S Corporation Holding Company Was Not Required to Recapture Share of LIFO Reserves

The C Corporation was a holding company that held over 80% of the stock of five corporations engaged in retail auto sales through six dealerships.

In 1993, C elected S status. It made the election pursuant to a restructuring plan that involved the creation of six new S corporations formed for the purpose of becoming general partners in six limited partnerships (LPs) that would operate the six dealerships. (This plan was based on valid business objectives and had economic substance.) Each subsidiary contributed the assets and liabilities of its dealership to an LP in exchange for an LP interest. Following the transfer of assets to the LPs, the subsidiaries were liquidated. As a result, C obtained the subsidiaries’ LP interests.

The IRS determined that, under Sec. 1363(d), C’s conversion to an S corporation triggered the inclusion of a pro-rata share of the affiliated group’s pre-S LIFO reserves into C’s income. C challenged this determination.

Using an "aggregate" (as opposed to "entity") approach and relying on the legislative history of Secs. 1374 and 1363(d), the Tax Court held for the Service. The Court of Appeals (opinion Hill, J.) reverses; under the plain language of Sec. 1363(d), C had no LIFO inventory requiring recapture on its S election.

Under its plain language, Sec. 1363(d) will apply, and recapture of LIFO benefits will be triggered, if two conditions are met: (1) a C corporation elects S status under Sec. 1363(a) and (2) the C corporation "inventoried goods under the LIFO method" in the last tax year before the first tax year in which the Sec. 1362(a) election was effective.

Clearly, the first prong is met. However, it is apparent that, by definition, the second prong is not. C never owned any inventories. Accordingly, it never made an election to use the LIFO method. In fact, the IRS concedes that the plain language of Sec. 1363(d) "does not literally apply to the facts of this case."

Continuing on with the statute’s plain language, a C corporation converting to S status needs only to recapture its "LIFO recapture amount," which is defined as the difference between the value of an inventory asset as it would have been valued using the FIFO method and its value using the taxpayer’s LIFO method. An inventory asset is defined as the stock in trade of a corporation or other property of a kind that would properly be included in the corporation’s inventory, if on hand at the close of the tax year.

C held no stock in trade nor any property of a kind that would properly be included in its inventory at the close of its tax year. Thus, under the plain meaning of Sec. 1363(d), there is no LIFO recapture amount that can be attributed to C.

Perhaps the Tax Court was straining to extend its interpretation of the legislative histories of Secs. 1373 and 1363(d) to close what it perceives to be a loophole for holding companies that own no inventory, yet elect S status.

It is undisputed that C’s 1993 restructuring transaction had economic substance and a valid business purpose. C is entitled to know what the tax consequences of its restructuring will be with reasonable certainty at the outset. Indeed, its own accountants advised C prior to the transaction that LIFO inventory should not be recaptured, as it did not inventory any goods under the LIFO method.

In a legitimate business transaction, a taxpayer deserves the right to be able to predict in advance what the tax consequences of such transaction will be with reasonable certainty. Here the statute just does not do what the Service’s litigation position would have it do.

C was a holding company that held stock in other C corporations. It was not engaged in the sale of automobiles. Under the plain language of Sec. 1363(d), it had no LIFO inventory requiring recapture on its S election. Coggin Automotive Corporation, 11th Cir., 6/6/02, rev’g 115 TC 349 (2000)

REFLECTIONS: See also Tax Clinic, this issue.

Anti-abuse regulations. Regs. Sec. 1.701-2(e) now specifically states that 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 Code or regulations. However, this regulation was not present when C undertook its restructuring.