Sec. 351 transfers as "bargain purchases."

In its continuing attempt to extend l the application of the decisions in: Hamilton Industries, Inc., 97 TC 120 (1991), and Kohler Co., 34 Ct. Fed. Cls. 379 (11/3/95), the IRS has raised the issue of whether the receipt of low-basis inventory in a Sec. 351 transfer can be equated to a bargain purchase of inventory, causing the acquired items to be treated as different LIFO items from goods subsequently purchased or produced at regular prices. Hamilton Industries and Kohler Co. each purchased inventory at prices significantly lower than normal cost; both companies then elected to use the LIFO method to retain the low-basis goods in their inventories. The courts, however, ruled that inventory subsequently produced, albeit similar in all respects except cost, should not be treated as the same LIFO items as the bargain goods for LIFO calculation purposes. This had the effect of causing the low-basis bargain purchase inventory to be treated as sold, thus subjecting the bargain element of that inventory to tax.

The Service is now extending the theory of Hamilton Industries and Kohler to Sec. 351 transactions. In situations in which the transferee receives low-basis inventory (usually LIFO inventory of the transferor), the IRS is contending that the inventory items received by the transferee are of a different nature and have different cost characteristics than similar items purchased or produced during the year. These "new" inventory items, although physically similar to the transferred inventory, are not, in the Service's view, comparable for purposes of LIFO computations, and should be treated as different LIFO items in order to clearly reflect income.

Letter Ruling (TAM) 9446003 addressed a situation in which a taxpayer received, in a Sec. 351 transfer, inventory that had previously been a part of a bargain purchase by the transferor. Although the physical goods transferred did not contain the original bargain items, the IRS ruled that the transferee must treat the transferred items differently from identical items subsequently purchased. Although there is ample doubt whether an adjustment attributable to the transferor can be imposed on the transferee, Letter Ruling 9446003 does (because of the transferor's history) contain a trace of the sort of bargain purchase identified in Hamilton Industries and Kohler

This differs significantly from a situation in which the "bargain" low-basis results only from the transferor's use of the LIFO method. The application of the Hamilton Industries theory to LIFO inventory transferred in a Sec. 351 transaction in such a situation (i.e., no true bargain purchase in the past) is currently under review in a request for technical advice at the IRS National Office. Taxpayers and their advisers contemplating transfers of LIFO inventory should be aware of the possible ramifications should the Service decide that Hamilton Industries can be extended to such a transaction.

FROM FRANK J. KALIS, JR., CPA, WASHINGTON, D.C.