Involuntary conversions with multiple payments.

Under IRC section 1033, if a taxpayer's property is destroyed or condemned, he or she can exclude any gain on such involuntary conversions by acquiring similar property within a period that ends two years after the close of the first year gain is realized. However, when a taxpayer receives compensation for the property in two or more different tax years because of questions about its value, what is the time period for replacing the property to be eligible for a section 1033 deferral?

John Mahon and his wife operated a citrus tree business as a sole proprietorship. During 1985, the state of Florida destroyed their trees to prevent the spread of disease. In 1986, the state paid the Mahons approximately $42,000 in compensation for the destroyed trees. In 1992, following a lawsuit by other affected parties, they received an additional $1.3 million, of which approximately $573,000 was labeled interest. The Mahons omitted most of the proceeds from their 1992 tax return on the grounds that they were excludible under section 1033. On audit, the IRS determined that the full proceeds were taxable--and should have been included on the Mahons' 1992 return--because no replacement property had been acquired during the required two-year period, which ended at the close of 1988. Following the audit, the Mahons filed a petition for bankruptcy. The IRS filed a claim for the taxes in U.S. Bankruptcy Court.

Result. For the IRS. The Bankruptcy Court rejected the Mahons' arguments for excluding the proceeds. They had claimed the proceeds were not taxable based on the doctrine of equitable recoupment, which allows taxpayers to recover taxes paid on related items, arising from the same transaction, that were treated inconsistently and now are barred by the statute of limitations. The court said that doctrine applies only when the IRS takes a different or inconsistent position on a return barred by the statute of limitations. In the Mahons' case, the IRS had not taken such a position on a prior return.

The Mahons also argued that the receipt of proceeds in two different years created two replacement periods. The Bankruptcy Court said the Tax Court had already rejected this position in Shipes, a case where the taxpayer was affected by the same citrus-tree-destruction program.

The Bankruptcy Court also found the two private letter rulings the Mahons cited as supporting multiple replacement periods to be irrelevant to their situation.

* In PLR 9028046, the taxpayer was permitted to exclude proceeds received after the close of the replacement period because the replacement property acquired during the period cost more than the sum of all the proceeds received. The exclusion was not the result of the IRS's having allowed two replacement periods.

* In PLB, 8915013, the taxpayer's replacement period appeared to have been extended beyond the statutory period. However, receipt of the proceeds was in dispute and therefore not recognizable until later. A replacement period runs for two years after the year the first gain is realized; in this case, that period did not start until the dispute was settled, making the actual replacement within the statutory period.

Finally, the Bankruptcy Court said the fact the Mahons did not receive or even know about the second payment until after the replacement period closed was immaterial. The IRC provides for an extended replacement period if the taxpayer requests an extension before the period closes. Since the Mahons had not requested one, an extension was not granted.

Future taxpayers who believe they might receive additional compensation must file for an extension in order to have time to reinvest subsequent recoveries.

* In re John Mahon, 1998 Bankr. Lexis 1056, 98-2 USTC [paragaraph] 50,684.

What Is a Capital Asset?

Corporate stock generally is a capital asset unless it is owned by a company that is a dealer in corporate stock. For corporate taxpayers, classification of an asset as a capital asset is undesirable since it results in capital gains being taxed at normal corporate rates while capital losses can reduce only capital gains and not other income. As a result, corporate taxpayers generally attempt to have the stock they own classified as an ordinary, rather than a capital, asset.

Cenex, Inc., is an agricultural cooperative corporation that sells petroleum products to farmers--among other things. Along with eight other cooperatives, it created Energy Cooperative, Inc. (ECI), to operate an oil refinery. Only ECI shareholders were entitled to purchase oil from the company. When ECI went bankrupt, Cenex deducted the loss as an ordinary loss. On audit, the IRS reclassified the loss as capital on the grounds that the ECI stock was a capital asset. Cenex appealed.

Result. For the IRS. IRC section 1221 defines as capital assets all assets except those that meet any one of five limited exceptions. Cenex argued that its ownership of ECI met the first of these exceptions--that stock in trade or other property of the kind a company would properly include in inventory is not a capital asset.

In the seminal Corn Products case, the U.S. Supreme Court held that corn futures were not a capital asset because they were an integral part of the company's inventory acquisition system. Following this decision, numerous courts accepted the argument that assets a company acquires for a corporate business purpose are not capital assets. However, in Arkansas Best, the Supreme Court rejected this expansion of its Corn Products decision and ruled that the exception is limited to inventory and items that are substitutes for inventory.

Cenex argued that it acquired the ECI stock to obtain inventory and thus it met the limited exception under Arkansas Best. Even if it did not qualify under this exception, Cenex said it qualified under several "source-of-supply" cases which the company said were unaffected by the Arkansas Best decision.

The Federal Circuit Court of Appeals rejected both arguments. It said that, to meet the Arkansas Best exception, an asset must be a surrogate or substitute for inventory. Although its ownership of ECI stock permitted Cenex to purchase inventory, the company was not guaranteed a particular quantity or price. Therefore, the ownership was not closely related to inventory and could not be considered a substitute for it. As for the source-of-supply cases Cenex cited, the Federal Circuit ruled that Arkansas Best had, in fact, overturned them.

The fact that a company purchases an asset for a business purpose does not automatically remove it from capital asset status. The asset must fit squarely within one of the five narrowly interpreted exceptions. Taxpayers attempting to argue that an asset is an inventory substitute must be able to show that ownership of the asset guarantees them the right to acquire a specific amount of inventory at a fixed price.

* U.S. v. Cenex, Inc. 156 E3d 1377 (Fed. Cir.), 82 AFTR 2d 6645.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accountancy and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.