New revenue procedure on LIFO recapture yields unexpected result.

• Author: Helmer, David H.

The IRS recently issued Rev. Proc. 94-61 to provide long-awaited guidance on how to properly account for the LIFO recapture resulting from a C corporation's conversion to S status.

Sec. 1363(d)(1) states that if an S corporation using the LIFO inventory method was a C corporation for the year prior to the year that the S election became effective, the C corporation must include in gross income the LIFO recapture amount (the amount by which the FIFO inventory exceeds the LIFO inventory) and make appropriate adjustments to the basis of the inventory to reflect the change. This section was enacted to prevent a C corporation from electing S status simply to avoid the built-in gains tax.

It was generally believed that the LIFO recapture amount should be allocated to the preelection LIFO layers based either on the relative base-year cost or the relative LIFO carrying value of the corporation's ending inventory for the last year it was a C corporation. However, Rev. Proc. 94-61 provides that the required method of allocating the LIFO reserve is to "collapse" (combine) the LIFO layers and add the LIFO recapture amount to the corporation's ending inventory for the last year it was a C corporation. However, if the taxpayer has experienced a decrease in its LIFO inventory for a tax year ending before Sept. 19, 1994 (the date the revenue procedure was issued), the Service will accept as appropriate any reasonable method used to allocate the LIFO recapture amount. The procedure further states that collapsing the LIFO layers is appropriate, since the revaluation of ending inventory to FIFO is inconsistent with the LIFO layering approach, and Sec. 1363(d) was enacted to create parity between LIFO and FIFO taxpayers electing to be taxed as S corporations. Accordingly, the required method of allocating the LIFO reserve yields a different result than was expected.

As a result of collapsing the LIFO layers, the LIFO carrying value will be stated at an average cumulative index. Thus, if there is a decrement into a pre-S election year layer, the taxpayer will be treated as selling less expensive goods, thus increasing taxable income (assuming there has been inflation in the preelection years). This point is illustrated by the analysis on pages 27-28 of the allocation method required by Rev. Proc. 94-61 and an alternative method based on the relative LIFO carrying value.

Based on this comparison, a C corporation using LIFO that elects S status may get an...