S Corporation Conversion Doesn’t Trigger Lifo Recapture

TAX CASE

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.