MMC Corp. v. Comm'r ( 2007 )

T.C. Memo. 2007-354
UNITED STATES TAX COURT
MMC CORP., MIDWEST MECHANICAL CONTRACTORS, INC.,
M W BUILDERS, INC., MIDWEST MECHANICAL
CONTRACTORS OF NEW JERSEY, INC., AND PAHOR AIR CONDITIONING,
INC., Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14742-05. Filed November 29, 2007.
Michael Thompson and Lori J. Sellers, for petitioners.
Allison O. Woodbury, for respondent.
MEMORANDUM OPINION
KROUPA, Judge: Respondent determined a $357,534 deficiency
in petitioners’ Federal income tax for 2000 and a $468,068
deficiency in petitioners’ Federal income tax for 2001. After
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concessions,1 we must determine whether petitioners are required
to include section 481 adjustments as recognized built-in gain
for 2000 and 2001 (the years at issue).2 We hold that they are.
Background
This case was submitted fully stipulated pursuant to Rule
122, and the facts are so found. The stipulation of facts, the
supplemental stipulation of facts, and the accompanying exhibits
are incorporated by this reference. Petitioners’ principal place
of business was Overland Park, Kansas, at the time they filed the
petition.
The Corporations and the Corporate Structure
The corporations involved in this litigation are in the
construction services business. MMC Corp. (MMC) was incorporated
under Kansas law in 1960. MMC owns several subsidiaries which
are also petitioners in this case. These subsidiaries include
Pahor Air Conditioning, Inc. (Pahor), a company MMC acquired in
June 2000, as well as Midwest Mechanical Contractors, Inc.
(Midwest), M W Builders, Inc. (MW), and Midwest Mechanical
Contractors of New Jersey, Inc. (Jersey). MMC wholly owned
Midwest, MW, and Jersey, which were all C corporations, from 1997
1
The parties have resolved all other issues raised in the
deficiency notice and the petition.
2
All section references are to the Internal Revenue Code
(Code) in effect for the years at issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure, unless
otherwise indicated.
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through 2001, and MMC filed consolidated corporate Federal income
tax returns with these entities for 1997, 1998, and 1999.
Petitioners are accrual basis taxpayers.
1997 Change in Accounting Method
Petitioners elected on the return for 1997 to change the
method of accounting for customer paper. Petitioners had
previously used the original cost basis method to account for
customer paper and elected to change to the mark-to-market method
on the return for 1997. MMC reported a deduction of $5,349,372
related to this change in accounting method (the 1997 deduction).
Change in Law and 1998 Change in Accounting Method
Congress amended the law governing the mark-to-market
accounting method in the Internal Revenue Service Restructuring
and Reform Act of 1998 (the RRA), Pub. L. 105-206, sec. 7003(a),
112 Stat. 832. The RRA added to the Code section 475(c)(4),
which provides that nonfinancial customer paper is ineligible for
mark-to-market treatment. This new provision of the Code applies
to petitioners’ customer paper, and thus petitioners could not
use the mark-to-market method any longer. One year after their
change to the mark-to-market method, they had to revert to their
original accounting method.
After petitioners reverted to the original method, the
effective date provisions of the RRA required petitioners to
offset the 1997 deduction, which they had taken when they
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originally changed their accounting method. The RRA provided
that petitioners had to include the 1997 deduction in income by
making section 481 adjustments ratably over the next 4 taxable
years. RRA sec. 7003(c)(2)(C), 112 Stat. 833.
Petitioners properly reported the ratable portions of the
section 481 adjustment as income on the returns for 1998 and
1999. Before petitioners could fully include the remaining
section 481 adjustments in income over the next 2 years, MMC
elected to be treated as an S corporation commencing with the
2000 taxable year. The subsidiaries that had previously been
consolidated with MMC also elected to be treated as S
corporations commencing with the 2000 taxable year.
Tax Returns for 2000 and 2001
MMC reported the section 481 adjustment as income on the S
corporation tax returns for the years at issue but did not report
the section 481 adjustment as recognized built-in gain pursuant
to section 1374 for either year at issue.
Respondent examined the returns for the years at issue and
issued a deficiency notice determining that petitioners should
have included the section 481 adjustment income as recognized
built-in gain under section 1374 and were therefore liable for
additional built-in gain tax for the years at issue.
Petitioners timely filed a petition.
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Discussion
We are asked to determine whether petitioners are required
to include the section 481 adjustments as built-in gain for the
years at issue.3 Petitioners argue that they are not required to
include the section 481 adjustments as built-in gain because they
elected S corporation status before the end of the 4-year ratable
inclusion period of the RRA amendments. Respondent, on the other
hand, argues that petitioners are required to include the section
481 adjustments as built-in gain because the section 481
adjustments relate to items attributable to periods before
petitioners became S corporations. We agree with respondent.
Overview
We begin by outlining the general rules of section 481
adjustments. When a taxpayer changes its method of accounting,
section 481 requires the taxpayer to adjust its income to prevent
items from being duplicated or omitted. Sec. 481(a). The
Secretary is authorized to issue regulations indicating the
taxable years over which the taxpayer is authorized to take these
adjustments into account. Sec. 481(c). The Secretary has issued
guidance under certain circumstances allowing taxpayers to take
the adjustments into account ratably over several years. See,
3
Petitioners have not asserted that they have any built-in
losses for the years at issue. Our determination whether the
sec. 481 adjustments are built-in gain therefore determines the
net recognized built-in gain because there are no built-in losses
to offset the built-in gain.
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e.g., Argo Sales Co. v. Commissioner, 105 T.C. 86, 87 (1995)
(section 481 adjustment taken into account over 6 years under
Rev. Proc. 85-36, sec. 4.03, 1985-2 C.B. 434, 435).
The RRA added a new paragraph (4) to section 475(c),
requiring petitioners to change their accounting method. The
effective date provisions accompanying the enactment of that
amendment specifically provided that taxpayers were to take the
resulting section 481 adjustments into account ratably over the
years beginning with their first taxable year ending after the
date of the enactment. RRA sec. 7003(c)(2).
Built-In Gain Rules
We now outline the built-in gain rules for corporations
electing S status. S corporations are not generally taxed on
their net income, unlike C corporations. Instead, the income is
passed through to the owners and taxed only to the owners. Sec.
1366(a). There is an exception to this general rule, however,
for net recognized built-in gain, which is taxed to the S
corporation itself. Sec. 1374(a). The built-in gain rules are
an attempt to prevent corporations from electing to be S
corporations to avoid corporate-level tax on any built-in gain on
their assets. Garwood Irrigation Co. v. Commissioner, T.C. Memo.
2004-195 (citing Tax Reform Act of 1986, Pub. L. 99-514, sec.
633(d)(8), 100 Stat. 2280).
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The built-in gain rules tax S corporations at the corporate
level on any built-in gain on disposal of an asset. Sec.
1374(d)(3); Garwood Irrigation Co. v. Commissioner, supra. Only
the appreciation present at the time the corporation becomes an S
corporation is taxed at the corporate level. Garwood Irrigation
Co. v. Commissioner, supra. Any gain attributable to post-S
status conversion is passed through and taxed to the shareholders
only. Id.
Certain income items are treated as built-in gain. For
example, income that the S corporation properly takes into
account during the recognition period but which is attributable
to the periods before the corporation became an S corporation is
treated as built-in gain. Sec. 1374(d)(5)(A). The recognition
period is the 10-year period beginning with the first day of the
first taxable year in which the corporation is an S corporation.
Sec. 1374(d)(7).
There are also specific rules addressing when section 481
adjustments are treated as built-in gain. A section 481
adjustment taken into account in the recognition period is
recognized built-in gain or loss to the extent the adjustment
relates to items attributable to periods before the beginning of
the recognition period under the principles for determining
built-in gain or loss for S corporations. Sec. 1.1374-4(d)(1),
Income Tax Regs. The principles for determining recognized
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built-in gain or loss include the accrual method rule. Id.
Under the accrual method rule, any item of income properly taken
into account during the recognition period is recognized built-in
gain if an accrual method taxpayer would have included it in
gross income before the beginning of the recognition period.
Sec. 1.1374-4(b)(1), Income Tax Regs.
We have previously decided two cases holding that certain
section 481 adjustments are recognized built-in gain under
section 1374. Argo Sales Co. v. Commissioner, 105 T.C. 86;
Rondy, Inc. v. Commissioner, T.C. Memo. 1995-372, affd. without
published opinion 117 F.3d 1421 (6th Cir. 1997). These cases
arose before the regulations under section 1374 were effective,
however. The taxpayer in Argo Sales Co. spread its section 481
adjustment over 6 years under the applicable revenue procedure.
In the fourth year of that 6-year period, it converted to S
corporation status. We examined the legislative history of
section 1374(d)(5) and decided that the section 481 adjustment
was properly built-in gain under section 1374 because the
adjustment came squarely within the description of “any item of
income” under section 1374(d)(5). Argo Sales Co. v.
Commissioner, supra at 91-92. In Rondy, Inc., a case involving
similar facts, we explained that section 481 adjustments were
intended to prevent the omission of items from corporate income
taxation. In addition, we explained that the section 481
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adjustments were permitted to be spread over a certain number of
years to ease the burden of recognizing the entire section 481
adjustment in the year of the change. On the other hand, to
allow the taxpayer to make an S election before the extended
period expired without recognizing built-in gain would allow the
taxpayer to wipe out the unrecognized corporate income that
section 1374 was intended to capture.
Petitioners seek to distinguish this case from Argo Sales
Co. and Rondy, Inc. Petitioners’ primary argument is that the
accrual method rule in the regulations under section 1374 plus
the RRA’s required 4-year-ratable-inclusion period for the
adjustment compels a different result. We disagree.
Distinction Between “Items” and “Adjustments” Under the
Regulation
Petitioners argue the section 481 adjustment is not built-in
gain because, under the accrual method rule, petitioners as
accrual method taxpayers could not have included the section 481
adjustment in income before electing S corporation status. See
sec. 1.1374-4(b), Income Tax Regs. The accrual method rule
provides that built-in gain includes income properly taken into
account during the recognition period if an accrual method
taxpayer would have included the income before the recognition
period began (i.e. before electing S corporation status).
Petitioners argue that, because the 4-year-ratable-inclusion
period for section 481 adjustments began with the enactment of
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the RRA in 1998, an accrual method taxpayer could not have taken
the last two of the adjustments into income before 2000, when
petitioners elected S corporation status.
Petitioners have mistakenly focused on the section 481
adjustment itself, rather than the related item that the section
481 adjustment is correcting. A section 481 adjustment is
recognized built-in gain or loss to the extent “the adjustment
relates to items attributable to periods before the beginning of
the recognition period.” Sec. 1.1374-4(d)(1), Income Tax Regs.
(emphasis added). Accordingly, when we examine whether the
section 481 adjustment is built-in gain, we consider the related
item, not the section 481 adjustment itself.
We examine whether an accrual method taxpayer would have
taken the related item into account before the beginning of the
recognition period under the accrual method rule. Sec. 1.1374-
4(b), Income Tax Regs. If the related item would have been
included, then the section 481 adjustment is built-in gain. See
sec. 1.1374-4(b), Income Tax Regs. Any alternate interpretation
of these provisions would allow a taxpayer to escape a corporate-
level tax on an accounting method adjustment by electing S
corporation status before the ratable inclusion period ended.
Section 1374 was designed to avoid this type of result. See Argo
Sales Co. v. Commissioner, supra at 91; Rondy, Inc. v.
Commissioner, supra.
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An example in the regulations further supports our
interpretation. See sec. 1.1374-4(d)(2), Example (2), Income Tax
Regs. In the example, the taxpayer, who elected to convert to S
corporation status effective January 1, 1996, deducted workers’
compensation claims when they were filed, under its accounting
method. The taxpayer then changed its accounting method in 1999,
requiring a positive section 481 adjustment to include in income
the previous deductions for filed claims that were still unpaid.
The example states that the section 481 adjustment is recognized
built-in gain insofar as it relates to items (the deductions for
workers’ compensation claims filed, but unpaid) attributable to
periods before the recognition period.
Petitioners’ section 481 adjustment reverses petitioners’
1997 deduction and includes the amount of the 1997 deduction
ratably in petitioners’ income over 4 years. The 1997 deduction
is the item to which the section 481 adjustment relates, and it
arose before the beginning of the recognition period (i.e. the
period beginning with the year petitioners elected S corporation
status). See sec. 1.1374-4(d)(1), Income Tax Regs. The section
481 adjustment thus relates to an item attributable to a period
before the beginning of the recognition period. Id. We
accordingly hold that petitioners’ section 481 adjustment is
recognized built-in gain.
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To reflect the foregoing,
Decision will be entered
for respondent.