Section of Taxation Publications
  VOL. 59
NO. 1
FALL 2005
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Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.

LIFO Recapture on C-to-S Conversions:

Filling the Gaps and Ameliorating the Deficiencies of Section 1363(d)


David W. LaRue, Ph.D.


Associate Professor and Director, Graduate Tax Program, McIntire School of Commerce, University of Virginia; University of Houston, B.B.A. Production Logistics Management, 1974, M.S., Accountancy, 1977, Ph.D. Accounting, Taxation and Economics, 1983. Dr. LaRue testified before the Treasury Department on the proposed section 1363(d) under regulations that were subsequently modified and finalized effective July 12, 2005 in T.D. 9210, 2005-33 I.R.B. 290.




   Prior to the enactment of section 1363(d) in 1987, the conversion of a C corporation to S corporation status was, with rare exception, considered to be a nonevent for tax purposes. None of the gain or loss built into the value of the converting corporation’s assets was recognized, and its tax attributes, including the basis and holding period in its assets, its earnings and profits account balance, and its accounting methods, continued unchanged. The policy of permitting nontaxable C-to-S transformations was and is grounded in the overall federal policy of promoting the formation and growth of small businesses, in part by allowing small businesses to “operate under whatever form of organization is desirable for their particular circumstances, without incurring unnecessary tax penalties.” For many, perhaps most, C corporations, treating the C-to-S conversion as a taxable event at the corporate level, the shareholder level, or both, would present a formidable obstacle to electing Subchapter S.


   The Revenue Act of 1987, which added section 1363(d) to Subchapter S, carved out a limited exception to this nonevent, nonrecognition treatment of C-to-S conversions. Section 1363(d) requires any C corporation that uses the “last-in, first-out” (LIFO) method to account for one or more of its inventories and that elects S status, to recognize the “LIFO recapture amount” built into its LIFO inventories as of the end of its last tax year as a C corporation. The “LIFO recapture amount” is the excess, if any, of the inventory’s value determined under the “first-in, first-out” (FIFO) method over its actual LIFO value. This amount is included in the converting corporation’s ordinary gross income on its final C corporation income tax return, and the resulting incremental income tax is payable in four interest-free annual installments, commencing with the due date for its final C corporation return. The statute also provides for the converting corporation to increase the tax basis of its LIFO inventories to reflect its recognition of this income. LIFO recapture under section 1363(d) does not terminate the converting corporation’s LIFO election.


   Regulations promulgated in 1994 extend the application of section 1363(d) to C corporations that transfer LIFO inventory to a new or existing S corporation in certain nontaxable carryover-basis transactions. Recently finalized regulations further extend the reach of section 1363(d) by overturning the decision of the Eleventh Circuit in Coggin Automotive Corp. to require LIFO recapture where the LIFO inventory is held indirectly by a converting C corporation through one or more partnerships or limited liability companies.



Published by
Section of Taxation, American Bar Association
With the Assistance of
Georgetown University Law Center


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