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

• Author: Fiore, Nicholas J.

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...