One of the more confusing questions partnerships face is when to use the so-called aggregate or entity approaches. Most partnerships apply the entity approach in determining partnership income; they use the aggregate approach for other decisions. The Tax Court recently considered which approach entities outside the partnership arena—where there is even less guidance—should use.
Coggin Automotive Corp. was a C corporation that owned six C corporations. Each operated a car dealership using the LIFO inventory method. The group filed a consolidated tax return. Luther Coggin decided to restructure the subsidiary corporations to permit the general manager of each dealership to acquire an ownership interest and to provide a means for these managers to buy him or his estate out when he retired or died. To do this Coggin completed a number of transactions, including these:
Each of the six subsidiaries transferred its assets (the dealership) to a newly formed limited partnership in exchange for a 99% limited partnership interest.
The subsidiaries were liquidated, transferring the limited partnership interests to Coggin Automotive, which then made an S corporation election.
The IRS determined that Coggin Automotive was required to report the LIFO reserves in the partnerships as income on its final return, as required under IRC section 1363. Coggin appealed.
Result. For the IRS. The government presented two arguments for its proposed tax treatment.
Argument 1. The IRS said the restructuring was a sham and should be ignored. It also argued that Coggin Automotive should be treated as owning the LIFO inventory before and after the S election, which would result in income recognition under section 1363. In responding to this argument, the Tax Court acknowledged that, while tax savings may have been a consideration, the restructuring involved unrelated third partners and Coggin Automotive was motivated by significant nontax considerations. As a result the court concluded the transaction was not a sham and could not be ignored.
Argument 2. The IRS argued that the aggregate approach to taxation should be applied to the partnership, which meant treating Coggin Automotive as owning 99% of the LIFO inventory subject to section 1363. The company argued in favor of the entity approach, viewing the issue as one of income determination where, under partnership taxation (subchapter K), this approach usually applied. In response, the Tax Court decision cited cases that applied both the entity and aggregate approaches to determining tax outside the partnership itself. The one thing all these cases had in common was that the decisions were based on which approach more closely fulfilled congressional intent.
Examining the intention behind section 1363 revealed that Congress was concerned taxpayers might find a way around the built-in gains tax imposed on S corporations that were previously C corporations. According to the Tax Court, the aggregate approach was more likely to produce the results Congress intended. Therefore, applying this approach, it treated the new S corporation as owning 99% of the LIFO inventory, thereby subjecting the old C corporation to tax under section 1363. If courts uphold the Tax Court’s reasoning in future cases, taxpayers will have a rule for determining the proper approach to partnership taxation outside the partnership itself. At the same time, this leaves the congressional intent still open to debate.
Coggin Automotive Corp., 115 TC no. 28.
Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.