Disaster-Affected Businesses Allowed To Defer Gain On Involuntarily Converted Inventory

PLR 201111004

In a Technical Advice Memorandum (TAM), IRS has determined that inventory held by a corporation that was involuntarily converted in a federally declared disaster constitutes property held for productive use in a trade or business for purposes of Code Sec. 1033(h)(2). Although inventory arguably isn't “productive,” IRS found it significant that similar provisions allowing for deferral of gain on an exchange or other disposition of property explicitly exclude inventory, whereas no such exclusion exists in Code Sec. 1033(h)(2).

Background. A taxpayer may elect to defer the tax on all or a part of a gain realized on property that was involuntarily converted as a result of its complete or partial destruction, theft, seizure, requisition or condemnation, or threat thereof. To qualify for deferral, the taxpayer must purchase replacement property that is “similar or related in service or use” to the property replaced within the applicable replacement period. If the foregoing requirements are met, gain is recognized only to the extent that the amount realized on the conversion exceeds the cost of the replacement property.

Under Code Sec. 1033(a), the replacement period is ordinarily two years (three years in the case of condemnation or threat of condemnation of real property held for productive use in a trade or business or for investment) beginning on the earlier of (1) the date on which the property was destroyed, stolen, condemned, etc., or (2) the date on which condemnation or requisition was first threatened or became imminent. However, the period was extended to five years for property (i) located in the Hurricane Katrina disaster area, (ii) compulsorily or involuntarily converted because of Hurricane Katrina on or after Aug. 25, 2005, and (iii) replaced by new property, substantially all of which is used in the Hurricane Katrina disaster area.

Under Code Sec. 1033(h)(2), if property held for productive use in a trade or business or for investment located in a disaster area is compulsorily or involuntarily converted as a result of a federally declared disaster, tangible property of a type held for productive use in a trade or business is treated as property similar or related in use to the property converted.

Observation: The TAM refers to “Presidentially declared” disasters, which was the terminology used in former Code Sec. 1033(h)(2) before it was amended in 2008. The current term used in Code Sec. 1033(h) is “federally declared disaster,” which is defined in Code Sec. 1033(h)(3) as a disaster later determined by the President to warrant federal assistance under the Robert T. Stafford Disaster Relief and Emergency Assistance Act.

Facts. A group of affiliated corporations, its common parent, and an operating limited partnership wholly owned by members of the group (collectively, “Taxpayer”) owned unspecified “business units.” The operations of some of Taxpayer's business units were damaged by the 2006 Gulf Coast hurricanes, which were federally declared disasters. Taxpayer received insurance and salvage proceeds relating to property that was involuntarily converted as a result of the hurricanes, more than half of which was for lost or damaged inventory, and realized gain in excess of its basis from these recoveries.

Taxpayer reinvested most of the insurance and salvage proceeds in new store construction property, included statements in its tax returns identifying the replacement property, and reduced the basis of the new property by the amount of the deferred gain. Taxpayer expects to reinvest the remaining proceeds within the extended five-year replacement period applicable to property damaged by Hurricane Katrina. Taxpayer has since purchased and sold inventory, but did not designate any acquired inventory as replacement property for the inventory destroyed.

Conclusion. The TAM states that inventory held by Taxpayer that was involuntarily converted in a Presidentially declared disaster is “property held for productive use in a trade or business,” and that the resulting gain realized by Taxpayer from insurance and salvage proceeds for the involuntarily converted property is eligible for deferral under Code Sec. 1033(h)(2).

Observation: Before this TAM, a taxpayer with funds attributable to inventory that was destroyed by a federally declared disaster may have limited its reinvestment to replacement inventory in order to qualify under Code Sec. 1033(a). This TAM reflects a significant development for such taxpayers since it allows a business to take funds from involuntarily converted inventory and apply those funds towards other tangible business property for which the business has a greater need.

IRS reasoned that, unlike other similar deferral provisions that explicitly exclude inventory, Code Sec. 1033(h)(2) contains no such disallowance. Rather, Code Sec. 1033(h)(2) merely refers to “productive property,” the plain meaning of which doesn't necessarily exclude inventory. Thus, had Congress intended for inventory to be ineligible for exclusion under Code Sec. 1033(h)(2), it would have expressly provided for its extension.

IRS found that its position is consistent with both Notice 2003-18, 2003-1 CB 699 and Code Sec. 1033(h)(2)’s legislative history. Under Notice 2003-18, which provided guidance on the treatment of grant payments to aid in the recovery from the 9/11 terrorist attacks, a business may elect under Code Sec. 1033 to defer the gain on payments received to compensate for losses due to damaged or destroyed property, including inventory. Also, the legislative history to Code Sec. 1033(h)(2) broadly states that it was intended to provide relief to businesses affected by Presidentially declared disasters by “allowing them to reinvest their funds in any tangible business property without being forced to recognized gain.”

Observation: A similar issue was raised in Chief Counsel Advice 200114046, in which IRS addressed the tax treatment of payments from the Federal Emergency Management Agency (FEMA) to individuals and businesses in New Mexico that suffered losses due to the Cerro Grande Fire. In that CCA, IRS determined that a taxpayer receiving insurance or other proceeds (such as FEMA payments) on an involuntary conversion of inventory may elect to defer gain under Code Sec. 1033. However, IRS further determined that any gain recognized results in ordinary income because inventory is neither a capital asset under Code Sec. 1221(a)(1) nor Code Sec. 1231 property.

References: For replacement property for trade or business property damaged as a result of a federally declared disaster, see FTC 2d/FIN ¶I-3772.6; United States Tax Reporter ¶10,334.2205; TaxDesk ¶871,010 229,752; TG ¶10444.