Automobile dealers may use replacement-cost method to approximate vehicle-parts inventory cost.

Rev. Proc. 2002-17 provided certain automobile dealers a safe-harbor accounting method for vehicle-parts inventory. This method permits them to use the replacement cost of parts to approximate the cost of their vehicle-parts inventory. The procedure is generally effective for tax years ending on or after Dec. 31, 2001.

Background

In Mountain State Ford Truck Sales, Inc., 112TC 58 (1999), the Tax Court held that the IRS did not abuse its discretion when it determined that a truck dealer's use of the replacement-cost method to determine the current-year cost of its parts inventory under the LIFO method did not clearly reflect income. The court permitted the IRS to restore the taxpayer's LIFO reserve to income without terminating its LIFO election, because the taxpayer was unable to reconstruct the corrected reserve amount or provide evidence from which an estimate could be made.

The court concluded that the use of replacement cost to determine current-year cost under the dollar-value LIFO method contravenes the Sec. 472(b)(2) actual-cost requirement, which requires a taxpayer using the LIFO method to value inventory at cost. It reasoned that "cost" in Sec. 472(b)(2) has the same meaning as in Regs. Sec. 1.471-3 (i.e., actual cost or invoice price). Thus, the court concluded that a reseller using the dollar-value LIFO method must determine current-year cost by reference to actual invoice prices, not replacement cost.

The use of replacement cost to value parts inventory is prevalent among automobile dealers and others. As such, Mountain State Ford prompted discussions between the IRS and the National Automobile Dealers Association, attempting to reach an agreement on the use of the replacement-cost method. The IRS cited four unique industry circumstances warranting a departure from actual cost and permitting the use of replacement cost:

* The industry's long-standing use of replacement cost for financial accounting and Federal income tax purposes;

* Third-party (i.e., franchisor) requirements that automobile dealers use replacement cost;

* The substantial burden (i.e., expense) of converting existing record-keeping systems from replacement cost to actual cost; and

* The fact that replacement cost approximates actual cost in the industry (due to high turnover and low inflation).

The IRS expressed a willingness to consider the use of replacement cost in other industries, under similar facts.

Automobile Dealers

Scope. The Rey. Proc. 2002-17 safe harbor applies to automobile dealers, defined as taxpayers engaged in the trade or business of selling vehicle parts at retail, and authorized by one or more vehicle manufacturers or distributors to sell new automobiles or new light-, medium- or heavy-duty trucks. The method may be used in conjunction with either FIFO or LIFO.

Safe-harbor method. The safe-harbor method requires dealers to:

* Determine the cost of a vehicle part by reference to replacement cost;

* Determine replacement cost using a standard price list; and

* Satisfy the book-tax conformity requirement.

The replacement cost of a vehicle part is either the amount at which the part was offered for purchase in a standard price list at the inventory date, or, if the vehicle part is not offered for purchase in such a list on that date, the price at which the part was last offered for purchase in a standard list. "Standard" price lists are those widely recognized by automobile dealers and used in the ordinary course of their business to purchase vehicle parts.

A taxpayer meets the book-tax conformity requirement by using the safe-harbor method to ascertain income and profit of loss of its trade or business for purposes of its books, records and reports (including financial statements), submitted to its shareholders, partners or other proprietors, beneficiaries and creditors. Taxpayers subject to Sec. 263A must include in inventoriable costs the additional amounts required by Regs. Sec. 1.263A-1 and -3 (e.g., freight costs).

Procedures if already using the safe-harbor method. An automobile dealer that was using the safe-harbor method on March 12, 2002, may continue using it without filing Form 3115, Application for Change in Accounting Method. If a dealer used this method for tax years ending prior to Dec. 31, 2001, the IRS will not raise the issue; if use is already an issue, the IRS will not pursue it further.

Procedures for changing to the safe-harbor method. An automobile dealer that was not using the safe-harbor method on March 12, 2002, but wants to change to the method for a tax year ending on or after Dec. 31, 2001, must file Form 3115. It must follow the automatic consent procedures in Rev. Proc. 2002-9.That procedure's scope of limitations, as set forth in Section 4.02 (relating to taxpayers under examination before an area office or a Federal court), does not apply to taxpayers changing for their first or second tax year ending on or after Dec. 31, 2001. The change is made on a cut-off basis.

A taxpayer changing to the safe-harbor method generally receives audit protection for tax years prior to the change year. However, a taxpayer changing for its first or second tax year ending on or after Dec. 31, 2001, will not be protected if its method of determining cost (other than by use of replacement cost) is an issue under consideration as of March 12, 2002.

Recordkeeping. An automobile dealer that uses the safe-harbor method must maintain records supporting all aspects of its inventory valuation, including a price list.

Application to Other Industries

The use of replacement cost to value parts is a potential issue in other industries (e.g., construction and farm-equipment sales). The IRS would not likely challenge the use of replacement cost by a non-LIFO taxpayer unless replacement cost is less than actual cost, because the change to actual cost will generally result in a taxpayer-favorable adjustment. However, a LIFO taxpayer that does not have the records to reconstruct its LIFO reserve at actual cost has its associated LIFO reserve at risk. LIFO taxpayers should consider changing to actual cost and obtaining audit protection. An obstacle to such change may be the determination of actual cost.

FROM KELLY C. GAFFANEY, WASHINGTON, DC