Learn about your options with Taxation of Exempt Income

Read on Taxation of Exempt Income



   By John Wolf

Tax-exempt income received by a corporation increases earnings and profits, Therefore, if a corporation receives a payment of tax-free life insurance proceeds, any excess over premiums paid (or cash values) will increase earnings and profits. Likewise, interest on state bonds and other obligations, although not taxable when received by a corporation, increases earnings and profits (Reg. §1.3126(b)). The proceeds and interest then lose their tax-free nature when they are distributed to shareholders as dividends (R.R. 71-79).

Note: Dividends paid out of the earnings and profits of a corporation are ordinary income to the shareholder (§316; Reg. §1.316-1(a); §61(a)(7); Reg. §1.61-9).

Exempt Income

Furthermore, a corporation’s receipt of tax-exempt income may trigger an alternative minimum tax problem.

Income Tax 2018

Accounting Periods & Methods

Before TRA ‘86, a corporation, as a new taxpayer, could adopt a calendar year or any fiscal year regardless of the tax year of its unincorporated predecessor (Reg. §1.441-1(b)(3)). This flexibility was not usually accorded to partnerships and S corporations. Similarly, a corporation could adopt the accounting method of its choice (Reg. §1.446-1(c)). Most corporations chose the cash method because of the ability to defer taxation on earnings until they are received. Billing and collection practices can further enhance the strength of the corporation on a cash basis to control its income. A new corporation could adopt the cash basis merely by filing its return on that basis.

Accounting Periods

A regular accounting period is either a calendar tax year or a fiscal tax year. If a corporation adopts the calendar year for its annual accounting period, it must maintain books and accounting and report on time its gain and lose and expenses for the calendar period from January 1 through December 31 of each year. A regular fiscal tax year is twelve consecutive months ending on the last day of any month except December. A 52-53 week year is a fiscal tax year that varies from 52 to 53 weeks (§441(a)).

What Is Tax-Exempt Income?

Generally, S corporations, partnershipsand personal service corporations must use “required tax years.” The required tax year does not have to be used if the partnership, S corporation, or personal service corporation establishes a business purpose for a different period, or makes a §444 election (§441(i); §706(b); §1378).

Section 444 Election

S corporations, Partnerships, and personal service corporations may elect to use a tax year that is different from the required tax year under §444. This election does not apply to any partnership, S corporation, or personal service a corporation that establishes a business motive for a different period. S corporation partnership, or personal service corporation may make a §444 election if it:

(a) Is not a member of a tiered structure,

(b) Has not previously had a section 444 election in effect, and

(c) Elects a year that meets the deferral period requirement (Reg. §1.444-

1T(b); Reg. §1.444-2T).

An election to change a tax year will be allowed only if the deferral period of the elected tax year is not longer than the shorter of:

(a) Three months, or

(b) The deferral period of the tax year being changed (§444(b); Reg. §1.444-1T(b)(2)).

For an S corporation partnership or personal service corporation that wants to adopt or change its tax year, by making a §444 election, the deferral period is the number of months between the end of the elected tax year and the close of the required tax year. If the tax year is the required tax year, the deferral period is zero (Reg. §1.444-1T(b)(4)(ii)(B)).

The §444 election is made by Form 8716, Election To Have a Tax Year Other Than a Required Tax Year, with the  IRS Internal Revenue Service Center where the tax return is usually filed Form 8716 must be filed before of:

(a) The 15th day of the sixth month of the tax year for which the election will be valid, or

(b) The due day (without regard to extensions) of the income tax return resulting from the section 444 election (Reg. §1.444-3T(b); Ann. 88-90).

Partnerships and S corporations that make a §444 election must make certain

required payments. An electing personal service corporation must make certain distributions.

Business Purpose Tax Year

A business motive for a tax year is an accounting period that has a substantial business purpose for its existence. Both tax and nontax factors must be considered in determining if there is a significant business purpose for a requested tax year.


A nontax factor that may be sufficient to establish a business purpose for a tax year is the annual cycle of business activity, called a “natural business year.” The accounting period of a natural business year includes all related income and expenses. A calendar business year exists when a business has a peak period and non-peak time. The regular business year is expected to end at or soon after the end of the peak period. A company whose income is steady from month to month, year-round, would not have a natural business year as such (Reg. §1.7061(b)(4)(iii); R.P. 74-33).

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