Changing an LLC’s Tax Year

Editor: Albert B. Ellentuck, Esq.

The tax year a limited liability company (LLC) is required to use generally is the tax year of the members who own, in the aggregate, more than 50% of the interests in the LLC’s capital and profits (Sec. 706(b)). If there is no member or combination of members with the same tax year owning more than 50% of capital and profits, the LLC’s required year is the tax year of its principal members. Principal members are those owning 5% or more of either capital or profits. If neither the majority-interest rule nor the principal-members rule applies, the LLC’s required year is the year end resulting in the least aggregate deferral of income to the members.

An LLC’s required year can change for several reasons:

1. The members holding majority interests change or their year ends change; however, the consistency rule discussed below may prevent a change in some cases.
2. The principal members or their year ends change.
3. The year end with the least aggregate deferral changes; however, the consistency rule or de minimis rule discussed below may prevent a change in some cases.

A change in the LLC’s required year is treated as automatically approved by the IRS (Rev. Proc. 2006-46). Annualization of the short period income is not permitted (Regs. Sec. 1.706-1(b)(8)).

Consistency and De Minimis Rules

The least aggregate deferral of income is determined by multiplying each member’s percentage of LLC profits for the year by the number of months of deferral that would arise through selection of the proposed year end (Regs. Sec. 1.706-1(b)(3)). Months of deferral are counted by going forward from the proposed LLC year end to the members’ year ends, using the information available at the beginning of the current tax year. After testing each proposed tax year, the year producing the least aggregate deferral of income is the required year. If the test produces more than one qualifying tax year, the LLC can select any one of those years. However, under a special consistency rule, if one of the year ends meeting the test is the LLC’s existing year end, the LLC must retain its existing tax year.

If the tax year with the least aggregate deferral produces a difference in aggregate deferral less than 0.5 in comparison to the aggregate deferral of the LLC’s existing tax year, a de minimis rule is applied. The LLC’s existing tax year is treated as the tax year with the least aggregate deferral, and no change in tax year is necessary or permitted (Regs. Sec. 1.706-1(b)(3)(iii)).

Impact of Members’ Year-End Changes on Required Year

A change in a member’s year end often will force an LLC to change its tax year. However, an LLC using a required year may be able to retain its year end after such a change under the consistency or de minimis rules previously discussed. Also, an LLC that made a Sec. 444 election may be able to retain its existing year end or adopt a new “nonconforming” year end if its required year changes.

Example 1: B LLC is classified as a partnership and has been using a June 30 required year end because all three members have a June 30 year end. Two members obtain permission to change their year ends to May 31. Since members owning more than 50% of capital and profits now have a May 31 year end, B is ­required to change its year end as well. Because the change is made under the majority-interest rule, no further change in tax year (due to changes in majority members’ tax years) will be required for the two tax years following the year of change (Sec. 706(b)(4)).

Example 2: L LLC is classified as a partnership and has been using a March 31 required year end because its principal member has a March 31 year end. None of the remaining members owns more than 3% of the LLC, and they have several different tax year ends. For valid business ­reasons, the principal member elects to change his tax year to June 30. Since the principal member has changed his tax year, the LLC must also change to a June 30 year end.

If L obtained IRS approval to retain the March 31 year end for a valid business purpose, it would not be required to change its year end even though the principal member’s year end has changed. The same is true if the LLC uses a natural business year under Rev. Proc. 2002-39.

Qualifying for a Natural Business Year

An LLC can apply for a nonautomatic change in tax year if it can show it has a natural business year. An LLC has a natural business year if it qualifies under (1) the annual-business-cycle test; (2) the seasonal-business test; or (3) the 25% gross-receipts test (Rev. Proc. 2002-39).

If an LLC’s gross receipts for the short period ending with the requested year end and the three preceding tax years indicate that it has a peak and nonpeak period of business, the LLC’s natural business year is deemed to end at, or soon after, the close of the highest peak period of business. An LLC that has not been in existence for a sufficient period to provide gross-receipts information may provide information other than gross receipts to demonstrate a peak and nonpeak period of business, such as a description of its business or reasonable estimates of ­future gross receipts.

An LLC also is deemed to have a natural business year if its gross receipts for the short period ending with the requested year end and the three preceding tax years indicate that its business is operational for only part of the year, resulting in insignificant gross receipts in the remainder of the year. (A safe harbor provides that any amount less than 10% of total gross receipts is insignificant.) This can result, for example, from businesses affected by the weather, such as water parks and ski resorts. If an LLC meets the seasonal-business test, its natural business year is deemed to end at, or soon after, operations end for the season. If the LLC has not been in business long enough to provide gross-receipts information for the required period, it may provide information other than gross receipts to show it has a seasonal business.

For annual-business-cycle and seasonal-business purposes, “soon after” is deemed to be one month after.

An LLC’s natural business year also can be determined by applying a mechanical 25% gross-receipts test over a three-year period (unless the LLC is part of a tiered structure). The gross-receipts test is based on the three most recent 12-month periods ending with the last month of the requested fiscal year. For example, if an LLC wants to change to an Aug. 31 year end in 2015, the “three most recent years” are the three years ending on Aug. 31, 2013, 2014, and 2015. To pass the test, more than 25% of the LLC’s gross receipts for each of the three 12-month periods must have occurred in the last two months of each respective period. If the LLC qualifies for more than one natural business year, the year end with the highest three-year average percentage of gross receipts is the LLC’s natural business year.

Qualifying for Automatic IRS Approval

Rev. Proc. 2006-46 contains the exclusive procedures for an LLC to receive automatic IRS approval to retain, adopt, or change its tax year. The revenue procedure generally provides that an LLC has automatic approval of a change in its tax year if it wants to:

1. Change to its required tax year or a 52-53-week tax year ending with reference to the required year.
2. Change to or retain a natural business year that satisfies the 25% gross-receipts test or to a 52—53-week tax year ending with reference to that year.
3. Change from a 52-53-week tax year that refers to a particular calendar month to a tax year that ends on the last day of the same calendar month that is a permitted tax year, or vice versa.

Automatic approval is also available if the LLC is required to concurrently change its annual accounting period as a term and condition for the approval of a related taxpayer’s change of annual accounting period.

Rev. Proc. 2006-46 does not apply in certain situations—for example, if the LLC is under examination. A change of tax year under the revenue procedure is also not available if the LLC has changed its tax year within the 48-month period ending with the last month of the requested tax year. For this purpose, a change to the required year (or ownership tax year) or a change to or from a 52-53-week tax year to a non-52-53-week tax year ending with reference to the same calendar month does not constitute a change in tax year.

Furthermore, an LLC that adopts, changes, or retains its tax year under Rev. Proc. 2006-46 may be required to change its tax year if there is a change in the material facts on which approval was granted.

This case study has been adapted from PPC’s Guide to Limited Liability Companies, 19th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2014 (800-431-9025; tax.thomsonreuters.com).