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Corporate Tax Law Professor Suggests Removal of Deadwood Tax Rules

MAY 14, 2018

Corporate Tax Law Professor Suggests Removal of Deadwood Tax Rules

DATED MAY 14, 2018
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May 14, 2018

Re: Eliminating Unnecessary Tax Regulations, Specifically §§ 1.312-4 and 1.312-5 REG–132197–17

I write to recommend removing Treasury Regulation § 1.312-5, which is “deadwood,” and § 1.312-4, which is not merely “deadwood” but has provided incorrect guidance to taxpayers ever since the 1986 enactment of the current version of I.R.C. § 311(b).

I. Section 1.312-4: Entire Regulation Is Inapplicable and Incorrect

The Treasury and the Service have proposed removing “regulations interpreting Code provisions that, while not repealed, have been significantly revised, and the existing regulations do not account for these statutory changes. To fall in this category, these statutory changes must have rendered the entire regulation inapplicable.”1 Section 1.312-4 falls squarely in this category and is ripe for removal.

Section 1.312-4 is titled “Examples of adjustments provided in section 312(c).” It dates from 19552 and consists of three examples of earnings and profits (E&P) adjustments from distributions of property subject to liabilities. Ever since the Tax Reform Act of 19863 added the current version of § 311(b), all three examples have been incorrect.

I teach Corporate Taxation at the University of Maryland, and several students through the years have come across § 1.312-4 and been quite confused by it. I suspect that many other taxpayers and practitioners have had the same experience.

Example 1: Assumes General Utilities Remains Good Law

In this example, a corporation distributes land with FMV $5,000, adjusted basis $3,100, and a $2,000 mortgage. Under current § 311(b), the corporation will recognize the built-in gain of $1,900. Of course, when § 1.312-4 was promulgated in 1955, such gain was not recognized because of General Utilities v. Helvering, 296 U.S. 200 (1935).

As a result, the analysis in Example 1 is incorrect under current law. An ill-informed taxpayer with facts similar to Example 1 could easily come across Example 1 and conclude, incorrectly, that no built-in gain needs to be recognized and reported.

Example 1's analysis of the E&P adjustments is that E&P goes down by $1,100, which is “$3,100, the basis, less $2,000, the amount of mortgage”. Under current law, the adjustments to E&P should, I believe, be as follows:

  • The $1,900 gain recognized under current § 311(b) increases E&P per § 312(b)(1) and § 1.312-3(b).

  • The $5,000 FMV of the land distributed decreases E&P, per § 312(a)(3) & (b)(2).

  • The $2,000 mortgage on the distributed land increases E&P, per § 312(c) and § 1.312-3(a).

Example 2: Also Assumes General Utilities Remains Good Law

Example 2 uses the same facts as Example 1, except with the mortgage on the distributed land being $4,000. Example 2 states, “There is a gain of $900 recognized to Corporation X, the difference between the basis of the property ($3,100) and the amount of the mortgage ($4,000)”. $900 is the incorrect amount of gain, since the land has FMV $5,000 and thus the corporation recognizes $1,900 in gain under current § 311(b). As with Example 1, an ill-informed taxpayer could easily come across Example 2 and incorrectly conclude that little or no built-in gain needs to be recognized. And, as with Example 1, the incorrect amount of gain results in a flawed analysis of E&P.

Example 3: Refers to pre-1986 version of § 311(b), which dealt with LIFO

Example 3 provides guidance on the version of § 311(b) in effect from 1954 to 1985. This old § 311(b) provided that if a corporation used the last-in-first-out (LIFO) method for inventories, and if the corporation distributed inventory assets to its shareholders, then the corporation had to recognize some or all of the inventory's built-in gain, calculated using the LIFO basis.4 Old § 311(b), which is reproduced in full in a footnote below,5 was repealed in 1986 and bears no resemblance to current § 311(b).

Relationship to § 1.312-3

Section 1.312-4's neighbor, section 1.312-3 is very much still relevant and has been updated repeatedly by Treasury and the Service, most recently in 1995.6Section 1.312-3(a) provides that E&P increases when a distribution relieves the corporation of a liability,7 which is the key to understanding § 312(c)'s language about “proper adjustment” to E&P for liabilities.

The sole citation to § 1.312-4 in Bittker & Eustice's treatise is a footnote that first cites § 1.312-3.8 The footnote supports the proposition in the treatise's main text that, in a distribution, “Liabilities reduce the downward adjustment made under § 312(a) and actually cause a net increase in earnings and profits (i.e., more E&P after accounting for the distribution than existed before) to the extent they exceed the basis of distributed property.”9 But this position would be fully supported solely by § 1.312-3(a), without § 1.312-4. And Bittker & Eustice's footnote adds the caveat that both sections “must be read in light of their reflection of the 1954 version of § 311 — before repeal of General Utilities,” highlighting how out-of-date § 1.312-4 is.10

Citations to § 1.312-4

No cases nor any IRS documents that I have found cite § 1.312-4 for any tax years after 1986. Westlaw shows that six secondary sources cite § 1.312-4. Two sources11 cite it for a proposition for which its neighboring section, § 1.312-3, provides complete support. The third secondary source also cites § 311(c),12 which was removed in the 1986 act, suggesting that that secondary source itself is sorely in need of an update! The fourth secondary source cites § 1.312-4 in what appears to be a typo.13 The fifth secondary source cites § 1.312-4 for a proposition for which § 312(a)(3) suffices.14 The sixth secondary source is a 50-state survey that lists § 1.312-4 as part of “a collection of regulations addressing income taxation of corporations.”15 The fact that such a survey still lists § 1.312-4 illustrates how its continued existence may cause confusion to practitioners and taxpayers.

II. Section 1.312-5: Interprets a Repealed Code Provision

The Treasury and the Service have proposed removing “regulations interpreting provisions of the Code that have been repealed. All of these regulations apply to provisions of the Code that no longer appear in title 26 of the United States Code.”16 Section 1.312-5 falls squarely in this category and is ripe for removal.

Section 1.312-5 is titled “Special rule for partial liquidations and certain redemptions.” It dates from 195517 and consists of a single sentence regarding the application of I.R.C. § 312(e), which was repealed in 1984.18 Prior to repeal, section 312(e) read:

(e) Special rule for certain redemptions.

In the case of amounts distributed in a redemption to which section 302(a) or 303 applies, the part of such distribution which is properly chargeable to capital account shall not be treated as a distribution of earnings and profits.

As the Service noted in Rev. Rul. 79-376, the term “capital account” in § 312(e) “is not defined in the Code or regulations.”19 The predictable result was litigation over the definition of “capital account” in § 312(e).20 When Congress repealed § 312(e) in 1984, it also enacted § 312(n)(7), which now governs the treatment of E&P when a redemption occurs to which section 302(a) or 303 applies. In 1995, the Service revoked its most recent revenue ruling defining “capital account,” as being obsolete.21

Bittker & Eustice never cite § 1.312-5, nor do any other secondary sources available on Checkpoint. The most recent case to cite it dealt with tax year 1978.22 The most recent Private Letter Ruling citing it was PLR 7203171370A.

Westlaw shows four secondary sources citing § 1.312-5. The first is a typo, since it intended to cite § 1.312-15, regarding depreciation.23 The second cites it for historical purposes.24 The third cites it saying, “IRC § 312(n)(7), superseding the limitations of Treas. Reg. § 1.312-5, . . .”25 confirming that § 1.312-5 has indeed been superseded — and thus ripe for removal. The fourth secondary source is the same 50-state survey that also lists § 1.312-4 as part of “a collection of regulations addressing income taxation of corporations,”26 highlighting how § 1.312-5 continues to cause potential confusion to practitioners and taxpayers.

III. Conclusion

The Treasury and the Service should remove Treas. Reg. §§ 1.312-4 and 1.312-5 entirely.

FOOTNOTES

1 Eliminating Unnecessary Tax Regulations, 83 Fed. Reg. 6,807 col. 2 (Feb. 15, 2018).

2 Treasury Decision 6152 (Dec. 2, 1955).

3 Pub. L. 99-514.

4 Under § 312(n)(4), corporations must now make annual adjustments to their E&P to reflect changes in the tax benefit from using LIFO. The existence of § 312(n)(4), which was first added in 1984, makes the continued existence of Example 3 in § 1.312-4 even more inappropriate.

5 At the time § 1.312-4 was promulgated in 1955, I.R.C. § 311(b) read as follows:

(b) LIFO inventory.

(1) Recognition of gain. If a corporation inventorying goods under the method provided in section 472 (relating to last-in, first-out inventories) distributes inventory assets (as defined in paragraph (2)(A)), then the amount (if any) by which —

(A) the inventory amount (as defined in paragraph (2)(B)) of such assets under a method authorized by section 471 (relating to general rule for inventories), exceeds

(B) the inventory amount of such assets under the method provided in section 472, shall be treated as gain to the corporation recognized from the sale of such inventory assets.

(2) Definitions. For purposes of paragraph (1) —

(A) Inventory assets. The term “inventory assets” means stock in trade of the corporation, or other property of a kind which would properly be included in the inventory of the corporation if on hand at the close of the taxable year.

(B) Inventory amount. The term “inventory amount” means, in the case of inventory assets distributed during a taxable year, the amount of such inventory assets determined as if the taxable year closed at the time of such distribution.

(3) Method of determining inventory amount. For purposes of this subsection, the inventory amount of assets under a method authorized by section 471 shall be determined —

(A) if the corporation uses the retail method of valuing inventories under section 472, by using such method, or

(B) if subparagraph (A) does not apply, by using cost or market, whichever is lower.

The above version of § 311(b) remained unchanged until it was removed by the Tax Reform Act of 1986, P.L. 99-514. I could find no legislative history for the repeal of old § 311(b). But it makes sense that the new § 311(b), which causes recognition of built-in gain on all distributed property, simply made obsolete the old § 311(b), which caused recognition of only some built-in gain, only on distributed inventory.

6 Specifically, § 1.312-3 has been amended by T.D. 6832 (1965), T.D. 7084 (1971), T.D. 7209 (1972), and T.D. 8586 (1995).

7 The wording § 1.312-3(a) uses to indicate the E&P increase is awkward, calling for the E&P “reductions” to be “reduced”.

8 Bittker & Eustice, Federal Income Taxation of Corporations & Shareholders ¶8.22[2] n.346 (7th ed. Supp. 2018-1).

9 Id. ¶8.22[2].

10 § 1.312-3 could use some trimming, as suggested by Bittker & Eustice, presumably to remove the references to § 311(c) and (d), which have been repealed. Such editing is probably beyond the scope of the Treasury and Service's current project. By contrast, § 1.312-4 should be removed entirely, which is within the scope of the current project.

11 10 Mertens Law of Federal Income Taxation § 38C:13 (“the amount of the reduction in earnings and profits for the distribution of the property is reduced by the amount of the obligation assumed by the shareholder and amount of any liability to which the property distributed is subject”); Federal Tax Coordinator, 2d ed. ¶ F-10508, Assumption of Liabilities in a Distribution (“the amount of the reduction in earnings and profits otherwise allowable . . . must be reduced by the amount of the liability”); accord Treas. Reg. § 1.312-3(a) (“The amount of any reductions in earnings and profits described in section 312(a) or (b) shall be . . . reduced by the amount of any liability to which the property distributed was subject and by the amount of any other liability of the corporation assumed by the shareholder in connection with such distribution”).

12 10 Mertens Law of Federal Income Taxation § 38C:17.

13 Gary L. Maydew, Mitigation Offers Escape From Expired Limitations Period, 65 Prac. Tax Strategies 153, 156 (2000) (citing “1.312-4(b)” although there has never been a subsection (b); the article cites it for double disallowances of charitable deductions, which seems far afield from the actual subject matter of § 1.312-4).

14 Ronald L. Rowland, Distributions of Cash and Property by S Corporations Require Careful Planning, 4. J. Partnership Tax'n 34, 43 (Spring 1987) (“The practitioner, however, should be alert that the adjustment to earnings and profits resulting from a property distribution is made by reference to the adjusted basis of the property at the corporate level and not its fair market value.”). This article was published soon after the 1986 Act, and so it might not have fully reflected the changes in the 1986 Act. Or, the article may be referring to the fact that the net result of increasing E&P by gain recognized under current § 311(b) and reducing E&P by FMV under current § 312(b)(2) is to subtract the basis of distributed property from E&P.

15 Income Tax Rates for Corporations, 50 State Regulatory Surveys, available using Westlaw citation “0130 REGSURVEYS 2”.

16 Eliminating Unnecessary Tax Regulations, 83 Fed. Reg. 6,807 col. 2 (Feb. 15, 2018).

17 Treasury Decision 6152 (Dec. 2, 1955).

18 Deficit Reduction Act of 1984, Pub. L. 98-369, 98 Stat. 494 § 61(a)(2)(B) (removing § 312(e)).

19 1979-2 C.B. 133.

20 An excellent overview of the litigation over “capital account” is on pages 534 to 541 of Anderson v. Comm'r, 67 T.C. 522 (1976). See Jarvis v. Comm'r, 43 B.T.A. 439 (1941), nonacq. 1970-2 C.B. xxii, aff'd, 123 F.2d 742 (4th Cir. 1941). The IRS provided its own broader, alternative definition, contrary to Jarvis's definition, in Rev. Rul. 70-531. But in Anderson, supra, the Tax Court held that the Jarvis definition, not the Service's definition from Rev. Rul. 70-531, governed. 67 T.C. at 540-41. The IRS acquiesced to this result in Rev. Rul. 79-376.

21 Rev. Rul. 95-71 (revoking as “obsolete” a number of revenue rulings, including Rev. Rul. 79-376, discussed supra footnote 20).

22 Woods Investment Co. v. Commissioner, 85 T.C. 274.

23 10 Mertens Law of Federal Income Taxation § 38C:46 n.5.

24 Susan A. Johnston & James R. Brown, Jr., Taxation of Regulated Investment Companies and Their Shareholders ¶ 3.04.

25 Daniel H. McCarthy, William P. Prescott & Steve Gorin, 28-FEB Probate & Property 38, 41 (2014).

26 Income Tax Rates for Corporations, 50 State Regulatory Surveys, available using Westlaw Citation “0130 REGSURVEYS 2”.

END FOOTNOTES

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