Letter Ruling 9729017, April 16, 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 24, 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.
Corporation P is the common parent of an affiliated group whose members include X, a second-tier subsidiary, and Y and Z, third-tier subsidiaries. The affiliated group will file a consolidated return as C corporations for the group's 52/53 week taxable year beginning on December 30, 1996. X, Y, and manufacture lumber and other wood products and sell logs on the open market, harvest lumber from timberlands that each corporation owns, and purchase additional timber and logs from outside sources. Y and Z also own cutting rights on some timberlands, and sell logs to each other as well as outside buyers. X, Y and Z either cut the timber themselves or retain contract loggers to cut the timber. They retain title to the logs cut by a contract logger, and either use the logs in their manufacturing facilities or sell the logs for their own account.
The shareholders of P propose to file an election to be an S corporation under §1362(a) of the Internal Revenue Code, effective for the 52/53 week taxable year beginning on December 29, 1997. P then intends to file an election under new §1361(b)(3) , enacted by the Small Business Job Protection Act of 1996, to treat X, Y, and Z as "qualified subchapter S subsidiaries." Under §1361(b) (3), a "qualified subchapter S subsidiary" is not treated as a separate corporation, and all assets, liabilities, and items of income, deduction, and credit of the subsidiary are treated as assets, liabilities, and items of the parent S corporation.
After X, Y and Z become "qualified subchapter S subsidiaries" and upon receipt of a favorable ruling on this request, P will elect under §631(a) to treat the cutting of timber by X, Y and Z as a sale or exchange of that timber.
P requests rulings that certain of its 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) of the Income Tax Regulations 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 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 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 during that tax year. 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) of the regulations 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 taxable 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 on the authority set forth above, and provided that the S corporation election by P's shareholders and P's election to treat X, Y, and Z as "qualified subchapter S subsidiaries" are valid, we rule as follows:
(1) Gain recognized by P pursuant to §631(a) on the cutting of timber by X, Y, and Z during the recognition period is not subject to tax under §1374 .
(2) Income of P from processing and selling lumber and other wood products by X, Y, and Z during the recognition period from timber that X, Y, and Z cut on their timberlands during the recognition period is not subject to tax under §1374 .
(3) Income of P from processing and selling lumber and other wood products by X, Y, and Z during the recognition period from logs X, Y, and Z purchase 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 treatment 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 yours, Assistant Chief Counsel (Corporate), Mark S. Jennings, Senior Technician Reviewer Branch 1.