Under the U.S. tax laws, partnership income and expenses flow through to each partner in a partnership, at a partnership’s tax year-end. Generally, the tax year of a partnership must conform to the tax years of its partners. In some situations, however, a partner, or multiple partners, and the partnership itself may have different tax years, there is a potential for income deferral.
While legitimate income deferral is allowed under the U.S. tax laws, the IRS has rules in place to prevent excessive deferral of partnership income. These rules are explained briefly below in three successive steps. A partnership must apply each rule in chronological order, and the first tax year that meets all of the criteria in a specific rule will be the required tax year for the partnership (subject to certain exceptions allowed by the IRS).
1) Majority partners’ tax year
In general, if one partner owns more than 50% of the partnership capital and profits, then that partner’s taxable year will apply to the partnership. Similarly, if a group of partners have the same taxable year and own more than 50% of the partnership capital and profits, then that shared taxable year will also apply to the partnership. Majority interest is generally determined on the first day of the partnership.
2) Principal partners’ tax year
If step 1 does not yield a majority interest tax year, then the tax year the principal partners who own more than a 5% interest of capital or partnership profits, will be used if they all have the same tax year.
3) Year with smallest amount of income deferred
If steps 1 and 2 do not yield a result, then the “least aggregate deferral rule” is used to determine the weighted-average deferral of partnership income by testing the tax year-ends of the partners. The tax year required to be selected under the test will be whichever tax year-end is calculated to yield the least amount of deferral of partnership income.
Example of the Three-Step Analysis
To illustrate, assume that Adam and Bob are equal partners, each owning a 50% share. Adam’s tax year ends August 31, while Bob uses the calendar year, December 31. Step 1 would determine that there is no majority interest because neither partner owns more than 50%, and Step 2 would show that neither partners have the same tax year (even though they are both considered to be principal partners owning more than 5%). Thus, the least aggregate deferral rule would be applied in this case.
Under the least aggregate deferral rule, to determine the weighted-average product, begin by counting forward from the end of one partner’s tax year to the end of the other partner’s tax year-end, and then vice versa. For example, counting forward from the end of Adam’s tax year (August 31) to the end of Bob’s (December 31) is four months. Then, the number of months is multiplied by the partnership percentage interest, to determine a weighted-average product. Multiplying four by the partnership interest of 0.5 equals a product of two (the aggregate deferral). Counting forward from the end of Bob’s tax year to the end of Adam’s, determines that eight months will be deferred. Multiplying eight by .50 equals a product of four. Since the product of two under Adam’s August 31 tax year is less than the product of four under Bob’s December 31 tax year, Adam’s tax year-end will also be the tax year-end for the partnership itself.
Described above are the basic rules for determining the required tax year for partnerships. In some cases, it may be possible to be granted an exception from the general rules. These options however often depend upon persuading the IRS of the necessity of adopting a different tax year than would be available under the standard rules. Often, complex legal rules and case law are involved, so it is advisable to seek legal counsel. Furthermore , individual partners may need specific guidance relating to partnership taxation scenarios. Sherayzen Law Office can assist you with these matters.
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