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Letter Ruling 9726015, March 28, 1997

Uniform Issue List Information:
UIL No. 1374.00-00
Tax imposed on built-in gains

Code Sec. 1374

This letter responds to your October 3, 1996 request for rulings on certain federal income tax consequences of a proposed transaction. The information submitted in that letter and in later correspondence is summarized below.

Taxpayer is a domestic C corporation engaged in the business of growing timber, cutting the timber, and selling the logs produced therefrom to third parties. In addition, Taxpayer buys logs from outside sources which it then sells to third parties. The average growth cycle for the various species of trees grown and harvested by Taxpayer is 60 years, with slight variations depending on altitude and soil characteristics.

Taxpayer has several classes of stock outstanding, some of which is owned by shareholders that are non-qualifying trusts. Taxpayer has three wholly owned subsidiaries.

Taxpayer intends to make an S corporation election and file a §631(a) election in 1997. Prior to electing S corporation status, Taxpayer will recapitalize its stock, have all qualifying shareholders as defined by the statute, and elect under §1361(b)(3) to treat its subsidiaries as qualified Subchapter S subsidiaries. Taxpayer requests rulings that certain income categories after it becomes an S corporation are not subject to tax under §1374 .

Section 1374 imposes a corporate-level tax on an S corporation's net recognized built-in gain during the 10-year recognition period following (a) a C corporation's conversion to S corporation status (§1374(a) ), or (b) an S corporation's acquisition of C corporation assets in a carryover basis transaction (§1374(d)(8) ).

Section 1374(d)(2) provides that an S corporation's net recognized built-in gain for any tax year is generally its taxable income for the year computed as if it was a C corporation, but taking into account only items treated as recognized built-in gain or recognized built-in loss.

Section 1.1374-4(a) provides that §1374(d)(3) applies to any gain or loss recognized during the recognition period in a transaction that is treated as a sale or exchange for federal income tax purposes.

Section 1374(d)(3) provides that recognized built-in gain includes any gain recognized on the disposition of an asset during the recognition period, except to the extent the S corporation shows that (a) it did not hold the asset on the conversion date, or (b) the gain recognized was greater than the excess of the asset's fair market value over its adjusted basis on the conversion date.

Section 1374(d)(6) provides that if the adjusted basis of any asset is determined (in whole or in part) by reference to the adjusted basis of any other asset held by the S corporation on the conversion date, the asset is treated as held by the S corporation on the conversion date, and any determination under §1374(d)(3) with respect to that asset is made by reference to the fair market value and adjusted basis of the other asset on the conversion date.

In Example 1 of §1.1374-4(a)(3) , X is a C corporation that converts to an S corporation effective January 1, 1996. On the conversion date, X owns a working interest in an oil and gas property on which production of oil has not yet begun, and the fair market value of the working interest exceeds X's adjusted basis in the working interest by $200,000. During the recognition period, X produces and sells oil from the working interest, and includes $75,000 in income on the sale. X's $75,000 of income is not recognized built-in gain because on the conversion date X did not hold the oil it sold for $75,000, it held only a working interest in an oil and gas property.

In Example 2 of §1.1374-4(a)(3) , Y is a C corporation that elects to become an S corporation effective January 1, 1996. On the conversion date, Y owns a royalty interest in an oil and gas property, and the fair market value of the royalty interest exceeds Y's adjusted basis in the royalty interest by $100,000. During the recognition period, Y sells the royalty interest and recognizes a gain of $75,000 on the sale. Y's $75,000 gain is recognized built-in gain because Y held the royalty interest on the conversion date.

Section 631(a) provides an election under which the cutting of timber by a taxpayer who owns or has a contract right to cut the timber is treated as a sale or exchange of the timber in the tax year the timber is cut, provided the timber or the contract right to cut the timber is held for more than 1 year, and irrespective of whether the timber or the products produced therefrom are sold in the tax year the timber is cut. If a §631(a) election is made, gain or loss is recognized in an amount equal to the difference between the fair market value of the timber and the adjusted basis for depletion of the timber in the hands of the taxpayer.

Section 1.611-3(b)(1) provides that the depletion of timber generally takes place at the time timber is cut. To the extent that depletion is allowable in a particular year but the products of the cut timber are not sold during the year, the depletion allowable is included as an item of cost in the closing inventory of the timber products for the year.

Based solely on the information submitted and provided Taxpayer makes a valid S corporation election, we rule as follows:

(1) Taxpayer's gain under §631(a) on cutting timber during the recognition period is not subject to tax under §1374 .

(2) Taxpayer's income from the sale of logs during the recognition period from timber Taxpayer cuts on its timberlands during the recognition period is not subject to tax under §1374 .

(3) Taxpayer's income from the sale of logs during the recognition period from logs Taxpayer purchases from other timber growers during the recognition period is not subject to tax under §1374 .

No opinion is expressed about the tax treatment of the proposed transaction under other provisions of the Code and regulations or the tax treatment of any conditions existing at the time of, or effects resulting from, the proposed transaction that are not specifically covered by the above rulings. In particular, no opinion is expressed about the tax consequences under §1374 of income categories other than the income categories described in the above rulings.

The above rulings are directed only to the taxpayer who requested them. Section 6110(j)(3) provides that they may not be used or cited as precedent.

A copy of this letter must be attached to the federal income tax returns of each taxpayer involved for the taxable years in which the proposed transaction is consummated.

Pursuant to a power of attorney on file in this office, a copy of this letter is being sent to your authorized representative.

Sincerely, Assistant Chief Counsel (Corporate), Mark S. Jennings, Senior Technician Reviewer, Branch 1