SECTION 5. BUSINESS — Internal Revenue Bulletin 2002-22

AND TERMS, CONDITIONS, AND ADJUSTMENTS

.10 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, 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, or retain an annual accounting period only if it establishes 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.

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.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, 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, 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. However, the Service anticipates that a taxpayer will be granted permission to adopt, change, or retain an annual accounting period under this facts and circumstances test only in rare and unusual 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 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 .

(a) In general . If the taxpayer’s gross receipts from sales and 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 highest peak period of business. A business whose income is steady from month to month throughout the year will not satisfy this test. A taxpayer that has not been in existence for a sufficient period to provide gross receipts

information for the three immediately preceding taxable years may provide information other than gross receipts to demonstrate a peak and non-peak period of business, such as a description of its business and/or reasonable estimates of future gross receipts.

(b) Safe harbor . For purposes of section 5.03(1)(a) of this revenue procedure, 1 month will be deemed to be “soon after” the close of the highest peak period of business.

retail business. The highest peak of A’s annual busi ness cycle occurs in December each year. In Janu ary, a significant amount of the merchandise that

was purchased by A’s customers in December is

either returned or exchanged. A’s natural business

year is deemed to end at (December 31st), or soon

after (January 31st), the close of the highest peak

period of business in December. Accordingly, under

the provisions of this revenue procedure, a request

by A for a taxable year ending either December 31st

or January 31st would be granted, subject to the

general terms and conditions of section 5.04 of this

revenue procedure.

(2) Seasonal business test .

(a) In general . If the taxpayer’s gross receipts from sales and services for the short period and the three immediately preceding taxable years indicate that the 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. A taxpayer that has not been in existence for a sufficient period to provide gross receipts information for the three immediately preceding taxable years may provide information other than gross receipts to demonstrate that it satisfies the requirements of a seasonal business, such as a description of its business and/or reasonable estimates of future gross receipts.

(b) Safe Harbor . For purposes of section 5.03(2)(a) of this revenue procedure, an amount equal to less than 10 percent of the taxpayer’s total gross receipts for the year will be deemed to be “insignificant,” and 1 month will be deemed to be “soon after” the close of operations.

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through March of each year. During September and October, and during April, employees prepare the resort for the ski season, and close it down for the season, respectively. The resort earns less than 10 percent of its annual gross receipts during the period of April through October, when it is closed to guests. B’s natural business year is deemed to end at (March 31st), or soon after (April 30th), the close of the resort operations. Accordingly, under the provisions of this revenue procedure, a request by B for a taxable year ending either March 31st or April 30th would be granted, subject to the general terms and conditions of section 5.04 of this revenue procedure.

(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 receipts .

(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 2 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.

as the taxpayer’s natural business year under the 25-percent gross receipts test.

for example, §§ 1.706–1(b)(8)(i)(B), 1.852–3(e), 1.857–2(a)(4), 1.1378– 1(c)(2), and 1.1502–76 for exceptions to the annualization rule for a partnership, RIC, REIT, S corporation, and subsidiary corporation ceasing to be a member of a consolidated group, respectively.

(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) Record keeping/book confor- mity . The books of the taxpayer must be closed as of the last day of the first effective year. Thereafter, the taxpayer must compute its income and keep its books and records (including financial statements and reports to creditors) on the basis of the requested taxable year, except that this requirement shall not apply (1) to books and records maintained solely for foreign law purposes ( e.g., foreign tax reporting purposes), or (2) if the requested taxable year is either the taxpayer’s required taxable year or ownership 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. Certain partnerships, S corporations, electing S corporations, and PSCs may qualify for automatic approval to change their annual accounting period under Rev. Proc. 2002–38. Other taxpayers must request approval under this revenue procedure.

(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 passthrough entity or PSC ends with reference to the same calendar month as one or more of its partners or shareholders or employee-owners).

(6) Creation of net operating loss or capital loss . If the taxpayer generates a net operating loss (NOL) or capital loss

(b) Natural business year .

(i) Except as provided in (b)(ii) below, if each of the three results described in (a) equals or exceeds 25 percent, the requested annual accounting period is deemed to be the taxpayer’s natural business year.

(ii) The taxpayer must determine whether any annual accounting period other than the requested annual accounting period also meets the 25-percent gross receipts test of paragraph (b)(i). If one or more annual accounting periods produce higher averages of the three percentages (rounded to the 1/100 of a percent) described in (a) than the requested annual accounting period, then the requested annual accounting period will not qualify

(i) To apply the 25-percent gross receipts test for any particular taxable 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 share of income from a pass-through entity generally must be reported as gross receipts in the month that the passthrough 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). The taxpayer’s taxable income for the short period generally must be annualized and the tax must be computed in accordance with the provisions of § 443(b) and § 1.443–1(b). However, for changes to (or from) a 52–53-week taxable year referencing the same month as the current (or requested) taxable year, see special rules in § 1.441–2. See also,

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determined by comparing the taxable year of the next lower-tier indirectly-owned pass-through 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, capital gain or loss, rents, royalties, interest, dividends, and the deduction equivalents of credits that accrue during the taxpayer’s first effective year. In the case of a partnership, the taxpayer’s share of income also includes 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 must 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) of this revenue procedure 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 passthrough 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

(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, except as otherwise provided in the Code or regulations ( e.g., § 280H and the regulations thereunder in the case of a PSC) 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 12-month 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.

(8) Concurrent change for related entities . In appropriate cases, if a taxpayer owns a majority interest in a pass-through 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. 2002–37 and Rev. Proc. 2002–38. .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 of 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 pass-through entity and the taxpayer’s taxable year. For this purpose, if the passthrough entity’s taxable year is determined based 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 pass-through 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

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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 (or the shifting of foreign taxes paid or accrued) 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) Other terms, conditions, and adjustments . 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 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 any distortion of income resulting from the change is substantial.

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 May 31st. In

2001, P acquires all the stock of S, a domestic cor poration, that maintains its books and files its tax

returns on the calendar year. S has a minority inter est 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

May 31st beginning on May 31, 2002. The change

will create a substantial distortion of income as a

result of increasing the deferral of S’s distributive

share of income from its partnership interest. Con sequently, S will be required, under section 5.05(2)

of this revenue procedure, to report the partnership

income that accrues between January 1 and May 31,

2002, as an ordinary income adjustment on its short

period tax return as a term, condition, and adjust ment of the change. Thereafter, on subsequent tax

returns filed for its taxable year ending on May 31st

(beginning May 31, 2003), S must report the part nership 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 5 months of partnership

income from January 1 to May 31, 2002, S must

recognize an ordinary deduction adjustment in each

of the four taxable years following the first effective

year equal to one-fourth 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 cur rently 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 May

31st. 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 31st and September 30th,

respectively, as required by the majority interest rule

of § 706(b)(1)(b)(i). If D changes its annual

accounting period to May 31st, and the first effec tive year ends on May 31, 2002, PS1 will be

required to conform its taxable year with D using a

first effective year of May 31, 2002, as required

under section 5.04(8) of this revenue procedure.

Accordingly, D’s requested change in its taxable

year would not increase the deferral of D’s distribu tive share of income or gain from PS1. However,

PS2 will retain its September 30th 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 distor tion of income, D will be required, under section

5.05(2) of this revenue procedure, to report its dis tributive share of PS2’s income and gain accruing

between January 1, 2002, and May 31, 2002, as an

ordinary income adjustment on its tax return for the

short period ending May 31st as a term and condi tion 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 part nership PS3, which has a December 31st taxable

year. Because D will be required as a term and con dition 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 May 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 end ing on May 31st. Y has a general business credit

carryover of $100x that will expire in the current

taxable year. Y reasonably expects to incur on June

30, 2002, a substantial amount that is deductible for

federal income tax purposes. If Y changes its annual

accounting period to May 31st, and the first effective year ends on May 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.