Triggering the LIFO Recapture Tax

Triggering the LIFO Recapture Tax
IRS Issues Final Rules

By Randy A. Schwartzman

In July the Internal Revenue Service issued final rules under Treasury Decision 9210 requiring Subchapter C corporations to pay tax on certain recapture amounts when they convert to Subchapter S corporation status. This tax will be paid in four installments, with the first installment paid in the final C corporation year and the remaining three installments paid in the first three S corporation years.

The final rules retain the IRS’ original position that the S corporation election triggers last-in, first-out (LIFO) recapture for amounts held in partnerships, and now require that the LIFO recapture amount reflect any adjustments to inventory basis from the start of the partnership’s tax year to the end of the recapture date. The IRS also issued rules under tax code Section 1363(d) to prevent taxpayers from escaping rules under Section 1374 that require them to pay tax on built-in gain.

Most specifically, the new rules have direct application to C corporations that hold an interest in a partnership owning LIFO inventory. The final rules continue to provide that such C corporations must include look-through LIFO recapture amounts in their gross income when the corporation (1) elects to be an S corporation, or (2) transfers its interest in the partnership to an S corporation in a tax-free deal (i.e., when a C corporation holding an interest in a partnership using LIFO merges or otherwise transfers its assets tax free to an S corporation that survives the transaction).

Under the rules, this recapture amount is defined as the amount of income that would be allocated to the corporation if the partnership sold all of its LIFO inventory for the first-in, first-out (FIFO) value. A corporate partner’s look-through LIFO recapture amount generally is determined the day before the effective date of the S corporation election or on the day of a partnership transfer of interest.

The rules continue to allow a corporation owning LIFO inventory through a partnership to increase its basis in the partnership interest by the look-through LIFO recapture amount. These rules also continue to allow partnerships to elect to adjust the basis of partnership inventory to account for LIFO recapture. This election clearly is very important in order to get a step-up in inside basis of assets for taxpayers, and should not be overlooked.

The original rules allowed taxpayers to calculate their look-through LIFO recapture amount based on inventory values of the partnership’s opening inventory for the year that includes the recapture date. The final rules are based on adjustments to inventory made from the start of the partnership’s tax year to the end of the recapture date.

The IRS said it did not make several changes to the rules requested by practitioners after the issuance of the proposed regulations. The rules not included in the final regulations are ones that would have allowed C corporations that subsequently make S elections to take a basis adjustment similar to that available under tax code Section 743(b); provide for retroactive revaluation of LIFO inventories in cases where non-C corporation partners have been admitted; reduce an S corporation’s earnings and profits upon payment of the LIFO recapture tax during an S year; and provide that the stock basis of S corporation shareholders not be reduced upon such a payment. In the preamble to the final regulations, the IRS indicated that these changes were beyond the scope of Treasury Decision 9210.

The final rules went into effect July 12.

Randy Schwartzman is the tax partner in charge of BDO Seidman, LLP’s Melville office, and a member of the NYSSCPA’s Closely Held and S Corporations Committee.