Tax-Free? Not Quite.
In general, a C corporation may achieve pass-through treatment for income tax purposes, without triggering immediate income or gain recognition, by electing to be treated as an S corporation.
One caveat to this general rule, however, is the so-called “LIFO Recapture” rule. Under IRC Sec. 1363(d), an electing C corporation that inventoried goods under the LIFO accounting method for its last taxable year as a C corporation must include in its income for such year the amount by which its inventory, had it been maintained under the FIFO method, would have exceeded the amount under LIFO. The inventory amounts are determined as of the close of the taxable year prior to the taxable year in which the taxpayer’s S election becomes effective.
On its face, the application of this rule may seem fairly straightforward.
However, in a recent Field Attorney Advice, when the IRS considered the application of the recapture recognition rule in the context of an S corporation’s acquisition of a consolidated corporate group, its application was anything but straightforward.
Taxpayer was a C corporation and the common parent of a consolidated group that included Subsidiary. Two of the entities owned by Taxpayer used the LIFO inventory method: LLC (an entity treated as a disregarded entity for federal income tax purposes) and Subsidiary.
Taxpayer entered into a merger agreement with S CORP, which had been an S corporation since its formation. Pursuant to this agreement, Taxpayer merged with Merger Corp, a corporation wholly owned by S CORP, and the separate existence of Merger Corp ceased, leaving Taxpayer as the surviving corporation in the merger. The merger was effective on Date 1 (the “Closing Date”).
The transaction was treated as a stock purchase by S CORP for federal income tax purposes and, so, did not terminate Taxpayer’s tax year or that of the consolidated group. (The merger structure may have been used because Taxpayer had many shareholders or some of its shareholders were recalcitrant. But why purchase the stock?)
S CORP filed qualified subchapter S subsidiary (“Qsub”) elections for Taxpayer and its subsidiaries. The Qsub elections were effective on the date immediately following the Closing Date; i.e. Date 2.
Taxpayer filed a short-period consolidated Form 1120 for the period ending Date 1 (the “short-period return”). Effective Date 2, Taxpayer was included in the consolidated Form 1120S filed by S CORP.
Recapture – Yes, But By Whom?
The parties to the merger agreed that the Qsub elections triggered LIFO recapture. However, they disputed the proper reporting of the recapture amount; pursuant to the merger agreement, they consulted an arbitrator. (Query how the tax burden was allocated between the parties under the agreement.)
The short-period consolidated Form 1120 originally filed by Taxpayer excluded the LIFO recapture amount. However, pursuant to the arbitrator’s findings, Taxpayer later filed a non-consolidated return for a stated period beginning and ending Date 1 (the “single-transaction return”). Taxpayer reported 100% of the LIFO recapture amount, and paid the associated tax, on the single-transaction return.
The Taxpayer’s short-period consolidated return reflected a net operating loss that was carried back two years. Taxpayer thus filed refund claims for the carry-back years. These refund claims would have been reduced had the LIFO recapture income been included in the short-period consolidated return rather than the single-transaction return.
Because a C corporation that accounts for its inventory using the LIFO method and elects S corporation status must include a “LIFO recapture amount” in gross income for the last taxable year before its S election becomes effective, Taxpayer was required to include a LIFO recapture amount in gross income for its last taxable year before the Date 2 Qsub election date. Taxpayer’s last taxable year before the S election ended on Date 1. Thus, the LIFO recapture amount was reportable by Taxpayer for the year ending Date 1.
The additional tax that is attributable to the inclusion of the LIFO recapture amount in gross income is payable in four equal installments. The first installment payment must be made on or before the due date of the electing corporation’s last income tax return as a C corporation. The additional installments must be paid on or before the due date of the corporation’s return for each of the three succeeding taxable years.
The recapture date is the day before the effective date of the S corporation election, and the LIFO recapture amount is determined as of the end of the recapture date for such an election. In the case of a nonrecognition transaction, the recapture date is the date of the transfer to the S corporation, and the LIFO amount is determined as of the moment before the transfer occurs.
Q-Subs and Recapture
When an S corporation elects to treat a wholly-owned domestic corporation as a Qsub, all assets, liabilities, and items of income, deduction and credit of the Qsub are treated as items of the S corporation parent. In this case, S CORP elected to treat the Taxpayer consolidated group, including Taxpayer and Subsidiary, as Qsubs.
When a Qsub election is made, the subsidiary is deemed to have liquidated into the S corporation on a nonrecognition basis at the close of the day before the Qsub election is effective. When Qsub elections for a tiered group of subsidiaries are effective on the same date, the S corporation may specify the order of the liquidations; otherwise, the liquidations will be treated as occurring first for the lower-tier entity and proceed successively upward.
On its face, the LIFO recapture rule does not apply to an electing Qsub; it refers only to an “S corporation [that] was a C corporation.” However, the regulations support the conclusion that LIFO recapture also applies to a Qsub election.
In the instant case, the Qsub elections were effective on Date 2. Thus, Subsidiary was deemed to liquidate first, and transferred its inventory to Taxpayer, on Date 1. On this date, Taxpayer was still a C corporation. Therefore, LIFO recapture did not apply to the deemed liquidation of Subsidiary into Taxpayer, because the distributee in that liquidation was not yet an S corporation. However, the subsequent deemed liquidation of Taxpayer into S CORP on Date 1 did trigger LIFO recapture, because Taxpayer was deemed to liquidate into S CORP which was an S corporation at the time of the liquidation.
Consolidated Return Rules
The deemed liquidation of all the members of the Taxpayer affiliated group did not terminate the Taxpayer consolidated group. However, the liquidation of the goup’s common parent – Taxpayer – terminated the consolidated group. A consolidated return must include the common parent’s items of income, gain, deduction, loss and credit for the entire consolidated return year, and each subsidiary’s items for the portion of the year for which it is a member.
When a corporation becomes or ceases to be a member during a consolidated year, it becomes or ceases to be a member at the end of the day on which its status as a member changes, and its tax year ends for all Federal income tax purposes at the end of that day (the “end of day rule”). Taxpayer correctly filed a consolidated tax return for the period ending on Date 1, the date Taxpayer was deemed to liquidate and cease its existence as common parent.
In general, if the consolidated return includes the items of a corporation for only a portion of its tax year, items for the portion of the year not included in the consolidated return must be included in a separate return, in such a manner as to prevent the duplication or elimination of the corporation’s items. Although this provision does not directly address the situation at hand, it provides support for the filing of a separate return for a corporation’s income that cannot properly be included in the consolidated return.
Single-Transaction Return Requirement
Section 1363(d)(4)(D) does not operate to exclude the converting company from the consolidated group for all purposes, or for a specific date or period; rather, it provides that the converting company is not a member of the affiliated group “with respect to the amount included in gross income under paragraph (1).” Hence, Taxpayer properly filed a consolidated return, but also properly reported the LIFO recapture income on a return separate from the affiliated group’s consolidated income. However the regulations do not explain how this provision should be implemented in practical terms.
Because Taxpayer could not be treated as a member of an affiliated group with respect to the recapture amount, the arbitrator concluded that Taxpayer could not include LIFO recapture income on its final consolidated return and was therefore required to report the LIFO recapture income on a separate “single transaction” return. The IRS agreed with this treatment, noting that Congress intended that, in the case of a converting C corporation that was previously a member of an affiliated group filing a consolidated return, and whose last taxable year as a C corporation would for other purposes be its last taxable year as a member of the group, the converting corporation, and not the group of corporations with which it filed a consolidated return during its last taxable year as a C corporation, would be liable for any tax attributable to the recognition of the LIFO recapture amount.
The fact that Taxpayer was the common parent of the consolidated group and not just a member did not change the result, according to the IRS. Congress intended for the LIFO recapture tax to be imposed on the converting corporation, not on the affiliated group.
For purposes of the recapture rule, the IRS said, the electing corporation is not be treated as a member of an affiliated group with respect to the LIFO recapture amount. Thus, a converted C corporation that was a member of an affiliated group which filed a consolidated return cannot use a consolidated loss to offset any tax liability attributable to the LIFO recapture amount. (Compare this to an S corp’s ability to use NOL carryforwards to offset built-in gain from C-tax years.)
Not So Simple?
What? The acquisition by an S corporation of a target corporation’s stock, followed by a Qsub election for the target?
As the above FAA illustrated, there’s a lot more to this transaction than meets the eye. The FAA dealt with only some aspects of the deal: the application of the LIFO recapture rule in the context of a Qsub election, and the inability of the target to use consolidated losses to offset the recapture.
Each of these factors is plugged into the calculus that determines the economic consequences of a sale or acquisition, and it is imperative that the various players be able to anticipate these consequences. My usual refrain: seek out tax advice throughout the transaction process – don’t allow yourself to be surprised.