IRS provides guidance on identifying separate trades or businesses
TAX ALERT |
Section 446 provides that accounting methods are adopted on a trade or business basis. Thus, a taxpayer engaged in more than one trade or business may use a different method of accounting for each separate and distinct trade or business, as long as such methods clearly reflect income. Identifying separate and distinct trade or business activities is therefore an important step for taxpayers seeking to adopt (or change) to proper and optimal methods of accounting.
The existence of multiple trades or businesses is primarily a factual determination, and there is little guidance that clearly defines separate and distinct trades or businesses for purposes of adopting and changing methods of accounting. Pursuant to Reg. section 1.446-1(d), if a taxpayer has two or more separate and distinct trades or businesses, a different method of accounting may be used for each trade or business, provided (1) the method used for each trade or business clearly reflects the income of that particular trade or business, (2) the taxpayer maintains separable books and records for each trade or business, and (3) the maintenance of different methods does not create or shift profits or losses between the trades or businesses.
The courts and the IRS have identified additional, relevant factors to look to when determining whether two or more lines of business should be treated as separate and distinct trades or businesses. Such factors include the existence of common management; whether the taxpayer holds out each line as a separate business; the maintenance of separate bank accounts; whether the businesses share employees; and the nature and geographical location of each business. It is also important to note that while the regulations require taxpayers to maintain separable books and records for each trade or business they do not require taxpayers to maintain separate books and records. Thus, as long as taxpayers can produce separate books and records if requested, they will satisfy this requirement.
In a recent released internal legal memorandum (ILM 201430013), the IRS ruled that a single member limited liability company (the SMLLC) treated as disregarded for federal income tax purposes should be treated as a separate trade or business from its sole owner (the Company) for purposes of adopting and changing methods of accounting. The IRS based its ruling on the following factors:
- Separate books and records were kept for the SMLLC and the Company
- The SMLLC engaged in a business that was different in nature from that of the Company
- The SMLLC and the Company operated in different geographical locations
- The SMLLC and the Company shared no employees other than the highest-level executives
Based on these factors, the IRS ruled that the Company and the SMLLC should be treated as separate and distinct businesses notwithstanding that the SMLLC was disregarded from the Company for federal income tax purposes. While the determination of whether multiple lines of businesses within one taxpayer should be treated as separate and distinct for purposes of adopting or changing methods of accounting is still susceptible to ambiguity, the ILM does provide some insight as to the factors that the IRS will look to when making this determination. Additionally, the ILM should serve as a reminder to taxpayers that multiple lines of business (e.g., divisions or disregarded entities within a taxable entity) should be evaluated to determine whether such lines are properly treated as separate and distinct trades or businesses.
Taxpayers should work with their tax advisors to ensure that proper and optimal methods of accounting are applied on a trade or business by trade or business basis.