Partnership and S Corp Ownership Changes

When preparing partnership and S corporation tax returns, practitioners must always consider changes in ownership and how that might affect the pass-through of income. Many tax software programs have special entries in their partnership or S corporation tax return modules that may allow the income to be split within the software. It is imperative to understand how these automated calculations work and whether or not they can be used for a given client.

For instance, if a partner’s ownership changes, two options are available for determining how income should be split based on the change in ownership.

Partnership Option 1 – Interim Closing of the Books

Interim closing of the books requires that the taxable year effectively be split into two (or more, depending on the number of ownership changes). For instance, if the ownership split between Partner A and Partner B changes on July 1 of a given taxable year, using this option would require the tax professional to run two profit and loss statements. One from January 1 through June 30 and the other from July 1 through December 31. If Partner A and Partner B were 50/50 in the first half of the year, and 75/25 for the second half of the year, the practitioner would have to manually calculate the amount of show on each partner’s K-1 and override the software to account for this change.

Interim closing of the books is the default method for a partnership.[1] If the partnership’s operating agreement or another agreement does not specify that the income should be allocated on a prorated basis, this method must be used. Within option 1, three different conventions may be applicable:[2]

1. Calendar Day Convention: default treatment
2. Semi-Monthly Convention: agreement from partners required
3. Monthly Convention: agreement from partners required

Partnership Option 2 – Proration Method

If the partnership agreement specifies that ownership changes result in averaging income daily throughout the year, then the partnership must calculate the average daily income or loss and prorate that to each partner based on their ownership percentage for any given period of ownership within the taxable year. If a tax professional’s software allows for the entry of ownership periods and applicable percentages for those periods, the software will complete this calculation for the practitioner.

Caution must be applied because this method may only be used when the partnership agrees. While option 2 may be significantly faster to calculate than option 1 (because the preparer will not have to calculate and allocate all items on Schedule K-1 manually), the changes in income allocation may be substantial.

For instance, businesses often do not earn income evenly throughout the year. Averaging the income daily may result in partners recognizing substantially more or less income than they are legally entitled to under the partnership agreement.

S Corporation Option 1 – Proration Method

While the default method for splitting income in the year of a partnership ownership change generally requires an interim closing of the books, S corporations provide for the exact opposite. By default, S corporations must prorate the income daily.[3] This may result in income and loss allocations that vary widely from what the shareholders are entitled to.

The bright side for practitioners is that this tends to be the easiest way to handle the income allocations in a year of ownership change.

S Corporation Option 2 – Interim Closing of the Books

While the interim closing of the books in an S corporation usually allows for the reporting of income that most closely resembles the economic reality of S corporation ownership, simply agreeing to an interim closing of the books may not allow the S corporation to apply this second option.

An S corporation may elect for an interim closing of the books in either of the two following circumstances, provided all affected shareholders agree:

1. Termination of a shareholder’s entire interest[4]
2. A qualifying stock disposition, defined as:[5]
1. A disposition by a shareholder of 20 percent or more of the outstanding stock of the corporation in one or more transactions during any thirty-day period during the corporation’s taxable year;
2. A redemption treated as an exchange under section 302(a) or section 303(a) of 20 percent or more of the outstanding stock of the corporation from a shareholder in one or more transactions during any thirty-day period during the corporation’s taxable year; or
3. Issuing an amount of stock equal to or greater than 25 percent of the previously outstanding stock to one or more new shareholders during any thirty-day period during the corporation’s taxable year.

Preparing the Partnership or S corporation Tax Return

Using any of the previously stated options, it is important to note that most changes in ownership do not require the filing of more than one tax return for a given tax year. For an interim closing of the books, one tax return will be filed, and it will be up to the practitioner to properly allocate income using this method on Schedule K-1.

For more information about income allocations for partnerships and S corporations, join us for Entity Essentials, where we will discuss this and many other topics related to business entity tax return preparation.

[2 IRS Reg §1.706-4(c)

[3] IRS Reg §1.1377-1(a)

[4] IRS Reg §1.1377-1(b)

[5] IRS Reg §1.1368-1(g)