A taxpayer valuing its inventory under the last-in, first-out (LIFO) method should consider two significant implications for taxable income when converting from a C corporation to an S corporation. First, the LIFO recapture rule under Sec. 1363(d) accelerates income related to the taxpayer's LIFO inventory. Second, the LIFO method affects the timing of recognition of additional built-in gain related to inventory.
Built-In Gains Tax
Sec. 1374 imposes a special corporate-level built-in gains (BIG) tax on corporations making a C-to-S conversion. The tax is intended to prevent a C corporation from converting to an S corporation to lessen the impact of a taxable liquidation.
For example, if a C corporation liquidates its assets and then distributes the proceeds to its shareholders, the earnings are subject to two levels of tax: one at the corporate level on the gain recognized on the sale of the assets, and one on the distribution received by the shareholders. Absent the BIG tax, if a C corporation converted to an S corporation prior to sale of its assets, the gain would flow through to the shareholders, making the gain subject to only one level of taxation.
The Sec. 1374 BIG tax imposes the highest corporate rate on gains recognized on sales of appreciated assets within the recognition period. Generally, the recognition period is the first 10 tax years after an S election. However, Congress has pro-vided shorter recognition periods for tax years beginning in 2009 through 2013. For tax years beginning in 2012 or 2013, the recognition period is the first five tax years after an S election.
The BIG tax applies to all assets, including inventory, owned by the company on its first day as an S corporation. Under Regs. Sec. 1.1374-7(a), for purposes of the BIG tax, a taxpayer must determine the fair market value (FMV) of its inventory using a bulk sale approach. Further, under Regs. Sec. 1.1374-7(b), a taxpayer must track its dispositions of inventory by the same inventory method used for tax purposes to determine the timing of the recognition of the built-in gain.
Under the LIFO method, inventory is considered to be sold (disposed of) on a last-in, first-out basis. This means that inventory on hand at the S election date is treated as being disposed of only to the extent that the LIFO layers as of the election date are decreased in subsequent years. If inventory quantities remain constant or increase in future years, a taxpayer using...