[Federal Register Volume 70, Number 132 (Tuesday, July 12, 2005)]
[Rules and Regulations]
[Pages 39920-39923]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-13383]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9210]
RIN 1545-BE75


LIFO Recapture Under Section 1363(d)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulation.

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SUMMARY: This document contains final regulations regarding LIFO 
recapture by corporations converting from C corporations to S 
corporations. The purpose of these 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. These 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. 
These regulations also affect S corporations receiving such partnership 
interests from C corporations in nonrecognition transactions.

DATES: Effective Date: These regulations are effective July 12, 2005.
    Applicability Date: These regulations apply to S elections and 
transfers made on or after August 13, 2004.

FOR FURTHER INFORMATION CONTACT: Pietro Canestrelli, at (202) 622-3060 
and Martin Sch[auml]ffer, at (202) 622-3070 (not toll free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)) under control number 1545-1906.
    The collection of information in these final regulations 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).
    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 control number assigned by the Office of 
Management and Budget.
    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.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, 
SE:W:CAR:MP:T:T:SP Washington, DC 20224, and 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.
    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 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 regulations 
did not explicitly address the indirect ownership of inventory through 
a partnership.
    A notice of proposed rulemaking (REG-149524-03, 2004-39 I.R.B. 528) 
was published in the Federal Register on August 13, 2004 (69 FR 50109). 
The proposed regulations provided guidance for situations in which a C 
corporation that owns LIFO inventory through a partnership (or through 
tiered partnerships) converts to an S corporation or transfers its 
partnership interest to an S corporation in a nonrecognition 
transaction. One person submitted comments in response to the notice of 
proposed rulemaking. A public hearing was held on December 8, 2004. 
After consideration of the comments, the proposed regulations are 
adopted as final regulations with the modifications discussed below.

Summary of Comments and Explanation of Revisions

    The proposed regulations provided 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 defined 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 recapture event 
is a transfer of a partnership interest to an S corporation, the date 
of the transfer (the recapture date). The proposed regulations provided 
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 sole commentator suggested that the regulations provide that, 
if the lookthrough LIFO recapture amount is determined based on 
inventory values of the partnership's opening inventory for the year 
that includes the recapture

[[Page 39921]]

date, then the lookthrough LIFO recapture amount must be adjusted to 
take into account any adjustments to the partnership's basis in its 
LIFO inventory that result from transactions occurring during the 
period from the start of the partnership's tax year to the end of the 
recapture date. Thus, the lookthrough LIFO recapture amount would have 
to reflect any adjustments to the basis of LIFO inventory during that 
period under sections 734(b), 737(c), or 751(b). The final regulations 
adopt this suggestion.
    The proposed regulations provided 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 allowed the partnership through which the 
LIFO inventory is owned to elect 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 
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 Treasury Department and the IRS requested 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. No comments were 
received on this question. Therefore, the final regulations follow the 
rule of the proposed regulations.
    The sole commentator recommended that the regulations should extend 
the availability of a section 743(b)-type basis adjustment to the 
purchase of a lookthrough partnership interest by a C corporation that 
subsequently makes an S election (or subsequently disposes of the 
partnership interest in a nontaxable carryover basis transaction). It 
has been determined that this recommendation is beyond the scope of the 
regulations and, so, is not included in the final regulations.
    The commentator recommended that the regulations provide for the 
retroactive revaluation of LIFO inventories under Sec.  1.704-
1(b)(2)(iv)(f) when a non-C corporation partner has been admitted to a 
partnership (or the non-C-corporation partner's relative interest in 
the partnership has increased) within a period of two years ending on 
the date when a C corporation partner in the same partnership makes an 
S election (or transfers its partnership interest to an S corporation 
in a nontaxable carryover basis transaction). It has been determined 
that this recommendation is beyond the scope of the regulations and, 
so, is not included in the final regulations.
    Regarding the payment of the LIFO recapture tax during an S year, 
the commentator made two suggestions. First, notwithstanding section 
1371(c)(1), the regulations should provide that the S corporation's 
earnings and profits be reduced upon such a payment. Second, 
notwithstanding section 1367(a)(2)(D), the regulations should provide 
that the stock basis of the shareholders of the S corporation not be 
reduced upon such a payment. The issues raised by the payment by an S 
corporation of taxes attributable to a taxable year in which the 
corporation was a C corporation are not unique to a payment of the LIFO 
recapture tax and are beyond the scope of these regulations.
    Finally, the commentator questioned whether it is appropriate to 
issue these regulations under the authority of section 337(d). The 
Treasury Department and the IRS continue to believe that issuing these 
regulations under the authority of section 337(d) is appropriate, 
because Congress's purpose in enacting section 1363(d) was to prevent 
taxpayers owning LIFO inventory from avoiding the built-in gain rules 
of section 1374. H.R. Rep. No. 100-391 (Parts 1 and 2), 1098 (1987).

Special Analyses

    It has been determined that this Treasury decision 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. These 
final regulations are necessary to prevent abusive transactions 
involving partnerships and S corporations. Accordingly, good cause is 
found for dispensing with a delayed effective date pursuant to 5 U.S.C. 
553(d)(3). Pursuant to section 7805(f) of the Code, the notice of 
proposed rulemaking preceding this regulation was submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business.

Drafting Information

    The principal authors of these regulations are Pietro Canestrelli 
and Martin Schaffer, 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.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding an 
entry in numerical order to read, in part, as follows:

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


0
Par. 2. Section 1.1363-2 is amended by:
0
1. Redesignating paragraphs (b), (c), and (d) as paragraphs (d), (e), 
and (g), respectively.
0
2. Adding new paragraphs (b), (c), (f), and (g)(3).
0
3. Revising newly designated paragraphs (d) and (e).
    The revision 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)(4) 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

[[Page 39922]]

lookthrough partnership interest (as defined in paragraph (c)(3) 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 and special rules--(1) Recapture date. In the case 
of a transaction described in paragraph (a)(1) or (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 (a)(2) or (b)(2) of this section, the recapture date is the 
date of the transfer of the partnership interest to the S corporation.
    (2) Determination of LIFO recapture amount. The LIFO recapture 
amount shall be determined as of the end of the recapture date for 
transactions described in paragraph (a)(1) of this section, and as of 
the moment before the transfer occurs for transactions described in 
paragraph (a)(2) of this section.
    (3) 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).
    (4) Lookthrough LIFO recapture amount--(i) In general. 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, determined in accordance with section 
1363(d)(4)(C).
    (ii) Determination of lookthrough LIFO recapture amount. Except as 
provided in paragraph (c)(4)(iii) of this section, the lookthrough LIFO 
recapture amount shall be determined as of the end of the recapture 
date for transactions described in paragraph (b)(1) of this section, 
and as of the moment before the transfer occurs for transactions 
described in paragraph (b)(2) of this section.
    (iii) Alternative rule. 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. A partnership that applies the alternative method of this 
paragraph (c)(4)(iii) to calculate the lookthrough LIFO recapture 
amount must take into account any adjustments to the partnership's 
basis in its LIFO inventory that result from transactions occurring 
after the start of the partnership's taxable year and before the end of 
the recapture date. For example, the lookthrough LIFO recapture amount 
must be adjusted to take into account any adjustments to the basis of 
LIFO inventory during that period under sections 734(b), 737(c), or 
751(b).
    (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) of this 
section 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) of this 
section 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 this 
paragraph (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, and 
there are no other adjustments to the partnership's basis in its 
LIFO inventory between January 1, 2005 and the end of the recapture 
date. G elects to be an S corporation effective July 1, 2005. The

[[Page 39923]]

recapture date is June 30, 2005 under paragraph (c)(1) of this 
section. GH elects to use the LIFO method for the inventory and 
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)(4)(iii) 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)(4) 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)(1) 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) * * *
    (3) The provisions of paragraphs (b), (c), (d), (e)(2), (e)(3), and 
(f) of this section apply to S elections and transfers made on or after 
August 13, 2004. The rules that apply to S elections and transfers made 
before August 13, 2004, are contained in Sec.  1.1363-2 as in effect 
prior to August 13, 2004 (see 26 CFR part 1 revised as of April 1, 
2005).

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 3. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.


0
Par. 4. In Sec.  602.101, paragraph (b) is amended by adding an entry 
in numerical order to the table to read as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b)* * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control No.
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                                * * * * *
1.1363-2................................................       1545-1906
 
                                * * * * *
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Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.

    Approved: June 23, 2005.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
[FR Doc. 05-13383 Filed 7-11-05; 8:45 am]
BILLING CODE 4830-01-P