Comments on Tax Technical Correction Act of 2009 - Taxable Year Vs. Tax Year

December 8, 2009

The Honorable Max Baucus, Chairman The Honorable Charles B. Rangel, Chairman Senate Committee on Finance House Committee on Ways & Means 511 Hart Senate Office Building 2354 Rayburn House Office Building Washington, DC 20510 Washington, DC 20515

The Honorable Charles Grassley The Honorable Dave Camp Ranking Member Ranking Member Senate Committee on Finance House Committee on Ways & Means 135 Hart Senate Office Building 341 Cannon House Office Building Washington, DC 20510 Washington, DC 20515

Dear Chairmen Baucus and Rangel, and Ranking Members Grassley and Camp:

We are writing to express our concern with one of the provisions in the Tax Technical Corrections Act of 2009 (H.R. 4169, introduced December 2, 2009). Section 2(h) of this legislation would strike the phrase “7th taxable year” and insert “7th year” in Internal Revenue Code section 1374(d)(7)(B), and would make the change retroactive to tax years beginning after December 31, 2008. While we understand that the purpose of Congress is to redraft the law to reflect original intent, we believe that the amendment, while perhaps reflecting such intent, would not only effect a substantive change in the application of the section 1374 built-in gains tax but would alter the tax treatment of transactions that taxpayers have already undertaken during 2009.

Section 1374(d)(7)(B) was added by section 1251 of the American Recovery and Reinvestment Act of 2009 (ARRA) in order to stimulate American businesses by allowing them to sell assets with net realized built-in gain up to three years earlier without incurring a corporate-level 35 percent tax thus providing them with needed cash during the economic downtown. This temporary rule effectively reduces the recognition period for qualifying S corporations.

Section 1374 provides generally that recognized gains from assets held by an S corporation with a carry-over basis from a C corporation period may be subject to a second level of tax if the assets are sold during the defined “recognition period.” Section 1374(d)(7)(A) provides that the recognition period is the 10-year period beginning with the 1st day of the 1st taxable year for which the corporation was an S corporation. Section 1374(d)(7)(B) as added by ARRA and which is the subject of the proposed technical correction, provides a special rule for 2009 and 2010: “In the case of any taxable year beginning in 2009 or 2010, no tax shall be imposed on the net recognized built- in gain of an S corporation if the 7th taxable year in the recognition period preceded such taxable year.” (Emphasis added.) In its explanation of this provision, the conference report to ARRA explained that this change provides that “no tax is imposed on an S corporation under section 1374 if the seventh taxable year in the corporation’s recognition period preceded such taxable year.”1 Both the statute and the legislative history use the same “taxable year” terminology, thus indicating that Congress may not have been initially aware of the problem. While Congress may have intended otherwise, its language to the contrary was consistent.

The term “taxable year” has a well settled meaning in tax law. For example, in section 7701(a)(23), it is defined as the calendar year, or the fiscal year ending during such calendar year, upon the basis of which the taxable income is computed under subtitle A and, in the case of a return made for a fractional part of a year under the provisions of subtitle A or under regulations prescribed by the Secretary, the period for which such return is made. In other words, if an entity is required to file a return for a fractional part of a calendar year, that fractional portion is counted as a “taxable year.” Similarly, in section 443(b)(3), “taxable year” is defined as “the period for which the return is made, if a return is made for a period of less than 12 months.” This meaning of the term “taxable year” is also well settled in regulations,2 IRS rulings3 and in case law.4

The following example illustrates the effect the proposed amendment would have on taxpayers.

A fiscal year C corporation made an S election effective July 1, 2002 and automatically converted to a calendar year, thus creating a short taxable year from July 1, 2002 until December 31, 2002. On January 1, 2009, the S corporation would begin its eighth taxable year (seven taxable years of 2002-2008 completed). Under the proposed language, the corporation would not begin its eighth year (12-month periods) until July 1, 2009 thus causing the corporation to fail to meet the requirement of having its seventh year precede 2009.

Relying on the language of the statute and the legislative history, S corporations have sold assets during 2009 believing that no built-in gains tax would be imposed. If the amendment included in the proposed Technical Corrections Act is enacted, the gains recognized in 2009 may be subject to tax under section 1374.5 Any S corporation that had short taxable years that precede 2010 is potentially affected by this change.

In deference to the taxpayers that have relied on a fair and clear reading of the law since the enactment of ARRA, we request that any change to the language in section 1374(d)(7)(B), whether included in a technical corrections or in a substantive bill be prospective only, and not effective for dispositions made prior to the date of enactment or after the date of enactment if subject to a written binding contract in place before the effective date of the legislation.

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1H. Rept. 111-16 (February 12, 2009). 2Treas. Reg. §§1.46-2(k), 1.56A-5(e)(1), 1.172-4(a)(2), 1.441-1(b)(1)(i), 1.812-4(a)(4), and 1.904-2(e). 3PLRs 8651019, 8743046, 8911049. 4Pennsylvania Electric Steel Casting Co. 20 BTA 602: “Any doubt or ambiguity regarding the meaning of “taxable year” has been removed in section 200 of the Revenue Acts of 1924 and 1926…Congress has seen fit to define a taxable year differently and to provide that the term “taxable year” includes, in the case of a return made for a fractional part of a year, the period for which such return is made.” Also Valley Paperback Manufacturers, Inc. TC Memo 1975- 311 and Young v. U.S. (1952, DC AR) 41 AFTR 920, aff’d 43 AFTR 744 (CA8). 5 Similarly taxpayers may be relying on short taxable years in order to avail themselves of this relief in 2010. If you have any questions about this matter, please contact Horacio Sobol, Chair of the S Corporation Taxation Technical Resource Panel at (202) 312-7656 or [email protected]; or Marc A. Hyman, AICPA Technical Manager at (202) 434-9231 or [email protected].

Sincerely,

Alan R. Einhorn Chair, Tax Executive Committee cc: Thomas A. Barthold, Chief of Staff, Joint Committee on Taxation Bernard A. Schmitt, Deputy Chief of Staff, Joint Committee on Taxation Harold E. Hirsch, Senior Legislation Counsel, Joint Committee on Taxation Cecily W. Rock, Senior Legislation Counsel, Joint Committee on Taxation