LIFO Inventory Considerations When Making a C-to-S Conversion

By Darrin Sohre, CPA, Washington, D.C.; Tom Sehman, CPA, Minneapolis; and Jim Martin, CPA, Washington, D.C.

Editor: Annette B. Smith, CPA

S Corporations

A taxpayer valuing its inventory under the last-in, first-out (LIFO) method should consider two significant implications for taxable income when converting from a C corporation to an S corporation. First, the LIFO recapture rule under Sec. 1363(d) accelerates income related to the taxpayer’s LIFO inventory. Second, the LIFO method affects the timing of recognition of additional built-in gain related to inventory.

Built-In Gains Tax

Sec. 1374 imposes a special corporate-level built-in gains (BIG) tax on corporations making a C-to-S conversion. The tax is intended to prevent a C corporation from converting to an S corporation to lessen the impact of a taxable liquidation.

For example, if a C corporation liquidates its assets and then distributes the proceeds to its shareholders, the earnings are subject to two levels of tax: one at the corporate level on the gain recognized on the sale of the assets, and one on the distribution received by the shareholders. Absent the BIG tax, if a C corporation converted to an S corporation prior to sale of its assets, the gain would flow through to the shareholders, making the gain subject to only one level of taxation.

The Sec. 1374 BIG tax imposes the highest corporate rate on gains recognized on sales of appreciated assets within the recognition period. Generally, the recognition period is the first 10 tax years after an S election. However, Congress has provided shorter recognition periods for tax years beginning in 2009 through 2013. For tax years beginning in 2012 or 2013, the recognition period is the first five tax years after an S election.

The BIG tax applies to all assets, including inventory, owned by the company on its first day as an S corporation. Under Regs. Sec. 1.1374-7(a), for purposes of the BIG tax, a taxpayer must determine the fair market value (FMV) of its inventory using a bulk sale approach. Further, under Regs. Sec. 1.1374-7(b), a taxpayer must track its dispositions of inventory by the same inventory method used for tax purposes to determine the timing of the recognition of the built-in gain.

LIFO Recapture

Under the LIFO method, inventory is considered to be sold (disposed of) on a last-in, first-out basis. This means that inventory on hand at the S election date is treated as being disposed of only to the extent that the LIFO layers as of the election date are decreased in subsequent years. If inventory quantities remain constant or increase in future years, a taxpayer using the LIFO method might not dispose of the inventory within the recognition period and, as a result, could avoid the BIG tax.

However, Congress added a LIFO recapture provision in Sec. 1363(d) to prevent a taxpayer from avoiding the BIG tax in such circumstances. This provision applies to a C corporation that uses the LIFO method in its last tax year before converting to an S corporation. Under Sec. 1363(d), the LIFO recapture amount is included in the C corporation’s income in its final tax return. Generally, the LIFO recapture amount is the amount by which the inventory value under the first-in, first-out (FIFO) lower-of-cost-or-market (LCM) method exceeds the inventory value under the LIFO method.

The tax attributable to the recaptured amount is paid in four installments. The first installment must be paid by the unextended due date of the C corporation’s final tax return, while the final three installments must be paid by the unextended due date of the S corporation’s three succeeding tax returns.

As provided in Regs. Sec. 1.1363-2(e)(1), a taxpayer must adjust the basis of its inventory to reflect the amount of LIFO recapture included in income. Rev. Proc. 94-61 explains that the LIFO layers as of the date of the S conversion must be collapsed into a single layer (the conversion layer), and the LIFO recapture amount must be added to the LIFO value of the inventory.

Additional Built-In Gain

Although Sec. 1363(d) prevents a taxpayer from avoiding the BIG tax related to the LIFO recapture amount, it does not eliminate the need to consider additional built-in gain related to LIFO inventory. Even after a taxpayer increases the basis of its inventory to the FIFO LCM value, this value may be less than the FMV of the inventory.

Example: X, a C corporation that converts to an S corporation, has inventory with a FIFO LCM value of $100 million and a LIFO value of $75 million at the conversion date. X determines by valuation analysis that the FMV of the inventory is $115 million. Under Sec. 1363(d), the C corporation must report taxable income equal to the LIFO recapture amount of $25 million. At the same time, the S corporation still has a deferred built-in gain—the difference between the FIFO LCM value and the FMV—of $15 million.

If a C corporation used the FIFO method prior to an S conversion, the S corporation would recognize built-in gain as it disposes of the inventory on hand at the conversion date. In most cases, this would occur during the first year of the S corporation, resulting in a BIG tax liability for the S corporation. However, under the LIFO method, the inventory on hand at the conversion date is not treated as being disposed of until the conversion layer is decreased. Therefore, unless the S corporation experiences a reduction in inventory quantities that results in a decrease to the conversion layer within the recognition period, the BIG tax would not apply.

To properly track the remaining amount of deferred built-in gain, an S corporation can establish a separate built-in gain layer and decrease the value of this layer on a pro rata basis in conjunction with future decreases to the conversion layer. It is unlikely that the conversion layer would be completely reduced, if at all, by the end of the recognition period, thus eliminating the need to pay the BIG tax on the remaining built-in gain.

Some taxpayers consider changing from the LIFO method before or after an S election, believing that the effort to maintain the LIFO calculation is not worth the benefit after the LIFO recapture amount is recognized as income. However, this approach overlooks the potential benefit of deferring the built-in gain and potentially avoiding the BIG tax on the excess of the FMV over the FIFO LCM value of the inventory. Notwithstanding the recognition of the LIFO recapture amount as income, the potential permanent benefit of avoiding the BIG tax by remaining on the LIFO method may be a sufficient reason in particular situations to stay the course.


Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

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