Recent Guidance Raises Long-Standing Issue of What Is a Separate Trade or Business

Editor: Greg A. Fairbanks, J.D., LL.M.

Tax Accounting

Taxpayers engaged in more than one trade or business can use different methods of accounting for each trade or business in computing taxable income, as long as the chosen method for each trade or business provides a clear reflection of income. The regulations under Sec. 446 provide that for different accounting methods to be used, the trades or businesses must be separate and distinct. So what constitutes a separate and distinct trade or business? Chief Counsel Advice (CCA) 201430013 takes a fresh look at whether divisions of a business are separate and distinct.

“Separate and distinct” is not defined in the regulations, although Regs. Sec. 1.446-1(d) provides that, to be considered separate and distinct, each trade or business must have a complete and separable set of books and records. However, even a taxpayer that maintains separate books and records is not considered to have separate and distinct trades or businesses if there is a creation or shifting of profits or losses between the trades or businesses by reason of their different methods of accounting. Given the lack of clarity in the regulations, taxpayers must look to case law for guidance in appropriately analyzing whether trades or businesses are separate and distinct.

The courts have looked to the following additional factors when considering whether a taxpayer is engaged in separate trades or businesses: (1) the existence of common management; (2) whether the taxpayer holds out each line as a separate business; (3) the use of separate bank accounts; (4) whether the businesses share employees; and (5) the nature of each business. However, case law has generally treated the last factor as the most important. One example in the regulations notes that a taxpayer may account for the operations of a personal service business by the cash method and of a manufacturing business by the accrual method (Regs. Sec. 1.446-1(d)(1)).

In Stern,14 B.T.A. 838 (1928), the Board of Tax Appeals noted that the two businesses examined were “wholly different in character”—one was a mercantile business, and the other bought and sold coal lands—in holding that the two businesses were separate and distinct. Two trades or businesses in different lines of business that have separate books and records likely will be considered separate and distinct. But what about businesses that are similar in activity or are vertically integrated?

Where activities are vertically integrated, such that one division conducts transactions primarily with the other division, showing that the divisions are separate and distinct becomes more difficult. The facts and circumstances become extremely important in the analysis. In two cases involving the poultry industry, district courts came to opposite holdings based on different fact patterns.

In Peterson Produce Co., 313 F.2d 609 (8th Cir. 1963), aff’g 205 F. Supp. 229 (W.D. Ark. 1962), the Eighth Circuit upheld the decision of a U.S. district court that the taxpayer’s newly formed broiler chicken farming division was not a separate and distinct trade or business from its existing business of raising and selling chicks and selling chicken feed. Once the broiler farming division was formed, the existing business primarily sold its chicks and feed to the new division. The district court noted that the outside sales were small, compared with the sales to the other department. Additionally, the taxpayer did not keep what the court deemed to be separate books and records. While the general ledger accounts of the two divisions could be separated, the books of original daily entries were not physically separable.

In Burgess Poultry Market, Inc., No. 4150 (E.D. Tex. 5/22/64), however, a district court held that the taxpayer’s two poultry-related divisions were separate and distinct trades or businesses. In this case, the taxpayer initially ran a broiler processing operation and later formed a farm division to raise chicks. The taxpayer kept completely separate books and records and bank accounts for the two divisions, and each division had its own employees. The farm division did sell chicks to the broiler division, but the broiler division purchased 60% of its chicks from outside sources. All sales were made at market prices and evidenced by invoices between the divisions, which were paid by check. None of the transactions were accounted for “merely” by bookkeeping entries between the divisions.

The differing holdings in these two poultry cases came down to just how integrated the two divisions really were.

Additional factors were considered in Rev. Rul. 74-270, where the IRS ruled that a bank’s commercial banking division and its trust department were separate trades or businesses for purposes of Sec. 446. The activities of the trust department were “basically” different from those of the commercial banking division, and separate books and records are required by law in that industry. Additionally, the departments had separate management, employees, and office space. There was no indication that the two departments were integrated in any way.

Businesses that are separate legal entities for tax purposes, such as subsidiary corporations, are taxpayers that must determine whether they have one or more separate trades or businesses for purposes of Sec. 446. However, the same treatment does not necessarily apply to single-member limited liability companies (SMLLCs) and qualified subchapter S subsidiaries (QSubs) that are disregarded for federal tax purposes. Instead, these entities are treated as divisions of the taxpayer for purposes of determining whether the SMLLC or QSub is a separate trade or business. In CCA 201430013, the IRS advised that a taxpayer and its SMLLC were separate trades or businesses within the meaning of Sec. 446(d) based on the information available to the IRS.

The SMLLC in the CCA had previously been a subsidiary of the taxpayer but had since converted to an LLC without making the election to be taxed as a corporation. Thus, the SMLLC was not regarded as an entity separate from the taxpayer for federal tax purposes. The IRS stated that the determination of whether the SMLLC is a separate trade or business from the taxpayer was based on the facts and circumstances of the taxpayer. In this CCA, the IRS looked at various factors indicating that the taxpayer and the SMLLC were separate and distinct trades or businesses, including that the taxpayer and SMLLC were engaged in different activities. The SMLLC was a manufacturer that sold products to a third party. The taxpayer was primarily engaged in sales, marketing, distribution, sales support, research and development, and administrative and headquarters functions. However, the CCA does not make clear whether the two businesses were vertically integrated. Additionally, the taxpayer and the SMLLC had separate books and records, were in different locations, and did not share employees (other than high-level executives).

As this CCA demonstrates, the fact that a taxpayer is the sole member of an LLC does not mean that it necessarily is or is not a separate trade or business for purposes of Sec. 446. A review of all the relevant facts and circumstances and application of factors considered in case law is necessary to make such a determination. If the result of such an analysis is that there are separate trades or businesses, each separate trade or business may adopt or change its own method of accounting. Additionally, if a taxpayer files a change in method of accounting on a Form 3115, Application for Change in Accounting Method, then SMLLCs, QSubs, and/or divisions that are considered separate trades or businesses should be listed separately as applicants, and the amount of the Sec. 481(a) adjustment should be broken out separately from the owner’s other trades or businesses.

EditorNotes

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.