Taxable income is figured on the basis of a tax year. A "tax year" is the accounting period used for keeping records and reporting income and expenses.

Partnership. A partnership determines its tax year as if it were a taxpayer. However, there are limits on the year it can choose. In general, a partnership must use its required tax year. Exceptions to this rule are discussed under Exceptions to Required Tax Year, later.

Partners. Partners can change their tax year only if they receive permission from the IRS. This also applies to corporate partners, who are usually allowed to change their accounting periods without prior approval if they meet certain conditions.

Closing of tax year. Generally, the partnership's tax year is not closed because of the sale, exchange, or liquidation of a partner's interest, the death of a partner, or the entry of a new partner. However, if a partner sells, exchanges, or liquidates his or her entire interest, or a partner dies, the partnership's tax year is closed for that partner. See Distributive share in year of disposition under Partner's Income or Loss, later.

Required Tax Year

A partnership generally must conform its tax year to its partners' tax years. The rules for determining the required tax year are as follows.

• Majority interest tax year. If one or more partners having the same tax year own an interest in partnership profits and capital of more than 50% (a majority interest), the partnership must use the tax year of those partners.

  Testing day. The partnership determines if there is a majority interest tax year on the testing day, which is usually the first day of the partnership's current tax year.

  Change in tax year. If a partnership's majority interest tax year changes, it will not be required to change to another tax year for 2 years following the year of change.

• Principal partner. If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. A principal partner is one who has a 5% or more interest in the profits or capital of the partnership.
• Least aggregate deferral of income. If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use a tax year that results in the least aggregate deferral of income to the partners.

Least aggregate deferral of income. The tax year that results in the least aggregate deferral of income is determined as follows.

1. Figure the number of months of deferral for each partner using one partner's tax year. Count the months from the end of that tax year forward to the end of each other partner's tax year.
2. Multiply each partner's months of deferral figured in step (1) by that partner's interest in the partnership profits for the year used in step (1).
3. Add the results in step (2) to get the total deferral for the tax year used in step (1).
4. Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years.

The partner's tax year that results in the lowest number in step (3) is the tax year that must be used by the partnership. If more than one year qualifies as the tax year that has the least aggregate deferral of income, the partnership can choose any year that qualifies. However, if one of the years that qualifies is the partnership's existing tax year, the partnership must retain that tax year.

Example. Rose and Irene each have a 50% interest in a partnership that uses a fiscal year ending June 30. Rose uses a calendar year while Irene has a fiscal year ending November 30. The partnership must change its tax year to a fiscal year ending November 30 because this results in the least aggregate deferral of income to the partners. This was determined as shown in the following table.

Year End 12/31:	Year End	Profits Interest	Months of Deferral	Interest × Deferral
Rose	12/31	0.5	-0-	-0-
Irene	11/30	0.5	11	5.5
Total Deferral				5.5
Year End 11/30:	Year End	Profits Interest	Months of Deferral	Interest × Deferral
Rose	12/31	0.5	1	0.5
Irene	11/30	0.5	-0-	-0-
Total Deferral				0.5

Special de minimis rule. If the tax year that results in the least aggregate deferral produces an aggregate deferral that is less than 0.5 when compared to the aggregate deferral of the current tax year, the partnership's current tax year is treated as the tax year with the least aggregate deferral.

Procedures. Generally, determination of the partnership's required tax year is made at the beginning of the partnership's current tax year. However, the IRS can require the partnership to use another day or period that will more accurately reflect the ownership of the partnership.

The change to a required tax year is treated as initiated by the partnership with the consent of the IRS. No formal application for a change in tax year is needed.

Notifying IRS. Any partnership that changes to a required tax year must notify the IRS by writing at the top of the first page of its tax return for its first required tax year, "FILED UNDER SECTION 806 OF THE TAX REFORM ACT OF 1986."

Short period return. When a partnership changes its tax year, a short period return must be filed. The short period return covers the months between the end of the partnership's prior tax year and the beginning of its new tax year.

If a partnership changes to the tax year resulting in the least aggregate deferral of income, a statement must be attached to the short period return showing the computations used to determine that tax year. The short period return must indicate at the top of page 1, "FILED UNDER SECTION 1.706-1T."

Exceptions to Required Tax Year

There are two exceptions to the required tax year rule.

Business purpose tax year. If a partnership establishes an acceptable business purpose for having a tax year different from its required tax year, the different tax year can be used. The deferral of income to the partners is not considered a business purpose.

See Business Purpose Tax Year in Publication 538 for more information.

Section 444 election. Partnerships can elect under section 444 of the Internal Revenue Code to use a tax year different from both the required tax year and any business purpose tax year. Certain restrictions apply to this election. In addition, the electing partnership may be required to make a payment representing the value of the extra tax deferral to the partners.

See Section 444 Election in Publication 538 for more information.

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