The following article is reprinted from The M&A Tax Report, Vol. 11, No. 12, July 2003, Panel Publishers, New York, NY.


By Robert W. Wood

Okay, so I admit sometimes I forget to look at the calendar. It does seem entirely too hot this time of year to think about football games, thermoses of coffee (!) and stadium blankets. Most NFL players have hardly made their way to their respective summer training camps and here we are talking about football. Still, those of us in the tax world are often accused of being myopic. So it seems to me it is football time when I can read about an NFL team involved in a serious tax dispute (how often does that happen?).

Pending in the Third Circuit is a case that is not only of interest to sports fans, but to M&A Tax Report readers as well. New York Football Giants, Inc. v. Commissioner, 3d Cir. Dkt. No. 02-4392, Tax Analysts Doc. No. 2003-9855, 2003 TNT 83-26, involves an appeal of a Tax Court decision involving the New York Giants professional football franchise. The New York Football Giants, Inc. owns and operates the New York Giants. In early March of 1993, the Giants elected S corporation treatment under Section 1361(a)(1) of the Code. Later in 1993, the NFL awarded new franchises to Charlotte and Jacksonville under a deal requiring the new teams to make "expansion payments" (sounds like a euphemism to me) to the existing NFL franchises, including the Giants.

The Giants got its share of this expansion booty (in six installments), reporting it as capital gains on its 1996, 1997 and 1998 S corporation tax returns (Forms 1120S, U.S. Income Tax Returns for an S Corporation). Significantly, though, the Giants reported this capital gain as a clean one-level tax (to the shareholders) and not subject to the entity-level built-in gain tax of Section 1374. The built-in gain tax, readers will recall, first came into "play" in 1986, with the repeal of the General Utilities Doctrine (I still get a little smile on my face and a warm feeling in my heart when I think back to the good ol' days of the General Utilities Doctrine in its heyday).

In the old days, being a C corporation and electing S would subject one to a 1374 tax (then known as a capital gain tax), but it was as easy as an off-side kick to avoid that built-in gain tax (the measurement period was a paltry three years, and backloaded installment sales were a pretty easy way to prevent the occurrence of the tax even if one did have a disposition within the statutorily prescribed three year period). The 1986 version of the built-in gain tax is a horse of a different color to be sure.

Under current law, Section 1374 of the Code imposes a corporate level tax on any built-in gain recognized by an S corporation within 10 years of first electing S corporation status. The Congressional wisdom (H. Conf. Rept. 99-841 (Vol. II), at II-203 (1986), 1986-3 C.B. (Vol. 4) 1, 203) tells us that "built-in gain is measured by the appreciation in value of any asset over its adjusted basis as of the time a corporation converts from C to S status." Pursuant to Section 1374(d)(3) of the Code, an S corporation is liable for the payment of the built-in gains tax with respect to the disposition of any asset, unless either: (i) the S corporation did not own the asset in question when it converted from C to S status; or (ii) when the corporation converted from C to S status, and the adjusted basis of the asset in question exceeded its fair market value.

Not surprisingly, the IRS issued a deficiency notice, alleging that these expansion payments made to the Giants were in fact subject to the Section 1374 built-in gain tax in the amount of $574,000 for fiscal year 1996, $914,334 for fiscal year 1997, and $220,156 for fiscal year 1998. Additionally, the Service asserted the Section 6662(a) accuracy-related penalty in the amount of $114,800 for fiscal year 1996, $182,867 for fiscal year 1997, and $44,031 for fiscal year 1998.

The matter went to Tax Court, where the taxpayer was arguing that Section 301.6245-1T of the Temporary Regulations was inconsistent with the Code. That temporary regulation basically provides that certain types of payments, such as the "expansion payments" received by the Giants, are more properly accounted for and taxed at the corporate level rather than at the shareholder level.

Tax Court Just Says No

The Tax Court concluded that Section 301.6245-1T of the Temporary Regulations was in fact valid, and that the tax on built-in gains is in fact a Subchapter S item. In doing so, the court stated that Section 301.6245-1T of the Temporary Regulations was promulgated under a particular concession of authority in Section 6245 of the Code. Citing Chevron U.S.A., Inc. v. NRDC, 467 U.S. 837, 844 (1984), the court stated that as a legislative regulation it is entitled to "greater deference" than a mere interpretive regulation issued under the Treasury Secretary's general authority found in Section 7805(a), and it will only be found to be invalid if it is "arbitrary, capricious, or manifestly contrary to the statute".

It was manifestly evident from the opinion that he Tax court did not buy the Giants' contention that Section 301.6245-1T of the Temporary Regulations should be held to be invalid because it is "illogical and inconsistent with the Internal Revenue Code" within the meaning of Goodson-Todman Enters., Ltd. v. Commissioner, 784 F.2d 66, 73-74 (2d Cir. 1986), affirming 84 T.C. 255 (1985). The Tax Court went on to say:

The regulation is consistent with the statutory scheme for unified audit and litigation procedures. . . . The regulations provide that the taxes imposed at the corporate level, namely taxes imposed under Sections 56, 1374, and 1375, are subchapter S items because they are more appropriately determined at the corporate level. The built-in gains tax of Section 1374 is more appropriately determined at the corporate level because it relates to assets held by the corporation when it converted from a C to an S corporation.

The court further stated that S corporations are responsible for the payment of certain corporate-level taxes, including the Section 1374 built-in gains tax; accordingly because the built-in gains tax is imposed against and funded directly by the S corporation, the shareholders of the S corporation are not responsible for the tax.

Because the "expansion payment" gains are Subchapter S items, and are dealt with on audit at the corporate level (and because here no final S corporation administrative adjustment ("FSAA") had been issued), the court granted the motion to dismiss for lack of jurisdiction for those returns. However, that motion to dismiss dealt only with the 1996 and 1997 tax years, so the dispute was not yet over (clearly it was fourth and long, but the final seconds had not yet ticked off the clock).

Interestingly, there was considerable procedural wrangling. The Tax Court ended up denying the Giants' motion to certify an interlocutory appeal on whether the built-in gain tax is a Subchapter S item, and whether the assessment of that tax against an S corporation may be determined in a TEFRA proceeding.

Referee Decision

The Third Circuit Court of Appeals has not yet decided this question, but the judges are presumably starting to huddle up. The Giants are arguing that Section 301.6245-1T of the Temporary Regulations is valid for the shareholders, but not for an S corporation. The Giants maintain that TEFRA was designed to deal with owners (not entities), and that the temporary regulation is invalid if it is applied to the built-in gain tax liability of an S corporation. The Giants' appeal emphasizes that the Service itself admits that S corporations are not subject to TEFRA (it is only their shareholders).

Furthermore, the Giants note that an S corporation cannot by definition be their own shareholders. The Giants argue that extending the TEFRA shareholder rules to an S corporation itself and its own tax liabilities is both unwarranted and unconstitutional. The tax matters person lacks standing for the corporation, and even lacks constitutional standing to prosecute an action to determine the corporation's liability. Finally, the Giants are arguing that the IRS is in fact estopped to deny that the built-in gain tax is not an S corporation item.

Anyone out there want to argue the government's side on this point? I'm guessing when the decision comes, we may want to see it again on instant replay. Until then, I'll be sitting on the edge of my seat.

Is it Football Time Yet?, Vol. 11, No. 12, The M&A Tax Report (July 2003), p. 7.