do not exceed $25 million and they otherwise qualify.42 Entities generally eligible to use the overall cash method of accounting must nevertheless use the accrual method to account for the purchase and sale of inventory unless they unless they have average annual gross receipts over the prior three years of
$25 million or less.
41§448(a)(2). In addition, §448(a)(3) prohibits partnerships classified as “tax shelters” from electing the cash method.
42§448(b)(3). If a partnership has not been in existence for at least three years, this test is applied based on the number of years it has been in existence.