Acquisition price establishes base-year cost of bargain inventory.

In the latest in a long line of cases and rulings addressing bargain-purchase inventories, the Federal Circuit ruled that a manufacturer should have used acquisition cost to establish the base-year cost of bargain-priced inventory (La Crosse Footwear Inc., 9/14/99). Reversing the Court of Federal Claims, the Federal Circuit concluded that the manufacturer's use of fair market value (FMV) resulted in avoidance of gain.

Background--Hamilton Industries

La Crosse Footwear must be viewed in the context of an earlier significant case addressing the bargain-purchase inventory issue--Hamilton Industries, Inc., 97 TC 120 (1991). In Hamilton Industries, the taxpayer acquired assets in two transactions, each of which involved a residual price allocation to the acquired inventory. The residual allocation resulted in an inventory value substantially less (approximately 96% and 60% for the two transactions) than the value assigned by the target corporation under FIFO. In keeping its inventory records, the taxpayer made no distinction between the acquired inventory and inventory subsequently purchased or produced. The acquiring corporation timely elected the dollar-value LIFO method of accounting and a single natural business pool. The result was that the discounted inventory value was treated as the base-year cost for items that could be inventoried. The IRS proposed a deficiency, claiming that Hamilton improperly treated as one item both the acquired inventory and the subsequently purchased or produced inventory. Because an adjustment in the acquisition year was barred by the statute of limitations (SOL), the Service argued that its adjustment was a change in Hamilton's method of accounting subject to Sec. 481.

The Tax Court agreed with the IRS and held that, while Hamilton correctly placed the acquired inventory in the same pool as subsequently purchased or produced inventory, it Constituted a separate item. The court concluded that the artificially low value assigned to the acquired base-year inventory would generate inventory value increases attributable not to inflation, but merely to the discount element. Further, the court noted that the disparity between the bargain-purchase inventory and any inventory subsequently acquired or produced evinced materially different cost characteristics, resulting in inventory with a different character. Accordingly, the court held that the bargain-purchase inventory must be accorded separate-item treatment.

Since Hamilton Industries was decided, the Service has issued a number of rulings indicating when its rationale should be applied; see Letter Rulings (TAMs) 9328002, in which the IRS ruled that base-year retail inventory acquired at a 50% discount required separate treatment from inventory subsequently acquired at normal prices, and 9446003, in which the Service ruled that the basis of transferred inventory in a Sec. 351 transaction retained its bargain-purchase attribute (despite the fact that the actual goods transferred were not the physical goods acquired by the transferor in the bargain purchase).

The IRS has also issued rulings indicating when the rationale should not be applied; see, e.g., Letter Rulings (TAMs) 9730003 and 9731002, in which the Service ruled that inventory received by a corporation in a Sec. 351 transaction need not be treated as separate from otherwise identical inventory subsequently acquired or produced in computing cost of goods sold under the dollar-value LIFO inventory method. In September 1995, the IRS's Industry Specialization Program issued a cross-industry coordinated issue paper tided "Dollar-Value LIFO Bargain Purchase Inventory Issues" the analysis and conclusions of which follow the Tax Court's holding in Hamilton Industries.

La Crosse Footwear

In 1982, La Crosse was formed to acquire the assets of Rubber Mills. La Crosse acquired all the assets of Rubber Mills, including its inventory, accounts receivable, plant, equipment and cash. The purchase price was approximately $7.5 million; however, the .book value was approximately $10.6 million.

La Crosse elected to use the dollar-value, double-extension, LIFO inventory accounting method. The company treated the bargain-priced inventory in the same way that it treated inventory subsequently acquired at FMV, putting subsequent inventory into the same pool as the bargain-priced inventory. Because both types of inventory were in the same pool, La Crosse was not required to realize the additional profit from selling goods manufactured from the discounted inventory, as long as inventory levels did not fall below those that existed after the original acquisition of the bargain-priced inventory.

The Service objected to valuing the base-year cost of the inventory at the bargain-purchase price and to allocating the bargain-priced inventory to pools. La Crosse agreed to adjust its tax liability and to pay interest and penalties for 1983-1986. It then filed a refund suit in the Court of Federal Claims. At trial, the IRS argued that La Crosse was required to assign the bargain-priced inventory and the subsequently acquired inventory to different pools, because of the significant price differential between the goods.

In its post-trial opinion, the Court of Federal Claims rejected the Service's argument on the ground that requiring taxpayers to determine when a price difference between goods is "substantial" enough to warrant assignment to different pools would create an unworkable standard. In addition, the court concluded that the base-year cost of the bargain-priced inventory should have been the inventory's FMV, rather than La Crosse's actual cost. Accordingly, the court held that La Crosse was entitled to recover on its tax refund claim and directed the parties to submit a joint status report on the computation of damages in conformity with its opinion.

Impact of Kohler and Thor Power Tool

Before the joint status report was filed, the Federal Circuit decided Kohler Co., 124 F3d 1451 (1997), holding that, for dollar-value LIFO accounting purposes, inventory acquired at a deep discount should be treated as a separate item from that subsequently manufactured or purchased. In light of Kohler, the Court of Federal Claims issued a second opinion acquiescing to the IRS's argument that the inventory purchased at a bargain should be treated as a separate item. However, the court reaffirmed its original holding that the base-year cost of the bargain-priced inventory should have been its FMV, and the Service appealed.

La Crosse cited Regs. Sec. 1.472-8 (e)(2)(iii) in support of its view that the base-year cost was the FMV of the items at issue. The appeals court disagreed, however, noting two issues. First, the regulations require that the reconstructed cost be established to the IRS's satisfaction. Second, the court said, "Kohler dictates that the LIFO accounting method cannot be used to postpone the realization of gains associated with bargain priced inventory" Unless the Service approved of the use of FMV, the acquisition cost must be used as the base-year cost.

The court also rejected La Crosse's argument that generally accepted accounting principles (GAAP) support the use of FMV for determining base-year cost. Citing Thor Power Tool, 439 US 522 (1979), the court pointed to the Supreme Court's two-prong test for the acceptability of an inventory accounting method: It must conform to GAAP and must clearly reflect income. Thus, the court concluded, conformance with GAAP is not enough. "Because La Crosse's method would Permit it to avoid realizing the gains frown its bargain purchase, its method does not clearly reflect income." Accordingly, "the base-year cost of the bargain priced inventory should have been its acquisition cost"

La Crosse was the last pending case to address the bargain-purchase inventory issue. The courts have consistently concluded that by not treating bargain-purchase inventory as a separate item, a LIFO taxpayer can defer recognition of income solely attributable to the discount element inherent in a bargain purchase. This, the courts have held, is inconsistent with the theory behind LIFO, which is to protect taxpayers from recognizing income resulting from increased inventory values attributable to inflation.

The IRS's position is that an adjustment related to a bargain inventory purchase is a change in accounting method. Thus, a corrective adjustment will include the bargain-purchase year and all subsequent years, whether or not the year remains open under the SOL. This means that the issue continues to exist until the bargain-purchase inventory layer is eliminated.

FROM DIANE HERNDON AND JANE ROHRS, WASHINGTON, DC