S Corporation holding company had to recapture pro rata share of LIFO reserves.

The C Corporation was a holding company that held over 80% of the stock of five corporations engaged in retail auto sales through six dealerships.

In 1993, C elected S status. This election was made pursuant to a restructuring plan that involved the establishment of six new S corporations formed for the purpose of becoming general partners in six limited partnerships that would generate the six dealerships. (This plan was based on valid business objectives and had economic substance.) Each subsidiary contributed the assets and liabilities of its dealership to a limited partnership in exchange for a limited partnership interest. Following the transfer of assets to the limited partnerships, the subsidiaries were liquidated. As a result, C obtained the subsidiaries' limited partnership interests.

The IRS determined that, under Sec. 1363(d), C's conversion to an S corporation triggered the inclusion of a pro rata share of the affiliated group's pre-S LIFO reserves into C's income. C challenged this determination and the Tax Court (opinion Jacobs, J.) holds for the Service.

Use of LIFO often allows a taxpayer the benefit of income deferral, particularly in periods of rising inventory costs and stable or growing inventory stock. The amount of cumulative income deferral obtained through the use of the LIFO method of accounting is represented in a taxpayer's LIFO reserve.

Sec. 1363(d) mandates recapture of the LIFO reserve on the conversion of a C corporation to an S corporation. In enacting Sec. 1363(d), Congress was concerned that a corporation maintaining its inventory under LIFO might circumvent the built-in gain rules of Sec. 1374 to the extent the corporation did not liquidate its LIFO layers during the 10 years following its conversion from a C to an S corporation.

For tax purposes, a partnership may be viewed either as (1) an aggregation of its partners, each of whom directly owns an interest in the partnership's assets and operations or (2) a separate entity, in which separate interests are owned by each of the partners. Subchapter K of the Code blends both approaches. In certain areas, the aggregate approach predominates; in other areas, the entity approach predominates. Outside of subchapter K, whether the aggregate or the entity approach is to be applied depends on which approach more appropriately serves the Code provision at issue.

The IRS argues that the legislative intent underlying Sec. 1363(d) requires the application of the aggregate theory. The Service asserts that Congress enacted Sec. 1363(d) to ensure that the corporate level of taxation be preserved on built-in gain assets (such as LIFO reserves) that fall outside the ambit of Sec. 1374. In this regard, the IRS contends that failure to apply the aggregate theory to Sec. 1363(d) would allow the gain deferred under the LIFO method to completely escape the corporate level of taxation on a C corporation's S election.

C maintains that, although there are no cases that apply the aggregate or entity approach to inventory items, the focus with respect to accounting for inventory is done at the partnership level. In essence, it asserts that the LIFO recapture amount under Sec. 1363(d) is a component of a partnership's taxable income that must be computed at the partnership level. C posits that it would be incongruent to treat the calculation of the LIFO recapture as an item of income under the entity approach while applying the aggregate approach to attribute the ownership of inventory to the partners. Moreover, C argues that Sec. 1363(d)(4)(D) operates to prevent the inventory of one member of an affiliated group from being attributed to another member.

The Service maintains that, for purposes of Sec. 1363(d), each of the limited partnerships should be viewed as an aggregation of its partners; consequently, C, as a limited partner in each of the partnerships, is deemed to own a pro rata share of each partnership's inventory of automobiles and light trucks. Conversely, C maintains that each of the limited partnerships should be viewed as a separate entity, and, consequently, none of any limited partnership's inventory or LIFO reserve is deemed to be owned by C or the other partners. We agree with the IRS.

The Tax Reform Act of 1986 did away with the General Utilities doctrine. (Under that doctrine, corporations generally had not been taxed on the distribution of assets whose fair market values exceeded their tax bases.) Sec. 1374 was amended to prevent the potential circumvention of the corporate level of tax on the distribution of appreciated (built-in gain) assets by a former C corporation that held such assets at the time of its conversion to an S corporation.

It became apparent that the goal of Sec. 1374 was not being achieved for former C corporations that used LIFO; a taxpayer that experienced rising acquisition costs would seldom, if ever, experience a decrease in its LIFO reserves. Congress thus recognized that the deferred built-in gain resulting from using the LIFO method might escape taxation at the corporate level. In light of this potential for abuse, Sec. 1363(d) was enacted in 1987.

The application of the aggregate approach to partnerships in this ease better serves Congress' intent. By enacting Secs. 1374 and 1363(d), Congress evinced an intent to prevent corporations from avoiding a second level of taxation on built-in gain assets by converting to S corporations. Application of the aggregate approach to Sec. 1363(d) is consistent with Congress' rationale for enacting this section and operates to prevent a corporate taxpayer from using LIFO to permanently avoid gain recognition on appreciated assets. In contrast, applying the entity approach to Sec. 1363(d) would potentially allow a corporate partner to permanently avoid paying a second level of tax on appreciated property by encouraging transfers of inventory between related entities. This result clearly would be inconsistent with the legislative history of Secs. 1363(d) and 1374 and the supersession of the General Utilities doctrine.

In several instances courts have found the entity approach better than the aggregate approach. However, the outcomes in those cases were based on the specific legislative histories and statutory schemes of the respective Code provisions at issue. Each court viewed the respective statute in the context in which it was enacted and concluded that the entity approach was more appropriate than the aggregate approach to carry out Congress' intent. Here, both the legislative history and the statutory scheme of Sec. 1363(d) mandate the application of the aggregate approach.

To conclude, the aggregate approach better serves the underlying purpose and scope of Sec. 1363(d) in the circumstances of this case. Consequently, C is deemed to own a pro rata share of the dealerships' inventories. Accordingly, on its election of S status, C was required to include in its gross income its ratable share of the LIFO recapture amount.

COGGIN AUTOMOTIVE CORPORATION; 115TC No. 28