Tax Matters

Contribution of Appreciated Stock
Owners of closely held corporations frequently contribute corporate stock to public charities or private foundations. The tax benefits from the contribution will vary greatly depending on whether the taxpayer can claim a deduction for the stock’s full value or whether the deduction is limited to the stock’s basis. Recently the Tax Court considered this issue.

In December 1994 John Todd contributed 6,350 shares of Union Colony Bancorp to a private foundation he had formed. He claimed a charitable contribution of $553,847. His basis in the stock was $33,338. Todd had based the stock value on the price in a sale of other shares around the same time he made the contribution.

Union Colony did not trade on an established market. Instead Gill & Associates, a member of the National Association of Securities Dealers, maintained a matching service for those who wanted to buy or sell shares of the company. Gill quoted a price to prospective customers upon request based on the corporation’s book value, which Gill believed was the equivalent of fair market value.

The IRS reduced Todd’s deduction to the stock’s basis. It argued that fair market value is available only if a stock is traded on an established market. And even if it was, the taxpayer failed to provide the required appraisal.

Result. For the IRS. The Tax Court first addressed the question of whether there were market quotations for the contributed stock on an established market. It concluded there were not. The fact an investment banking house maintained a matching service and was willing to quote book value did not constitute an established market. The limited number of sales proved the shares were not readily tradable. Congress enacted the deduction limit to prevent overstatement of contributions—this was the type of case that concerned it. The fact the taxpayer’s expert witness opined the broker’s actions created a market did not actually create one.

Although the court could have stopped at this point, it went on to address the absence of an appraisal. The regulations require the taxpayer to provide an appraisal for all gifts of property that are not traded on an established exchange. Todd failed to supply one and therefore would again be denied a deduction in excess of his basis. The court did not even discuss the fact the stock value was determined from a sale of other shares at the same time as the contribution.

Because of the significant potential for abuse, the courts strictly enforce the contribution rules. Deductions for gifts of stock to private foundations are limited to basis unless the stock trades on an established market, has a quoted market price and the taxpayer provides an appraisal. CPAs should encourage clients to follow the substantiation rules exactly. The fact the value of the gift can be proven by alternative means is insufficient.

John C. Todd v. Commissioner, 118 TC no. 334.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama at Tuscaloosa.

Taxing Social Security Benefits
Under IRC section 86 a taxpayer must reach a certain income level before his or her Social Security benefits are taxable. For married taxpayers filing separately and living apart, that threshold is $25,000. But if the taxpayer files separately and lives with his or her spouse, the threshold is zero.

For example, a taxpayer is 72 years old and earns $20,000 in 2002. He also receives $10,000 in Social Security benefits. The taxpayer is married filing separately and did not live with his wife for the entire year. His base amount is $25,000; thus, none of his Social Security benefits are taxable. If he lived with his wife the entire year, his base amount would be zero and $8,500 of his Social Security benefits would be taxable.

In 1998 Thomas McAdams claimed the $25,000 married filing separately Social Security base amount because he was married and believed he lived apart from his wife, Norma, for the entire year. He also claimed married filing separately status because he and his wife were not legally separated or divorced. McAdams used her address in Boise, Idaho, as a mailing address and kept things at her home. Although he lived in different parts of the country during most of the year, he stayed at his wife’s home when he was in Boise. In 1998 this amounted to more than 30 days. The IRS issued a deficiency notice, claiming McAdams was not entitled to the $25,000 base amount. The taxpayer appealed.

Result. For the IRS. The Tax Court, in a case of first impression, determined that an individual estranged from his wife who lived in her home for more than 30 days during the tax year at issue did not “live apart” from her at all times during the tax year. Thus, his base amount for computing Social Security benefits includable in his gross income was zero, maximizing the taxability of these benefits.

Neither the code nor its legislative history defines “live apart”; thus, the Tax Court looked to case law, which generally held that any time spent living under the same roof was not “living apart.” Therefore, the taxpayer was not entitled to any base amount other than zero.

Thomas W. McAdams, 118 TC no. 24, 2002.

Prepared by Lesli S. Laffie, JD, LLM, editor, The Tax Adviser.

S Corporation Conversion Doesn’t Trigger Lifo Recapture
IRC section 1363(d) generally requires a C corporation that elects to become an S corporation to include a “Lifo recapture amount” in its gross income. The amount is the difference between the inventory reported under the Lifo method and the inventory the company would report under the Fifo method.

Coggin Automotive operated as a C corporation holding company from 1970 to 1993. It owned varying majority interests in five other C corporations that in turn owned and operated automobile dealerships. Coggin was a holding company and did not operate any businesses.

The dealerships decided to restructure for nontax business reasons. Coggin shareholders created six S corporations to act as general partners in six new limited partnerships. Each S corporation contributed cash in exchange for a 1% general partnership interest in a limited partnership. The five original subsidiaries then contributed the assets and liabilities of their automobile dealerships to the partnerships in exchange for a limited partnership interest. The assets included inventory accounted for under the Lifo method. The original subsidiaries then liquidated into Coggin, making it a limited partner in each partnership. Coggin then elected to be an S corporation.

The Tax Court, using an aggregate approach, concluded that Coggin owned a pro rata share of the dealerships’ inventory, requiring it to apply section 1363(d) when it elected to become an S corporation. The treatment would require Coggin to include the Lifo recapture amount in gross income. The taxpayer appealed to the Eleventh Circuit Court of Appeals.

Result. For the taxpayer. The Tax Court had reasoned that applying an aggregate approach to partnership treatment served Congress’ intent to prevent corporations from avoiding a second level of taxation on built-in gain by electing S corporation treatment. The court had concluded that “both the legislative history and statutory scheme of section 1363(d) mandate the application of the aggregate approach.” The Eleventh Circuit concluded the facts did not necessarily require the use of the aggregate approach to partnership treatment. It said the Tax Court had relied entirely on the legislative history of section 1363(d) and had used the aggregate approach to reach its conclusion in “quantum leap fashion.” The Eleventh Circuit instead favored a plain language interpretation of the statute.

The appellate court judges reasoned that section 1363(d)’s plain language has two requirements:

A C corporation must elect S corporation status.

The C corporation must own inventory accounted for under the Lifo method in the last taxable year before S corporation status became effective.

Under the statute’s plain language, the taxpayer met the first condition, but not the second. Coggin had owned only stock, not inventory. Therefore, it had no Lifo recapture.

The judges concluded that the general rule is unless there is some ambiguity in a statute’s language, a court’s analysis must end with the plain language (Caminetti v. United States, 37 Sup. Ct. 192 (1917)). After discussing various cases, the judges concluded that in a situation where there is a clear and unambiguous wording of a statute, a taxpayer should be entitled to know the tax consequences of a restructuring with reasonable certainty. Applying the aggregate theory on an ad hoc basis would not allow for this certainty. Congress should cure any potential windfall from this approach.

As noted in footnote 18 to the case, Treasury regulations section 1.701-2(e) was finalized after Coggin restructured. This regulation now says the IRS “can treat a partnership as an aggregate of its partners in whole or in part as appropriate to carry out the purpose of any provision of the Internal Revenue Code or the regulations promulgated thereunder.” Consequently, taxpayers entering into restructuring transactions involving a C corporation that elects to be an S corporation should carefully evaluate the effect of section 1363(d). If the corporation owns inventory accounted for under the Lifo method, section 1363(d) will require it to recapture the Lifo recapture amount. If the corporation owns interests in partnerships that use the Lifo method, the IRS might now use regulations section 1.701-2(e) and have better success in the courts.

Coggin Automotive Corp., 89 AFTR2d 2002-2826.

Prepared by Karyn Bybee Friske, CPA, PhD, associate professor of accounting and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University at Canyon.