S elections and LIFO recapture.

With the recent changes in the S provisions, many companies are again examining the benefits of electing S status One of the costs of an S election for companies using the LIFO method of inventory valuation is the recapture of the LIFO reserve. Sec. 1363(d) provides that a corporation using the LIFO method must recapture the excess of the FIFO value of its inventory over the LIFO value of its inventory at the close of the corporation's last C tax year. In addition, appropriate adjustments shall be made to the basis of the inventory to take into account the amounts included in gross income.

It should be noted that this provision merely requires the recapture of the LIFO reserve; the company is still required to use the LIFO method of inventory valuation, unless it requests permission to discontinue the LIFO method by filing a properly executed Form 3115, Application for Change in Accounting Method.

To determine the tax that would be due to the LIFO recapture, a calculation is made on a with-and-without basis adjusted for all items affected by a taxable income limit, including contribution limits, alternative minimum tax, foreign tax credit and other credit calculations. The difference between the calculation without the LIFO recapture and with the LIFO recapture becomes the LIFO recapture amount. Sec. 1363(d) provides further that any increase in the tax due as a result of the LIFO recapture amount is payable in four equal installments. One-fourth of the tax payable is due in the last C corporation return year with the remaining three-quarters payable equally during the first three S years. This tax is not considered a tax for estimated payment purposes; quarterly payments by the S corporation are not required for this item. Additionally, to the extent that the annual payments are timely made, no interest is due on the deferred payments.

In enacting Sec. 1363(d), Congress believed that, absent this LIFO recapture provision, taxpayers using the LIFO inventory method could avoid the built-in gains tax when an S election was made.

In 1994, the IRS issued Rev. Proc. 94-61, which provided procedures for reporting the LIFO recapture amount and discussed the method to compute appropriate adjustments to the basis of the inventory. In making these computations, the company will collapse its LIFO layers and increase the LIFO carrying value for the LIFO recapture amount. The Service has determined that collapsing the LIFO layers is appropriate; revaluing the ending inventory at FIFO is inconsistent with the LIFO layering approach and Sec. 1363(d) was enacted to eliminate the difference in inventory between LIFO and FIFO taxpayers when an S election is made. See the example below.

Rev. Proc. 94-61 addressed other questions concerning the LIFO inventory of a corporation electing S status and is very informative in addressing issues such as disclosure, net operating loss utilization and situations in which LIFO inventory exceeds FIFO inventory. This revenue procedure should be reviewed for any taxpayer considering the election of S status and employing the LIFO method of inventory valuation.

Example: LIFO Inventory

The calculations below represent company X's current LIFO inventory. X had a decrement in 1993, which reduced the 1992 layer.

Base                Base-year                          LIFO
Year                  cost            Index        carrying value

12/31/90             $10,000          100%            $10,000
12/31/91                 500          105                 525
12/31/92               1,750          112               1,960
12/31/93                  --          120                  --
12/31/94               1,500          130               1,950
Total                $13,750          105%            $14,435

Assuming the LIFO recapture amount is $900, X's LIFO inventory
at Dec. 31, 1994 is as follows:

Base                Base-year                          LIFO
Year                  cost            Index        carrying value

12/31/90
12/31/91
12/31/92
12/31/93
12/31/94
12/31/94
 special
 collapsed
 layer Sec.
 1363 (d)
 adjustment        $13,750         111.53%          $15,335

Note: The index has been changed to reflect the adjusted relationship between the new LIFO carrying value and the base-year cost. The base year and the base-year cost do not change, nor do the annual LIFO calculations used to determine the change in price or quantities. The index computed for the special collapsed layer is relevant only for purposes of computing the LIFO base-year inventory would require determining the LIFO carrying value arising in years prior to the S election for purposes of pricing the decrement. For example, if base-year inventory was determined to be $12,000 at Dec. 31, 1995, the LIFO carrying value will be reduced by approzimately $1,950 ($1,950 x 111.53%).

FROM JEFFERY A. HACKNEY, CPA, OAK BROOK, ILL.