Choosing a tax year for a personal service corporation

Editor: Michael C. Swenson, CPA

Personal service corporations (PSCs) generally must use a calendar year unless (1) a business purpose for having a different tax year is established (Sec. 441(i)); (2) they elect to use a 52-53-week tax year that ends with reference to the calendar year; or (3) they make a Sec. 444 election (Regs. Sec. 1.441-3(a)).

Establishing a business purpose for a fiscal year

Two benefits from qualifying to use a business-purpose fiscal year are that:

  • Any year end can be used (i.e., the corporation is not restricted to the Sec. 444 three-month deferral period discussed later in this column); and
  • The corporation (because it does not have to make the Sec. 444 election) is not subject to the Sec. 280H minimum distribution requirements discussed later in this column.
Establishing a fiscal year based on natural business year

Regs. Sec. 1.442-1(b)(2) provides that the business-purpose requirement will be satisfied in the case of a PSC if the requested annual accounting period coincides with the PSC's natural business year.

Rev. Proc. 2006-46, Section 5.07, provides a test for determining the existence of a natural business year. Under this test, a PSC is considered to have a natural business year if 25% or more of its gross receipts for the 12-month period ending with the last month of the requested year occur in the last two months of such period, and this requirement has also been met for the two immediately preceding 12-month periods.

Establishing a fiscal year based on the facts and circumstances

PSCs that do not meet the natural-business-year test can attempt to establish a business purpose by demonstrating that the facts and circumstances support a business purpose for the desired year end under Rev. Rul. 87-57. IRS approval is required (and is difficult to obtain).

Rev. Rul. 87-57 discusses the tax and nontax factors the IRS considers in determining whether a sufficient business purpose has been established. The ruling addresses eight examples illustrating valid or insufficient business purposes for using a fiscal year. The examples that illustrate insufficient business purposes deal with administrative convenience (e.g., lower accounting costs or recordkeeping consistency). The examples that allow the use of a fiscal year are simply variations of the 25% gross receipts test. Thus, the IRS does not appear to give the facts-and-circumstances test much credence by itself, which means that the practitioner might want to consider this option only if no others are available.

Newly organized PSCs attempting to adopt a fiscal year using a business purpose supported by the facts and circumstances should file Form 1128, Application to Adopt, Change, or Retain a Tax Year.

Electing a fiscal year under Sec. 444

Generally, a Sec. 444 election can be made only if the deferral period (number of months between the beginning of the year and the end of the first required year) of the desired tax year does not exceed three months (Sec. 444(b)(1)). Since the required year end for PSCs is a calendar year end, only September, October, and November year ends can be elected pursuant to Sec. 444.

Practice tip: As a practical matter, most existing PSCs use a calendar year and will not be able to make a Sec. 444 election to change year ends because their present deferral period is zero. The election is available, however, to new PSCs.

The election to select a fiscal year end is made by filing Form 8716, Election to Have a Tax Year Other Than a Required Tax Year, with the IRS by the earlier of (Temp. Regs. Sec. 1.444-3T(b)):

  • The 15th day of the fifth month following the first calendar month of the tax year for which the election will first be effective; or
  • The due date (without regard to extensions) of the tax return resulting from the Sec. 444 election.

The form should be filed with the IRS Service Center indicated in the instructions for Form 8716. A copy of Form 8716 must also be attached to the tax return when it is filed.

Example 1. Making the Sec. 444 election: H Inc. is a PSC that was formed and began business on March 1, 2020. It wants to make a Sec. 444 election to use an Oct. 31 year end. How does H make the election?

Form 8716 must be filed by the earlier of the 15th day of the fifth month following the month that includes the first day of the tax year the election will be effective (Aug. 15, 2020, in H's case) or the due date of the tax return for the short period (Feb. 15, 2021, for H).

Note: C corporation returns are generally due 3½ months following the close of the corporation's tax year (April 15 for calendar-year corporations).

Therefore, H should file Form 8716 by Aug. 15, 2020. A copy of that form should be attached to the corporation's first tax return.

Practice tip: PSCs requesting a business-purpose fiscal year end can make a backup election to use Sec. 444 in case the business-purpose request is denied (Temp. Regs. Sec. 1.444-3T(b)(4)).

The Sec. 444 election is a one-time election. If the election is terminated, future elections are prohibited (Sec. 444(d)(2)(B)). The election for a PSC can be terminated when the corporation changes its tax year, liquidates, fails to comply with the requirements of Sec. 280H, becomes a member of a tiered structure, or ceases to be a PSC (Temp. Regs. Sec. 1.444-1T(a)(5)).

Meeting the minimum distribution requirement

Once a fiscal year is elected under Sec. 444, a PSC must meet the minimum distribution requirement in order to deduct all payments made to employee-owners (e.g., salaries, rents, bonuses) during the tax year. The purpose of this requirement is to prevent employee-owners from making payments to themselves after the end of their tax year (i.e., Dec. 31) but before the end of the corporation's tax year, thus obtaining a current corporate deduction while deferring their recognition of the income.

Failure to meet the minimum distribution requirement will not cause the PSC to forfeit its fiscal year. Instead, the corporation's deduction for amounts paid to employee-owners will be limited (Sec. 280H(a)). To satisfy the minimum distribution requirement, a PSC must pay to its employee-owners during the deferral period an amount at least equal to the lesser of the following (Sec. 280H(c)):

  • Preceding-year test: Applicable amounts paid to employee-owners during preceding year × (Number of months in deferral period of preceding tax year ÷ Total number of months in preceding tax year).
  • Three-year-average test: (Applicable amounts paid to employee-owners during the three preceding tax years ÷ Adjusted taxable income of the three preceding tax years) × Adjusted taxable income of the current year's deferral period.

The percentage obtained in the three-year-average test cannot exceed 95%.

An applicable amount is an item that is deductible by the PSC (other than for Sec. 280H purposes) and includible (directly or indirectly) by the employee-owner in gross income (Temp. Regs. Sec. 1.280H-1T(b)(4)). Amounts are indirectly included in the employee-owner's income if they are includible in the gross income of the employee-owner's spouse, child under 14, or a corporation, partnership, or trust in which the employee-owner holds a more-than-50% ownership interest.

The only items that do not have to be included in the applicable amount are (1) gain from the sale of property between the employee-owner and the corporation and (2) dividends paid by the corporation (Sec. 280H(f)(1)).

An employee-owner is an individual who performs personal services for the corporation on any day of the corporation's tax year (even if performed as an independent contractor) and who owns outstanding stock on any day of the corporation's tax year (Temp. Regs. Sec. 1.280H-1T(c)(1)(ii)).

Adjusted taxable income is taxable income without regard to (1) amounts paid and taxable to employee-owners and (2) any portion of an NOL carryover that is attributable to such amounts (Sec. 280H(f)(4); Temp. Regs. Sec. 1.280H-1T(c)(3)(iii)). Adjusted taxable income of the current year's deferral period for purposes of the three-year-average test may be based on a reasonable estimate.

Newly organized PSCs are deemed to satisfy both the preceding-year test and the three-year-average test for the first year of the corporation's existence (Temp. Regs. Sec. 1.280H-1T(e)(1)). An existing corporation that is not a PSC, but becomes one and makes a Sec. 444 election, will apply the preceding-year test and the three-year-average test as though it had been a PSC in the three years preceding the election year (Temp. Regs. Sec. 1.280H-1T(e)(2)).

Example 2. Electing a fiscal tax year for the first year of a PSC: A has operated her consulting business as a sole proprietorship. She has now decided to incorporate as B Inc. B Inc. will be a PSC and will be limited in its choice of a tax year.

B Inc. can elect a year end that results in a deferral period of three months or less (i.e., it may have a year end of Sept. 30, Oct. 31, or Nov. 30). Because the corporation is newly organized, for its first year of existence it meets the tests for the minimum distribution requirements.

As stated earlier, if the corporation does not meet the minimum distribution requirement, the deduction for amounts paid to employee-owners is limited. The maximum deductible amount is equal to (Sec. 280H(d); Temp. Regs. Sec. 1.280H-1T(d)): Applicable amounts paid to employee-owners during the current tax year + (Applicable amounts paid to employee-owners during the current tax year's deferral period × [Number of months not in deferral period ÷ Number of months in deferral period]).

A PSC making the Sec. 444 election must compute on Schedule H, Section 280H Limitations for a Personal Service Corporation (PSC), of Form 1120, U.S. Corporation Income Tax Return, for each year that the election is in effect, the required minimum distribution for that year and the maximum deduction that can be taken by the corporation for payments to employee-owners.

This case study has been adapted from PPC's Tax Planning Guide — Closely Held Corporations, 33d Edition (April 2020), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).

 

Contributor

Michael C. Swenson, CPA, MPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.

 

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