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Letter Ruling 9732030, May 14, 1997

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

Code Sec. 1374

This letter responds to your January 3, 1997 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.

P is the parent of an affiliated group of corporations that files a consolidated federal income tax return. P wholly owns Sub 1, Sub 2, Sub 3, and Sub 4. Sub 1 and Sub 2 wholly own M, a partnership. P, Sub 1, Sub 2, Sub 3, Sub 4, and M (the "Timber Companies") are engaged in the growing and harvesting of timber and the production and sale of wood products. About 50 percent of the timber used in the Timber Companies' wood products operations is from timber the Timber Companies harvest on their own timberland. The other 50 percent is from timber the Timber Companies purchase from unrelated parties.

P's shareholders will elect under §1362(a) for P to become an S corporation for its taxable year beginning March 1, 1997. P then will elect under §1361(b)(3) for Sub 1, Sub 2, Sub 3, and Sub 4 to become "qualified subchapter S subsidiaries." P then will elect under §631(a) to treat the Timber Companies' cutting of their own timber as a sale or exchange of that timber.

P 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) 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 631(b) provides that in the case of disposal of timber (held for more than 1 year before disposal) by the owner under any form of contract under which the owner retains an economic interest in the timber, the difference between the amount realized from the disposal of the timber and the adjusted depletion basis of the timber disposed of shall be considered as gain or loss on the sale of the timber. The date of disposal is deemed to be the date the timber is cut, but is the owner is paid under the contract before the timber is cut, the owner may elect to treat the payment date as the disposal date.

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.

Section 1361(b)(3)(B) defines the term "qualified subchapter S subsidiary" (QSSS) as any domestic corporation which is not an ineligible corporation (as defined in §1361(b)(2) ), if 100 percent of the stock of the corporation is held by the S corporation, and the S corporation elects to treat the corporation as a QSSS.

Section 1361(b)(3)(A) provides that, for purposes of the Internal Revenue Code, a corporation which is a QSSS is not treated as a separate corporation, and all assets, liabilities, and items of income, deduction, and credit of a QSSS are treated as assets, liabilities, and such items (as the case may be) of the S corporation.

Section 301.7701-2(c)(1) defines the term "partnership" as a business entity that is not a corporation under §301.7701-2(b) and that has at least two members.

Section 301.7701-2(c)(2) provides that a business entity that has a single owner and is not a corporation under §301.7701-2(b) is disregarded as an entity separate from its owner.

Based solely on the information submitted and on the authority set forth above, and provided P's shareholders make a valid S election for P and P makes valid QSSt elections for Sub 1, Sub 2, Sub 3, and Sub 4, we rule as follows:

(1) M is treated as owned directly by P and, as an entity with a single owner, is no longer eligible to be treated as a partnership for federal tax purposes. Thus, M is disregarded as an entity separate from P.

(2) P's gain recognized pursuant to §631(a) on the cutting of timber by the Timber Companies during the recognition period is not subject to tax under §1374 .

(3) P's income on the sale of logs or other wood products by the Timber Companies during the recognition period produced from timber the Timber Companies either cut from their timberlands or purchased from unrelated parties during the recognition period is not subject to tax under §1374 .

No opinion is expressed about the tax treatment of the proposed transaction under any 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 ruling. 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.

This letter is directed only to the taxpayer who requested it. Section 6110(j)(3) provides that it 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 year in which the proposed transaction is consummated.

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