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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. Commissioner, supra at 91; Rondy, Inc. v.
Commissioner, supra.
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Last modified: March 27, 2008