IRS Revenue Ruling
2001-50

Code Sec. 1374

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26 CFR 1.1374-4: Recognized built-in gain or loss.

Built-in gains tax. The built-in gains tax under section 1374 will not
apply to the timber, coal and domestic iron ore transactions described in
the four situations in the ruling.


REV. RUL. 2001-50

ISSUE

Is the S corporation's gain recognized in each of the situations
described below recognized built-in gain for purposes of section 1374 of
the Internal Revenue Code?


FACTS

SITUATION 1: An S corporation holds timber property with built-in gain
on the date its election to convert from a C corporation to an S
corporation is effective (or acquires timber property with built-in gain
from a C corporation in a transaction to which section 1374(d)(8)
applies). During the 10-year period beginning with the first day of the
first taxable year for which the corporation was an S corporation (or
beginning on the day of the section 1374(d)(8) transaction) (the
recognition period), the S corporation cuts the timber and sells the
resulting wood products and recognizes that built-in gain in a transaction
to which section 631 does not apply.

SITUATION 2: An S corporation holds timber property with built-in gain
on the date its election to convert from a C corporation to an S
corporation is effective (or acquires timber property with built-in gain
from a C corporation in a transaction to which section 1374(d)(8)
applies). During the recognition period, the S corporation recognizes that
built-in gain on cutting the timber pursuant to an election under section
631(a).

SITUATION 3: An S corporation holds timber property with built-in gain
on the date its election to convert from a C corporation to an S
corporation is effective (or acquires timber property with built-in gain
from a C corporation in a transaction to which section 1374(d)(8)
applies). During the recognition period, the S corporation recognizes that
built-in gain on the disposal of the timber under a contract to which
section 631(b) applies.

SITUATION 4: An S corporation holds coal or domestic iron ore property
with built-in gain on the date its election to convert from a C
corporation to an S corporation is effective (or acquires coal or domestic
iron ore property with built-in gain from a C corporation in a transaction
to which section 1374(d)(8) applies). During the recognition period, the S
corporation recognizes that built-in gain on the disposal of the coal or
domestic iron ore under a contract to which section 631(c) applies.


LAW AND ANALYSIS

Section 1374 imposes a corporate-level tax on an S corporation's net
recognized built-in gain during the recognition period in the case of a C
corporation's conversion to S corporation status (section 1374(a)) or an S
corporation's acquisition of assets in a transaction in which the S
corporation's basis in the acquired assets is determined by reference to
the basis of such assets in the hands of a C corporation (section
1374(d)(8)). 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 establishes that it did not hold the asset on the
conversion date or section 1374(d)(8) transaction date, or that the gain
recognized was greater than the excess of the asset's fair market value
over its adjusted basis on the conversion date or section 1374(d)(8)
transaction date (section 1374(d)(3)). Section 1374(d)(3) applies to any
gain recognized during the recognition period in a transaction treated as
a sale or exchange for Federal income tax purposes (section 1.1374-4(a) of
the Income Tax Regulations). In Example 1 of section 1.1374-4(a)(3), X is
a C corporation that elects to become an S corporation effective January
1, 1996. On that date, X owns a working interest in an oil and gas
property with a fair market value of $250,000 and an adjusted basis of
$500,000. During the recognition period, X produces and sells oil
extracted from the oil and gas property for $75,000. The example concludes
that the $75,000 is not recognized built-in gain under section 1374
because, as of the beginning of the recognition period, X held only a
working interest in the oil and gas property, and not the oil itself.

Section 631(a) provides that, under certain circumstances, a taxpayer's
cutting of timber is treated as a sale or exchange of the timber in the
year it is cut. Section 631(b) provides that, under certain circumstances,
a taxpayer's disposition of timber shall be treated as giving rise to gain
or loss on a sale of such timber. Section 631(c) provides that, under
certain circumstances, a taxpayer's disposition to unrelated parties of
coal or domestic iron ore shall be treated as giving rise to gain or loss
on a sale of such coal or iron ore. In general, section 631 permits a
taxpayer to benefit from capital gain treatment in circumstances that
would otherwise give rise to ordinary income.

If an S corporation holds timber property on the date its election to
convert from a C corporation to an S corporation is effective and, during
the recognition period, cuts the timber and sells the resulting wood
products in a transaction to which section 631 does not apply, the tax
consequences to the S corporation under section 1374 are determined using
the same analysis contained in Example 1 of section 1.1374-4(a)(3). The
wood products sold as inventory during the recognition period did not
constitute separate assets held by the S corporation on the conversion
date and thus their production and sale do not constitute a partial
disposition of the timber property. See Rev. Rul. 72-515 (1972-2 C.B. 466)
(treating growing timber as part of the underlying real property for
purposes of section 1031). Accordingly, the S corporation's income on the
sale of the resulting wood products during the recognition period is not
recognized built-in gain within the meaning of section 1374(d)(3) and is
not taxed under section 1374.

Notwithstanding the treatment accorded income under section 631, the
income received from the sale of the resulting wood product, produced
coal, or produced iron ore involves the receipt of normal operating
business income in the nature of rent or royalties. See Rev. Rul. 77-109
(1977-1 C.B. 87) (holding that payments received from a disposal of coal
to which section 631(c) does not apply is ordinary income). The receipt of
normal operating business income in the nature of rents and royalties is
not subject to tax under section 1374. There is no indication that
Congress intended the capital gain tax rate benefits provided by section
section 631 to cause normal operating business income from the cutting of
timber or the extraction of minerals to be subject to tax under section
1374. Moreover, section 631(c) is designed to favor domestic production of
iron ore and sales of coal and iron ore to unrelated parties. Applying
section 1374 to income taxed under section 631(c) could have the anomalous
effect of taxing sales of domestic iron ore more heavily than sales of
foreign production and taxing sales of coal and iron to unrelated parties
more heavily than sales to related parties. Accordingly, an S
corporation's gain recognized pursuant to section 631(a), section 631(b),
or section 631(c) during the recognition period is not recognized built-in
gain within the meaning of section 1374(d)(3).


HOLDINGS

The S corporation's gain recognized in the transactions described in
Situation 1, 2, 3, and 4 is not recognized built-in gain for purposes of
section 1374.

See also Rev. Proc. 2001-51 (2001-43 I.R.B. 369), which modifies Rev.
Proc. 2001-3 (2001-1 I.R.B. 111), by deleting therefrom section 5.06 (the
no-rule under section 1374, regarding the tax imposed on certain built-in
gains).


DRAFTING INFORMATION

The principal author of this revenue ruling is Cristian P. Silva of the
Office of Associate Chief Counsel (Corporate). For further information
regarding this revenue ruling, contact Mr. Silva at (202) 622-7750 (not a
toll-free call).

<<END RULING>>

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