December 20, 2002

The Honorable Pamela F. Olson
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Room 1330
Washington, D.C. 20220

The Honorable B. John Williams
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, N.W.
Room 3026
Washington, D.C. 20224

Mr. James L. Atkinson
Assistant Chief Counsel (Income Tax & Accounting)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Room 5501
Washington, D.C. 20224

Re: Revenue Procedures 2002–37, 2002–38, and 2002–39

Dear Ms. Olson, Mr. Williams, and Mr. Atkinson:

We would like to bring your attention to a harsh consequence that, if uncorrected, will result from changes made by Rev. Proc. 2002–37, 2002–22 I.R.B. 1030, Rev. Proc. 2002–38, 2002–22 I.R.B. 1037, and Rev. Proc. 2002–39, 2002–22 I.R.B. 1046. Partners and shareholders of partnerships or S corporations with fiscal years ending on or after May 10, 2002, which no longer meet the "25-percent gross receipts test" for a natural business year (or where the facts and circumstances relied upon by the Internal Revenue Service in its prior approval of a natural business year have changed) may have to include more than 12 months of partnership or S corporation income on their 2002 or 2003 individual tax returns. This letter recommends a four-year spread of this additional income, relief that Treasury and the Service has often implemented in similar circumstances, to lessen this harsh consequence.

The harsh consequence results from a provision in Rev. Proc. 2002–38 (also included in Rev. Procs. 2002–37 and 2002–39), which supersedes a provision relating to the same subject in Rev. Proc. 87–32, 1987–2 C.B. 396. The subject specifically relates to partnerships and S corporations that previously qualified under Rev. Proc. 87–32 for a fiscal taxable year based upon having satisfied the "25-percent gross receipts test," but that no longer qualify under that test for a later fiscal taxable year. We understand that it is the position of the Service that unless the partnership or S corporation can obtain a determination under Rev. Proc. 2002–39 that it has established a business purpose for its fiscal taxable year, "it is using an impermissible annual accounting period and should change to a permitted taxable year." In most cases, this permitted taxable year will be the required calendar year. Rev. Proc. 2002–39 appears to further provide that even a partnership or S corporation (in addition to an electing S corporation or personal service corporation) that previously obtained a ruling from the Service that it has a business purpose for its desired fiscal taxable year is using an impermissible annual accounting period if the facts and circumstances that provided the basis for that ruling no longer exist.

This statement that a partnership or an S corporation that no longer satisfies the "25-percent gross receipts test" is using an impermissible annual accounting period is a significant change from Rev. Proc. 87–32 and its implementation by the Service. Rev. Proc. 87–32, section 11 ("MONITORING OF THE 25-PERCENT TEST"), provided that "taxpayers using a fiscal year on the basis of a natural business year under section 4.01(1) of this revenue procedure [the "25-percent gross receipts test"] may be required periodically to demonstrate the continued existence of such a year." Members of our Tax Accounting Technical Resource Panel are not aware of, nor has our research located, any case where a taxpayer, with a fiscal taxable year on the basis of having satisfied the "25-percent gross receipts test," has been required upon examination by the Service to demonstrate the continued existence of such a year.

We have no disagreement with this change by the Service to better regulate and enforce its rules. However, the harsh consequence of this change is that partners and shareholders of partnerships or S corporations that no longer meet the "25-percent gross receipts test" (or where the facts and circumstances that provided the basis for your office's prior business purpose determination have changed) may be required to include more than 12 months of partnership or S corporation income on their returns for the calendar year (either 2002 or 2003) in which ends the first taxable year of the partnership or S corporation ending on or after May 10, 2002 (the effective date of Rev. Proc. 2002–38). For example, calendar year individual partners of a profitable partnership with a 2002 taxable year that ended May 31, 2002, which will change to the calendar year pursuant to Rev. Proc. 2002–38 because it no longer satisfies the "25-percent gross receipts test" for the May year-end, will include in their 2002 calendar year returns 19 months of partnership income. Furthermore, this bunching of 19 months of partnership income in the partners' 2002 calendar year returns may cause for this year an increase in their tax brackets, a reduction or elimination of their itemized deductions and personal exemptions, and a reduction or elimination of various other deductions and credits that provide an AGI limitation.

To ameliorate this harsh consequence, we recommend that the Service (pursuant to its authority set forth under reg. section 1.442–1(b)(3)) modify Rev. Procs. 2002–37, 2002–38, and 2002–39 to provide the same remedy that Congress provided under section 806(e)(2)(C) of the Tax Reform Act of 1986. Under that section, partners and S corporation shareholders were permitted to spread the partnership's or S corporation's "income in excess of expenses" for the short taxable year resulting from the required change of taxable year ratably over a four-taxable year period beginning with year of change.

Reg. section 1.442–1(b)(3) provides as follows:

(3) Administrative procedures. The Commissioner will prescribe administrative procedures under which a taxpayer may be permitted to adopt, change, or retain an annual accounting period. These administrative procedures will describe the business purpose requirements (including an ownership taxable year and a natural business year) and the terms, conditions, and adjustments necessary to obtain approval. Such terms, conditions, and adjustments may include adjustments necessary to neutralize the tax effect of a substantial distortion of income that would otherwise result from the requested annual accounting period including: a deferral of a substantial portion of the taxpayer's income, or shifting of a substantial portion of deductions, from one taxable year to another; a similar deferral or shifting in the case of any other person, such as a beneficiary in an estate; the creation of a short period in which there is a substantial net operating loss, capital loss, or credit (including a general business credit); or the creation of a short period in which there is a substantial amount of income to offset an expiring net operating loss, capital loss, or credit… (Emphasis added).

Although reg. section 1.442–1(b)(3) includes descriptions of situations where terms, conditions, and adjustments may be needed to prevent an inappropriate reduction in tax (see, for example, section 5.05 of Rev. Proc. 2002–39), we believe these regulations also set forth the authority of the Service to prescribe terms, conditions, and adjustments to prevent the inappropriate increase in tax. The Service appears to have used this authority in its issuance of a transition rule with respect to owners of pass-through entities, where either the entity or its owner uses a 52–53-week taxable year, who as a result of the final regulations under section 441 published May 17, 2002, are required for their first taxable year ending on or after that date to include in income amounts attributable to two taxable years of the pass-through entity (reg. section 1.441-2(e)(5)). Under this transition rule, the amount that otherwise would be required to be included into income for such first taxable year by reason of the final regulations is included into income ratably over the four-taxable-year period beginning with such first taxable year, unless the owner elects otherwise. Also, final regulations issued on July 23, 2002, with respect to the tax years of partnerships with foreign partners (T.D. 9009), do not require existing partnerships to change their taxable years to conform to the regulations. However, existing partnerships were encouraged to conform to the regulations by permitting its partners a ratable four-year spread of items of income, gain, loss, deduction, and credit attributable to such partnerships' first taxable year beginning on or after July 23, 2002 (reg. section 1.706–1(b)(6)(v)(D)).

This letter was drafted by the Tax Accounting Technical Resource Panel, and approved by the Tax Executive Committee of the American Institute of Certified Public Accountants (AICPA).

Thank you in advance for your consideration of our recommendation to modify Rev. Procs. 2002–37, 2002–38, and 2002–39. We would be pleased to discuss with you our recommendation. Please contact Robert A. Kilinskis, Chair of the Tax Accounting Tax Technical Resource Panel, at (312) 242–9855, or George White, AICPA Technical Manager, at (202) 434–9268.

Sincerely,

Robert A. Zarzar, Chair
Tax Executive Committee

cc: Roy A. Hirschhorn
Michael F. Schmit