Coordinated Issue Paper released on bargain purchases.

The IRS continues to press the issues raised by the Tax Court in Hamilton Industries, Inc., 97 TC 120 (1991), with respect to bargain purchases of inventory. Hamilton Industries made two bargain purchases: In the first acquisition, a residual purchase price allocation method resulted in a discount of 94% of the inventory's FIFO value. In the second acquisition, an allocation of purchase price equal to the inventory's LIFO value in the seller's hands resulted in a more than 60% disc Tax Court held that, in order to clearly reflect income, the taxpayer should be required to treat the bargain purchase items as separate items. Thus, the profit element attributable to the bargain purchased inventory items would be recognized immediately on disposition. The court also held that the IRS treatment of the items constituted a change in accounting method, and thus, that Sec. 481 (a) applied and permitted the Service to reconstruct the cost of the opening inventory (even though one o the bargain purchases occurred in a year closed by the statute of limitations).

In a Coordinated Issue Paper released on Sept. 12, 1995, the IRS has asserted that, for purposes of calculating inventory value under the dollar-value LIFO method, inventories purchased in bulk at discounted amounts are generally treated as separate items from goods purchased or produced subsequently. Such treatment would effectively eliminate the ability under LIFO to include the discounted inventory values in old layers. The Service noted that, based on the rationale of Hamilton Industries, gain from bargain cost inventory should be realized when the actual bargain cost units are sold. Furthermore, the taxpayer has the burden of proving that the specific inventory items purchased at a discount remain in ending inventory. Finally, a change in treatment of bargain purchases in order to conform with Hamilton Industries will constitute an accounting method change, necessitating a Sec. 481 (a) adjustment.

Interestingly, after the Tax Court decision, the IRS and Hamilton Industries agreed to a settlement stipulation under which the taxpayer received a substantial refund. Although the stipulation was ostensibly based on "difficulties in agreeing to computations," it is likely that the Service also sought to avoid a taxpayer appeal and reversal of the Tax Court decision. Thus, the conclusions of Hamilton Industries may yet be subject to challenge.

Furthermore, the IRS National Office has held that inventory purchased at a discount and subsequently transferred in a Sec. 351 transaction must be treated as a class separate from nonbargain purchase inventory. In Letter Ruling (TAM) 9446003, a subsidiary corporation purchased all the assets of a target company; as result of purchase price allocation, the inventory was acquired at a substantial discount. At a later date, the subsidiary transferred the acquired inventory tory assets to a second-tier subsidiary in a Sec. 351 transaction. Citing Hamilton ton Industries, the Service held that the bargain purchase attribute carried over to the new subsidiary and, the fore, that its LIFO method, as applied, was erroneous, since it did not treat the bargain purchase inventory as a separate class. Note that this holding is open to question, since the IRS arguably should have pursued the transferor; by the time of the transfer, none of the bargain purchase items were physically part of the inventory. Nonetheless, the holding may suggest a similar IRS stance with respect to other types of nontaxable transfers, such as Sec. 721 partnership contributions.

The question of how far the Service will pursue its analysis remains. The Coordinated Issue Paper states that the "significance or materiality of the discount is a question of fact to be determined on a case-by-case basis." Thus, while it is likely that taxpayers that make deeply discounted purchases (such as the 60% and 94% discounted purchases in Hamilton Industries) will fall prey to separate item treatment, it is less clear that moderate or slight discounts should subject taxpayers to such a regime.

From Barry A. Tovig, CPA, and Scott W. Vance, Esq, Washington, D.C.