Change in Accounting Method for Tax

Advance or Automatic Consent for Accounting Method Change
Curated by
Robert Recchia, J.D., M.B.A., C.P.A., Sr. Content Management Analyst, Wolters Kluwer
Taxpayers cannot change from an established accounting method to a different method unless they first obtain the IRS’s consent for the change. The two types of IRS consent are automatic consent and advance or non-automatic consent.
Accounting Method Change Consent Procedures
The IRS has issued procedures[1] that taxpayers must follow to receive the IRS’s consent for an accounting method change. The procedures apply to both changes qualifying for automatic consent and advance consent.
The IRS has compiled a list of accounting method changes that are eligible for automatic consent. The IRS List of Automatic Changes[2] includes information on over 150 accounting method changes. A taxpayer that is eligible to make an automatic change of accounting method and follows all the stated procedures will automatically receive the IRS’s consent for the change.
Comment
The current List of Automatic Changes[3] was released in February 2022. It is generally effective for Forms 3115 filed on or after January 31, 2022, for a year of change ending on or after May 31, 2021. The former List of Automatic Changes[4] is generally effective for Forms 3115 filed before January 31, 2022, for a year of change ending before May 31, 2021.
If a taxpayer wants to make a change of accounting method that is not on the IRS’s List of Automatic Changes, the request for the change is an advance or non-automatic consent request. A taxpayer following the advance or non-automatic consent procedure will receive a letter ruling if the IRS approves the change.
Compliance Note
Taxpayers must file an application[5] on Form 3115, Application for Change in Accounting Method, for both automatic and advance or non-automatic consent requests for an accounting method change. Taxpayers making advance or non-automatic consent requests for an accounting method change must submit a user fee with their Form 3115. For more information, see Changing Accounting Methods Using Form 3115.
The IRS will not grant its consent for a requested change unless the taxpayer agrees to the IRS’s terms and conditions for the change. See “Terms and Conditions for an Accounting Method Change,” below. These terms and conditions are the year of change, whether the change is to be made with a section 481(a) adjustment or on a cut-off basis, and the section 481(a) adjustment period. For a discussion of section 481(a) adjustments, see Section 481(a) Adjustments After an Accounting Method Change.
A taxpayer that receives the IRS’s consent to a change of accounting method can generally rely on the consent. However, the taxpayer may be required to change or modify[6] that method of accounting if the situation under which consent was granted changes. The IRS can also review a taxpayer’s compliance with the consent procedures.
A taxpayer that timely files Form 3115, Application for Change in Accounting Method, with the National Office and complies with all provisions of the IRS consent procedures generally receives audit protection[7] for tax years before the year of change. Audit protection means that the IRS will not require the taxpayer to change its method of accounting for the same item that is the subject of the Form 3115 for a tax year prior to the year of change. For more information, see “Audit Protection for Years Before Year of Accounting Method Change,” below.
Failure to obtain IRS consent to change accounting methods. If a taxpayer does not file a request to change an accounting method, the absence of IRS consent[8] to a change does not:
(1) prevent the IRS from imposing a penalty or addition to tax; or
(2) reduce the amount of any penalty or addition to tax that is imposed.
A taxpayer who uses an improper accounting method and fails to request a change to a proper method cannot assert that using the improper method was not negligent because the IRS did not consent to a change to a proper method. The lack of IRS consent to an accounting method change when no request for the change was made is no defense to penalties or additions to tax for using an improper method.
Automatic Accounting Method Change Requests
Taxpayers must satisfy a number of requirements to request the IRS’s consent for an accounting method change under the automatic change procedures. A taxpayer can request automatic consent[9] if:
(1) the change is on the IRS List of Automatic Changes[10] as of the date the taxpayer files the application on Form 3115;
(2) the taxpayer meets all the requirements for the change, as of the date taxpayer files Form 3115;
(3) the taxpayer does not engage in certain corporate liquidation or reorganization transactions[11] within the requested year of change;
(4) the requested year of change is not the final year of the taxpayer’s trade or business;
(5) the taxpayer has not made or requested an overall accounting method change during any of the five tax years ending with the year of change (prior five-year overall method change); and
(6) the taxpayer has not made or requested an accounting change for the same item during any of the five tax years ending with the year of change (prior five-year item change).
Five-year overall method change. Generally, a taxpayer cannot request the IRS’s consent to change its overall accounting method under the automatic change procedures if the taxpayer changed its overall accounting method, or applied for consent to change its overall accounting method, within the last five tax years including the year of change. It does not matter whether the taxpayer actually implemented the change. However, a taxpayer that changed its overall accounting method during the last five tax years may obtain automatic consent to change a method of accounting for a specific item.
Five-year item change. Generally, a taxpayer cannot request the IRS’s consent to change its method of accounting for a specific item under the automatic change procedures if the taxpayer changed its method of accounting for the same item, or applied for consent to change its accounting method for the same item, within the last five tax years including the year of change. It does not matter whether the taxpayer actually implemented the change. However, exceptions apply where certain LIFO inventory sub-methods are being changed and where the change in the method of accounting for a specific item is required as part of another accounting method change that is allowed.
Application procedures. A taxpayer making an automatic change of accounting method that follows all the stated procedures, including properly completing and filing Form 3115, Application for Change in Accounting Method, will automatically receive the IRS’s consent for the change. For a discussion of the application procedures, see Changing Accounting Methods Using Form 3115.
Advance or Non-automatic Accounting Method Change Requests
Nearly every taxpayer can request the IRS’s consent for an accounting method change under the advance or non-automatic change procedures. A taxpayer can request advance consent[12] if:
(1) the taxpayer is not eligible to use the automatic change procedures to make the change, as of the date that the taxpayer files the application on Form 3115; and
(2) the requested year of change is not the final year of the taxpayer’s trade business.
Application procedures. Taxpayers making advance or non-automatic consent requests for an accounting method change must file an application[13] on Form 3115, Application for Change in Accounting Method, and submit a user fee with their Form 3115. A taxpayer following the advance or non-automatic consent procedures will receive a letter ruling if the IRS approves the change. For a discussion of the application procedures, see Changing Accounting Methods Using Form 3115.
Terms and Conditions for an Accounting Method Change
The IRS can dictate the terms and conditions[14] that must be met in order to receive its consent for a change in accounting method. These terms and conditions are the year of change, whether the change is to be made with a section 481(a) adjustment or on a cut-off basis, and the section 481(a) adjustment period.
A taxpayer who receives the IRS’s consent for an accounting method change must implement the change according to the general terms and conditions in the IRS consent procedure[15] and:
(1) the terms and conditions in the IRS List of Automatic Changes[16] , for an automatic change; and
(2) the terms and conditions in the letter ruling for the change, for a non-automatic change.
Comment
The IRS can impose different terms and conditions in the letter ruling for a non-automatic change than the general terms and conditions in the IRS consent procedure[17] based on the particular facts of the taxpayer’s situation.
Change implemented on cut-off basis. The IRS can require certain accounting method changes to be made without a section 481 adjustment, using a cut-off method. Under a cut-off method[18] , only items arising on or after the beginning of the year of change, or other operative date, are accounted for under the new method of accounting.
Section 481(a) adjustment period. Under the general terms and conditions, a taxpayer making a change of accounting method under the IRS consent procedure[19] must take the section 481(a)[20] adjustment into account over the following adjustment periods:
(1) one tax year for a negative adjustment, which is the year of change; and
(2) four tax years for a positive adjustment, which is the year of change and the next three tax years.
A taxpayer must use a different section 481(a) adjustment period if required by the IRS in the letter ruling for a non-automatic change, or if a different adjustment period is provided in the IRS consent procedure[21] , the IRS List of Automatic Changes[22] , or other published guidance. The IRS consent procedure details several situations where a change must be implemented with a shortened section 481(a) adjustment period or an accelerated adjustment period. For more information, see Section 481(a) Adjustments After an Accounting Method Change.
Taxpayer under examination. A taxpayer contacted for examination and required by the IRS to change its method of accounting typically will receive less favorable terms and conditions and may also be subject to penalties. A taxpayer required to make an involuntary accounting method change must take a positive section 481(a) adjustment into account in the earliest tax year under examination[23] with a one-year adjustment period.
Effect of IRS Consent to Accounting Method Change
A taxpayer that receives the IRS’s consent to a change of accounting method can generally rely on the consent. However, the taxpayer may be required to change or modify[24] that method for the following reasons:
· the enactment of legislation;
· a decision of the U.S. Supreme Court;
· the issuance of temporary or final regulations;
· the issuance of a revenue ruling, revenue procedure, notice or other statement published in the Internal Revenue Bulletin;
· the issuance of written notice to the taxpayer that the change in method of accounting was granted in error or is not in compliance with the current views of the IRS; or
· a change in the material facts on which the consent was based.
Except in rare or unusual circumstances, a taxpayer that changes its accounting method, and is subsequently required to change or modify that accounting method, will not have to apply the required change or modification retroactively if:
· the taxpayer complied with all the applicable provisions of the IRS consent procedure[25] ;
· the taxpayer did not misstate or omit material facts;
· the material facts on which the consent was based have not changed;
· the applicable law has not changed; and
· the taxpayer to whom consent was granted acted in good faith in relying on the consent, and applying the change or modification retroactively would be to the taxpayer’s detriment.
Audit Protection for Years Before Year of Accounting Method Change
A taxpayer that timely files a Form 3115, Application for Change in Accounting Method, and complies with all provisions of the IRS consent procedures generally receives audit protection[26] for tax years before the year of change. Audit protection means that the IRS will not require the taxpayer to change its method of accounting for the same item that is the subject of the Form 3115 for a tax year prior to the year of change.
Exceptions to audit protection The IRS will not grant audit protection[27] and may require the taxpayer to change its method of accounting for years prior to the year of change in the following situations:
(1) taxpayers under examination;
(2) a change lacking audit protection;
(3) a change not made or made improperly;
(4) a change in a sub-method of accounting;
(5) a change on behalf of a controlled foreign corporation (CFC)[28] or 10/50 corporation[29] ;
(6) a pending or future criminal investigation; and
(7) an issue under consideration.
Taxpayers under examination. The IRS may require the taxpayer to change its method of accounting for the same item that is the subject of a Form 3115 for tax years prior to the requested year of change if the taxpayer is under examination on the date the taxpayer files the Form 3115. However, under the following exceptions, taxpayers may receive audit protection for:
· changes filed during certain window periods if the change was not an issue under consideration in the examination on the date that the Form 3115 was filed;
· changes from a clearly permissible accounting method or from a clearly impermissible method that was adopted after the tax years under examination; or
· changes that result in a negative section 481(a) adjustment for the year of change and would have resulted in negative adjustments for the tax years under examination if the change had been made for those years.
Change lacking audit protection. The IRS may change a taxpayer’s method of accounting for the same item that is the subject of a Form 3115 for tax years prior to the requested year of change if the description of the change in the List of Automatic Changes, or other guidance published in the Internal Revenue Bulletin, provides that the change is not subject to the audit protection provisions.
Change not made or made improperly. The IRS may change a taxpayer’s method of accounting for the same item for tax years prior to the year of change if:
(1) the taxpayer withdraws or does not perfect its request for the change;
(2) the National Office denies the request;
(3) the taxpayer declines to implement the change in method of accounting under the terms and conditions of the consent agreement and the voluntary change procedure;
(4) the taxpayer implements the change but does not comply with the terms and conditions contained in the consent agreement and the voluntary change procedure; or
(5) the National Office modifies or revokes the ruling retroactively because there has been a misstatement or an omission of material facts.
Change in sub-method. The IRS may change a taxpayer’s method of accounting for the same item for tax years prior to the year of change if the taxpayer is changing a sub-method of accounting within the method. For example, an examining agent may propose to terminate the taxpayer’s use of the LIFO inventory method during a prior tax year even though the taxpayer changes its method of valuing increments in the current year. In addition, a taxpayer that changes a LIFO inventory sub-method within five years of adopting or changing to the LIFO inventory method does not receive audit protection.
Change on behalf of CFC or 10/50 corporation. The IRS may change a method of accounting for the same item for tax years prior to the year of change where the change was made on behalf of a controlled foreign corporation (CFC)[30] or 10/50 corporation[31] and any of the corporation’s domestic corporate shareholders computed amounts of foreign taxes deemed paid in excess of a certain average threshold.
Criminal investigation. The IRS may change a taxpayer’s method of accounting for the same item for tax years prior to the year of change if there is any pending or future criminal investigation or proceeding concerning:
(1) directly or indirectly, any issue relating to the taxpayer’s federal tax liability for any tax year before the year of change; or
(2) the possibility of false or fraudulent statements made by the taxpayer with respect to any issue relating to its federal tax liability for any tax year before the year of change.
Issue under consideration. The IRS may change a taxpayer’s method of accounting for the same item that is the subject of a Form 3115 for tax years prior to the requested year of change if the taxpayer’s method of accounting for the same item is an issue under consideration as of the date the taxpayer filed the Form 3115.
IRS Review of Application and Compliance
IRS review of taxpayer’s application. Any application filed under the IRS consent procedure[32] may be reviewed by the IRS National Office. If the National Office reviews an application and determines that the application on Form 3115 is not properly completed or if supplemental information is needed, the IRS notifies the taxpayer. The notification specifies the information that needs to be provided, and the taxpayer is given 21 calendar days for a non-automatic change or 30 calendar days for an automatic change to furnish the necessary information. The IRS reserves the right to impose shorter reply periods if subsequent requests for additional information are made. Taxpayers may receive an extension of the 21-day or 30-day period to furnish information, not to exceed 15 calendar days for a non-automatic change or 30 calendar days for an automatic change. A request for an extension must be made in writing within the 21-day or 30-day period. If the extension request is denied, there is no right of appeal.
If the National Office tentatively determines that the taxpayer’s request for a change in accounting method does not comply with all the applicable provisions for an automatic change, or that a request to change an accounting method filed under the non-automatic change procedures may be denied, the National Office notifies the taxpayer of its tentative adverse determination and offers the taxpayer a conference of right, if the taxpayer has requested a conference.
IRS review of taxpayer compliance. The IRS must apply a change in accounting method[33] that was made in compliance with all the procedures in determining the taxpayer’s liability, unless the IRS director recommends that the change should be modified or revoked. The IRS director determines if the accounting method change complies with all the procedures, including whether:
· the facts and representations on which the change was based reflect an accurate statement of the material facts;
· the amount of the section 481(a) adjustment was properly determined;
· the change in accounting method was implemented in compliance with all the applicable provisions;
· there has been any change in the material facts on which the change was based during the period the accounting method for which consent was granted was used; and
· there has been any change in the applicable law during the period the accounting method for which consent was granted was used.
If the IRS director recommends that a change in accounting method, other than the adjustment, made in compliance with all the applicable provisions should be modified or revoked, the director will forward the matter to the IRS National Office for consideration before any further action is taken. Referral to the National Office is treated as a request for technical advice.
Citations
1. REVPROC2015-13
2. REVPROC2022-14
3. REVPROC2022-14
4. REVPROC2019-43
5. §1.446-1(e)(3)(i)
6. REVPROC2015-13
7. REVPROC2015-13
8. §446(f)
9. REVPROC2015-13
10. REVPROC2022-14
11. §381(a)
12. REVPROC2015-13
13. §1.446-1(e)(3)(i)
14. §1.446-1(e)(3)(ii)
15. REVPROC2015-13
16. REVPROC2022-14
17. REVPROC2015-13
18. REVPROC2015-13
19. REVPROC2015-13
20. §481(a)
21. REVPROC2015-13
22. REVPROC2022-14
23. REVPROC2015-13
24. REVPROC2015-13
25. REVPROC2015-13
26. REVPROC2015-13
27. REVPROC2015-13
28. §957
29. §904(d)(4)
30. §957
31. §904(d)(4)
32. REVPROC2015-13
33. REVPROC2015-13

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What’s all this?

This web page consists of tax tips that we have developed from our day-to-day dealing with tax issues. We hope that you find something of value.

If you are looking for something specific, type it into the search box to the right. If you want to get back here, just click on “Home” in the banner above which appears on all of my web pages.

If you would like to discuss any of these or other issues, or explore how I can be of assistance to you, click on “Contact Me” in the banner above. We look forward to hearing from you.

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Taxation of Capital Gains in NH: Capital Gains are not taxed!

https://learn.valur.io/new-hampshire-capital-gains-tax/

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IRS, Security Summit partners warn taxpayers of new scam

IRS, Security Summit partners warn taxpayers of new scam; unusual delivery service mailing tries to trick people into sending photos, bank account information

IR-2023-123, July 3, 2023

WASHINGTON ― The Internal Revenue Service warned taxpayers today to be on the lookout for a new scam mailing that tries to mislead people into believing they are owed a refund.

The new scheme involves a mailing coming in a cardboard envelope from a delivery service. The enclosed letter includes the IRS masthead and wording that the notice is“in relation to your unclaimed refund.”

Like many scams, the letter includes contact information and a phone number that do not belong to the IRS. But it also seeks a variety of sensitive personal information from taxpayers – including detailed pictures of driver’s licenses – that can be used to by identity thieves to try obtaining a tax refund and other sensitive financial information.

“This is just the latest in the long string of attempts by identity thieves posing as the IRS in hopes of tricking people into providing valuable personal information to steal identities and money, including tax refunds,” said IRS Commissioner Danny Werfel. “These scams can come in through email, text or even in special mailings. People should be careful to watch out for red flags that clearly mark these as IRS scams.”

The Security Summit – a coalition between the IRS, state tax administrators and the nation’s tax industry – continue to warn people to protect their personal information to protect against tax-related identity theft as well as scams like this.

In this new scam, there are many warning signs that can be seen in many similar schemes via email or by text. An unusual feature of this scam is that it tries tricking people to email or phone very detailed personal information in hopes of stealing valuable information.

The letter tells the recipients they need to provide “Filing Information” for their refund. This includes some awkwardly worded requests like this:

“A Clear Phone of Your Driver’s License That Clearly Displays All Four (4) Angles, Taken in a Place with Good Lighting.”

The letter proceeds for more sensitive information including cellphone number, bank routing information, Social Security number and bank account type, followed by a poorly worded warning:

“(You’ll Need to Get This to Get Your Refunds After Filing. These Must Be Given to a Filing Agent Who Will Help You Submit Your Unclaimed Property Claim. Once You Send All The Information Please Try to Be Checking Your Email for Response From The Agents Thanks”

This letter contains a variety of warning signs, including odd punctuation and a mixture of fonts as well as inaccuracies.

For example, the letter says the deadline for filing tax refunds is Oct. 17; the deadline for people on extension for their 2022 tax returns is actually Oct. 16, and those owed refunds from last year have time beyond that. And the IRS handles tax refunds, not “unclaimed property.”

Important reminders about scams
The IRS and Security Summit partners regularly warn people about common scams, including the annual IRS Dirty Dozen list.

Taxpayers and tax professionals should be alert to fake communications posing as legitimate organizations in the tax and financial community, including the IRS and states. These messages can arrive in the form of an unsolicited text or email to lure unsuspecting victims to provide valuable personal and financial information that can lead to identity theft, including phishing and smishing.

The IRS never initiates contact with taxpayers by email, text or social media regarding a bill or tax refund.

As a reminder: Never click on any unsolicited communication claiming to be the IRS as it may surreptitiously load malware. It may also be a way for malicious hackers to load ransomware that keeps the legitimate user from accessing their system and files.

Individuals should never respond to tax-related phishing or smishing or click on the URL link. Instead, the scams should be reported by sending the email or a copy of the text/SMS as an attachment to phishing@irs.gov. The report should include the caller ID (email or phone number), date, time and time zone, and the number that received the message.

Taxpayers can also report scams to the Treasury Inspector General for Tax Administration or the Internet Crime Complaint Center. The Report Phishing and Online Scams page at IRS.gov provides complete details. The Federal Communications Commission’s Smartphone Security Checker is a useful tool against mobile security threats.

The IRS also warns taxpayers to be wary of messages that appear to be from friends or family but that are possibly stolen or compromised email or text accounts from someone they know. This remains a popular way to target individuals and tax preparers for a variety of scams. Individuals should verify the identity of the sender by using another communication method; for instance, calling a number they independently know to be accurate, not the number provided in the email or text.

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IRS BACKLOG ON AMENDED RETURNS

I.1, IRS Has Made Little Progress On Amended Return Backlog, NTA Reports
Jun. 22, 2023

Federal Tax

The Internal Revenue Service has made progress on clearing out the backlog of paper original returns in the wake of the COVID-19 pandemic, but the backlog of unprocessed amended returns remains an issue for the agency, National Taxpayer Advocate Erin Collins reported.

In the NTA Objectives Report to Congress for Fiscal Year 2024, released June 21, 2023, Collins reported that as of April 22, 2023, there were 2.6 million unprocessed paper tax returns, down from 13.3 million unprocessed paper returns from the same date one year earlier.

“The IRS caught up in processing paper-filed original Forms 1040 for individuals and various business returns; refunds were generally issued quickly; and taxpayers calling the IRS were much more likely to get through – and with substantially shorter wait times,” Collins reported. “Overall, the difference between the 2022 filing season and the 2023 filing season was like night and day.”

However, for those who have filed amended returns, the backlog numbers tell a different story.

The backlog of unprocessed amended paper tax returns on April 22, 2023, was 3.4 million returns, down only 200,000 returns from the same date one year ago. Part of the delay stems from the fact that while the IRS accepts amended individual returns (Forms 1040-X) electronically, the agency processes the forms manually.

“This creates delays in both data intake and the issuance of refunds,” Collins stated. “As of the end of the filing season, it was taking the IRS about seven months to process Forms 1040-X.” She attributed the ongoing backlog of amended individual returns to the agency’s prioritization of telephone customer support over paper processing.

On the business side, delays were attributed to processing of amended returns with Employee Retention Credit claims and the amount of fraud the ERC claims have generated.

“The influx of fraudulent claims has put the IRS between a rock and a hard place,” Collins wrote. “If the IRS pays out claims quickly without taking the time to review them individually, it will be making some payments to individuals potentially engaged in fraud. If it takes the time to review claims individually, legitimate businesses who need the funds Congress authorized to help them say afloat may not receive them in time.”

Another area where a backlog persists is in the amount of unprocessed taxpayer correspondence and accounts management cases, with the backlog dropping to 5 million on April 22, 2023, from 5.3 million on April 22, 2022.

“Because of the Treasury Department’s decision to prioritize telephone service over paper processing, the IRS has not made much progress in reduction its AM inventories over the past year,” Collins noted, adding that for victims of identity theft, “the delays have been particularly long and frustrating. The average cycle time for Identity Theft Victim Assistance cases closed in April 2023 was 436 days – nearly 15 months. That’s about three months longer than the 362-day cycle time in April 2022”.

The report also highlighted other issues that the agency needs to address. Collins identified two areas where the agency needs to provide clear and timely guidance – the federal tax treatment of special state tax refunds or payments in more than 20 state and Form 1099-K reporting requirements.

By Gregory Twachtman, Washington News Editor

IR-2023-119

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Cryptocurrency – Tax Ramfications

Great article about it:
https://www.forbes.com/sites/irswatch/2021/06/14/thinking-of-getting-into-cryptocurrency-the-top-10-crypto-tax-mistakes-to-avoid/?ss=taxes&sh=318f06ae4628

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Biden & Taxes

Good recap:

https://www.forbes.com/sites/sarahhansen/2021/04/28/here-are-the-biggest-winners-and-losers-in-bidens-individual-tax-plan/?ss=taxes&sh=5859b63050f6

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Employee Retention Credit for 2020 & 2021 Revised and Expanded

The employee retention credit (ERC) is still available until December 31, 2021. This is an extremely beneficial tax credit that definitely should be considered by any employer.

The credit was available in 2020 but until the law was changed on 12/27/20, if you had received a PPP loan and expected it to be forgiven then you were not eligible for the ERC. If you are eligible for the credit due to this law change you will need to file amended Form 941s for each quarter that you qualified in 2020 as well as amend income tax returns to reflect the non-deductibility of expenses covered by the credit.

It is important to note that a number of the other requirements that needed to be met to get the credit in 2020 have been relaxed in 2021.

Contact me if you need assistance determining if you qualify for the credit now and in 2020, the amount of the credit you are eligible for, and when you will receive it.

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Making a new S election after termination

Making a new S election after termination
Editor: Linda Markwood, CPA
August 1, 2020

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TOPICS
S Corporation Income Taxation
Terminations
Generally, once a corporation has revoked or terminated its S election, the corporation (or a successor corporation) must wait five years before it can reelect S status, unless the IRS consents to waive the five-year period. Technically, the corporation (and any successor corporation) is not eligible to make an S election for any tax year before its fifth tax year that begins after the first tax year for which the termination was effective unless the IRS consents to the election (Sec. 1362(g); see also IRS Letter Rulings 9033041 and 9634021). This five-year rule applies whether the termination was voluntary or involuntary.

Example 1. Calculating the five-year waiting period: XYZ Inc., a calendar-year S corporation, revoked its S election effective Jan. 1, 2020. Once the S election is terminated (voluntarily or involuntarily), the corporation cannot make a new S election before its fifth tax year that begins after the first tax year for which the termination was effective. (The year ended Dec. 31, 2020, is the first tax year in which the termination was effective.) The tax year beginning Jan. 1, 2025, will be the fifth tax year beginning after the first tax year for which the termination was effective. Therefore, the earliest that XYZ can reelect S status without IRS permission is Jan. 1, 2025.

Example 2. Variation: Assume now that XYZ Inc. revoked its S election effective May 1, 2020. Here, the C corporation short-year period between May 1 and Dec. 31, 2020, is treated as the first tax year in which the termination was effective. The tax year beginning Jan. 1, 2025, will be the fifth tax year beginning after the first tax year for which the termination was effective. Therefore, XYZ can reelect S status on Jan. 1, 2025. If XYZ wanted to reelect S status before that date, it could request the IRS to waive the five-year period.

Exceptions to the five-year rule
The IRS has the authority to waive the five-year rule in certain situations. The corporation has the burden of establishing that under the relevant facts and circumstances, the IRS should consent to a new election. The fact that more than 50% of the stock in the corporation is owned by persons who did not own any stock in the corporation on the date of the termination tends to establish that consent should be granted. In the absence of this fact, consent ordinarily is denied unless the corporation shows that the event causing termination was not reasonably within the control of the corporation or shareholders having a substantial interest in the corporation and was not part of a plan on the part of the corporation or those shareholders to terminate the election (Regs. Sec. 1.1362-5(a)).

This means that, if the corporation loses its S status because it inadvertently ceased to qualify as an S corporation or inadvertently violated the restriction on excess passive investment income, the IRS may allow it to retain S status upon establishing that the termination was unintentional, and the corporation and its shareholders have taken steps to correct the event within a reasonable period. The IRS, for example, waived the five-year rule when a depressed economy caused a company to have excess passive investment income (Rev. Rul. 78-275).

Requesting waiver of the five-year rule
An S corporation requests the IRS to waive the five-year rule or waive an inadvertent termination of the S election by applying for a letter ruling. A user fee must accompany the request.

Example 3. Reapplying for S corporation status (five-year rule): N Inc. is a calendar-year S corporation. During the current year, N’s controller discovers that passive investment income has been in excess of 25% of gross receipts for the past three years and that N has accumulated earnings and profits (AE&P) from prior years as a C corporation. As a result, N’s S corporation status terminated, and its last day as an S corporation was Dec. 31, 2019. This situation was due to an inadvertent error on the part of N and was corrected by distributing all of the AE&P to shareholders in April 2020. Does N have to wait five years to reapply as an S corporation?

The corporation’s first tax year for which the termination is effective (its first C year) is 2020. The fifth tax year that begins after that year is 2025. Thus, the five-year rule would ordinarily prevent the corporation from reelecting S status until the tax year beginning Jan. 1, 2025. However, the possible exceptions to the five-year waiting period rule include one for inadvertent termination. If the corporation loses its S corporation status because it inadvertently ceased to qualify as an S corporation or because it inadvertently violated the restriction on passive investment income, the IRS may allow retention of S status upon establishing that the termination was unintentional and the corporation and its shareholders have taken steps to correct the event within a reasonable period of time.

Another potential exception to the five-year rule occurs when more than 50% of the stock is owned by new shareholders.

Example 4. Reelecting S status when more than 50% of the stock is owned by new shareholders: G Inc., a calendar-year S corporation, revokes its S election on Jan. 1, 2020. Each of G’s five shareholders owns 100 shares of stock. In 2020, three shareholders sell all of their stock to an unrelated shareholder. Can G reelect S status after the new stockholders acquire their shares? The IRS would probably grant permission to reelect S status before the expiration of the five-year period because more than 50% of the stock in the corporation is owned by persons who did not own the stock at the time the S election terminated. To request the IRS’s permission, G must file a request for a letter ruling and remit the applicable user fee.

Automatic consent after certain terminations
A corporation may make a new S election before the five-year period expires, without the consent of the IRS, if the termination occurred because the corporation (Regs. Sec. 1.1362-5(c)):

Failed the eligibility tests on the first day for which its S election was to become effective.
Revoked its S election effective on the first day of the first tax year for which its election was to be effective.
Because the five-year waiting period does not apply under the preceding two circumstances, the S corporation is not required to file for a letter ruling or pay a user fee.

Successor corporation defined
The rule prohibiting an S corporation from reelecting S status for five years also applies to a “successor corporation” of the S corporation. A successor for these purposes is defined as any corporation whose election under Sec. 1362 has been terminated if (Regs. Sec. 1.1362-5(b)):

50% or more of the stock of the new corporation is owned, directly or indirectly, by the same persons who, on the date of the termination, owned 50% or more of the stock of the prior corporation whose S election terminated; and
Either the new corporation acquires a substantial portion of the assets of the prior corporation, or a substantial portion of the assets of the new corporation were assets of the prior corporation.
Example 5. Applying the five-year rule to a successor corporation: O Inc., a calendar-year S corporation, revokes its S election effective on Jan. 1, 2020. Each of O’s four shareholders owns 100 shares of stock. In 2020, three of the four O shareholders formed a new corporation, F Inc. Thereafter, they merged O into F and redeemed all of the stock owned by the fourth O shareholder. The three shareholders of F want to once again elect S status.

O is prohibited from reelecting S status until the tax year beginning on Jan. 1, 2025. The five-year rule also applies to F if it is the “successor corporation” ofO.

In this case, since the F shareholders owned 75% of the O stock at the time the S termination was effective, F is a successor to O and is subject to the five-year waiting period and cannot elect S status without IRS permission until Jan. 1, 2025. It is unlikely that the IRS would grant permission to reelect S status before that date because more than 50% of F’s stock is owned by persons who owned O’s stock at the time the S election terminated. (Note that if F were owned instead by persons unrelated to the O shareholders, F would not be a successor corporation and could immediately elect S status without IRS permission.)

This case study has been adapted from PPC’s Tax Planning Guide: S Corporations, 34th edition (March 2020), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).


Contributor

Linda Markwood, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.

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IRS Webpage on Corona Virus

This page has a lot of useful information and is the best source on corona virus related relief:
https://www.irs.gov/coronavirus

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“Marriage penalty” longer exists!

The “marriage penalty” is due to tax rates for married taxpayers paying more than twice what they would have paid if they has not been married and filed separately. 2019 tax brackets eliminated this for tax brackets below 35%.

The effect of this is that depending upon what a married couple’s tax situation is it could be more beneficial to file married filing separate. One example would be if one spouse’s income is much lower than the other’s. Another example would be if one spouse does not want to be involved with potential tax consequences of the other spouse’s actions.

It is not difficult to determine if filing separately is a good decision for a married couple, and we would be happy to assist you with making the choice. Please contact us if you are interested in exploring this more.

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