Academic Comments on Proposed LIFO Recapture Regs

I am writing to comment on the proposed amendments to 26 CFR Part 1 under Section 1363(d) of the Internal Revenue Code of 1986, and to request to be heard at the public hearing scheduled for Wednesday, December 8, 2004.¹

Unfortunately, the statute suffers from a number of congenital defects. As most recently illustrated by the Eleventh Circuit's reversal of the Tax Court's decision in Coggin Automotive,⁶ the statutory language of Section 1363(d) inexplicably fails to anticipate three scenarios under which LIFO recapture might be avoided with relative ease.⁷ Regulations finalized in 1994 have already addressed one class of avoidance schemes that the taxpayers in United Dairy Farmers Inc.⁸ successfully used to circumnavigate Section 1363(d). The principal effect of these regulations was to extend the scope of the application of Section 1363(d) to C corporations that transferred LIFO inventory to a new or pre-existing S corporation in an otherwise nontaxable carryover basis transaction. These regulations reflected the Treasury's concern that taxpayers, like the taxpayer in United Dairy Farmers, could otherwise use the reorganization provisions⁹ to circumvent Section 1363(d) and permanently escape corporate-level taxes on the LIFO reserve that built up during the corporation's C years.¹⁰ Under these regulations, a LIFO-method C corporation must recognize its LIFO recapture amount as gross income when it transfers LIFO inventory to an S corporation in a "nonrecognition transaction" (as defined in Section 7701(a)(45)) in which the transferred assets constitute "transferred basis property" (as defined in Section 7701(a)(43)).¹¹

The proposed regulations to which my comments below are directed would further extend the reach of Section 1363(d) by overturning the decision of the Eleventh Circuit in Coggin Automotive to require LIFO recapture where the LIFO inventory is held indirectly by a converting C corporation through one or more partnerships or limited liability companies.

Through an elaborate series of pre-arranged transactions,¹² each of these subsidiaries transferred all of their respective assets, including their LIFO inventories, to a newly formed limited partnership in exchange for a 99% limited partnership interest.¹³ The 1% general partnership interest in each of these limited partnerships was held by one of the six S corporations that had been formed a month earlier by CAC's shareholders for this purpose.¹⁴ The formation of the limited partnerships was immediately followed by the tax-free liquidation¹⁵ of the subsidiaries and their distribution of the limited partnership interests to CAC, and then by CAC's S election.

The sole issue in this case was whether Section 1363(d) required the LIFO recapture amount built into the inventories transferred by the CAC subsidiaries to their respective limited partnerships (and held by those partnerships at the time of the CAC's S election) to be recaptured on the CAC group's final consolidated tax return.¹⁶ Had CAC held the inventory directly, it clearly would have been subject to LIFO recapture. CAC, however, argued that the reorganization was undertaken for business purposes,¹⁷ and that Section 1363(d) was not applicable because (1) CAC had itself never actually held any LIFO inventory, and because (2) under the "entity concept" of partnership taxation¹⁸ CAC could not be deemed to own the LIFO inventory that was actually held by its limited partnerships.

The Government argued that the taxpayer's sole or principal objective for the series of transactions preceding CAC's S election was to reap the benefits of that election while permanently avoiding corporate tax liability on the accumulated LIFO reserves of its various consolidated subsidiaries. It argued further that even if the transactions had been motivated by business purposes and not by a principal tax avoidance purpose, under the "aggregate concept" of partnership taxation, CAC was subject to Section 1363(d) as a matter of law.

Although the Tax Court concluded that there was a real and substantial business purpose supporting the transactions, it applied the "aggregate concept" to treat CAC as the owner of the LIFO inventories that were actually held by its limited partnerships on the date of its S election. The Tax Court's analysis and holding were based on the legislative history of Section 1363(d).

On appeal, the Eleventh Circuit Court of Appeals rejected the Tax Court's application of the aggregate concept and held for the taxpayer. Under a strict construction of the literal language of Section 1363(d), the appellate court concluded that LIFO recapture is required only when the corporation electing S status directly holds the inventory which it accounted for under the LIFO method in its last year as a C corporation. The Eleventh Circuit concluded that since CAC had never directly owned any inventories and it never itself made an election to use the LIFO method, Section 1363(d) was inapplicable. According to the Eleventh Circuit, unless there is some ambiguity in the language of a statute, a court's analysis must end with the statute's plain language.²⁰ Therefore, under the "plain meaning" of the Section 1363(d), the LIFO reserves built-into the inventory held by the limited partnerships was not subject to recapture.

Under these regulations, Section 1363(d) would apply regardless of whether the LIFO inventory was transferred to a partnership in anticipation of an S election²⁷ (or in anticipation of a nontaxable disposition of assets to an S corporation) or is held by a partnership in which the electing corporation owns a long-standing interest.²⁸ They would apply regardless of the corporation's percentage of ownership in the partnership, regardless of the value or relative value of the LIFO inventory held by the partnership or the magnitude of the LIFO recapture amount,²⁹ and irrespective of the presence or absence of a business purpose.³⁰

A "converting corporation"³¹ that holds LIFO inventory indirectly through an interest in one or more partnerships is required to include the "lookthrough LIFO recapture amount" in its gross income for the tax year that includes the "recapture date." The "recapture date" is the last day of the tax year preceding the converting corporation's first tax year as an S corporation (or the date the converting corporation transfers its partnership interest to an S corporation in a nontaxable carryover basis transaction).³² The "lookthrough LRA" is the amount of income that would have been allocated to the converting corporation under Section 704, including Section 704(c)³³, if the partnership had sold all of its LIFO inventory for the inventory's FIFO value on the recapture date (or, in some cases, on the first day of the partnership's tax year that includes the recapture date). The proposed regulations also permit and require a converting corporation to increase its "outside" basis in its "lookthrough partnership interest" by the amount of the lookthrough LRA.³⁴ Additionally, the partnership may elect to make a section 743(b)-type "special basis adjustment" for its LIFO inventory to reflect the amount of the lookthrough LRA recaptured by the converting corporation.³⁵ But for this adjustment, the converting corporation could be required to recognize the lookthrough LRA again when the LIFO inventory is subsequently disposed of in a taxable sale or exchange.³⁶

"Reverse Section 704(c) Adjustments." The proposed regulations do not anticipate a scenario wherein a portion of a partnership's LRA might escape Section 1363(d) through the threshold admission of a new partner (or an increase in another partner's interest in the partnership). Upon the admission of a new partner (or an increase in another partner's interest in the partnership), Reg. Sec. 1.704-1(b)(2)(iv)(f) permits, but does not require, the partnership to revalue its assets and to make corresponding adjustments to the partners' capital accounts on the books of the partnership.⁴⁷ These adjustments are generally referred to as "reverse Section 704(c) adjustments." If the partnership does not elect to make these adjustments, a portion of the "inside" gain or loss built into each of the partnership's assets will be allocated away from the existing partners and to the incoming partner.

Special Basis Adjustment To LIFO Inventory Held By The Partnership. As previously noted, the proposed regulations allow a partnership to elect to make a Section 743(b)-type "special basis adjustment" in its LIFO inventory to reflect the converting corporation's recognition of the lookthrough LRA as gross income under Section 1363(d). Generally stated, Section 743(b) permits the purchaser of a partnership interest (or the beneficiary of a deceased partner's interest) (the "transferee") to treat the acquisition of the partnership interest in roughly the same manner as if that transferee had instead purchased or inherited its proportionate share of each of the partnership's assets directly from the partnership, and had then contributed those assets to the partnership in exchange for a partnership interest. The effect of these hypothetical transactions is to give the transferee partner an inside basis in the partnership's assets which equals his/her/its outside basis in the acquired partnership interest, and to thereby purge these assets of the unrealized gains or losses built into them as of the date of the transferee's acquisition of the partnership interest.⁵⁰

In order to insure that these basis adjustments affect only the transferee partner, the partnership will retain its "common basis" in each of its assets (i.e., its inside basis determined immediately before the Section 743(b) adjustment), and it will compute and record a transferee-specific "special basis adjustment" for each of these assets. Because the Section 743(b) adjustment is to be made "with respect to the transferee partner only," it normally affects only the transferee's distributive share.⁵¹ For example, when a partnership sells an asset, it will calculate its gain or loss using the partnership's common basis in that asset. The partnership allocates this gain or loss among its partners, including the transferee partner, in the normal manner and adjusts the partners' capital accounts accordingly. The partnership then adjusts the transferee's distributive share of the items gain or loss to reflect the transferee's special basis adjustment under Section 743(b).⁵²

Since Section 743(b) applies only upon the "transfer of an interest in a partnership by sale or exchange or upon the death of a partner," the converting corporation's recognition of its share of the partnership's LRA would not, under this provision, translate into a basis adjustment in the partnership's LIFO inventory (or in the partnership's interest in a lower-tier LIFO-method partnership), even where the partnership had a Section 754 election in effect.⁵³ The election now available under the proposed Section 1363(d) regulations changes this result by incorporating the principles of Section 743(b) and permitting special basis adjustments that will prevent the converting corporation from recognizing income for a second time when the LIFO inventory (or interest in a lower- tier LIFO-method partnership) is disposed of in a taxable sale or exchange.

Acquisition Of An Interest In An Existing LIFO Method Partnership. Where a C corporation purchases an interest in a partnership that holds LIFO inventory, the seller will be required to recognize its distributive share of the LRA built into the partnership's LIFO inventory at the time of the sale as ordinary income under Section 751(a). If the partnership has a Section 754 election in effect, the adjustments permitted and required under Section 743(b) will prevent the incoming C corporation's share of the LRA built into the partnership's LIFO inventory at the time of the purchase from being taxed to it under Prop. Reg. Sec. 1.1363-2(b) if and when the corporation subsequently makes an S election (or subsequently transfers its partnership interest to an S corporation in a nontaxable carryover basis transaction). Otherwise, these events will trigger the converting corporation's recognition of the LRA that had already been fully taxed, as ordinary income, to the seller at the time that the converting corporation acquired its interest in the partnership.⁵⁴

In my opinion, the proposed regulations should extend the availability of a Section 743(b)-type adjustment to the purchase of a lookthrough partnership interest by a C corporation that subsequently makes an S election (or that subsequently disposes of the partnership interest in a nontaxable carryover basis transaction). This special treatment would be consistent with the elective Section 743(b)-type adjustment provided for in the proposed regulations upon the recognition of the converting corporation's lookthrough LRA. This special treatment is warranted by several factors. First, it would prevent a converting corporation from being taxed on "phantom income," i.e., technical income that results from anomalies in Subchapter K rather than from the economic realities of the converting corporation's investment in the partnership-income that has, in fact, already been fully taxed (to the seller). Rules designed to prevent the taxation of phantom income or the multiple taxation of the same income are laudable wherever they exist, but especially in this context. Where it applies, Section 1363(d) forces LIFO-method corporations to recognize, immediately, unrealized income that has accumulated over several years, perhaps decades, and that, but for Section 1363(d), might have otherwise been deferred for many years or decades into the future. The acceleration and bunching of income mandated by Section 1363(d) can dramatically increase the present value of the economic burden of the tax liability on the corporation's LIFO recapture amount, which, in turn can discourage C corporations with substantial LIFO reserves from availing themselves of the benefits of Subchapter S or quell otherwise deserving corporate acquisitions where the prospective target of an S corporation is a C corporation with substantial LIFO reserves.⁵⁵ And since the income recognized under Section 1363(d) does not derive from actual sales or exchanges of the corporation's LIFO inventory, the cash burden of the resulting taxes can give rise to a potentially severe wherewithal-to-pay problem.

Second, although a timely election under Section 754 would solve this problem, this election would have to have been effective for the date that the C corporation acquired its partnership interest.⁵⁶ The directors and shareholders of a C corporation often lack the clairvoyance required to have anticipated the subsequent conversion of the corporation to S status, or the subsequent disposition of its assets in a nontaxable carryover basis transaction. Furthermore, even where the possibility of a subsequent conversion event is anticipated, a C corporation that acquires a minority interest in the lookthrough partnership may not be able to compel the partnership to make a Section 754 election.⁵⁷ And although the complex calculations and recordkeeping burden required to implement a full-blown Section 754 election can be extremely cumbersome, restricting Section 743(b)-type adjustments to (1) the lookthrough LRA, (2) of an incoming C corporation partner, (3) only for the purpose of applying Section 1363(d) upon that partner's subsequent conversion to S status, would be relatively simple and straightforward.

Where a C corporation acquires a lookthrough partnership interest in a purchase or exchange that is taxable to the selling partner, then, if the partnership had no Section 754 election in effect at the time of the acquisition,⁵⁸ the proposed regulations should be modified to permit the converting corporation to elect to make a contemporaneous "protective" Section 743(b)-type adjustment to the partnership's LIFO inventories at the time of a C corporation's purchase of a lookthrough partnership interest. Furthermore, where, as a result of indifference or inadvertence, the partnership failed to make a protective Section 743(b) adjustment at the time of the C corporation's acquisition of its partnership interest, then, if the partnership's books and records relating to its LIFO inventory are sufficient to make an accurate determination of the correct amount,⁵⁹ then the partnership should be permitted to make a retroactive Section 743(b) adjustment to the partnership's LIFO inventory for the purpose of computing its lookthrough LRA on a subsequent conversion.

In my opinion, the proposed regulations should be modified to provide that where the partnership's opening inventory is used to compute the lookthrough LRA, the opening LRA must also be adjusted to take into account any adjustments to the partnership's basis in its LIFO inventory that result from transactions occurring subsequent to the start of the partnership's tax year and prior to the close of the recapture date. These adjustments include:

Basis Adjustment to LIFO Inventory: In General. In order to prevent the income recognized under Section 1363(d) from being recognized a second time when the inventory is subsequently disposed of in a taxable transaction, the statute and regulations permit and require the converting corporation make "appropriate adjustments" to the tax basis of its LIFO inventory.⁷⁰ Neither, however, describes how the amount of the adjustment is to be calculated, how this amount is to be allocated to the inventory's LIFO layers or, where the corporation uses the dollar-value LIFO method, how it will affect the computation of the LIFO indexes used in making subsequent LIFO calculations.

Revenue Procedure 94-61, however, does address these issues with regard to LIFO inventory held directly by the converting corporation. The amount of the adjustment is the amount of the LRA recognized as gross income under Section 1363(d), without regard to any of the corporation's current losses or net operating loss carryovers that may have been used to reduce the amount of this income that was actually taxed.⁷¹ According to the IRS, there is only one appropriate method for allocating these adjustments to the LIFO inventory, and that method is to collapse (i.e., combine) all of the LIFO layers into a single layer and to add the LRA to the LIFO value of the ending inventory as of the end of the taxpayer's last taxable year as a C corporation.⁷² This conclusion is premised on two assertions:

X Corp's LRA is $300 and it will add that entire amount to the LIFO carrying value at the close of its 2004 tax year notwithstanding the fact that the last three installments of the resulting tax liability are not payable until later years.

• The layers are collapsed into a single 12/31/91 layer having a base-year cost of $1,500 and a LIFO carrying value of $1,900 ($1,600 + $300);

• Neither the base-year, nor the cumulative base-year cost, nor, in the case of dollar-value LIFO-method corporations,⁷⁴ the base-year costs (used in computing subsequent LIFO indexes under the "double-extension" method⁷⁵), nor the cumulative index (used in computing subsequent LIFO indexes under the "link chain" method⁷⁶) change;

• A recomputed index for the combined layer would be 126.67 ($1,900/$1,500), but this index is relevant only for the purpose of computing the LIFO-carrying value of subsequent decrement to this collapsed layer (i.e., where base-year cost of ending inventory in a subsequent tax year falls below $1,500).⁷⁷

The proposed regulations do not specify how the basis adjustment to the partnership's LIFO inventory is to be made. In contrast to LIFO inventory held directly by the converting corporation, only the converting corporation's distributive share of the LRA built into the value of the LIFO inventory held by the partnership is recognized. In order to implement the principles set for in Rev. Proc. 94-61, the partnership should continue to account for its LIFO inventory as if nothing had happened, i.e., it should retain its base year, the base-year costs and LIFO values of each of the layers, the dollar-value indexes, etc. It should record the lookthrough LRA recognized by the converting corporation as a separate amount. If and when the partnership experiences a decrement in the quantity of the inventory on hand as of the date the lookthrough LRA was determined,⁸¹ the converting corporation's distributive share of partnership income should be reduced (as a result of increasing its share of cost of goods sold) by the portion of the LRA adjustment balance allocable to those decremented units⁸² of inventory. This allocable portion should be determined quite simply by multiplying the LRA balance by a fraction, the numerator of which would be the number of decremented units and the denominator of which would be the number of units in the partnership's LIFO inventory on the valuation date used to determine the partnership's LRA (i.e., either the recapture date or the first day of the partnership's tax year that includes the recapture date).⁸³

Validity of the Current and Proposed Regulations

In extending the reach of Section 1363(d) to include both (1) nontaxable LIFO inventory dispositions by C corporations to S corporations, and, most recently, (2) indirect ownership of LIFO inventories through a partnership or through tiered partnerships, the current and proposed regulations go well beyond the literal language of the statute. Not surprisingly, it has been suggested that the Treasury, in issuing the 1994 regulations, may have overstepped its statutory authority,⁸⁴ a contention that is likely to be repeated in connection with the new proposed regulations. In the end, the type and degree of deference accorded these regulations by the courts in any judicial review of their validity is likely to depend, in part, on whether these regulations are considered "legislative" or merely "interpretive."⁸⁵

Administrative law distinguishes the rules issued by governmental agencies as being either "legislative" or "interpretive." Generally stated, a "legislative rule" is one that creates legally enforceable duties that did not exist prior to its promulgation.⁸⁶ A legislative rule is valid only if the agency adopting it has congressional authority to do so and only if it has followed the notice and comment procedures required by the Administrative Procedure Act in adopting the regulation.⁸⁷ If valid, legislative rules bind the issuing agency, the courts, and taxpayers. By contrast, interpretive rules typically clarify the duties already imposed by statute, rather than creating new ones.⁸⁸ Interpretive rules can be promulgated without following the notice and comment procedures,⁸⁹ and, although they may bind taxpayers as a practical matter, they do not as a legal matter bind either taxpayers or the courts.

In tax cases, the courts have distinguished between legislative regulations and interpretive regulations based largely on the source from which the Treasury⁹⁰ derives its authority to promulgate the regulation. Regulations promulgated under the general authority of Section 7805(a) are generally considered "interpretive," and regulations promulgated pursuant to a grant of authority under a particular code section are considered "legislative."⁹¹

Source of Authority for Section 1363(d) Regulations. Although Section 1363(d) was enacted as a backstop to Section 1374, Section 1363(d) does not itself contain provisions corresponding to either Section 1374(d)(8), which extends the built-in gains tax rules to assets acquired by an S corporation from a C corporation in a nontaxable carryover basis transaction, or Section 1374(e), which expressly authorizes the Secretary of the Treasury to ". . . prescribe such regulations as may be necessary to carry out the purposes [of Section 1374] . . . ."⁹² The statutory authority for regulations expanding the scope of the application of Section 1363(d) beyond that expressly provided in the statutory language, therefore, rests either on the Secretary's general rule- making authority under Section 7805(a),⁹³ or on Section 337(d), which empowers the Secretary to prescribe regulations that are necessary or appropriate to effectuate the repeal of the General Utilities doctrine and to "ensure that [the new anti- General Utilities rules] may not be circumvented through the use of any provision of law or regulations (including the consolidated return regulations and part III of this subchapter[ ⁹⁴ ]). . . . " T.D. 8567,⁹⁵ which issued the 1994 regulations, does not itself reveal the statutory basis upon which those regulations were issued, but the proposed anti-Coggin regulations expressly state that they derive their authority from Section 337(d).

A literal reading of the statutory language does not authorize an extension of the authority granted to the Secretary under Section 337(d) to Section 1363(d). The anti-General Utilities rules to which the scope language of Section 337(d) refers are those found in "the amendments made by subtitle D of title VI of the Tax Reform Act of 1986" (which included pre-1986 Tax Reform Act Sections 336, 337, and 1374).⁹⁶ Since Section 1363(d) was not enacted until 1987⁹⁷ and is not included in the list of sections referred to in Section 337(d), both the 1994 regulations and the proposed regulations may be vulnerable to attack.

Nevertheless, the legislative purpose of Section 1363(d), i.e., to further effectuate the repeal General Utilities in the special case of LIFO-method C corporations electing S status, arguably justifies the extension of the broad authority granted to the Secretary under Section 337(d) to Section 1363(d). Furthermore, as previously noted, failure to extend the scope of Section 1363(d) could have the absurd effect of nullifying Section 1363(d).⁹⁸

One of the adjustments required in computing a C corporation's current E&P is the adjustment for annual increases or decreases in its LRA.¹⁰² This adjustment has the general effect of placing LIFO-method C corporations on a FIFO basis for E&P purposes.¹⁰³ Consequently, as of the beginning of the tax year in which a converting corporation's LRA is recognized under Section 1363(d), most or all of the net cumulative amount of all post-1984¹⁰⁴ changes in its LRA will have already been reflected in its E&P.¹⁰⁵ To prevent double counting in the year of conversion, a negative adjustment must be made to the amount of the LRA recognized under Section 1363(d) to derive the converting corporation's E&P.

Adjustments For Taxes Imposed Under Section 1363(d). The E&P of a C corporation, the AAA of an S corporation,¹⁰⁶ and the basis the shareholders of an S corporation have in their stock¹⁰⁷ are all reduced by nondeductible, noncapital expenses.¹⁰⁸ Federal income taxes, or more specifically, the federal income taxes resulting from the application of Section 1363(d), fall into this category. Since the converting corporation will be a C corporation at the time the taxes resulting from the recapture of the LRA become "fixed and determinable,¹⁰⁹ but it will be an S corporation at the time these taxes are actually paid,¹¹⁰ questions arise as to whether or when the converting corporation's E&P, AAA, and/or its shareholders' stock basis are to be adjusted for them.

The statute expressly provides that in computing an S corporation's AAA, no reduction is to be made for federal taxes "attributable to" any tax year in which the corporation was a C corporation.¹¹¹ Although neither the statute nor the regulations define the term II" attributable," the LIFO recapture tax falls clearly within the scope of this term.

The statute, the regulations, and the proposed regulations are all silent, however, as to how these taxes affect the converting corporation's E&P or the basis of its shareholders in their stock.

The "Economic Performance" Test. An accrual method corporation's liability for federal, state, and local income taxes is "recognized" for any and all federal income tax purposes ¹¹² only when the "all events" test of Section 461(h)(4) is met.¹¹³ The "all events" test is met no earlier than when the "economic performance" test of Section 461(h)(2) and (3) is met.¹¹⁴ For liabilities in the form of "taxes," economic performance does not generally occur until the tax in question is actually paid."¹¹⁵ One exception to the "payment" requirement is the "recurring item exception" of Section 461(h)(3). Under that exception, taxes will be treated as having been incurred during a particular taxable year if and only if (1) the all events test is met before the close of that taxable year, (2) payment of the tax is made within the shorter of a reasonable period after the close of such taxable year, or 8 1/2 months after the close of such taxable year, (3) the taxes are recurring in nature and the taxpayer consistently treats taxes of the kind in question as incurred in the taxable year in which the all events test is satisfied, and (4) either the taxes are not a "material item," or the accrual of the taxes in the taxable year in which the all events test is met results in a more proper matching against income than would accruing those taxes in the taxable year in which economic performance occurs.¹¹⁶

The converting corporation will have been a C corporation at the time the "all events" test is satisfied with respect to the taxes resulting from the recapture of its LRA, but it will be an S corporation at the time these taxes are actually paid.¹¹⁷ Economic performance will probably occur with respect to the first installment payment under the recurring item exception, but none of the three subsequent installments will meet this exception and each will therefore accrue at the time of payment.

Earnings and Profits. The E&P of an accrual method taxpayer is reduced by accrued federal income taxes. Section 1371(c), however, generally provides that no adjustments are to be made to the E&P of an S corporation except where they are distributed out to the shareholders as dividends under Section 1368(c)(2), where the corporation redeems its stock or liquidates, or where the corporation acquires, dispose, or allocates E&P as a result of the application of a subchapter C provision to a reorganization or division.¹¹⁸

A literal application of Sections 1371(c) and 461(h) would therefore seem to preclude a reduction in E&P for the last three installment payments of the Section 1363(d) tax, a result clearly at odds with the whole concept of corporate E&P and with the tax policy underlying Section 1363(d). Furthermore, even if these taxes are held to reduce E&P, there is no guidance as to whether this reduction should take place immediately upon the recognition of the LRA or as the installment payments are actually made.

In my opinion, the statute and/or regulations should be amended to expressly provide an exception to the economic performance requirement for the federal income taxes imposed under Section 1363(d). These taxes should not only reduce E&P, the full amount should reduce E&P as of the date the LRA is recognized by the converting corporation, rather than at the later date when the installment payments are actually made. I believe that this approach is congruent with the concept of E&P and that it is consistent with the regulations under Section 1374 which apply the all events test without regard to the economic performance requirement in distinguishing deductions that were built-in as of the last day of the converting corporations last tax year as a C corporation, and those that accrued subsequent to the start of the recognition period.¹¹⁹

Stock Basis. A literal application of Section 1367(a)(2)(D) would seem to require that the shareholders of the converted corporation reduce their stock bases by their pro rata share of these taxes in the year in which they are recognized, i.e., in the year they are paid and economic performance has occurred.¹²⁰ Unfortunately, additional support for this view can be read into the wording of Section 1368(e)(1)(A) which directs that AAA is computed by making adjustments that are "similar to the adjustments under Section 1367," but that "no adjustment shall be made for Federal taxes attributable to any taxable year in which the corporation was a C corporation."¹²¹ This language implies that federal taxes attributable to taxable years in which the corporation was a C corporation are taken into account in making the basis adjustments under Section 1367.¹²²

In my opinion, the statute and/or regulations should also be amended to expressly provide an exception to the economic performance requirement for the federal income taxes imposed under Section 1363(d). These taxes should not reduce the stock basis of the shareholders of the converting corporation (or the stock basis of the shareholders of the successor corporation where the converting corporation was acquired by an S corporation in a nontaxable carryover basis transaction).

Thank you for your time and consideration.

² Section 1373(b) provides that the making of an S election by a C corporation with foreign business operations is a "disposition" within the meaning of Section 904(f)(3)(B)(i). Under Section 904(f)(3)(A), such a disposition will generally trigger the immediate recognition of income to the extent of any unrecaptured "overall foreign losses" that the corporation has previously offset against its U.S.-source income.

Prior to the enactment of Section 1371(d) in 1982, Reg. Sec. 1.47-4(b)(1) required the recapture of investment credits claimed by a C corporation upon its making of an S election, unless all of the corporation's shareholders agreed to assume personal liability for any future recapture taxes. See Tri-City Dr. Pepper Bottling Co. v. Comm., 61 T.C. 508 (1974) (upholding the validity of this regulation). The Subchapter S Revision Act of 1982 effectively repealed this regulation by providing that the filing of an S election was not a recapture event and that the electing corporation would itself be liable for any recapture. Section 1371(d).

³ Section 1363(d)(1) was added by Section 10227 of the Revenue Act of 1987 (Omnibus Budget Reconciliation Act of 1987, Pub. L. No. 100-203, 101 Stat. 1330). Section 1363(d) was a response to the belated realization that the 10-year reach of Section 1374 was generally inadequate in preventing the permanent avoidance of corporate-level taxes on the gains built into the value of a C corporation's LIFO inventories. This is because, for most LIFO-method taxpayers, the combined effect of (1) rising inventory acquisition costs and of (2) stable or increasing ending inventory quantities is to defer indefinitely the taxable recognition of these built-in gains. Once income has been initially deferred under LIFO, that deferral will continue for as long as (1) the layer or layers in which all or some portion of the LIFO reserve is embedded remains in ending inventory and (2) the current unit cost of the inventory item is greater than or equal to the cost of that item at the time the LIFO reserve was created or increased.

⁴ Section 1363(d) generally applies to any C corporation that made an S election that was effective after December 17, 1987 (or after January 1, 1989 if, on or before December 17, 1987, either the corporation's board of directors adopted a resolution to make an S election or the corporation requested a ruling from the IRS in which it expressed an intent to make an S election). Section 10227(b)(2) of the Revenue Act of 1987.

⁵ The "LIFO recapture amount" is the excess, if any, of the inventory's value determined under the "first-in, first-out" ["FIFO"] method over its actual LIFO value. Stated differently, at any given point in time, the LRA is the cumulative net amount of gross income that the corporation has deferred using LIFO, rather than FIFO, since its adoption of LIFO. Although it is possible for a taxpayer to have a negative "LIFO reserve" (i.e., LIFO value exceeds FIFO value), the LRA cannot be negative. Section 1363(d)(3). (See also Rev. Proc 94-61, 1994-2 CB 775, Q&A #4.) This revenue procedure applies to S elections made after December 17, 1987.) Thus, in the unusual case where the corporation's LIFO value exceeds its FIFO value, the LRA is zero and the converting corporation is not permitted to reduce its gross income for the negative LIFO reserve.

The FIFO value of the inventory is determined by using the "retail method" if the corporation uses the retail LIFO method in computing its regular taxable income, or by using the "lower of cost or market" method if it does not.

⁶Coggin Automotive Corporation v. Commissioner, 292 F.3d 1326 (11th Cir 2002), rev'g 115 T.C. 349 (2000). See also T.A.M. 9716003 (April 18, 1997).

⁷ Although there are at least three scenarios under which a C corporation might use an S corporation to avoid LIFO recapture, the language of Section 1363(d)(1) anticipates only one -- the making of an S election by a C corporation that maintained one or more LIFO inventories for the taxable year immediately preceding its first taxable year as an S corporation. Section 1363(d)(1); Reg. Sec. 1.1363-2(a)(1). Section 1363(d) does not expressly require LIFO recapture:

• Where an C corporation disposes of its LIFO inventory to an S corporation in a nontaxable carryover basis transaction,

• Where, in anticipation of making an S election (or as of the date of the transfer of the partnership interest to an S corporation in a nontaxable transaction), a C corporation (or one or more of its subsidiaries) disposes of its LIFO inventory by transferring that inventory to a partnership in a nontaxable exchange for a partnership interest under Section 721, or

• Where a C corporation already owns an interest in an existing partnership that holds LIFO inventory as of the effective date of its S election (or as of the date of the transfer of the partnership interest to an S corporation in a nontaxable transaction).

⁸United Dairy Farmers Inc. v. U.S., 267 F.3d 510 (6th Cir. 2001), aff'g. 107 F Supp 2d 937. (Dist. Ct. Ohio 2000). The shareholders of United Dairy Farmers, Inc. ("UDC"), a family owned C corporation with ten wholly owned subsidiaries, decided to convert UDC into an S corporation. Its tax advisors advised the shareholders that while UDF would be subject to a significant Section 1363(d) LIFO recapture tax if it made an S corporation election, this tax could be easily avoided by forming a new S corporation into which UDF and its subsidiaries could then merge. Under the reorganization provisions, the transfer of assets by UDC and its subsidiaries to the new S corporation would be tax-free and the transferor's tax bases in their respective assets, including their LIFO inventories, would carry over to the new S corporation. Under Section 381(c)(5), the new S corporation would continue to use the LIFO method to account for these inventories.

The tax advisors believed this strategy would be effective in circumventing Section 1363(d). First, then and now, the statute itself requires LIFO recapture only when a LIFO-method C corporation makes an S election. Second, at the time of the proposed UDC transaction, the regulations were silent as to whether Section 1363(d) would apply where a LIFO-method C corporation merged into an S corporation in a nontaxable carryover basis transaction. Finally, in 1988, the year after Section 1363(d) was enacted, Congress added Section 1374(d)(8) which extended the scope of Section 1374 to the gains built into the value of assets received by an S corporation from a C corporation in a nontaxable asset acquisition, but it did not make a corresponding amendment to Section 1363(d) to deal with analogous situations that could arise under that provision. UDC's tax advisors apparently concluded that it was logical to infer that Congress had made an affirmative decision to exempt such transactions from the LIFO recapture provisions of Section 1363(d).

UDF's strategy seems to have been effective in avoiding LIFO recapture under Section 1363(d): the IRS apparently either failed to raise this issue with the taxpayer or conceded it prior to trial. Nevertheless, the facts of the case serve to illustrate the impunity with which, in the absence of remedial legislation, administrative ruling, or case law, LIFO recapture under Section 1363(d) could be avoided.

⁹ Or, where a C corporation liquidates (or, under Section 1361(b)(3)(B), is deemed to liquidate) into its S corporation parent, the liquidation provisions of Sections 332 and 337. At the time these regulations were issued, an S corporation could not own an 80% interest (as defined in Section 1504(a)) in another corporation. Sec. 1361(b)(2)(A) (pre-1997). This restriction was removed by the Small Business Job Protection Act of 1996.

¹⁰ "If a corporation could avoid the LIFO recapture amount by merging with either a new or pre-existing S corporation, the reorganization provisions of the Code could be used to circumvent both Sections 1363(d) and 1374." PS-16-93, Notice of Proposed Rulemaking, 1993-2 C.B. 636, 637 (August 18, 1993).

¹¹ A Section 7701(a)(45) nonrecognition transaction is any property disposition in a transaction in which gain or loss is not recognized in whole or in part for income tax purposes. Transferred basis property under Section 7701(a)(43) is property having a basis determined under any income tax provision that provides that the transferee's basis in property acquired from the transferor is determined wholly or partly by reference to the property's basis in the transferor's hands.

The transactions to which these rules are applicable include Type A reorganization (statutory merger or consolidation), Type C reorganization (stock-for-asset acquisition or "practical merger"), Type D reorganizations (both acquisitive and divisive), Type G reorganizations (both acquisitive and divisive insolvency reorganizations), and Section 332 liquidations (liquidation of an 80%-controlled subsidiary into its parent).

Section 1363(d) will also apply where an S corporation makes a "qualified subchapter S subsidiary" election with respect to an existing 100%-controlled LIFO-method C corporation subsidiary. Such elections are treated as if the subsidiary had completely liquidated, a transaction that generally qualifies as a nontaxable carryover basis transaction under Section 332. (However, if the subsidiary is insolvent, Section 332 is not applicable and the deemed liquidation is fully taxable at the corporate (Section 336) and shareholder (Section 331) levels. Reg. Sec. 1.1361-4(d), Ex (5).)

These rules generally do not apply to a Section 351 exchange because the transferee of a C corporation's LIFO inventory cannot be an S corporation: Section 1361 (b)(1)(B) does not permit an S corporation to have a C corporation as a shareholder. Nor do these rules apply to a Section 368(a)(1)(F) ("Type F") reorganization ("a mere change in the identity, form, or place of incorporation of one corporation, however effected, . . ."). A Type F reorganization is treated as a nonevent for virtually all tax purposes. Under Section 381(b), for example, the tax year of the transferor corporation does not close as of the date of the transfer. Presumably, this also means that the first day of the transferor's tax year is deemed to be the first day of the transferee's tax year for the year of the transfer. Although there does not appear to be any authority bearing directly on this point, it seems clear that a C corporation could not, in a Type F reorganization, transfer its assets mid-year to a new transferee corporation for which an S election is already in effect. So if the transferor is a C corporation, the transferee would have to wait until after the end of the year of the reorganization to elect S, in which case the C to S conversion rule of the statute would apply.

¹² All of these transactions occurred within about a month (May 25 through June 27, 1993) and were carried out pursuant to instructions contained in a memo from the taxpayer's accounting firm titled "Outline of Steps."

¹³ These exchanges were nontaxable under Section 721. There were six limited partnerships in all. One of the subsidiaries had owned and operated two dealerships, each of which was transferred to a separate limited partnership.

¹⁴ CAC's three shareholders owned the stock of these S corporations in the same proportion as they held stock in CAC. These shareholders had transferred a $9,000 note to each of these corporations in exchange for all of the corporations' stock. These notes were used by the S corporations to acquire their respective 1% general partnership interests in the limited partnerships. These notes were never paid.

¹⁵ Sections 332 and 337.

¹⁶ Stated differently, can a subsidiary C corporation, through a pre-arranged series of transactions culminating in the S election of its successor parent corporation, avail itself of the nonrecognition provisions of Section 721 and then Sections 332 and 337 to circumvent the built-in gain tax regime of Subchapter S and to thereby permanently elude corporate-level taxes on the income it deferred under the LIFO method of accounting throughout the years that it conducted its business as a C corporation?

¹⁷ The taxpayer contended that the restructuring was motivated by the succession planning needs and desires of CAC's majority shareholder and by the need to provide flexible ownership incentives to the key employees of the respective dealerships. At trial and on brief, the Government had argued that the restructuring was motivated solely by the desire to avoid Section 1363(d).

¹⁸ Section 1363(d) requires LIFO recapture only where the corporation making the S election "inventoried goods under the LIFO method" in the "last taxable year before the first taxable year for which the election under Section 1362(a) was effective." As a holding company, CAC in Coggin Automotive did not directly hold any inventory at any time. Under the entity concept, CAC would not be deemed to hold any of the LIFO inventories that were actually owned by its subsidiary limited partnerships and Section 1363(d) would not, according to CAC, be applicable. Conversely, under the aggregate concept, CAC would be deemed to have held its share of the LIFO inventories actually held by its subsidiary limited partnerships and Section 1363(d) would require the recapture of the LIFO reserves built-into that inventory at the time of CAC's S election.

¹⁹ 115 TC 349 at p. 363-365. In reaching its decision, the Tax Court followed Casel v. Commissioner, 79 T.C. 424 (1982) (which applied the aggregate approach to disallow losses between related parties under Section 267); Holiday Village Shopping Center v. U.S., 773 F.2d 276 (Fed. Cir. 1985) (applying the aggregate approach to require depreciation recapture upon a corporation's distribution of a partnership interest to its shareholders); and Unger v. Commissioner, 936 F.2d 1316 (D.C. Cir. 1991) (to determine whether the corporation maintained a permanent establishment in the U.S.). It distinguished these decisions from others that had embraced the entity approach by contrasting the relevant Congressional intent in enacting provision involved in each case: P.D.B. Sports, Ltd. v. Commissioner, 109 T.C. 423 (1997) (application of Section 1056); Madison Gas & Electric Co. v. Commissioner, 72 T.C. 521, 564 (1979), aff'd. 633 F.2d 512 (7th Cir. 1980) (which applied the entity approach in determining whether expenditures were deductible under Section 162 or were nondeductible start-up expenditures); and the Eighth Circuit's decision in Brown Group. Inc. & Subs. v. Commissioner, 77 F.3d 217 (8th Cir. 1996), revg. 104 T.C. 105 (1995) (which held that the entity approach, rather than the aggregate approach, should be used in characterizing income earned by a partnership as Subpart F income or non-Subpart F income). The court observed that the application of the aggregate concept or the entity concept was a function of the Congressional intent supporting the enactment of each of the non-subchapter K provisions involved in these respective cases.

²⁰Caminetti v. United States, 37 S.Ct. 192 (1917). "[W]hen the terms of a statute are clear, its language is conclusive and courts are not free to replace that clear language with an unenacted legislative intent." United States v. Morrison, 844 F.2d 1057, 1064 (4th Cir. 1988). "[W]hen the import of the words Congress has used is clear . . . we need not resort to legislative history, and we certainly should not do so to undermine the plain meaning of the statutory language." Harris v. Garner, 216 F.3d 970, 976 (11th Cir. 2000)(en banc).

The appellate court also observed that in Gitlitz v. Comm., 531 U.S. 206 (2001), in a case dealing with a potential double windfall to S corporation shareholders, the Supreme Court held that "[b]ecause the Code's plain text permits the taxpayers here to receive these benefits, we need not address this policy concern." At p. 220. "[T]he result is required by statute." At note 10. If "this is an inequity in the United States Tax Code . . . only Congress or the Secretary (as the holder of delegated authority from Congress) has the authority to ameliorate" it. (Congress did in fact reverse the result in Gitlitz by amending Section 108(d)(7)(A) as part of The Job Creation and Worker Assistance Act of 2002, P.L. 107-147, 116 Stat. 21.)

The Eleventh Circuit court also cited in support the appellate decisions of the Fourth Circuit in Hillman v. I.R.S., 250 F.3d 228, 234 (4th Cir. 2001), rev'g. 114 T.C. 103 (2000), the Eighth Circuit's decision in Brown Group, Inc. v. Comm., 77 F.3d 217, 222 (8th Cir. 1996), rev'g. 102 T.C. 616 (1994) (which reversed the Tax Court's use of the aggregate method of partnership taxation to close what it perceived to be a loophole, holding that "such a tax loophole is not ours to close but must rather be closed or cured by Congress."), and the Fifth Circuit in Petroleum Corp. of Texas, Inc. v. U.S., 939 F.2d 1165 (5th Cir. 1991), rev'g. 90-2 U.S. Tax Cas. (CCH) para. 50,395 (N.D. Tex. 1990). In this last case, the issue presented was whether a corporate partner in a partnership was subject to depreciation and depletion recapture under Sections 1245, 1250 and 1254 upon the liquidating distribution of interests it held in three partnerships. The Commissioner argued that although the transactions were motivated by a valid business purpose, the aggregate theory of partnerships must be applied to protect the integrity of the recapture provisions. The Fifth Circuit rejected this position. It found that the language of the statute was unambiguous, that, under the statute, partnership interests were not among the specific properties listed as being subject to recapture upon distribution, and that the aggregate theory could not be used to circumvent the clear language of the Internal Revenue Code.

Note that on several other occasions, the Supreme Court has held that the touchstone of interpretation is legislative intent. See, for example, Philbrook v. Glodgett, 421 U.S. 707, 713 (1975) (court's objective in construing a statute is to ascertain the Congressional intent and give effect to the legislative will); Marcus v. Hess, 317 U.S. 537, 542 (1943), United States v. N.E. Rosenblum Truck Lines, Inc., 315 U.S. 50, 53 (1942) (The question here, as in any problem of statutory construction, is the intention of the enacting body."); United States v. American Trucking Association, 310 U.S. 534, 542 (1940) ("In the interpretation of statutes the function of the courts is easily stated. It is to construe the language so as to give affect to the intent of Congress."), Public Citizen v. United States Dept. of Justice, 491 U.S. 440, 452-54 (1989) ("Clear and unambiguous statutory language can be trumped by 'other evidence of Congressional intent."); Commissioner v. Engle, 464 U.S. 206, 214 (1984) ("sole task" of court in statutory interpretation is to determine Congressional intent).

²¹ 292 F.3d 1326 at 1331. The Court of Appeals also complained that the Tax Court's resort to the aggregate view of partnerships created an unacceptable level of uncertainty. "It is worrisome to think that a taxpayer may not know in advance whether this would be the day that the fictional aggregate theory or the fictional entity theory of partnerships will be applied on an ad hoc basis." 292 F3d 1326 at 1333.

²² The significance of the Eleventh Circuit's decision to LIFO-method C corporations contemplating an S election is unclear.

First, the Section 1363(d) proposed regulations (discussed Infra.) which, if valid, extend the application of Section 1363(d) to LIFO inventories held by partnerships in which the electing C corporation holds an interest. Second, it is clear from the issuance of these regulations that the Commissioner does not intend to acquiesce to the Eleventh Circuit's decision, and under the Golson rule (Golson v. Comm., 54 TC 742 (1970), affirmed on another issue, 445 F.2d 985 (10th Cir, 1971)) the Tax Court is not bound by the Eleventh Circuit's decision outside the jurisdiction of the Eleventh Circuit.

Third, CAC was vulnerable under several alternative arguments that were not pursued at trial or on appeal by the government in Coggin Automotive: the tax benefit doctrine, the clear reflection of income doctrine, the assignment of income doctrine, and the step- transaction doctrine. See Dawson, James P. and LaRue, David W. "Eluding the LIFO Recapture Provisions of Subchapter S After the Eleventh Circuit's Decision in Coggin Automotive: Part II" Business Entities 22 (September,/October, 2003): at pp. 22-26. These alternative arguments were not raised because the Service believed that its application of the aggregate approach to the Coggin limited partnerships was sufficient. If a fact pattern similar to that before the courts in Coggin Automotive arises, the I.R.S. can be expected to raise all of arguments at its disposal.

Finally, the Treasury Department has since promulgated the so-called "Anti-Abuse Regulations" under Section 701. Treas, Reg. Sec. 1.701-2. At trial and on appeal the Government stated that it was not asserting the anti-abuse regulations. Those regulations did not become effective until after the 1993 restructuring in Coggin Automotive had been consummated. The Commissioner will not be precluded from arguing the application of these regulations for taxpayers engaging in Coggin-like transactions after their effective date.

These anti-abuse regulations are designed to prevent taxpayers from using the partnership tax rules of Subchapter K for tax avoidance purposes by empowering the Commissioner to disregard or recast transactions engaged in by an entity taxable under Subcbapter K if to do so would prevent tax avoidance. In effect, the Commissioner has broad authority to modify the operation and interpretation of any statutory provision or regulation relevant to partnership taxation in order to prevent tax avoidance.

The anti-abuse rule is made up of two components:

• Intent of Subchapter K rule: The Commissioner is empowered to recast a transaction that reduces partners' aggregate tax liability in a manner that is "inconsistent with the intent of Subchapter K." The regulations describe the legislative intent for the partnership tax rules and set forth certain tests a partnership transaction must satisfy to be consistent with that intent. If the transaction is inconsistent, the Commissioner may disregard the partnership, disregard a taxpayer's status as a partner, adjust the partnership's or partner's accounting method, reallocate partnership income or loss, or otherwise change the claimed tax treatment.

• Abuse of entity rule. The Commissioner is empowered to treat a partnership as an aggregate of its partners, rather than as a separate entity, to the extent necessary to carry out the purpose of any provision of the Code or regulations. This treatment may apply regardless of the taxpayer's intent in structuring the transaction. This rule may not be applied, however, where a provision of the Code or regulations prescribes entity treatment and contemplates the ultimate tax consequences resulting from that treatment.

²⁵ The look-through approach taken by these proposed regulations generally mirrors the approach taken by the regulations in applying Section 1374 to S corporations that hold interests in partnerships that dispose of built-in gain assets during the recognition period. These regulations are designed to prevent the avoidance of Section 1374 when built-in gain assets are disposed of by a partnership in which the S corporation owns an interest. Reg. Sec. 1.1374-4(i) generally applies the aggregate concept to treat S corporation partners as direct owners of the assets held by their partnerships for the purpose of taxing the built-in gains recognized upon the sale of such assets by the partnership within the 10-year recognition period.

The look-through approach taken by these proposed regulations is also required in computing a C corporation's adjustment to its "adjusted current earnings" for changes in the LIFO recapture amount of inventories held by a partnership in which the corporation owns an interest.

²⁷ As was the case with respect to four of the original CAC subsidiaries in Coggin Automotive.

²⁸ As was the case with respect to the fifth CAC subsidiary in Coggin Automotive.

²⁹ Note, however, that unlike the Section 1374 regulations, these proposed Section 1363(d) regulations do not have a diminimus exception. Under Reg. 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 eliminates the potentially substantial burden of tracking built-in gain assets that are relatively small in value. Since Section 1363(d) recapture occurs all at once, the Treasury believes that the relatively minimal burden of looking through the partnership to determine the corporation's share of LIFO recapture amount does not warrant a diminimus exemption.

³⁰ The proposed regulations, in relevant part, read as follows:

³² Prop. Reg. Sec. 1.1363-2(c)(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)."

³³ Under Section 704(c)(1)(A) any pre-contribution gain or loss built into the value of property contributed by a partner to the partnership in nontaxable exchange for a partnership interest under Section 721 (a) must be allocated back to the contributing partner upon the recognition of that gain or loss by the partnership. Section 704(c)(1)(B) provides an exception to Section 731(b) ("No gain or loss shall be recognized to a partnership on a distribution to a partner of property . . .") that requires the contributing partner recognize this pre-contribution built-in gain or loss if the contributed property is distributed to another partner within seven years of the date of its contribution to the partnership.

Under Section 737(a), the contributing partner is also required to recognize any remaining net pre-contribution gain to the extent that that partner receives a distribution of noncash property with a fair market value in excess of the distributee partner's basis within seven years of the date of the contribution.

³⁴ Prop. Reg. Sec. 1.1363-2(e)(2)(i).

³⁵ Prop. Reg. Sec. 1.1363-2(e)(2)(ii) (first sentence). Where the LIFO inventory is held by a lower tier partnership, an election is also available to the higher-tier partnership that will permit the higher-tier partnership to make a Section 743(b)-type "special basis adjustment" with respect to the interest it owns in the lower-tier partnership. Prop. Reg. Sec. 1.1363-2(e)(2)(ii) (second sentence).

³⁶ If the disposition occurred within the 10-year recognition period of Section 1374(d)(7), this gain would be taxable at both the corporate level (for a second time) and at the shareholder level (also for a second time if the earnings and profits resulting from the earlier recognition of the lookthrough LRA under Section 1363(d) have been, or will ultimately be, distributed to the shareholders as an ordinary dividend under Section 301(c)(1)).

³⁷ Assume in this example that the "book value" of the inventory, i.e., the amount that is used in determining the contributing partner's capital account under Reg. Sec. 1.704-1(b)(2)(iv)(d), is the same value as that described under Reg. Sec. 1.1374-7(a).

³⁸ I.e., there has been no recognition of any of X Corporation's precontribution built-in gain.

³⁹ $26M FIFO-value at 1/1/06 less $15M LIFO-value at 1/1/06 less X Corporation's $6M Section 704(c) pre-contribution LRA.

⁴⁰ Under Reg. Sec. 1.1374-7(b), the inventory method used by an S corporation for tax purposes must be used to identify whether the inventory it disposes of during the recognition period is inventory it held on the first day of that period.

⁴¹ $26M FIFO-value at 1/1106 less $15M LIFO-value at 1/1/06 less the $6M Section 704(c) pre-contribution LRA allocable to X Corporation.

⁴² 50% times ($14M of unrealized built-in gain less $9M of pre-contribution built-in gain allocable to X Corporation under Section,704(c)) less $2,5M of post-contribution LRA recognized by Y Corporation under Section 1363(d)).

⁴³ Prop. Reg. 1.1363 -2(c)(2)(second sentence).

⁴⁴Supra., note 5.

⁴⁵ Under LCM, the taxpayer compares the cost of each article in its ending inventory to the "market" price of that item. If the cost exceeds "market," then the FIFO cost of that item is written down to "market." Except in the case of certain "abnormal" or "subnormal" goods, "market," therefore, is not the estimated "net realizable value" (i.e., expected sales price less direct selling costs) of an inventory item, as the name suggests, but rather the replacement cost of that item as of the inventory date. For retailers and wholesalers, "market" will be the inventory-date cost of replacing the item plus the amount of any additional costs required to be capitalized to their inventories under the uniform capitalization rules of Section 263A. Manufacturers and processors will apply LCM to their work in process and finished goods inventories, and the basic elements of cost will include the inventory-date cost of direct materials, direct labor, and any indirect costs required to be included in costing inventories under Section 263A.

⁴⁶ C corporations are generally required to determine the FIFO value of their LIFO inventories (using the retail method or the lower-of-cost-or-market method) in order to compute changes in the LIFO recapture amount that they use to compute changes in their LIFO recapture amount to derive their "adjusted current earnings" (under Section 56(g)) and their current "earnings and profits" (under Section 312(n)(4)). Additionally, in making these determinations in the case of a C corporation that holds an interest in a LIFO-method partnership, the look-through approach taken by the Section 1363(d) proposed regulations is also taken. "Similarly, a corporate partner takes into account its proportionate share of the partnership's LIFO inventory assets for the partnership taxable year that ends within or with the corporation's taxable year." Preamble to TD 8454 (12/21/1992). See also Rev. Rut. 79-20, 1979-1 CB 137 (the computation of the earnings and profits of each corporate member of a partnership is subject to the adjustments under Section 312(k) of the Code, and each corporate member is required to restore to its share of partnership earnings the excess of accelerated depreciation over straight line depreciation).

However, many C corporations are exempt from the AMT under the "small corporation exemption" of Section 55(e). For tax years beginning after December 31, 1997, the tentative minimum tax of a corporation is zero for any taxable year if the corporation's average annual gross receipts for all three-tax-year periods beginning after December 31, 1993 and ending before the taxable year in question have never exceed $7,500,000. Section 55(e)(1)(A). (The gross receipts test is applied by substituting $5,000,000 for $7,500,000 for the first three-tax-year period of the corporation that is taken into account in determining whether or not the corporation qualifies for this exemption. Section 55(e)(1)(B).) Note that in applying this test, a corporation's gross receipts may have to be aggregated with the gross receipts one or more other corporations (under Section 448(c)(2)) and/or the test may have to be applied by taking into account the gross receipts of certain predecessor corporations (under Section 448(c)(3)(D)). Section 55(e)(1)(D). If a corporation loses its exemption, the exemption is lost for all future years. Senate Report No. 105-174 (PL 105-206) p. 153. With important exceptions, a corporation's tentative minimum tax for its first tax year is zero. Section 55(e)(1)(C).

⁴⁷ Reg. Sec. 1.704-1(b)(2)(iv)(f). The Regulations permit the partners' capital accounts to be increased or decreased to reflect the revaluation of partnership property on the partnership's books if the adjustments are made principally for a substantial nontax business purpose and the adjustments are made either (1) in connection with a contribution or distribution of money or other property (other than a diminimis amount) as consideration for the acquisition or relinquishment of an interest in the partnership; (2) under generally accepted industry accounting practices, provided substantially all of the partnership's property (excluding money) consists of stock, securities, commodities, options, warrants, futures, or similar instruments that are readily tradable on an established securities market; (3) in connection with a liquidation of the partnership; or, under regulations proposed in 2003, (4) in connection with the grant of an interest in consideration of services performed to or for the benefit of a partnership by an existing or new partner.

⁴⁸ Similar anti-avoidance two-year look-back rules can be found, for example, in Section 269(b)(1)(C) (acquisitions made to avoid or evade income tax); Section 5881(b)(1) (definition of "greenmail"); Section 1059(a) (basis reduction for nontaxed portion of extraordinary dividend); Section 454 (e)(2) (dispositions of installment notes to a related person); Section 382(c)(1) (disallowance of carryforwards following an ownership change); Section 336(d)(2)(B)(ii) (disallowance of deduction for built-in losses upon complete liquidation); Section 355(e)(2)(B) (recognition of gain on certain distributions of stock or securities in connection with acquisition).

⁴⁹ See, for example, the 7-year period specified in Section 704(c)(1)(B) (and by cross-reference, Section 737).

⁵⁰ As a general rule subject to numerous exceptions, a partnership interest is an asset that is treated as separate and distinct from the assets owned by the partnership. This treatment is reflected in the general rule of Section 743(a), which provides that a transfer of a partnership interest in a sale or exchange, or at a partner's death, does not affect the partnership's basis in partnership property.

⁵¹ One exception is where the partnership contributes its property to a corporation in a Section 351 exchange. The corporation's basis in the acquired assets will include the balance of any special basis adjustments made with respect to the contributed property. Reg. Sec. 1.743-1(h)(2)(i).

⁵² Reg. Sec. 1.743-1(j)(2). Similar adjustments are made in computing the purchasing partner's distributive share of depreciation. Reg. Sec. 1.743-1(j)(4).

These adjustments to the transferee's distributive shares must be reflected on Schedules K and K-1 of the partnership's return (Form 1065). These adjustments to the transferee's distributive shares do not affect the transferee's capital account.

⁵³ Where the conversion results from the making of an S election, the "sale or exchange" required to animate Section 743(b) does not occur. Where the conversion is the result of an on taxable exchange of stock for assets, Section 743(b) would not apply because the transferee corporation's basis in the partnership interest would be the same as the converting corporation's basis (which would have already been stepped up, at the instant before the transfer, to reflect the recognition of the LRA under Prop. Reg. 1.1363-2(b)(2)). Section 362(b). The issue is moot since the proposed regulations allow the partnership to elect to apply the principles of Section 743(b) to the converting corporation's lookthrough LRA and do not otherwise condition this election on the presence or absence of a Section 754 election.

⁵⁴ This is true even where the purchase of the partnership interest resulted in a termination of the partnership under Section 708(b)(1)(B). Prior to May 9, 1997, the regulations under Section 708 would have treated the termination as if the partnership had distributed its properties to the purchase and the other remaining partners in proportion to their respective interests in the partnership properties; and, immediately thereafter, the purchaser and the other remaining partners contribute the properties to a new partnership. Reg. Sec. 1.708-1(b)(1)(iv). The purchasing partner would therefore get a step-up in its basis in its share of the LIFO inventory. The balance of the gain built into the LIFO inventory would have been allocable to the other partners as a precontribution built-in gain under Section 704(c).

The current regulations under Reg. Sec. 1.708-1(b)(1)(iv), which are applicable to terminations of partnerships occurring on or after May 9, 1997, reverse the previous fictional order of events. These regulations treat the termination as if the old partnership had contributed all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership and then distributed the interests in the new partnership to the purchasing partner and the other remaining partners in proportion to their respective interests in the terminated partnership in liquidation of the terminated partnership. Consequently, the basis of the terminated partnership's assets is not affected by the termination since the new partnership is deemed to have acquired them with a carryover basis from the terminated partnership under Section 723.

The terminated partnership may make a Section 754 election in order to apply the special basis adjustment rules of Section 743(b). If a Section 754 election is made or if the terminated partnership already had a Section 754 election in effect, the election applies to the partner whose purchase was the cause of the termination and the purchasing partner can obtain the benefit of a basis adjustment under Section 743(b) (although the hypothetical distribution by the terminated partnership of the interests in the new partnership not a "sale or exchange," it is nevertheless treated as a sale or exchange for purposes of bringing Section 743(b) into play.

⁵⁵ See, for example, August, Jerald David. "Technical Corrections Act Of 1988 And Revenue Act Of 1987 Impose Toll Charge For C To S Conversions." 5 Journal of Partnership Taxation 181 at 186 (Summer, 1988).

See also, Yanoshak, John. "Rethinking the S Election: Disadvantages of S Status May Outweigh Tax Benefits." 1-95 Tax Advisor 42 (January, 1995). Watkinson, Troy S. "LIFO Recapture on Conversion from C Corporation to S Corporation: An S Corporation Penalty and Failure in Tax Policy," 42 Tax Lawyer 841 (Spring, 1989).

⁵⁶ A Section 754 election is made by the partnership by filing a statement with its return for its taxable year for which the election first applies. Reg. Sec. 1.754-1(b). Consequently, the election can be made retroactively to cover the preceding tax year if made on or before the extended due date for the partnership return. An election, once made, remains in effect until revoked (which requires the consent of the District Director). Reg. Sec. 1,754-1(c).

⁵⁷ A Section 754 election is not always desirable. Because the operational provisions that this election animates (Sections 734(b) and 743(b)) are more or less symmetrical in their application to built-in gains and to built-in losses, this election frequently results in unfavorable negative adjustments to the partnership's asset bases.

⁵⁸ If the partnership has a Section 754 election in effect at the time of the acquisition, the special basis adjustments proposed here will be made to the partnership's LIFO inventory (and to its other assets as well) under Section 743(b).

⁵⁹ LIFO method taxpayers are required, as a condition of adopting and using the LIFO method, to keep fairly detailed records going back all the way to the year the LIFO method was adopted. Reg. Sec. 1.472-2(h). IRS takes the position that failure to maintain adequate books and records can be grounds for termination of the LIFO election. Rev. Proc. 79-23, Sec. 3.01(d), 1979-1 C.B. 564. See Gertzman, Stephen F. Federal Tax Accounting. Second Ed., Warren Gorham Lamont, Boston, 1993: pp: 7-28 and 7-29 --

⁶¹ Prop. Reg. Sec. 1.1363-2(c)(3). Supra., note 32.

⁶² Prop. Reg. See. 1.1363-2(c)(2).

⁶³ Prop. Reg. Sec. 1.1363-2(c)(2).

⁶⁴ Section 751(c).

⁶⁵ Section 751(d).

⁶⁶ The partnership receives a cost basis in a portion of its undistributed unrealized receivables and inventory automatically, without regard to whether a Section 754 election is in effect. See Reg. Sec. 1.751-1(g), Examples (2)(e)(1), (3)(e)(1), (4)(e)(1), and (5)(e)(1).

⁶⁷ Section 734(b) applies only where the partnership has a Section 754 election in effect. The adjustment required under Section 734(b) is allocated between and among the partnership's retained assets in accordance with the rules set forth in Section 755 and Reg. Sec. 1.755-1.

⁶⁸ Under Section 737(a), if a partner receives a distribution of noncash property having a fair market value in excess of that partner's basis in its partnership interest (after reduction for any money distributed in the same distribution), then the distributee partner must recognize gain on the distribution in an amount equal to the lesser of that excess or the distributee's "net precontribution gain." Section 737(b) defines the net precontribution gain as the net amount of any as-yet-unrecognized precontribution gains and losses built into assets still held by the partnership immediately before the distribution.

Section 737 does not apply to the extent that Section 751(b) applies to the distribution. Reg. Sec. 1.737-1(a)(2). Reg. Sec. 1.737-3(c) describes the assets to which the adjustments required under Section 737(c)(2) are to be made and the manner in which the adjustment is to be allocated between them. These adjustments are not elective and are required to be made regardless of whether the partnership has an election in effect under Section 754.

⁶⁹ Section 743(b) applies only where the partnership has a Section 754 election in effect. The adjustment required under Section 743(b) is allocated between and among the partnership's assets in accordance with the rules set forth in Section 755 and Reg. Sec. 1.755-1. Section 743(b) is discussed in

⁷⁰ Section 1363(d)(1), Reg. Sec. 1.1363-2(c).

⁷¹ Rev. Proc. 94-61 (Q&A #5), 1994-2 CB 775.

⁷² Or as of the date of the inventory's transfer under Sections 368((a)(1)(D)/355. Other systematic, if not theoretically sound, approaches would be to allocate the adjustment between the layers based on relative base-year costs or relative LIFO carrying values, or as a function of the annual increases in each year's increase in the LRA. See, for example, Helmer, David H. "New Revenue Procedure on LIFO Recapture Yields Unexpected Result," 1-95 The Tax Adviser 27 (January, 1995). See also Stone, Howard A. "Treatment of LIFO Inventory Reserve When Converting From C to S Status." 10-91 The Tax Adviser 646 (October, 1991). Note that for corporations that experienced a decrease in their LIFO inventory for a tax year ending before September 19, 1994 (the date the revenue procedure was issued), the Service accepted "any reasonable method" used to allocate the LIFO recapture amount. Rev. Proc. 94-61, Q&A #2, 1994-2 CB 775. Otherwise, corporations that converted to S status before that date must retroactively apply the allocation method required by this revenue procedure.

⁷³ Adapted from Rev. Proc. 94-61, Q&A #2, 1994-2 CB 775.

⁷⁴ The "dollar-value" adaptation of the LIFO method uses inflation "indexes" and "inventory pools" to ameliorate the deficiencies inherent in specific-goods LIFO. The defining characteristic of the dollar-value LIFO method is the substitution of base-year-dollar units for physical units as the accounting measure of the ending inventory quantity and for changes in that quantity. Since, under dollar-value LIFO, physical quantities are expressed in a term which is common to all types of merchandise inventory, but which is entirely unrelated to the physical characteristics of the inventory items, it is possible to group nonfungible merchandise into a single inventory "pool." Rather than applying all of the LIFO accounting procedures to many separate inventories, each of which would be comprised of specific types of identical or near-identical goods, the dollar-value LIFO method makes it possible for a taxpayer to group or "pool" similar types of goods and account for all these goods together--as if they were the same. This greatly simplifies accounting for inventories. More importantly, pooling affords significantly greater protection from the consequences that typically result from involuntary LIFO layer "liquidations." This is due to the fact that (1) decreases in the quantity of one item in a pool are offset by increases in the quantity of other items in the same pool, and to the fact that (2) newer versions of older items that are phased out are accounted for in the same pool, rather than in a new pool. (See Reg. Sec. 1.472-8(b), (c), and (d) for the rules governing the establishment and composition of dollar-value LIFO inventory pools.)

Mechanics of the Cost-Dollar-Value Approach. The dollar-value LIFO method employs the same cost flow assumption as the specific-goods LIFO method. As with specific-goods LIFO, the quantity of units in ending inventory and the manner in which this quantity is dispersed among the various LIFO layers must be determined. But instead of expressing these quantities in terms of physical units, a cost index is used to abstract the physical units of all of the items in the ending inventory of a given pool into their equivalent number of "base-year-dollar-value" units. This is achieved by first multiplying the number of units of each item in the ending inventory of a given pool by their respective current costs and by then summing these amounts to produce a current cost of ending inventory. Then, in order to eliminate the effect of the cumulative changes that have taken place in the taxpayer's cost of these inventory items--and to thereby isolate the quantity changes-Ending Inventory (at current cost) is divided by a cost index to determine its equivalent base-year cost. The amount thus derived is then used to represent the quantity of the goods in ending inventory (not, as is often mistakenly assumed, their cost basis).

The process by which the ending inventory quantity thus derived is converted into its actual cost basis starts by comparing the ending inventory quantity (in base-year costs) with the beginning inventory quantity (in base-year costs). If the former is greater than the latter, then an increment has occurred and the total cost of ending inventory is computed by adding the current cost of the base- year-cost-dollar units that make up that increment to the cost of beginning inventory.

Conversely, if the quantity of the current year's ending inventory is less than beginning inventory, then there has been a decrement in this pool. Ending Inventory (at cost) is therefore equal to Beginning Inventory (at cost) less the costs of the base-year-cost-dollar units that were sold during the current year. Under LIFO, these units are deemed to come from the units that comprise most recently added LIFO layers.

Cost Indexes. The accuracy of the allocation of the total cost of the goods available for sale between ending inventory and cost of goods sold is largely a function of the accuracy of the cost indexes that are used to implement the dollar-value LIFO method. As noted above, the annual cost indexes computed under dollar-value LIFO are used to achieve two distinct objectives. First, the reciprocal of the current cost index is applied to convert current costs into base- year costs so that the ending inventory quantity can be measured. Once this quantity has been allocated to each of the layers that comprise ending inventory, these quantities are each multiplied by their respective cost indexes in order to convert them into their actual cost bases.

The cost indexes so used can be developed internally using one of the two basic alternative computational procedures (the "double-extension" procedure and the "link-chain" procedure) or they may, in some cases, be derived by reference to externally developed price change indexes. "External" indexes are not based on the firm's own experience with inflation. Instead, the index represents the increase in the costs (or, under the conventional retail LIFO method, the retail prices) of a representative sample of goods held by a representative sample of firms in the same type of activities (e.g., manufacturing, wholesaling, retailing, etc,). The federal government, commodity exchanges, and many trade associations compute and publish cost indexes that can sometimes be used in lieu of developing internal indexes. Additionally, as will be noted in the subsequent Section on the conventional retail-dollar-value LIFO method, the Bureau of Labor Statistics ["BLS"] publishes several sets of indexes that measure the changes in retail prices.

⁷⁵ This index gets its name from the basic computational procedure that is used to derive it. Under the double-extension method, all of the physical units of each item in the ending inventory of a given pool are multiplied (or "extended") by (1) their respective base-year costs, and then by (2) their respective current-year costs. Ending inventory at current-year cost is then divided by ending inventory at base-year costs to derive the index.

The principal advantage of the double-extension procedure is that it results in a very accurate cost index--assuming, however, that each item has an actual base-year cost. Where a new item for which a base-year cost is not available has entered the pool, that item must be generally extended either using a "reconstructed" base-year cost or, if a base-year cost cannot be reconstructed, its cost for the year in which it was introduced into the pool. This distorts the index and has the undesirable effect of eliminating some of the benefits of LIFO.

⁷⁶ Under the link-chain method, the cost index is computed in two steps. The first step is very similar to the procedure described in note for the double-extension method. But instead of double extending the items at base-year costs and current- year costs, they are extended at their costs in the immediately preceding year and their current-year costs. The resulting index reflects the cost changes that have taken place during the past year. The cumulative index for the current year is then derived by multiplying this current annual index by the cumulative index for the year immediately preceding the current year. Each year's cumulative index can thus be characterized as a "link" in a "chain" that connects the current year with the base year.

The principal advantage of the link-chain method is that it deals much more effectively with the introduction of new items into the LIFO inventory pool. For these items, only the cost at the beginning of the year must be known and there is no need to reconstruct a base-year cost where none existed. The principal objection to the link-chain method is that the accuracy of each year's index is dependent upon the accuracy of all of the indexes computed for prior years. This gives rise to two concerns. First, any errors made in the computation of the index in any prior year will permanently distort all future indexes. Second, the link-chain index will reflect the cost changes of the items in the current year's ending inventory only if either (1) all such costs have been rising at a uniform rate, or (2) the relative number of units of each item in the pool (i.e., the item "mix") does not change from one year to the next.

⁷⁷ But see Stone, "Treatment of LIFO Inventory Reserve When Converting From C to S Status," 22 Tax Adviser 646 (October 1991), where the author recommends preserving and restating each LIFO layer using the overall LIFO index (126.67 in the example) and, again, using the recomputed index only for the purpose of valuing a decrement in one or more of these layers.

⁷⁸ Prop. Reg. Sec. 1.1363-2(e)(2)(i).

⁷⁹ Prop. Reg. Sec. 1.1363-2(e)(2)(ii) (first sentence).

⁸⁰ Prop. Reg. Sec.1.1363-2(e)(2)(ii) (second sentence). The election is made by the partnership (not by the converting corporation) by attaching a statement to its original or amended income tax return for the first taxable year ending on or after the conversion date.

⁸¹ I.e., as of the end of the recapture date or as of the first day of the partnership's taxable year that includes the recapture date adjusted for any contributions or distributions of inventory between that date and the recapture date).

⁸² For partnerships using specific goods LIFO, units means whatever units are used to record the physical quantity of the inventory (gallons, barrels, pounds, cases, etc.). For dollar-value LIFO partnerships, units are measured in terms of base-year dollars.

⁸³ Since Rev. Proc. 94-61 requires that the pre-conversion layers be collapsed, it would be inappropriate to apportion the LRA adjustment to the "common basis" layers maintained by the partnership on the basis of the relative LIFO values of each respective layer.

⁸⁴See, for example, American Bar Association, Section on Taxation. "ABA Members Object to Scope of LIFO Recapture Regs." 61 Tax Notes 544 (Doc 93-10896) (November 1, 1993); Gillette, Michele R. ABA/AICPA/IRS Roundtable Panelists Discuss Several Subchapter S Issues." 61 Tax Notes 911 (November 22, 1993) (comments attributed to Sam Starr); Ross, Ronald S. and Kramer, John L. "LIFO Recapture Tax Issues Remain Despite New Regulations and a Revenue Procedure." 82 Journal of Taxation 92 (February, 1995).

The Treasury and the IRS, of course, disagree. The Preamble to the Section 1363(d) regulations finalized in 1994 states, without elaboration, that ". . . the IRS and Treasury Department believe that the regulations are a valid exercise of authority to prevent the circumvention of section 1363(d)." T.D. 8567, 1994-2 CB 199. See also comments of Richard Manfreda, deputy, IRS Office of Assistant Chief Counsel (Passthroughs and Special Industries): " . . . the section '1363 proposed regulation is sustainable and a natural complement to the statute.' . . . He added that the 'generic nature of the statute would allow for such a reading.' Gillette, Michele R. ABA/AICPA/IRS Roundtable Panelists Discuss Several Subchapter S Issues." 61 Tax Notes 911 (November 22, 1993).

But see FSA 1999-1120 (October 4, 1993), which begins:

Note that Congress implicitly endorsed the extension of Section 1363(d) to carryover basis transactions in the House committee report explaining the enactment of Section 1361(b)(3) (pertaining to the treatment of qualified subchapter S subsidiaries under Section 1361(b)(3)) as part of the Small Business Job Protection Act of 1996.

⁸⁶ "A legislative rule is essentially an administrative statute -- an exercise of previously delegated power, new law that completes an incomplete legislative design. Legislative rules frequently prescribe, modify, or abolish duties, rights, or exemptions." Asimow, Michael. Nonlegistative Rulemaking and Regulatory Reform, 1985 Duke Law Journal 381, 383.

⁸⁷Administrative Procedure Act of 1946, 5 USC Sections 553(b), (c), (e). For the Treasury's procedures for implementing these requirements, see Statement of Procedural Rules, 26 CFR Pt. 601, at Section 601.601(c).

By contrast, interpretive rules do not typically create new duties, but instead clarify existing ones. They can be promulgated without following the notice and comment procedures and they do not, as a legal matter, bind taxpayers or the courts.

⁸⁸ For problems in distinguishing between "rule making" and "interpretation," see Asimow, Public Participation in the Adoption of Interpretive Rules and Policy Statements, 75 Michigan Law Review 521, 530-84 (1977).

⁸⁹Administrative Procedure Act of 1946, 5 USC §§ 553(b)(3)(A), (B).

⁹⁰ The Assistant Secretary for Tax Policy, as delegate for the Secretary of the Treasury, is responsible for drafting tax regulations with the help of advisors in the Office of Tax Legislative Counsel. Initial drafting responsibility, however, has been delegated to the Commissioner of Internal Revenue with the help of the attorneys in the Office of Associate Chief Counsel (Technical).

⁹¹ The IRS takes the position that tax regulations are almost always interpretive and only rarely legislative, notwithstanding the fact that the Treasury generally follows the kind of procedures that the Administrative Procedure Act requires only for legislative regulations,i.e., notice to taxpayers and the opportunity to comment. Internal Revenue Manual §§ 211, 212, 531.1; Asimow, Regulatory Reform, supra. note 86, at 390. Some notices of proposed rule making cite both Section 7805(a) and a specific grant of authority.

⁹² Neither the Treasury nor the IRS has suggested that Congress intended either of these sections to extend by implication to Section 1363(d). In a field service advisory, the IRS attributed the failure to amend Section 1363(d) to include transactions described in Section 1374(d)(8) to "inadvertant oversight," and it expressly rejected as "unlikely" the notion that Congress intended the principles set forth in the latter to be extended by implication to the former. FSA 1999-1120 (October 4, 1993).

⁹³ Section 7805(a) reads as follows: "Except where such authority is expressly given by this title to any person other than an officer or employee of the Treasury Department, the Secretary shall prescribe all needful rules and regulations for the enforcement of this title, including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue."

⁹⁴ Referring to Part III of Subchapter C, which includes Sections 351 through 368 (taxation of corporate organizations, divisions, and reorganizations).

⁹⁵ 1994-2 CB 199.

⁹⁶ In 1998, P.L. 100-647, Sec. 1006(e)(5)(A), substituted "made by subtitle D of title VI of the Tax Reform Act of 1986" for "made to this subpart of the Tax Reform Act of 1986".

⁹⁷Supra., note 3.

⁹⁸ It is well established that any construction of a statutory provision that would render the provision completely ineffective must be presumed to be invalid. This is especially true where a reasonable alternative construction would be effective in carrying out legislative intent. See, for example, U.S v. Public Utilities Commission of California, 345 U.S. 295 (1953) ("Where the language and purpose of the questioned statute is clear, courts, of course, follow the legislative direction in interpretation. Where the words are ambiguous, the judiciary may properly use the legislative history to reach a conclusion. And that method of determining congressional purpose is likewise applicable when the literal words would bring about an end completely at variance with the purpose of the statute." Emphasis supplied.); Amalgamated Associates of Street, E. R. & M. Employees, v. Las Vegas-Tonopah-Reno Stage Coach Line, Inc., 202 F. Supp. 726 (Dist Ct Nevada 1962) ("It is obvious, of course, that if we were to read Section 14(b) literally, the states would only have the power to prohibit agreements which require membership' in a union as a condition of employment. [Footnote omitted.] But, as the Supreme Court has indicated on numerous occasions, we need not be bound by the strict letter of a statute if, by doing so, we would defeat the congressional purpose or create an absurd result. . . . It is our purpose to demonstrate that a literal construction of Section 14(b) would frustrate the very purpose for which it was enacted and would create a patently absurd result.").

⁹⁹ The E&P of the target corporation carry over to the acquiring corporation under Section 381(a)(1) (liquidation of 80% controlled subsidiary into its parent under Section 332) or Section 381(a)(2) (acquisition of the target corporation's assets in certain specified types of non taxable reorganizations). Section 381(c)(2). The E&P of a distributing corporation in a Section 355 corporate is allocable to the distributing corporation and the distributed corporation(s) under Section 312(l).

¹⁰⁰ Under the general rule of Section 301(c), distributions made by a corporation to its shareholders (in their capacity as shareholders) come first from earnings and profits. However, Section 1368(c)(1) overrides this rule to allow an S corporation that has C corporation E&P to distribute its entire "accumulated adjustments account" balances to its shareholders tax-free (with rare exceptions), before any distribution is deemed to come from its taxable E&P. The "accumulated adjustments account" keeps track of how much undistributed net income has been taxed to the corporation's shareholders under Subchapter S. Section 1368(e)(1). An S corporation can, however, elect to reverse this order (and pay out taxable E&P before paying out nontaxable AAA) by making an election under Section 1368(e)(3).

Section 1368(c)(1) provides that distributions not in excess of the corporation's accumulated adjustments account are governed by Section 1368(b). 221 Thus, such distributions first reduce stock basis and are tax-free under Section 1368(b)(1). 222 Any excess over stock basis is taxed as gain. 223 Thus, to the extent of the accumulated adjustments account, distributions are treated as if the corporation had no earnings and profits. This treatment applies even if the shareholder just acquired the shares and even if the distribution is in property rather than money.

¹⁰¹ Section 1362(d)(3)

¹⁰² Section 312(n)(4). If the corporation's LRA is larger at the end of the current year than it was at the end of the preceding year, the difference increases E&P; if it is smaller, the difference reduces E&P. Although the LRA cannot be negative, negative LRA adjustments reduce E&P. However, except as otherwise provided in regulations yet to be issued, these negative adjustments cannot reduce the LRA below the LRA that existed as of the close of the tax year immediately preceding the corporation's first tax year beginning after September 30, 1984. Recall that the regulations under Section 56(g) do permit negative adjustments even where these adjustments exceed the cumulative net positive LRA adjustments (if any) made in computing ACE in prior years. Reg. Sec. 1.56(g)(1)(f)(3)(v), Ex. 1.

¹⁰³ Note, however, that the increases in the corporation's current E&P that results from increases in the corporation's LRA cannot be reduced by the additional income taxes that will be payable in later years when the LRA is actually taken into account in computing taxable income.

¹⁰⁴ Section 312(n)(4) is effective for tax years beginning after September 30, 1984.

¹⁰⁵ Although the LRA is calculated in the same manner under Section 1363(d) and under Section 312(n)(4) (i.e., subtracting the LIFO value of the inventory from its FIFO value), the LIFO and FIFO inventory values used in making these respective calculations may, presumably, differ. Although the regulations do not address the issue, it would seem that the corporation must, for example, use the depreciation computed under Section 312(k), rather than depreciation computed under Sections 167 and 168 in determining the amount that it must capitalize to its inventory under Section 263A.

¹⁰⁶ Section 1368(e)(1)(A); Reg. Sec. 1.1368-2(a)(3)(i)(C)(1).

¹⁰⁷ Section 1367(a)(2)(D); Reg. Sec. 1.1367-1(c)(2).

¹⁰⁸ Examples of expenses falling into this category include illegal bribes, kickbacks, and other payments not deductible under Section 162(c); fines and penalties not deductible under Section 162(f); expenses and interest relating to tax-exempt income under Section 265; losses for which the deduction is disallowed under Section 267(a)(1); the portion of meals and entertainment expenses disallowed under Section 274; and the two-thirds portion of treble damages paid for violating antitrust laws not deductible under Section 162.

¹⁰⁹ I.e., as of the last day of the converting corporation's last C year, all events will have occurred which determine the fact of its liability under Section 1363(d) and the amount of that liability will have become determinable with reasonable accuracy. See Section 461(h)(4).

¹¹⁰ This assumes, of course, that the converting corporation's S election (or the S election of its successor corporation) does not terminate prior to the payment of the final installment.

¹¹¹ Section 1368(e)(1)(A); Reg. Sec. 1.1368-2(a)(3)(C)(1). Note, by way of contrast, that taxes paid under Section 1374 on the S corporation's net recognized built-in gains are treated as a loss incurred by the S corporation and reduces both its AAA and the stock basis of its shareholders. Section 1366(f)(2).

¹¹² Section 461(h)(1) reads as follows:

¹¹⁴ Section 461(h) which generally applies to amounts incurred on or after July 18, 1984.

¹¹⁵ Reg. Sec. 1.461-4(g)(6).

¹¹⁶ Section 461(h)(3).

¹¹⁷ This assumes, of course, that the converting corporation's S election (or the S election of its successor corporation) does not terminate prior to the payment of the final installment.

¹¹⁸ Consequently, for example, neither the recognition of built-in gains and losses under Section 1374, nor the payment of corporate-level taxes on net recognized built-in gains will have any effect on an S corporation's E&P. Nor will the payment of corporate level taxes on excess net passive income under Section 1375 reduce the S corporation's E&P.

¹¹⁹ Reg. Sec. 1.1374-4(b)(2), which reads, in part, as follows:

¹²¹ Section 1368(e)(1)(A).

¹²² Reg. Sec. 1.1367-1(c)(2) does not list the LIFO recapture tax in its inclusive listing of the types of nondeductible, noncapitalizable expenses that fall into this category.