Parent Corp Disputes Having to Take Share of LIFO Recapture Amount Into Income

Coggin Automotive Corp., formerly Coggin-O'Steen Investment Corp., was a holding company and a C corporation. Before June 21, 1993, the company held 80 percent of the stock of five C corporations. Coggin Pontiac, Inc., Coggin Nissan, Inc., Coggin- O'Steen Imports, Inc., Coggin-O'Steen Motors, Inc., and Coggin Imports Inc. (the subsidiaries) sold cars and light trucks. From 1972-1973 until June 26, 1993, Coggin, as the common parent, filed consolidated returns with the subsidiaries. The subsidiaries maintained their inventories under the dollar-value LIFO method of accounting, without Coggin directly owning any inventory, and their accumulated reserves were $5,077,808.

In 1993, Coggin determined that because (1) the general managers wanted to participate in the profits of a stand-alone partnership dealership and (2) the owner wanted, for estate tax purposes, an effective way for the general managers to buy him out, they should change the structure of Coggin from a C corporation to an S corporation and operate the dealerships through partnerships. The board adopted a plan to change the structure, and established six corporations. The new corporations were incorporated to be general partners in limited partnerships that would operate the dealerships. At the same time, the subsidiaries, the S corporations, and several of the dealership's general managers entered into limited partnership arrangements. Each general partner had a 1 percent interest in the limited partnership, and the limited partner had a 99 percent interest. Next, the stock of the subsidiaries owned by four individuals was redeemed for promissory notes. Next, each of the newly formed S corporations contributed cash to the limited partnership in which it was to hold an interest. At the same time, the four individuals also contributed the notes to the S corporations for limited partnership interests.

After transfer of the assets to the partnerships, the subsidiaries were liquidated, and Coggin obtained the subsidiaries' limited partnership interests. The company elected S corporation status on August 27, 1993, effective June 27, 1993. Between 1993 and 1998, various general managers purchased larger interests in the dealerships. In 1997, Coggin agreed to sell the stock of CF Motor Corp. and the assets of the dealerships to Asbury Automotive and agreed to sell Asbury its 50 percent interest in a Coggin-Andrews partnership. Andrews objected to selling the dealership and sought to block the sale. Andrews eventually agreed to sell his interest in the partnership to Coggin and Asbury for $7.3 million.

The IRS issued Coggin two deficiency notices, one for the year ending June 26, 1993 and the other for the tax years ending December 31, 1993, 1994, and 1995, determining that under section 1363(d), Coggins' conversion to an S corporation triggered the inclusion of the affiliated group's pre-S election LIFO reserves ($5,077,808) into Coggin's gross income. The IRS's primary argument was that the restructuring was a sham with no tax-independent purposes. Alternatively, the IRS maintained that under the aggregate approach of partnerships a pro rata share ($4,792,372) of the Pre-S election LIFO reserves was attributable to Coggins.

The Tax Court first held that the restructuring was a "genuine multiple-party transaction with economic substance" and not a sham, rejecting the IRS's position that there was no tax-independent business purpose for the restructuring. The court, however, agreed with the IRS that the aggregate approach to partnerships better serves the underlying purpose and scope of section 1363(d) and that Coggin was therefore deemed to own a pro rata share of the partnerships' inventories and was required to include $4,792,372 in its gross income for 1993 as its ratable share of the LIFO recapture amount. (For a summary of this opinion, see Tax Notes, Oct 23, 2000, p. 492; for the full text, see Doc 2000-26953 (28 original pages) or 2000 TNT 203-7 .)

Coggin argues that neither section 1363(d), nor its legislative history, nor case law, supports the Tax Court's interpretation of this section and the ad hoc approach that is being advanced by the government to support that decision. Coggin also emphasizes that it is not appropriate to apply the aggregate approach for purposes of section 1363(d).

I. INTRODUCTION.

[1] The Government's brief ("G. Br.") fails to adequately address crucial flaws in the Tax Court's opinion. The Government agrees that the clear language of Section 1363(d) of the Internal Revenue Code of 1986, as amended (the "Code") does not apply in the instant situation. However, the brief fails to explain why this Court should reject a long line of cases, including the Supreme Court's recent decision in Gitlitz v. Commissioner, 531 U.S. 206, 121 S. Ct. 701 (2001), that require that the literal language of the statute be followed.

[2] In Gitlitz, the Supreme Court specifically held that the plain language of a statute was to be followed despite the Internal Revenue Service's (the "Service") contention that to do so would result in a windfall to the taxpayer. Similarly, in a very recent decision, this time at the behest of the Service, the Fourth Circuit Court of Appeals reversed a decision of the Tax Court (which was in favor of the taxpayer) because the Tax Court did not follow the plain meaning of a statute. The taxpayer and Tax Court felt that the legislative history of the section required an interpretation favorable to the taxpayer. The Fourth Circuit pointed out that there was no ambiguity in the statute and that "unless there is some ambiguity in the language of a statute, a court's analysis must end with the statute's plain language (the Plain Meaning Rule)." Hillman v. Internal Revenue Service,__ F.3d __, 87 A.F.T.R.2d 2001-1731 (4th Cir. April 17, 2001).

[3] Abandoning the clear statutory language, the Government's brief here primarily relies on one case (Holiday Village Shopping Center v. United States, 773 F.2d 276 (Fed. Cir. 1985)) and a vague "appropriateness" argument. While there are two Circuit Court cases more closely in point, the brief insists that they were incorrectly decided.

[4] The Tax Court's decision in this case not only ignores the plain language of the statute in question, but resorts to legislative history that does not support departing from the statute. Moreover, the decision is inconsistent with the relevant partnership provisions of Subchapter K of the Code and reaches a result that cannot be consistently applied. It represents an ill-advised and unwarranted judicial invasion of an area where if any change is at all necessary, that change can best be handled by, and is in the province of, the legislature.

II. THE GOVERNMENT MAKES SEVERAL IMPORTANT ADMISSIONS IN ITS BRIEF.

[5] Before discussing the flaws in the Government's argument, it is important to stress certain admissions that the Government has made in its brief. First, and most importantly, the Government specifically agrees that, by its terms, Section 1363(d) of the Code "does not LITERALLY apply to the facts of this case." (G. Br. p. 24.) This is because, as the Government has conceded, Coggin Automotive Corporation ("Coggin") never owned any inventories and accordingly never made an election to use the LIFO method, two prerequisites to application of the statute. (G. Br. p. 14).

[6] Moreover, the Government acknowledges that, contrary to the position it urges here, in certain other cases, "it would make no sense to require" LIFO recapture under Section 1363(d) when a C corporation, which is a partner in a partnership, elects S corporation status. In fact, the Government agrees with the taxpayer that applying the Tax Court's decision to other fact patterns involving C corporation partners in partnerships produces absurd results and, accordingly, that "treating a partnership as an aggregate will not result in achieving the purposes of I.R.C. section 1363(d) in ALL instances." (G. Br. pp. 27, 29-30 (emphasis in original).)

[7] Finally, the Government concedes that despite Section 1363(d)'s directive to make an appropriate basis adjustment if LIFO reserve recapture is required, there is absolutely no guidance in the Section, in the partnership provisions of Subchapter K, or elsewhere for doing so. Nothing in the Code explains how such a basis increase would be accomplished if Section 1363(d) is expanded to deem a partner to hold a portion of the partnership's inventory. (G. Br. pp. 32-34.) The Government's only response to this point is to argue that "the proper manner of making the correlative adjustments to inventory is not before this Court," and to make the less-than-comforting statement that:

We are confident that, if this Court should affirm the

[8] Thus, because the Government has conceded that Section 1363(d) by its terms does not apply to the facts at hand and that applying the aggregate approach to partnerships for purposes of Section 1363(d) in many cases would produce absurd results, the Government is reduced to arguing that the law provides that, in interpreting Section 1363(d), the Service has been given the authority to deem a portion of partnerships' inventory to be owned by a partner (the "aggregate approach") on a case-by-case basis solely based upon its determination of whether doing so would be "appropriate." Moreover, because there simply is no guidance in the Code as to how the Tax Court's decision could be implemented in this case to carry out Section 1363(d)'s requirement for an adjustment to basis, the Government is reduced to assuring the taxpayer that the parties will be able to "work out" the details at a later date. With all due respect, this simply cannot be the law.

III. NEITHER CODE SECTION 1363(D), NOR ITS LEGISLATIVE HISTORY, NOR

[10] To support its argument, the Government relies heavily (G. Br. pp. 17, 37, 38) on the following paragraph from the 1954 legislative history:

Both the House provisions and the Senate amendment provide

[11] Casel v. Commissioner, 79 T.C. 424 (1982), which was relied upon by the Government (G. Br. p. 17), is instructive on this point. In that case, the Tax Court held that a regulation that applied the aggregate approach of partnerships for purposes of Section 267 of the Code was valid both because it "followed the long-standing position taken by the courts" and because the application of the aggregate approach did not give rise to "an unreasonable interpretation" of the Code section. Id. at 433-34. In reaching the conclusion that the regulation was valid, the court explained the 1954 legislative history relied upon by the Government here. It stated that "the conference report . . . clearly stated that whether an aggregate or entity theory of partnerships should be applied TO A PARTICULAR CODE SECTION depends on which theory is more appropriate TO SUCH SECTION." Id. at 433 (emphasis added). In other words, the Casel Court interpreted the legislative history as requiring a section-by-section analysis and not a case-by-case analysis. ¹ This is entirely appropriate because if the Service is able to recast partnership transactions on a case-by-case basis when there is no abuse present, taxpayers simply will have no way to determine their tax liability with any certainty.

[12] Some of the language in Holiday Village Shopping Center v. United States, 773 F.2d 276 (Fed. Cir. 1985), on which the Government puts such great reliance, might be read to suggest that the Federal Circuit applied a case-by-case approach to the aggregate versus entity determination (e.g., "Under these circumstances the partnership should not be viewed as an independent taxable entity . . . ."). As the Fifth Circuit, in Petroleum Corporation of Texas, Inc. v. United States, 939 F.2d 1165 (5th Cir. 1991), appropriately recognized, however, the court in Holiday Village was faced with circumstances indicating a transaction without a valid business purpose that had been entered to avoid taxes. This understanding explains the Federal Circuit's reliance in Holiday Village on the seminal case of Gregory v. Helvering, 293 U.S. 465 (1935). Gregory v. Helvering is widely considered as the case that gave rise to the business purpose requirement in tax law. 773 F.2d at 280.

[13] If the Federal Circuit meant to apply the case-by-case approach universally, it misinterpreted the legislative history discussed above, which clearly does not envision such an approach; if it was merely attempting to apply the business purpose/sham transaction doctrines, then the outcome of the case may have been appropriate. And this is exactly why the Fifth Circuit limited the holding of Holiday Village to its facts as follows:

[W]e find Holiday Village inapposite to the instant case.

[14] While the Government asserts that "Petroleum Corp. of Texas was incorrectly decided," its only criticism of the case appears to be the assertion that the case creates a potential for abuse. (G. Br. p. 26.) The business purpose, economic substance, substance-over-form, and sham transaction doctrines are all legitimate devices for combating potential abuse. Ad hoc distortion of the law to prevent a result disfavored by the Service is not.

[15] Petroleum Corp. is directly in point, was decided correctly, and strongly supports Coggin's position. The Service makes no attempt to distinguish Petroleum Corp. or to offer any argument against the reconciling construction of the Petroleum Corp. and Holiday Village decisions offered by the Fifth Circuit.

[16] Brown Group, Inc. v. Commissioner, 722 F.2d 695 (8th Cir. 1996), yet another Circuit Court case that the Government feels "simply was wrong," (G. Br. p. 38) also supports the conclusion that the Government's ad hoc approach cannot stand. As discussed in the taxpayer's opening brief, in December 1994, AFTER THE TRANSACTION at issue, the Service adopted a controversial regulation purporting to give itself authority on a prospective basis to apply the aggregate method using a case-by-case approach. Treas. Reg. section 1.701-2(e). The Government argues that this was just a clarification of what the law already was, and it cites some self-serving language by the Service in the preamble to the final regulations to support that conclusion. (G. Br. p. 38.) As just explained, however, Congress has never given the Service the authority to treat partnerships as aggregates on an ad hoc basis, and the anti-abuse regulation was a questionable attempt by the Service to extend its authority in that respect.

[17] The history of Treas. Reg. section 1.701-2(e) makes this very clear. When first proposed in May 1994, the anti-abuse regulation specifically provided that the Service could only apply the aggregate approach in cases in which a taxpayer formed or availed itself of a partnership "with a principal purpose of substantially reducing the present value of the partner's aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter K," which included, among other things, using "the existence of [a] partnership[] to AVOID the purposes of other provisions of the Internal Revenue Code." Prop. Reg. section 1.701-2(a), (b). In other words, the regulation was clearly limited to situations in which it could be shown that the taxpayer abused the partnership form -- which, as the Tax Court found in this case, Coggin did not do. The fact that the proposed regulation was limited to abusive transactions was made clear in its preamble, which explained that "[t]he proposed regulation clarifies the authority of the Commissioner of Internal Revenue to recast those transactions that exploit and misuse the provisions of subchapter K in an attempt to avoid tax," and that "[t]he Commissioner can continue to rely upon applicable principles and authorities to challenge ABUSIVE transactions occurring before and after the effective date of the regulation." 1994-1 C.B. 832, 833-34 (emphasis added).

[18] In the final regulations, the Service elected to eliminate the requirement that the aggregate approach could only be used in situations of abuse, and in the preamble language cited by the Government in its brief (G. Br. p. 38), the Service attempted to suggest that it had always had the power to treat partnerships as aggregates on a case-by-case basis without regard to taxpayer intent. However, as explained above, the suggestion that existing legislative history and case law gives the Service the authority to apply such an ad hoc approach is simply not tenable, and the Service obviously recognized as much when it gave paragraph (e) of the final regulation its own special prospective effective date as of the date of the final regulation as opposed to the date of the proposed regulation. As explained in the preamble:

Also, in light of the elimination of the proposed

Indeed, as we read the regulations, the IRS does NOT have the

[19] The Government's reliance on the history of former Section 386 of the Code to support its ad hoc approach is equally misplaced. First of all, Section 386, during its existence, had absolutely nothing to do with Section 1363(d) of the Code. Section 386 was adopted by Congress so that partnerships would be treated as aggregates for specific purposes (not including for purposes of Section 1363(d)). The Government appears to argue here that by enacting Section 386, Congress somehow "endorsed" the ad hoc approach being advanced by the Government. Nothing could be farther from the truth -- there simply is nothing in former Section 386, the legislative history to its enactment, or the legislative history to its repeal that supports any such conclusion. If anything, Section 386 shows that Congress knows how to apply the aggregate approach to partnerships when it so chooses, and that when it chooses not to do so, courts should refrain from legislating on Congress' behalf.

[20] Moreover, while the Government contends that Section 386's repeal somehow supports its argument (G. Br. pp. 22-23), in fact it does the opposite. The Government is entirely correct that the legislative history to Section 386's repeal includes the assertion that the Service can continue to use "the step-transaction or other doctrines to prevent certain of the abuses to which I.R.C. section 386 had been directed." (G. Br. pp. 22-23.) This, of course, is exactly what the taxpayer has argued here all along -- the Service has at its disposal a number of doctrines to attack abusive transactions, and thus, the judicial expansion of Section 1363(d) is in no way necessary to prevent abuses. The Tax Court specifically held that Coggin's transactions were entered into for valid business purposes, and that holding should have been the end of this matter.

IV. IT IS NOT APPROPRIATE TO APPLY THE AGGREGATE APPROACH FOR

[22] As pointed out in Coggin's opening brief, in the instant situation, (i) the plain language of Section 1363(d) does not cover the case at hand, (ii) the regulations promulgated under Sections 1363(d) and 1374 make it clear that the Service chose not to attempt to include LIFO inventories held by a partnership within the recapture requirement of Section 1363(d) and that instead built-in gain on such inventory need only be recognized when a LIFO layer is invaded, (iii) the legislative history to Section 1363(d) in no way supports applying the aggregate approach for purposes of Section 1363(d), and (iv) attempting to apply the aggregate approach for purposes of Section 1363(d) is inconsistent with Subchapter K of the Code and creates significant difficulties in the application of the Section that could only be dealt with through legislation.

[23] To support its argument that it is somehow appropriate to apply an aggregate approach here, the Government constantly reiterates that Coggin filed consolidated returns with the corporations that actually had LIFO inventory. (G. Br. pp. 5, 8, 9, 28-29, and 30-31.) This fact is of no significance to the issues raised by this appeal. Section 1363(d), by its terms, does not operate on LIFO reserves of a consolidated group -- it only operates on the reserves of THE C corporation that converts to S corporation status. Moreover, nothing in the Tax Court's opinion suggests that it is limited to cases involving consolidated groups. In fact, other than mentioning that consolidated returns were filed, the Tax Court in no way relied upon this fact. Its holding would apply whether or not consolidated returns were filed. Consequently, the Government's repeated reference to the filing of consolidated returns is simply a red herring.

[24] Moreover, whether or not the Government's proposed ad hoc approach to applying the aggregate method were allowed, it simply could not be allowed in this case because it is entirely inconsistent with Subchapter K of the Code. As explained in detail in Coggin's opening brief, both Subchapter K and the case law interpreting it make clear that for purposes of determining a partnership's income and deductions, the entity approach must be used unless a specific provision of Subchapter K provides otherwise. In fact, the legislative history to the 1954 Code, on which the Government places so much reliance, also stresses this point. As explained in the Senate report:

Both versions of the bill provide that all elections with

[25] The Government's weak attempt to distinguish P.D.B. Sports, Ltd. v. Commissioner, 109 T.C. 423 (1997) fails. In that case, the Tax Court concluded that due to basis complexities that would have been created if the aggregate approach were applied for purposes of Section 1056 of the Code and the fact that Congress provided no rules that would explain how such basis complexities should be dealt with, it was not appropriate to apply the aggregate method for purposes of such Code section. The Government tries to distinguish P.D.B. Sports by arguing that in this case, the Government is "confident" that the parties can "work out" the basis adjustments that need to be made. ² (G. Br. p. 34.) The Government makes this assertion despite the fact that it apparently has no suggestion for how that should be done and the fact that the Code provides no guidance for doing so. The Court in P.D.B. Sports made it very clear that in cases like that at hand, where the integration of Section 1363(d) and Subchapter K would create substantial difficulties, any integration must be left to Congress because only it can appropriately deal with the complexities created.

V. CONCLUSION.

[26] The Tax Court held that Coggin's restructuring had economic substance, a valid business purpose, and was not effected to evade taxation. Nonetheless, the Government asks this Court to find as a matter of law that, in this case, it can recast the transaction using the aggregate method and thus require LIFO reserve recapture under Section 1363(d). The problem is that doing so requires departing from the plain language of the statute, and there exists no authority or basis for such a departure. Nor is there any authority for the Government's ad hoc approach to the aggregate versus entity determination -- and rightfully so, because if there were, taxpayers would have no way of determining the amount of taxes, if any, resulting from a transaction involving a partnership.

[27] As Coggin pointed out in its opening brief, it appears that the Tax Court was disturbed by the possibility that Section 1363(d) might have a loophole, and it undertook to judicially craft what it thought to be a solution to that loophole. It appears that the Government is inviting this Court to follow that same course. Although it does not argue so directly, the Government refers to Coggin's transaction as a "ploy" (G. Br. p. 29) and suggests to this Court that if it holds for the taxpayer, it "would be nothing short of a road map instructing C corporations on how to circumvent the recapture of their LIFO reserves upon electing S status." (G. Br. p. 26.) We urge this Court not to follow the path suggested by the Government. The Service already has the tools to attack abusive transactions, and its primary argument below invoked such tools. Using the economic substance, business purpose, sham, and step- transaction doctrines, the Service can recharacterize transactions by C corporations if they are entered into, in the Government's words, "to circumvent the recapture of their LIFO reserves upon electing S status." (G. Br. p. 26.) The Service does not need, and there is absolutely no authority to support, the immense broadening of its authority to recast legitimate transactions.

[28] Outside of abusive transactions, it is up to Congress to legislate if it desires its statutory language to be broadened. As the Supreme Court recently reaffirmed, even if there were a loophole here (which we do not believe there to be), only Congress would have the authority to address it. In Gitlitz v. Commissioner, 531 U.S. 206, 121 S. Ct. 701 (2001), the Supreme Court recognized that the Code's rules must be respected by a Court even if the Court believes that the rules give rise to a result that is not consistent with appropriate tax policy. As explained by the Supreme Court in that case, which dealt with a potential "double windfall" to S corporation shareholders in the context of a discharge of indebtedness, "[b]ecause the Code's plain text permits the taxpayers here to receive these benefits, we need not address this policy concern." 531 U.S. at, 121 S. Ct. at 710. In other words, if Congress creates a loophole, the Supreme Court has made it clear that it is up to Congress to fix it. See also Hillman v. Internal Revenue Service, __ F.3d, 87 A.F.T.R.2d 2001-1731 (4th Cir. 2001) (holding that, because a statute's language was plain and the Service had not exercised the legislative regulatory authority it had been given by Congress, although the statute arguably produced an inequitable result, "this is an inequity in the United States Tax Code that only Congress or the Secretary (as the holder of delegated authority from Congress) has the authority to ameliorate.")

[29] We urge this Court to leave to Congress the decision WHETHER to integrate Section 1363(d) and the partnership provisions. Only Congress has the right to determine whether to do so, only Congress can deal with the complexities that would be created by such an integration, and only Congress can make any amendments prospective so as not to upset legitimate business transactions and settled expectations.

[30] For the reasons set forth in the taxpayer's opening brief and above, it is respectfully requested that the Court reverse the decision of the Tax Court below and direct it to enter judgment for Coggin.

[31] This 24th day of May, 2001.

N. Jerold Cohen

² Coggin does not share the Government's confidence.