SECTION 5. BUSINESS — Internal Revenue Bulletin 2001-23

AND TERMS, CONDITIONS, AND ADJUSTMENTS

in the case of a change, the first effective year is the short period required to effect the change. The first effective year is also the first taxable year for complying with all the terms and conditions set forth in the letter ruling granting permission to effect the adoption, change, or retention of the taxpayer’s annual accounting period.

.04 Short period . In the case of a change in annual accounting period, a taxpayer’s short period is the period beginning with the day following the close of the old taxable year and ending with the day preceding the first day of the new taxable year.

.05 Field Office, Area Office, Director . The terms “field office,” “area office,” and “director” have the same meaning as those terms have in Rev. Proc. 2001–1, 2001–1 I.R.B. 1 (or any successor). .06 Under examination .

(1) In general .

(a) Except as provided in section 4.06(2) of this revenue procedure, an examination of a taxpayer with respect to a federal income tax return begins on the date the taxpayer is contacted in any manner by a representative of the Service for the purpose of scheduling any type of examination of the return. An examination ends:

(i) in a case in which the Service accepts the return as filed, on the date of the “no change” letter sent to the taxpayer;

(ii) in a fully agreed case, on the earliest of the date the taxpayer executes a waiver of restrictions on assessment or acceptance of overassessment (for example, a Form 870, 4549, or 4605), the date the taxpayer makes a payment of tax that equals or exceeds the proposed deficiency, or the date of the “closing” letter (for example, Letter 891 or 987) sent to the taxpayer; or

(iii) in an unagreed or a partially agreed case, on the earliest of the date the taxpayer (or its representative) is notified by an appeals officer that the case has been referred to an area office from a field office, the date the taxpayer files a petition in the Tax Court, the date on which the period for filing a petition with the Tax Court expires, or the date of the notice of claim disallowance.

(b) An examination does not end as a result of the early referral of an issue to an area office under the provisions of Rev. Proc. 96–9, 1996–1 C.B. 575.

(c) An examination resumes on the date the taxpayer (or its representative) is notified by an appeals officer (or otherwise) that the case has been referred to a field office for reconsideration.

(2) Partnerships and S corporations subject to TEFRA . For a partnership or an S corporation that is subject to the TEFRA unified audit and litigation provisions (note that an S corporation is not subject to the TEFRA unified audit and litigation provisions for taxable years beginning after December 31, 1996. See Small Business Job Protection Act of 1996, Pub. L. No. 104–188, § 1317(a), 110 Stat. 1755, 1787 (1996)), an examination begins on the date of the notice of the beginning of an administrative proceeding sent to the Tax Matters Partner/Tax Matters Person (TMP). An examination ends:

(a) in the case in which the Service accepts the partnership or S corporation return as filed, on the date of the “no adjustments” letter or the “no change” notice of the final administrative adjustment sent to the TMP;

(b) in a fully agreed case, when all the partners or shareholders execute a Form 870–P, 870–L, or 870–S; or

(c) in an unagreed or a partially agreed case, on the earliest of the date the TMP (or its representative) is notified by an appeals officer that the case has been referred to an area office from a field office, the date the TMP (or a partner or shareholder) requests judicial review, or the date on which the period for requesting judicial review expires.

(1) During an examination . A taxpayer’s annual accounting period is an issue under consideration for the taxable years under examination if the taxpayer receives written notification (for example, by examination plan, information document request (IDR), or notification of proposed adjustments or income tax examination changes) from the examining officer(s) specifically citing the taxpayer’s annual accounting period as an issue under consideration. For example, a taxpayer’s annual accounting period is an issue under consideration as a result of an examination plan that identifies the propriety of the taxpayer’s annual accounting period as a matter to be examined. The question of whether the taxpayer’s annual

.07 Issue under consideration .

.01 In General.

(1) Approval of requests. Except as provided in section 5.01(2) of this revenue procedure, a request to adopt, change, or retain an annual accounting period ordinarily will be approved if the taxpayer:

(a) establishes a business purpose (within the meaning of section 5.02 of this revenue procedure) for the requested annual accounting period; and

(b) agrees to the Commissioner’s prescribed terms, conditions, and adjustments (as described in sections 5.04 and 5.05 of this revenue procedure) under which the adoption, change, or retention will be effected.

(2) Exceptions. Notwithstanding the general rule of section 5.01(1)(a) of this revenue procedure, a taxpayer with a required taxable year (other than a partnership, S corporation, electing S corporation, or PSC) will not be granted approval under this revenue procedure to adopt, change to,

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or retain a taxable year other than its required taxable year or, in appropriate circumstances, a 52–53-week taxable year that ends with reference to its required taxable year. In addition, a partnership, S corporation, electing S corporation, or PSC will be granted approval to adopt, change to, or retain an annual accounting period only if they establish a business purpose under section 5.02(1) for that annual accounting period. Notwithstanding the general rule of section 5.01(1)(b) of this revenue procedure, the Service may determine that, based on the unique facts of a particular case and in the interest of sound tax administration, terms, conditions, and adjustments that differ from those provided in this revenue procedure are more appropriate for an adoption, change, or retention made under this revenue procedure.

services for the short period and the three immediately preceding taxable years indicate that the taxpayer has a peak and a non-peak period of business, the taxpayer’s natural business year is deemed to end at, or soon after, the close of the peak period of business. A business whose income is steady from month to month throughout the year generally will not satisfy this test.

(2) Seasonal business test . If a taxpayer’s business is operational for only part of the year ( e.g., due to weather conditions) and, as a result, the taxpayer has insignificant gross receipts during the period the business is not operational, the taxpayer’s natural business year is deemed to end at, or soon after, the operations end for the season.

(3) 25-percent gross receipts test . A natural business year may be established by any taxpayer other than a member of a tiered structure (as defined in § 444 and § 1.444–2T) using the 25-percent gross receipts test. The 25-percent gross receipts test is determined as follows:

(a) Prior three years’ gross re- ceipts .

(i) Gross receipts from sales and services for the most recent 12-month period that ends with the last month of the requested annual accounting period are totaled and then divided into the amount of gross receipts from sales and services for the last two months of this 12-month period.

(ii) The same computation as in (a)(i) above is made for the two preceding 12-month periods ending with the last month of the requested annual accounting period.

(i) To apply the 25-percent gross receipts test for any particular tax

.02 Business Purpose .

(1) Taxpayers that establish a busi- ness purpose . Taxpayers that establish a business purpose for the requested annual accounting period under this section 5.02(1) ordinarily will be granted approval to adopt, change to, or retain that annual accounting period under this revenue procedure subject only to the general terms and conditions described in section 5.04 of this revenue procedure. (a) Natural business year . A taxpayer (including a partnership, S corporation, electing S corporation, or PSC) requesting to adopt, change to, or retain an annual accounting period that is the taxpayer’s natural business year (as described in section 5.03 of this revenue procedure) has established a business purpose to the satisfaction of the Commissioner.

(b) Facts and circumstances . A taxpayer (including a partnership, S corporation, electing S corporation, or PSC) may establish a business purpose for the requested taxable year based on all the relevant facts and circumstances. For this purpose, deferral of income to owners will not be treated as a business purpose. In addition, administrative and convenience business reasons such as those described in Rev. Rul. 87–57, 1987–2 C.B. 117, and the following will not be sufficient to establish a business purpose under this section:

(i) the use of a particular year for regulatory or financial accounting purposes;

(ii) the hiring patterns of a particular business , e.g., the fact that a firm

typically hires staff during certain times of the year;

(iii) the use of a particular year for administrative purposes, such as the admission or retirement of partners or shareholders, promotion of staff, and compensation or retirement arrangements with staff, partners, or shareholders;

(iv) the fact that a particular business involves the use of price lists, model years, or other items that change on an annual basis;

(v) the use of a particular year by related entities; and

(vi) the use of a particular year by competitors.

(2) Taxpayers that are deemed to have established a business purpose. A taxpayer other than a partnership, S corporation, electing S corporation, or PSC that does not establish a business purpose for the requested annual accounting period under section 5.02(1) of this revenue procedure generally will be deemed to have established a business purpose if it provides a non-tax reason for the requested annual accounting period and agrees to the additional terms, conditions, and adjustments described in section 5.05 of this revenue procedure, which are intended to neutralize the tax effects of any resulting substantial distortion of income. For this purpose, non-tax reasons for the requested annual accounting period may include administrative and convenience business reasons such as those described in section 5.02(1)(b) that Congress intended, and the Service has held, to be insufficient to satisfy the business purpose requirement for a partnership, S corporation, electing S corporation, or PSC to adopt, change to, or retain a taxable year other than its required taxable year. The Service anticipates that an individual taxpayer that is not a sole proprietor will be able to establish a non-tax reason for a fiscal year only in rare and unusual circumstances.

.03 Natural business year. A natural business year is the annual accounting period encompassing all related income and expenses. The natural business year of a taxpayer may be determined under any of the following tests (taking into account the principles of Rev. Rul. 87–57):

(1) Annual business cycle test . If the taxpayers’s gross receipts from sales and

(b) Natural business year .

(i) If each of the three results described in (a)(i) and (ii) equals or exceeds 25 percent, then the requested annual accounting period is the taxpayer’s natural business year.

(ii) Notwithstanding (b)(i), if the taxpayer qualifies under (b)(i) for more than one natural business year, the annual accounting period producing the highest average of the three percentages (rounded to 1/100 of a percent) described in (a)(i) and (ii) is the taxpayer’s natural business year.

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able year, the taxpayer must compute its gross receipts under the method of accounting used to prepare its federal income tax returns for such taxable year.

(ii) Regardless of the taxpayer’s method of accounting, the taxpayer’s allocable share of income from a passthrough entity generally must be reported as gross receipts in the month that the pass-through entity’s taxable year ends.

(iii) If a taxpayer has a predecessor organization and is continuing the same business as its predecessor, the taxpayer must use the gross receipts of its predecessor for purposes of computing the 25-percent gross receipts test.

(iv) If the taxpayer (including any predecessor organization) does not have a 47-month period of gross receipts (36-month period for requested taxable year plus additional 11-month period for comparing requested taxable year with other potential taxable years), then it cannot establish a natural business year using the 25-percent gross receipts test.

(v) If the requested taxable year is a 52–53-week taxable year, the calendar month ending nearest to the last day of the 52–53-week taxable year is treated as the last month of the requested taxable year for purposes of computing the 25-percent gross receipts test.

.04 General terms and conditions . The following general terms and conditions apply to all taxpayers that obtain approval under this revenue procedure to adopt, change, or retain an annual accounting period:

(1) Short period tax return . The taxpayer must file a federal income tax return for the short period required to effect a change in annual accounting period by the due date of that return, including extensions pursuant to § 1.443–1(a). However, for changes to (or from) a 52–53week taxable year referencing the same month as the current (or requested) taxable year, see special rules in § 1.441–2. The taxpayer’s taxable income for the short period must be annualized and the tax must be computed in accordance with the provisions of §§ 443(b) and 1.443–1(b). But see § 1.706–1(b)(4)(i) for an exception from this annualization requirement for a partnership.

(2) Subsequent year tax returns . Returns for subsequent taxable years generally must be made on the basis of a full 12

months (or on a 52–53-week basis) ending on the last day of the requested taxable year, unless the taxpayer secures the approval of the Commissioner to change its requested taxable year.

(3) Book conformity . The books of the taxpayer must be closed as of the last day of the requested taxable year. The taxpayer must compute its income and keep its books (including financial statements and reports to creditors) on the basis of the requested taxable year.

(4) Changes in natural business year. If a partnership, S corporation, electing S corporation, or PSC changes to or retains a natural business year under this revenue procedure and that annual accounting period no longer qualifies as a permitted taxable year, the taxpayer is using an impermissible annual accounting period and should change to a permitted taxable year. For this purpose, the term “permitted taxable year” means the required taxable year, a natural business year, the ownership taxable year, a taxable year elected under § 444, or any other taxable year for which the taxpayer establishes a business purpose to the satisfaction of the Commissioner. Certain partnerships, S corporations, electing S corporations, and PSCs may qualify for automatic approval to change their annual accounting period under Rev. Proc. 2001–XX. Other taxpayers must request approval under Rev. Proc. 2001–XX.

(5) 52–53-week taxable years. If applicable, the taxpayer must comply with § 1.441–2(e) (relating to the timing of taking items into account in those cases where the taxable year of a pass-through entity or PSC ends with reference to the same calendar month as one or more of its partners, shareholders, or employee-owners).

(6) Creation of net operating loss or capital loss . If the taxpayer has a net operating loss (NOL) or capital loss (CL) in the short period required to effect a change in annual accounting period, the taxpayer may not carry the NOL or CL back, but must carry it over in accordance with the provisions of §§ 172 and 1212, respectively, beginning with the first taxable year after the short period. However, the short period NOL or CL is carried back or carried over in accordance with §§ 172 or 1212, respectively, if it is either: (a) $50,000 or less, or (b) results from a short period of 9 months or longer and is

less than the NOL or CL for a full 12month period beginning with the first day of the short period.

(7) Creation of general business credits . If there is an unused general business credit or any other unused credit generated in the short period, the taxpayer must carry that unused credit forward. An unused credit from the short period may not be carried back.

.05 Additional Terms, Conditions, and Adjustments . The additional terms, conditions, and adjustments described in this section 5.05 apply to taxpayers that obtain approval under this revenue procedure to change an annual accounting period and that establish a business purpose under section 5.02(2) of this revenue procedure. These additional terms, conditions, and adjustments are necessary to neutralize the tax effects of a substantial distortion of income that otherwise would result from the change, 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 NOL, CL, 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 NOL, CL, or credit.

(1) Substantial distortion. Distortion of income will not be considered substantial and no adjustments under this section 5.05 will be required for such distortion if the amount of the distortion is less than both:

(i) five percent of the taxpayer’s estimated gross receipts for its current taxable year (computed as if the taxpayer remained on its existing taxable year); and

(ii) $500,000. (2) Deferral of substantial pass- through income.

(a) In general. An adjustment will be required under this section 5.05(2) if the change creates a substantial distortion of income as a result of increasing the deferral of the taxpayer’s distributive share of income from a pass-through entity between the taxable year of the passthrough entity and the taxpayer’s taxable year. For this purpose, if the pass-through entity’s taxable year is determined based

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on the taxable year of its owners, the taxpayer must compare the existing deferral period ( i.e., between the pass-through entity’s and the taxpayer’s current taxable years) with the proposed deferral period ( i.e., between the taxable year of the passthrough entity that would be required after the requested change and the taxpayer’s requested taxable year) to determine whether the deferral period is increased. If the taxpayer indirectly owns an interest in a pass-through entity through one or more other pass-through entities, the existing and proposed deferral periods generally must be determined by comparing the taxable year of the directly-owned pass-through entity with the taxpayer’s taxable year. However, if the proposed change does not increase the deferral period between the taxable year of the directly-owned pass-through entity and the taxpayer’s taxable year, the existing and proposed deferral periods must be determined by comparing the taxable year of the next lower-tier indirectly-owned passthrough entity with the taxpayer’s taxable year until either: (1) an increase in the deferral period is found, or (2) the next lower-tier entity either does not exist or is not a pass-through entity.

(b) Computing deferral. The amount of deferral that results from the change is the taxpayer’s allocable share of income from each pass-through entity described in (a), including ordinary income or loss, rents, royalties, interest, dividends, and the deduction equivalent of credits that accrue during the taxpayer’s first effective year and, in the case of a partnership, guaranteed payments to the taxpayer that are both deductible by the partnership under its method of accounting during the partnership’s first taxable year ending after the taxpayer’s first effective year and attributable (on a ratable basis) to the taxpayer’s first effective year. A taxpayer may aggregate the deferral of income from each pass-through entity described in (a). However, if the aggregate deferral of income from all pass-through entities described in (a) is negative ( i.e., an aggregate loss), there is no deferral of income. For this purpose, the taxpayer may use reasonable estimates to determine the income that accrues during the first effective year. The Service may, on examination, use any available data, including information on previous

years’ Schedules K-1, to verify the reasonableness of the taxpayer’s estimates.

(c) Adjustment. If the deferral of income computed in section 5.05(2)(b) represents a substantial distortion of income (as defined in section 5.05(1)), the taxpayer must include the entire amount of the distortion (and not merely the excess over the amounts specified in section 5.05(1)) as ordinary income for the first effective year. The taxpayer also must report its allocable share of income from the pass-through entity in the taxable year following the first effective year in accordance with general tax principles ( e.g., § 706). The taxpayer must establish a suspense account for the amount included in ordinary income for the first effective year and deduct this amount ratably over the four taxable years immediately succeeding the first effective year. Notwithstanding the preceding sentence, if all or a portion of the suspense account is attributable to an interest in a passthrough entity that is subsequently disposed of, any amount so attributable that remains in the suspense account in the year of the disposition may be deducted in that year. In all cases, the deduction under this paragraph will be treated as an ordinary deduction. The adjustments described in this section do not affect the taxpayer’s basis in the pass-through entity (such as basis in a partnership determined under § 705). See Examples 1, 2, and 3, section 5.06 of this revenue procedure.

(3) Special rule for certain pass- through entities. An adjustment similar to that described in this paragraph 5.05(2) will be required in the case of a deferral of income or shifting of deductions to another taxpayer, such as a beneficiary of an estate.

(4) Use of expiring NOLs, CLs, and credits. An adjustment will be required under this section 5.05(4) if the change creates a substantial distortion of income as a result of the creation of income in the short period to offset expiring NOLs, CLs, or credits (including general business credits). The amount of distortion that results from a change is the amount by which any NOL, CL, and credit that is carried over to the first effective year and that expires in that year exceeds the NOL, CL, and credit that could have been used to offset income in the taxpayer’s current taxable year (computed as if the taxpayer

remained on its existing taxable year). If this distortion is substantial (as defined in section 5.05(1)), any NOL, CL, or credit carried over to the first effective year will be allowed to offset income in the first effective year only to the extent that such NOL, CL, or credit could have been used to offset income in the taxpayer’s current taxable year. See Example 4, section 5.06 of this revenue procedure.

(5) Concurrent change for related entities. In appropriate cases, if a taxpayer owns a majority interest in a passthrough entity, the entity will be required to concurrently change its annual accounting period as a term and condition of the approval of the taxpayer’s request to change its annual accounting period, notwithstanding the testing date provisions in § 706(b)(4)(A)(ii), § 898 (c)(1)(C)(ii), § 1.921–1T(b)(6), and the special provision in § 706(b)(4)(B). If this condition applies, the pass-through entity must comply with the appropriate procedures to obtain approval for the change. See, e.g., Rev. Proc. 2001–XX and § 1.898–4(b) of the proposed regulations.

(6) Other terms, conditions, and ad- justments. In addition to the terms, conditions, and adjustments described in this section 5.05, the Service may impose any other term, condition, or adjustment that it deems appropriate under the circumstances.

.06 Examples . The following examples illustrate the additional terms, conditions, and adjustments that may be required under section 5.05 of this revenue procedure to obtain the Commissioner’s approval for a change of an annual accounting period. In all the examples, the taxpayer is within the scope of this revenue procedure, the taxpayer has established a business purpose under section 5.02(2) of this revenue procedure, and a substantial distortion of income will result from a change to the requested taxable year.

Example 1 . P, a foreign corporation, maintains its books and files its foreign country tax returns on the basis of a taxable year ending on March 31. In 2001, P acquires all the stock of S, a domestic corporation, that maintains its books and files its tax returns on the calendar year. S has a minority interest in a partnership that uses the calendar year. In order to facilitate the filing of consolidated financial statements for P and S, S applies for approval to change its taxable year to a taxable year ending on March 31 beginning on March 31, 2002. The change will cre

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ate a substantial distortion of income as a result of increasing the deferral of S’s distributive share of income from its partnership interest. Consequently, S will be required, under section 5.05(2) of this revenue procedure, to report the partnership income that accrues between January 1 and March 31, 2002, as an ordinary income adjustment on its short period tax return as a term, condition, and adjustment of the change. Thereafter, on subsequent tax returns filed for its taxable year ending on March 31 (beginning March 31, 2003), S must report the partnership income for the partnership’s taxable year ending December 31 based on the Schedule K-1 in accordance with § 706. To take into account S’s double inclusion of the three months of partnership income from January 1 to March 31, 2002, S must recognize an ordinary deduction adjustment in each of the four taxable years following the first effective year equal to onefourth of the ordinary income adjustment amount included on S’s short period tax return. Neither adjustment will affect S’s basis in the partnership.

Example 2. D is a domestic corporation that currently maintains its books and files its tax returns on the calendar year, but applies in 2002 for approval to change its taxable year to a year ending on March 31. D owns a majority interest in a partnership, PS1, which in turn owns a minority interest in another partnership, PS2. PS1 and PS2 have taxable years ending on December 31 and June 30, respectively, as required by the majority interest rule of § 706(b)(1)(b)(i). If D changes its annual accounting period to March 31, and the first effective year ends on March 31, 2002, PS1 will be required to conform its taxable year with D using a first effective year of March 31, 2002, as required under section 5.05(5) of this revenue procedure. Accordingly, D’s requested change in its taxable year would not increase the deferral of D’s distributive share of income or gain from PS1. However, PS2 will retain its June 30 taxable year; thus, D’s requested change will increase the deferral of D’s distributive share of income and gain from PS2, which is passed through to D from PS1. Assuming the deferral results in a substantial distortion of income, D will be required, under section 5.05(2) of this revenue procedure, to report its distributive share of PS2’s income and gain accruing between January 1, 2002, and March 31, 2002, as an ordinary income adjustment on its tax return for the short period ending March 31 as a term and condition of the change in D’s taxable year.

Example 3. The facts are the same as in Example 2, except that PS2 owns a minority interest in partnership PS3, which has a December 31 taxable year. Because D will be required as a term and condition of the change in D’s taxable year to report its distributive share of PS2’s income and gain accruing between January 1, 2002, and March 31, 2002, and because that distributive share will include a portion of PS2’s distributive share of income from PS3, D does not need to make any additional ordinary income adjustment to take account of any increased deferral from PS3.

Example 4 . Y, a domestic corporation that files its tax returns on the calendar year, applies in 2002 for consent to change its taxable year to a year ending on March 31. Y has a general business credit carryover of $100x that will expire in the current taxable year. Y reasonably expects to incur on April 30, 2002, a substantial amount that is deductible for federal income tax purposes. If Y changes its annual

accounting period to March 31, and the first effective year ends on March 31, 2002, Y reasonably expects it would be able to use $90x of the $100x credit. However, if Y continues to use the calendar year for 2002, Y reasonably estimates that it would be able to use only $25x of the expiring credit. Under section 5.05(4) of this revenue procedure, Y will be allowed to use only $25x of the credit to offset income in the first effective year as a term, condition, and adjustment of the change.