Category: Corporations
Subject: S Corporation
Title: Built-in Gains Tax, TRA 86 and TAMRA Transition Rules
IRC Sections: 1374
Filename: 1281.html
Date Produced: 10/95

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Background
Taxpayer (TP), an independent insurance agency, elected S corporation status effective 1/1/87. On 1/1/91, TP sold all its assets which included insurance expirations. TP is in all respect qualified for the small corporation transition exception to the built-in gains tax pursuant to TRA '86 Section 633(d) as amended by TAMRA Section 1006(g) whereby long-term capital gains are not subject to the built-in gains tax.

The IRS contends that the gain from the sale of insurance expirations is not long-term capital gain and is thus subject to the built-in gains tax of IRC Section 1374.

Capital Asset Issue
1. It is clear from TRA '86 Section 633(d) as amended by TAMRA Section 1006(g) that no special "capital gain" concept was invented solely for purposes of these transition rule provisions. In other words, the normal standards and definitions of capital gain apply.

2. Capital gain or loss results from the sale or exchange of a capital asset. Section 1222. I gather that it is clear to the agent that a sale or exchange has occurred, and the issue is whether or not the insurance expirations constitute capital assets.

3. Section 1221 provides that a capital asset is any asset held by the taxpayer except certain explicitly enumerated items.

-1221(1) inventory or stock in trade;

-1221(2) land or depreciable property used in the taxpayer's trade or business;

-1221(3) a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by a taxpayer whose personal efforts created such property;

-1221(4) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale inventory or stock in trade;

-1221(5) a publication of the United States Government (including the Congressional Record) which is received from the United States Government or any agency thereof, other than by purchase at the price at which it is offered for sale to the public, and which is held by a taxpayer who so received such publication, or a taxpayer in whose hands the basis of such publication is determined, for purposes of determining gain from a sale or exchange, in whole or in part by reference to the basis of such publication in the hands of a taxpayer described in subparagraph (A).

It seems obvious that none of these statutory exceptions are relevant; hence, the insurance expirations should be capital assets by virtue of the plain language of the statue.

There are, however, some additional, nonstatutory, judicially-imposed exceptions, and this is what the agent is arguing. The agent argues that the insurance expirations represent the right to receive income in the future. Under this exception, if the sale of a contract right is simply a substitute for what would have been ordinary income to the seller, the contract right is not a capital asset. See for example, Jones v. Comr., 306 F.2d 292 (5th Cir. 1962); Fisher v. Comr., 209 F.2d 513 (6th Cir. 1954), cert. denied, 347 U.S. 1014 (1954); Lasky v. Comr., 22 T.C. 13 (1954); Ayrton Metal Co., Inc. v. Comr., 299 F.2d 741 (2d Cir. 1962); Buena Vista Farms, Inc. v. Comr., 68 T.C. 405 (1977); Hallcraft Homes, Inc. v. Comr., 336 F.2d 701 (9th Cir. 1964); and Rhodes Est. v. Comr., 131 F.2d 50 (6th Cir. 1942).

I must say that this is an extremely astute point the agent has raised; however, it is point that has been resolved in the taxpayer's favor with respect to insurance expirations. This was apparently a very hot topic in the insurance business about 35 years ago. The IRS pressed this issue quite vigorously, but finally gave up after losing repeatedly in court. There are several dozen cases in the early 1960's where this question or some variation thereon was at issue. With the exception of some cases with peculiar factual aberrations, the IRS consistently lost this issue. See Rev. Rul. 65-180, 1965-2 CB 279, in support of the IRS's having given up the fight on this issue.

See also the following cases.

Aitken v. Commissioner, 35 TC 227. This is a leading case and ideal for presentation to the agent. It is very short and contains no extraneous issues. The IRS acquiesced to the holding in this case. Also there is a basic explanation of the nature of insurance expirations.

Commr. v. Killian, 63-1 USTC ¶9347, (CA-5, 1963). Aff'g 20 TCM 376 (1961).

Kinney v. Commr., 58 TC 1038 (1972).

Section 1374 Issue
As far as old-versus-new Section 1374 is concerned, the point of the transition rule is to partially shield the qualified small corporation from application of new Section 1374. The effect of the transition rule provision is antithetical to that of new Section 1374 at least with respect to long-term capital gains. Clearly, the transition rule provides only partial relief; however, and new Section 1374 applies to everything other than capital gains. See Revenue Ruling 84-141, 1986-2 CB 151.

I assume that the covenants and consulting amounts were paid directly to individuals such that new Section 1374 does not matter with respect to these ordinary income items. Of course, to the extent the sale of fixed assets gave rise to recapture income, there is at least an issue with respect to new Section 1374; however, since the built-in gains tax is measured on an asset-by-asset basis, there may be no post-election appreciation with respect to these assets.

Old Section 1374 clearly applies with respect to long-term capital gains from transition rule companies, however, the recognition window under old Section 1374 is three years. Since the recognition event in this case occurred five years after conversion, old Section 1374 is moot.Amortization Issue
Even though you represent the seller, you raised the issue as to whether the purchased expirations are amortizable. This is a rather controversial matter it seems. Due to budgetary and time constraints, I was advised by Mr. Simon to hold on this issue until Mr. Ricca returns.