[Federal Register Volume 69, Number 156 (Friday, August 13, 2004)]
[Proposed Rules]
[Pages 50109-50112]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-18559]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-149524-03]
RIN 1545-BC66


LIFO Recapture Under Section 1363(d)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations regarding LIFO 
recapture by corporations converting from C corporations to S 
corporations. The purpose of the proposed regulations is to provide 
guidance on the LIFO recapture requirement when the corporation holds 
inventory accounted for under the last-in, first-out (``LIFO'') method 
(LIFO inventory) indirectly through a partnership. The proposed 
regulations affect C corporations that own interests in partnerships 
holding LIFO inventory and that elect to be taxed as S corporations or 
that transfer such partnership interests to S corporations in 
nonrecognition transactions. The proposed regulations also affect S 
corporations receiving such partnership interests from C corporations 
in nonrecognition transactions.

DATES: Written or electronic comments must be received by Novembre 12, 
2004. Requests to speak and outlines of topics to be discussed at the 
public hearing scheduled for Wednesday, December 8, 2004, must be 
received by Wednesday, November 17, 2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-149524-03), Room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-
149524-03), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC, or submitted electronically via the IRS 
Internet site at: http://www.irs.gov/regs or via the Federal 
eRulemaking Portal at www.regulations.gov (IRS and REG-149524-03).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Pietro Canestrelli, (202) 622-3060, or Martin Sch[auml]ffer, (202) 622-
3070; concerning submissions, Robin Jones, (202) 622-7180 (not toll-
free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget in 
accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)). Comments on the collection of information should be sent to 
the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, 
Washington, DC 20224. Comments on the collection of information should 
be received by October 12, 2004. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information can be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in this proposed regulation is in 
Sec.  1.1363-2(e)(3). This information is required to inform the IRS of 
partnerships electing to increase the basis of inventory to reflect any 
amount included in a partner's income under section 1363(d). Thus, the 
collection of information is required to obtain a benefit. The likely 
respondents are businesses or other for-profit institutions.
    The burden for the collection of information in Sec.  1.1363-
2(e)(3) is reflected on Form 1065, ``Partnership Return of Income''.
    The estimated burden for the collection of information in Sec.  
1.1363-2(e)(3) is as follows:
    Estimated total annual reporting burden: 200 hours.
    The estimated annual burden per respondent varies from 1 to 3 
hours, depending on individual circumstances, with an estimated average 
of 2 hours.
    Estimated number of respondents: 100.
    Estimated annual frequency of responses: On occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid OMB control number assigned by the Office 
of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed amendments to 26 CFR part 1 under 
section 1363(d) of the Internal Revenue Code (Code). Section 1363(d)(1) 
provides that a C corporation that owns LIFO inventory and that elects 
under section 1362(a) to be taxed as an S corporation must include in 
its gross income for its final tax year as a C corporation the LIFO 
recapture amount. Under section 1363(d)(3), the LIFO recapture amount 
is the excess of the inventory amount of the inventory using the first-
in, first-out (FIFO) method (the FIFO value) over the inventory amount 
of the inventory using the LIFO method (the LIFO value) at the close of 
the corporation's final tax year as a C corporation (essentially, the 
amount of income the corporation has deferred by using the LIFO method 
rather than the FIFO method).
    Final regulations (TD 8567) under section 1363(d) were published in 
the Federal Register on October 7, 1994 (59 FR 51105) to describe the 
recapture of LIFO benefits when a C corporation that owns LIFO 
inventory elects to become an S corporation or transfers LIFO inventory 
to an S corporation in a nonrecognition transaction. The final 
regulations do not explicitly address the indirect ownership of 
inventory through a partnership. These proposed regulations provide 
guidance for situations in which a C corporation that owns LIFO 
inventory through a

[[Page 50110]]

partnership (or through tiered partnerships) converts to an S 
corporation or transfers its partnership interest to an S corporation 
in a nonrecognition transaction.
    Section 1374, modified as part of the repeal of the General 
Utilities doctrine, see General Utilities & Operating Co. v. Helvering, 
296 U.S. 200 (1935), imposes a corporate level tax on certain income or 
gain recognized by an S corporation to the extent the income or gain is 
attributable to appreciation that occurred while the assets were held 
by a C corporation. Specifically, section 1374 imposes a corporate 
level tax on an S corporation's net recognized built-in gain 
attributable to assets that it held on the date it converted from a C 
corporation to an S corporation. The tax is imposed only during the 10-
year period beginning on the first day the corporation is an S 
corporation. In addition, section 1374 imposes a corporate level tax on 
an S corporation's net recognized built-in gain attributable to assets 
that the S corporation acquires if the S corporation's bases in such 
assets are determined (in whole or in part) by reference to the bases 
of such assets (or any other property) in the hands of a C corporation. 
This tax is imposed only during the 10-year period beginning on the 
date that the S corporation acquires the assets.
    In Announcement 86-128 (1986-51 I.R.B. 22), the IRS stated that, 
for purposes of section 1374(d)(2)(A), the inventory method used by a 
taxpayer for tax purposes (FIFO, LIFO, etc.) shall be used in 
determining whether goods disposed of following a conversion from C 
corporation to S corporation status were held by the corporation at the 
time of conversion. After the issuance of this announcement, Congress 
became concerned that taxpayers owning LIFO inventory might avoid the 
built-in gain rules of section 1374. Congress believed that taxpayers 
owning LIFO inventory, who have enjoyed the deferral benefits of the 
LIFO method during their status as a C corporation, should not be 
treated more favorably than their FIFO counterparts. To eliminate this 
potential disparity in treatment, Congress enacted section 1363(d) in 
1987, requiring a taxpayer owning LIFO inventory to recapture the 
benefits of using the LIFO method. H.R. Rep. No. 100-391 (Parts 1 and 
2), 1098 (1987).
    In Coggin Automotive Corp. v. Commissioner, 292 F.3d 1326 (11th 
Cir. 2002), rev'g 115 T.C. 349 (2000), a holding company owned majority 
interests in several subsidiaries that operated automobile dealerships 
owning LIFO inventory. As part of a restructuring, each subsidiary 
contributed its assets (including its LIFO inventory) to a different 
partnership. The subsidiaries were then merged into the holding 
company, which elected to be taxed as an S corporation. The court of 
appeals held that the holding company's S corporation election did not 
trigger LIFO recapture under section 1363(d) because it was the 
partnerships in which the holding company held interests, and not the 
holding company itself, that used the LIFO method.
    Section 337(d)(1) authorizes the Secretary to prescribe regulations 
to prevent the circumvention of the purposes of the repeal of the 
General Utilities doctrine through the use of any provision of law or 
regulations. The Treasury Department and the IRS believe that these 
proposed regulations are necessary to implement General Utilities 
repeal. Congress enacted section 1363(d) because the use of the LIFO 
method by a C corporation that converts to S corporation status creates 
the potential for the permanent avoidance of corporate level tax on the 
built-in gain reflected in the LIFO reserve. This avoidance possibility 
is present regardless of whether the converting corporation owns 
inventory directly or indirectly through a partnership or tiered 
partnerships. Accordingly, the Treasury Department and the IRS believe 
it is appropriate to require the recapture of a converting 
corporation's share of the LIFO reserves of partnerships in which it 
participates. Such an approach is consistent with the regulations under 
section 1374, which generally adopt a lookthrough approach to 
partnerships.

Explanation of Provisions

    The proposed regulations provide that a C corporation that holds an 
interest in a partnership owning LIFO inventory must include the 
lookthrough LIFO recapture amount in its gross income where the 
corporation either elects to be an S corporation or transfers its 
interest in the partnership to an S corporation in a nonrecognition 
transaction. The proposed regulations define the lookthrough LIFO 
recapture amount as the amount of income that would be allocated to the 
corporation, taking into account section 704(c) and Sec.  1.704-3, if 
the partnership sold all of its LIFO inventory for the FIFO value. A 
corporate partner's lookthrough LIFO recapture amount must be 
determined, in general, as of the day before the effective date of the 
S corporation election or, if the recapture event is a transfer of a 
partnership interest to an S corporation, the date of the transfer (the 
recapture date). The proposed regulations provide that, if a 
partnership is not otherwise required to determine inventory values on 
the recapture date, the lookthrough LIFO recapture amount may be 
determined based on inventory values of the partnership's opening 
inventory for the year that includes the recapture date.
    The proposed regulations provide that a corporation owning LIFO 
inventory through a partnership must increase its basis in its 
partnership interest by the lookthrough LIFO recapture amount. The 
proposed regulations also allow the partnership through which the LIFO 
inventory is owned to adjust the basis of partnership inventory (or 
lookthrough partnership interests held by that partnership) to account 
for LIFO recapture. This adjustment to basis is to be patterned in 
manner and effect after the adjustment in section 743(b). Thus, the 
basis adjustment constitutes an adjustment to the basis of the LIFO 
inventory (or lookthrough partnership interests held by that 
partnership) with respect to the corporate partner only; no adjustment 
is made to the partnership's common basis. The IRS and the Treasury 
Department request comments on whether the partnership should be 
required, in some or all circumstances, to increase the basis of 
partnership assets by the lookthrough LIFO recapture amount 
attributable to those assets.
    Under Sec.  1.1374-4(i)(1), an S corporation's distributive share 
of partnership items is not taken into account in determining the S 
corporation's share of net recognized built-in gain or loss if the S 
corporation's partnership interest represents less than 10 percent of 
the partnership capital and profits and has a fair market value of less 
than $100,000. This exception reduces the burden on the S corporation 
and the partnership of tracking built-in gain assets that are 
relatively small in amount.
    The burden of looking through a partnership interest under section 
1374 is greater than the burden of looking through a partnership 
interest under section 1363(d). Under section 1374, partnership assets 
must be tracked for a 10-year period. No such tracking problem exists 
under section 1363 because recapture generally occurs on the date of 
the S election. Accordingly, the proposed regulations do not contain an 
exception for partnership interests that are smaller than a specified 
threshold.

Proposed Effective Date

    These regulations are proposed to apply to S elections and 
transfers made

[[Page 50111]]

on or after August 13, 2004. No inference is intended as to the tax 
consequences of S elections and transfers made before the effective 
date of these regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866; therefore, 
a regulatory assessment is not required. It is hereby certified that 
these regulations will not have a significant economic impact on a 
substantial number of small entities. This certification is based upon 
the fact that few corporations engage in the type of transactions that 
are subject to these regulations (the conversion from C corporation to 
S corporation status while holding an interest in a partnership that 
owns LIFO inventory or the transfer of an interest in such a 
partnership by a C corporation to an S corporation in a nonrecognition 
transaction). Therefore, a Regulatory Flexibility Analysis under the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. 
Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The IRS and Treasury Department request comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for Wednesday, December 8, 2004 
beginning at 10 a.m. in the auditorium of the Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC. Due to 
building security procedures, visitors must enter at the Constitution 
Avenue entrance. In addition, all visitors must present photo 
identification to enter the building. Because of access restrictions, 
visitors will not be admitted beyond the immediate entrance area more 
than 30 minutes before the hearing starts. For information about having 
your name placed on the building access list to attend the hearing, see 
the FOR FURTHER INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (signed original and eight (8) copies) 
by Wednesday, November 17, 2004. A period of 10 minutes will be 
allotted to each person for making comments. An agenda showing the 
scheduling of the speakers will be prepared after the deadline for 
receiving outlines has passed. Copies of the agenda will be available 
free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are Martin Sch[auml]ffer 
and Pietro Canestrelli, Office of Associate Chief Counsel (Passthroughs 
and Special Industries). However, other personnel from the IRS and the 
Treasury Department participated in their development.

List of Subjects 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read as follows:

    Authority: 26 U.S.C. 7805. * * * Section 1.1363-2 is issued also 
under 26 U.S.C. 337(d). * * *

    Par. 2. Section 1.1363-2 is amended by:
    1. Redesignating paragraphs (b), (c), and (d) as paragraphs (d), 
(e), and (g), respectively.
    2. Adding paragraphs (b), (c), (f), and (g)(3).
    3. Revising newly designated paragraphs (d) and (e).
    The revisions and additions read as follows:


Sec. 1.1363-2  Recapture of LIFO benefits.

* * * * *
    (b) LIFO inventory held indirectly through partnership. A C 
corporation must include the lookthrough LIFO recapture amount (as 
defined in paragraph (c)(2) of this section) in its gross income--
    (1) In its last taxable year as a C corporation if, on the last day 
of the corporation's last taxable year before its S corporation 
election becomes effective, the corporation held a lookthrough 
partnership interest (as defined in paragraph (c)(1) of this section); 
or
    (2) In the year of transfer by the C corporation to an S 
corporation of a lookthrough partnership interest if the corporation 
transferred its lookthrough partnership interest to the S corporation 
in a nonrecognition transaction (within the meaning of section 
7701(a)(45)) in which the transferred interest constitutes transferred 
basis property (within the meaning of section 7701(a)(43)).
    (c) Definitions--(1) Lookthrough partnership interest. A 
partnership interest is a lookthrough partnership interest if the 
partnership owns (directly or indirectly through one or more 
partnerships) assets accounted for under the last-in, first-out (LIFO) 
method (LIFO inventory).
    (2) Lookthrough LIFO recapture amount. For purposes of this 
section, a corporation's lookthrough LIFO recapture amount is the 
amount of income that would be allocated to the corporation, taking 
into account section 704(c) and Sec.  1.704-3, if the partnership sold 
all of its LIFO inventory for the inventory's FIFO value. For this 
purpose, the FIFO value of inventory is the inventory amount of the 
inventory assets under the first-in, first-out method of accounting 
authorized by section 471. The lookthrough LIFO recapture amount 
generally shall be determined as of the end of the recapture date. 
However, if the partnership is not otherwise required to determine the 
inventory amount of the inventory using the LIFO method (the LIFO 
value) on the recapture date, the partnership may determine the 
lookthrough LIFO recapture amount as though the FIFO and LIFO values of 
the inventory on the recapture date equaled the FIFO and LIFO values of 
the opening inventory for the partnership's taxable year that includes 
the recapture date. For this purpose, the opening inventory includes 
inventory contributed by a partner to the partnership on or before the 
recapture date and excludes inventory distributed by the partnership to 
a partner on or before the recapture date.
    (3) Recapture date. In the case of a transaction described in 
paragraph (b)(1) of this section, the recapture date is the day before 
the effective date of the S corporation election. In the case of a 
transaction described in paragraph (b)(2) of this section, the 
recapture date is the date of the transfer of the partnership interest 
to the S corporation (but only the portion of that date that precedes 
the transfer).

[[Page 50112]]

    (d) Payment of tax. Any increase in tax caused by including the 
LIFO recapture amount or the lookthrough LIFO recapture amount in the 
gross income of the C corporation is payable in four equal 
installments. The C corporation must pay the first installment of this 
payment by the due date of its return, determined without regard to 
extensions, for the last taxable year it operated as a C corporation if 
paragraph (a)(1) or (b)(1) of this section applies, or for the taxable 
year of the transfer if paragraph (a)(2) or (b)(2) of this section 
applies. The three succeeding installments must be paid--
    (1) For a transaction described in paragraph (a)(1) or (b)(1) of 
this section, by the corporation that made the election under section 
1362(a) to be an S corporation, on or before the due date for the 
corporation's returns (determined without regard to extensions) for the 
succeeding three taxable years; and
    (2) For a transaction described in paragraph (a)(2) or (b)(2) of 
this section, by the transferee S corporation on or before the due date 
for the transferee corporation's returns (determined without regard to 
extensions) for the succeeding three taxable years.
    (e) Basis adjustments--(1) General rule. Appropriate adjustments to 
the basis of inventory are to be made to reflect any amount included in 
income under paragraph (a) of this section.
    (2) LIFO inventory owned through a partnership--(i) Basis of 
corporation's partnership interest. Appropriate adjustments to the 
basis of the corporation's lookthrough partnership interest are to be 
made to reflect any amount included in income under paragraph (b) of 
this section.
    (ii) Basis of partnership assets. A partnership directly holding 
LIFO inventory that is taken into account under paragraph (b) may elect 
to adjust the basis of that LIFO inventory. In addition, a partnership 
that holds, through another partnership, LIFO inventory that is taken 
into account under paragraph (b) may elect to adjust the basis of that 
partnership interest. Any adjustment under this paragraph (e)(2) to the 
basis of inventory held by the partnership is equal to the amount of 
LIFO recapture attributable to the inventory. Likewise, any adjustment 
under this paragraph (e)(2) to the basis of a lookthrough partnership 
interest held by the partnership is equal to the amount of LIFO 
recapture attributable to the interest. A basis adjustment under this 
paragraph (e)(2) is treated in the same manner and has the same effect 
as an adjustment to the basis of partnership property under section 
743(b). See Sec.  1.743-1(j).
    (3) Election. A partnership elects to adjust the basis of its 
inventory and any lookthrough partnership interest that it owns by 
attaching a statement to its original or amended income tax return for 
the first taxable year ending on or after the date of the S corporation 
election or transfer described in paragraph (b) of this section. This 
statement shall state that the partnership is electing under Sec.  
1.1363-2(e)(3) and must include the names, addresses, and taxpayer 
identification numbers of any corporate partner liable for tax under 
paragraph (d) of this section and of the partnership, as well as the 
amount of the adjustment and the portion of the adjustment that is 
attributable to each pool of inventory or lookthrough partnership 
interest that is held by the partnership.
    (f) Examples. The following examples illustrate the rules of this 
section.

    Example 1. (i) G is a C corporation with a taxable year ending 
on June 30. GH is a partnership with a calendar year taxable year. G 
has a 20 percent interest in GH. The remaining 80 percent interest 
is owned by an individual. On April 25, 2005, G contributed 
inventory that is LIFO inventory to GH, increasing G's interest in 
the partnership to 50 percent. GH holds no other LIFO inventory. G 
elects to be an S corporation effective July 1, 2005. The recapture 
date is June 30, 2005 under paragraph (c)(3) of this section. GH 
determines that the FIFO and LIFO values of the opening inventory 
for GH's 2005 taxable year, including the inventory contributed by 
G, are $200 and $120, respectively.
    (ii) Under paragraph (c)(1) of this section, GH is not required 
to determine the FIFO and LIFO values of the inventory on the 
recapture date. Instead, GH may determine the lookthrough LIFO 
recapture amount as though the FIFO and LIFO values of the inventory 
on the recapture date equaled the FIFO and LIFO values of the 
opening inventory for the partnership's taxable year (2005) that 
includes the recapture date. For this purpose, under paragraph 
(c)(2) of this section, the opening inventory includes the inventory 
contributed by G. The amount by which the FIFO value ($200) exceeds 
the LIFO value ($120) in GH's opening inventory is $80. Thus, if GH 
sold all of its LIFO inventory for $200, it would recognize $80 of 
income. G's lookthrough LIFO recapture amount is $80, the amount of 
income that would be allocated to G, taking into account section 
704(c) and Sec.  1.704-3, if GH sold all of its LIFO inventory for 
the FIFO value. Under paragraph (b)(1) of this section, G must 
include $80 in income in its taxable year ending on June 30, 2005. 
Under paragraph (e)(2) of this section, G must increase its basis in 
its interest in GH by $80. Under paragraphs (e)(2) and (3) of this 
section, and in accordance with section 743(b) principles, GH may 
elect to increase the basis (with respect to G only) of its LIFO 
inventory by $80.
    Example 2. (i) J is a C corporation with a calendar year taxable 
year. JK is a partnership with a calendar year taxable year. J has a 
30 percent interest in the partnership. JK owns LIFO inventory that 
is not section 704(c) property. J elects to be an S corporation 
effective January 1, 2005. The recapture date is December 31, 2004 
under paragraph (c)(3) of this section. JK determines that the FIFO 
and LIFO values of the inventory on December 31, 2004 are $240 and 
$140, respectively.
    (ii) The amount by which the FIFO value ($240) exceeds the LIFO 
value ($140) on the recapture date is $100. Thus, if JK sold all of 
its LIFO inventory for $240, it would recognize $100 of income. J's 
lookthrough LIFO recapture amount is $30, the amount of income that 
would be allocated to J if JK sold all of its LIFO inventory for the 
FIFO value (30 percent of $100). Under paragraph (b)(1) of this 
section, J must include $30 in income in its taxable year ending on 
December 31, 2004. Under paragraph (e)(2) of this section, J must 
increase its basis in its interest in JK by $30. Under paragraphs 
(e)(2) and (3) of this section, and in accordance with section 
743(b) principles, JK may elect to increase the basis (with respect 
to J only) of its inventory by $30.

    (g) Effective dates. * * *
    (3) The provisions of paragraphs (b), (c), (e)(2), (e)(3), and (f) 
of this section apply to S elections and transfers made on or after 
August 13, 2004.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 04-18559 Filed 8-12-04; 8:45 am]
BILLING CODE 4830-01-P