Continuation of LIFO benefits following a sec. 721 transfer.

• Author: O'Connell, Frank J., Jr.
• Position: IRS regulation

In Letter Ruling 200123035, the IRS reaffirmed its position that the transfer of LIFO inventories in a partnership formation does not trigger recapture of a taxpayer's LIFO benefits.

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...