Sec. 444 elections for S corporations - should you revoke?

• Author: Wendland, Sherri L.

Under pre-1983 law, an S corporation was allowed to select any fiscal year. Because of perceived abuses, current law requires that an S corporation generally be on a calendar year. There are, however, a few exceptions to this general rule.

The first exception is the valid business purpose test. An S corporation may adopt any fiscal year-end if it can establish that there is a business purpose for that fiscal year. If a fiscal year is permitted under the business purpose exception, no deposits are required to maintain a noncalendar year.

There are two other exceptions available, at the corporation's election. First, an S corporation was able to elect to retain the fiscal year it had in 1986. (This election had to be made no later than July 26, 1988.) In addition, an S corporation may elect a fiscal year that does not defer income for the shorter of three months, or the deferral period of the tax year from which the corporation is changing. Thus, a new S corporation may elect a fiscal year ending in September, October or November.

If a fiscal year is elected under these latter exceptions (i.e., an election other than the business purpose exception), the S corporation is required to make interest-free deposits with the IRS per Sec. 7519. The deposits are based on the deferral period, and the tax is calculated at 1% above the highest individual rate.

With the increase in tax rates in 1993, required deposits have increased from 32% to 40.6%. Because of this increase, many S corporations are considering revoking their fiscal year elections and switching to a calendar year-end. This may, however, cost the corporation more tax than it would to retain a fiscal year-end.

There are two major disadvantages to revoking a fiscal year

election. One is the permanent loss of the deferral. The other is that, in the year of revocation, the shareholders must bunch possibly up to 23 months of income, depending on the deferral period. With dependency exemptions and other phase-out rules, this can become quite expensive.

In many cases it may be beneficial to keep a fiscal year-end. One of the determining factors to be considered is how much of the corporation's income is earned during the deferral period. If a large enough percentage of the income is earned during the deferral period, it would cost the corporation more to revoke its fiscal year than it would to make the required deposits.

Example 1: An S corporation with a sole shareholder has a September 30...