Continuation of LIFO benefits following a sec. 721 transfer.
With the increased use of limited liability companies (LLCs), many planning methods using entities taxed as partnerships have gained popularity. One strategy involves the transfer of an operating business to an LLC, together with providing an ownership opportunity to one or more key employees of the transferred business. For a business with LIFO inventories, avoiding recapture of the LIFO benefits may be a significant concern.
In the ruling, an S corporation owned several automobile dealerships, each operated as a separate division. The corporation used the LIFO method for new vehicle and parts inventories. As an incentive for the general manager of three of the dealerships, the corporation wanted to offer him an ownership opportunity. For the general manager to acquire an ownership interest in only the dealerships managed, the corporation formed an LLC (classified as a partnership) and contributed the net assets of the three dealerships in exchange for a membership interest. The S corporation continued in existence and maintained a majority ownership of the LLC, as well as continuing to operate nontransferred dealerships. The general manager contributed cash to the LLC for an ownership interest, equal to the amount of the capital contributed compared to the total value of the LLC's capital.
The LLC's opening inventory consisted of the transferred LIFO inventory. The LLC adopted the LIFO method to value the new vehicle and parts inventories. The amount of the LIFO reserve allocated to the inventories of the transferred dealerships approximated the same percentage of the actual cost as existed prior to the transfer.
The IRS ruled as follows:
1. Under Sec. 721 (a), the corporation would not recognize gain or loss on the contribution of the assets to the LLC in exchange for a membership interest.
2. Because the general manager contributed cash and did not receive a membership interest in exchange for services provided, he also would not recognize, under Regs. Sec. 1.721-1(b)(1), gain or loss on the contribution.
3. Under the general rule of Sec. 721(a), the contribution of the LIFO inventory would not trigger recapture of the LIFO reserve.
4. The LLC must file Form 970, Application to use LIFO Inventory Method, and otherwise comply with the requirements of Sec. 472 and the regulations thereunder to elect the LIFO method.
5. The LLC will elect, under Regs. Sec. 1.704-3(e)(2)(iii), to aggregate each item of inventory for purposes of making allocations under Sec. 704(c). The LIFO inventories contributed to the LLC constitute Sec. 704(c) property, and any built-in gain or loss attributable to the inventories contributed by the corporation must be allocated back to the corporation when the LLC recognizes it.
6. The LLC is not required to treat the inventory transferred and inventory subsequently acquired as separate items. The Service ruled that the separation of inventory, per Hamilton Industries, Inc., 97 TC 120 (1991), does not apply, while indicating that a different position would frustrate the underlying purpose of Sec. 721.
This letter ruling is similar to prior rulings, including Letter Ruling 9644027, which dealt with an S corporation contributing its LIFO inventory to four LLCs classified as partnerships. In addition, the IRS has ruled that a transfer by an S corporation to qualified subchapter S subsidiaries is not subject to LIFO recapture (Letter Ruling 9807023). The Service also has ruled, in Letter Ruling 9731002, with similar conclusions, on the transfer of LIFO inventories under Sec. 351.
For the unwary, unexpected traps can produce surprising LIFO consequences. While the opportunity to maintain LIFO benefits exists, to avoid negative results, corporations must pay careful attention to the details, which includes, for example, satisfying the conformity requirement of Sec. 472(c). Under this section, a corporation that uses the LIFO method must also use the same method in inventorying goods to ascertain income, profit or loss when preparing a report or statement covering a tax year to be presented to shareholders, partners, other beneficiaries or creditors. The corporation must also make sure to properly elect the LIFO method on Form 970.
New entities should avoid using certain dollar-value LIFO methods, including the inventory price index computation (IPIC) method or the alternative LIFO methods described in either Rev. Proc. 97-36 or 2001-23. The strict mechanical requirements of these methods may prevent the continuation of full LIFO benefits. Proposed regulations under Regs. Sec. 1.472-8(h) would correct this unintended result. Prior to the finalization of these regulations, if the taxpayer prefers to use one of these methods, another method may be elected on Form 970 for the initial year. The new entity can then change to the IPIC or an alternative method in any subsequent year. This change generally would require the corporation to file Form 3115, Application for Change in Accounting Method, under the automatic change provisions of Rev. Proc. 99-49.
Changes in inventory mix could also be problematic if they occur during the first year after an inventory transfer for a corporation that elects to use the link-chain method. For a corporation using the double-extension method, this detrimental effect can continue for any subsequent year, unless the corporation obtains a new base year.
While LIFO benefits may continue in a Sec. 721 transaction, transferred inventories may still be subject to recapture of LIFO reserves under Sec. 1363(d). In Letter Ruling 9716003, a C corporation that transferred inventory subject to Sec. 721 had to include in income its ratable share of the partnership's LIFO reserve in the year it converted to an S corporation. This result was upheld by the Tax Court in Coggin Automotive Corp., 115 TC No. 349 (2000), in which the aggregate approach to partnerships, as opposed to the entity approach, was found to better serve the underlying purpose and scope of Sec. 1363(d).
The popularity of LLCs has expanded the use of entities taxed as partnerships and formed under Sec. 721 .When such an entity is using the LIFO method, these benefits may be maintained for the transferred inventories. However, corporations should protect the LIFO reserve relating to the transferred inventory.
FROM JOSEPH A. MAGYAR, CPA, SOUTH BEND, IN
Editor: Frank J. O'Connell, Jr., CPA, J.D. Crowe Chizek Oak Brook, IL
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|Title Annotation:||IRS regulation|
|Author:||O'Connell, Frank J., Jr.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 2001|
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