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.
                               - 3 -

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.
                               - 5 -

                            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.
                                - 6 -

e.g., Argo Sales Co. v. Commissioner, 

, 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).
                               - 7 -

     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. 

.        Only

the appreciation present at the time the corporation becomes an S

corporation is taxed at the corporate level.      Garwood Irrigation

Co. v. 

.   Any gain attributable to post-S

status conversion is passed through and taxed to the shareholders

only.

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
                                - 8 -

built-in gain or loss include the accrual method rule.

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, 

;

Rondy, Inc. v. Commissioner, T.C. Memo. 1995-372, affd. without

published opinion 

(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.

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
                               - 9 -

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
                                - 10 -

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. 

at 91; Rondy, Inc. v.

.
                               - 11 -

     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.

that petitioners’ section 481 adjustment is

recognized built-in gain.
                        - 12 -

To reflect the foregoing,


                                 Decision will be entered

                             for respondent.