Recapture of LIFO Reserve

The Eleventh Circuit has reversed the Tax Court in Coggin Automotive Corp., 115 TC 349 (2000). It decided not to re-quire a holding company that changed from a C to an S corporation to recapture its pro-rata share of partnership LIFO reserves, because the company had no LIFO inventory itself. In so holding, the Court of Appeals also struck down the Tax Court’s arbitrary invocation of the "aggregate" theory of subchapter K, relying instead on the statute’s plain meaning.

Coggin was a C holding company that filed a consolidated return with five subsidiaries. Each of the subsidiaries operated as an automobile retailer and used the dollar-value LIFO method for their inventories. Coggin merely owned stock in its subsidiaries, without operating any business. More importantly, Coggin did not own inventory and never made a LIFO election.

In 1993, Coggin’s majority shareholder elected S status for the corporation in a restructuring plan consummated for non-tax-motivated business reasons. In the plan, Coggin shareholders created six new S corporations to act as general partners in six new limited partnerships (LPs). Each S corporation contributed cash in exchange for a 1% general partnership interest. Immediately thereafter, each of Coggin’s subsidiaries contributed its assets and liabilities (including its inventory) to the partnerships in exchange for an LP interest. The subsidiaries were then liquidated into Coggin, and Coggin became the LPs’ limited partner. Following the liquidations, Coggin elected S status.

Tax Court

The Tax Court acknowledged the valid business purpose of the restructuring; it assisted Coggin’s majority shareholder’s succession planning and allowed the businesses to provide flexible ownership incentives to their key employees. The court looked to subchapter K to determine whether the tax consequences related to the LIFO inventory reserves in the newly created partnerships should be determined under the "entity" or "aggregate" theory. Under the entity theory, the partnerships are considered entities separate from their owners. Under the aggregate theory, each partner is viewed as owning a direct interest in each partnership asset and is directly taxed on a share of partnership income.

The Tax Court held that the legislative history and Sec. 1363(d) mandate the application of the aggregate approach. Further, the application of an aggregate approach better served Congress’ intent to prevent corporations from avoiding double taxation on built-in gain assets by electing S status. Thus, it reasoned the S corporation owned a direct, pro-rata interest in the LIFO inventory on the books of each newly created partnership, requiring the corporation to recapture its pro-rata share of the partnerships’ LIFO inventory reserves into income.

Eleventh Circuit

In overruling the Tax Court, the Court of Appeals stated that the Tax Court used the aggregate approach to provide a pro-IRS interpretation without adequately explaining how it arrived at that conclusion. The Eleventh Circuit looked directly to the plain language of Sec. 1363(d), which states that the recapture of LIFO benefits will be triggered if a C corporation (1) elects S status and (2) inventoried goods under the LIFO method in the last tax year before the first tax year for which the election under Sec. 1362(a) was effective. The taxpayer met the first condition; Coggin elected S status. However, it did not meet the second condition, because Coggin did not own any inventories or elect the LIFO method. As such, under the statute’s plain meaning, no LIFO recapture amount was attributable to Coggin.

In the Eleventh Circuit’s opinion, the general rule is that unless the law is somewhat ambiguous, a court’s analysis must end with the statute’s plain language. In Petroleum Corp. of Texas, Inc., 939 F2d 1165 (5th Cir. 1991), a corporate partner was subject to depreciation and depletion recapture under Secs. 1245, 1250 and 1254 in connection with its liquidating distributions to shareholders of its interests in three partnerships.

The Service argued that the aggregate theory of partnerships should be applied to protect the recapture provisions, notwithstanding that the transactions had a valid business purpose. Similar to Coggin, the Fifth Circuit rejected the IRS’s position, holding that the statute’s language was unambiguous and that under the statute, partnership interests were not among the specific properties listed as being subject to recapture on distribution. The court concluded that the aggregate theory could not be used to circumvent the statute’s clear language.

The outcome in Coggin is another step in removing some of the uncertainty in the interpretation of the application of subchapter K. Coggin provides more assurance to a taxpayer relying on the statute’s plain meaning that the taxpayer will be able to know with reasonable certainty the consequences of its tax planning. However, the promulgation of the partnership anti-abuse provisions in Regs. Sec. 1.702-2(e) occurred subsequent to Coggin’s restructuring. The question is whether the case would have been decided any differently had these regulations been in effect.

The anti-abuse provisions allow the IRS to disregard a partnership transaction and invoke the aggregate theory if a taxpayer’s principal purpose is to achieve a substantial tax reduction and this tax reduction is inconsistent with subchapter K. However, in light of Coggin’s non-tax-motivated business purposes for forming the partnerships, it would appear that the anti-abuse provisions would not have applied. Nonetheless, taxpayers should consider the anti-abuse provisions in structuring partnership transactions along the lines of the strategies implemented in Coggin. (See also Tax Trends, this issue.)

From Michael R. Schuth, CPA, Oak Brook, IL