The accounting method trap.

• Author: Belman, Bruce J.

Effective for tax years beginning after 1986, three types of taxpayers may not use the cash method of accounting, but must use the accrual method (Sec. 4481a}1:

1. c corporations with gross receipts greater than $5 million,

2. Partnerships with a C corporation partner and gross receipts greater than $5 million; and

3. Tax shelters.

The prohibition normally does not apply to S corporations or to partnerships in which all partners are individuals. However, the definition of tax shelter for purposes of Sec. 448 is written very broadly and may encompass flowthrough entities that would otherwise be exempt from this requirement.

The definition of a tax shelter for purposes of Sec. 448 is found only after examining various sections of the Code, starting with Sec. 448(b)(3)and including Sec. 1256(e){3)(B) and (C)and Sec. 464(c)(2). In essence, if there is a flowthrough entity, owned 35% or more by passive owners, and it shows a loss in any year, the entity will be deemed a tax shelter.

Under this definition of a tax shelter, many operating entities that would ordinarily be able to use the cash method of accounting will be forced to switch to the accrual method when there are significant nonactive owners and the company sustains a loss. One common scenario would encompass a business in which the owner has transferred ownership to inactive family members for income or estate tax purposes.

A partnership, entity or enterprise that is a tax shelter must change from the cash method to the accrual method for the tax year that the partnership, entity or enterprise becomes a tax shelter under Temp. Regs. Sec. 1.448IT(b)(5). If the taxpayer voluntarily makes the change to the accrual method of accounting, it may get automatic IRS consent by filing a Form 3115 with its return no later than the due date (including extensions)for the year of change (Temp. Regs. Sec...