IPIC as an alternative to regular LIFO.

Many taxpayers using LIFO to determine the cost of inventory are examining whether they should modify their LIFO calculations, either to simplify them or to reverse a trend in which recent calculations show little inflation (or even deflation). These taxpayers are considering a switch to the inventory price index computation (IPIC) method for their LIFO calculations. The IPIC method replaces a taxpayer's internal inflation/deflation calculations with external inflation/deflation factors, taken from the Bureau of Labor Statistics (BLS) Consumer Price Index (CPI) and Producer Price Index (PPI) reports.

Simplifying LIFO

Taxpayers and practitioners agree that IPIC usually mitigates the complexity of item definition, one of the most difficult aspects of a regular LIFO calculation. "Items" are the detailed categories by which a taxpayer must classify its inventory to compute inflation properly. Item definition (the process of determining whether specific inventory goods are similar enough to be grouped together as an item) is subjective in nature and often a source of controversy between the IRS and taxpayers.

Neither the Code nor the regulations has defined the term "item," but the Service has intensified its examinations of item definition in industries in which it believes the number of LIFO items have been inadequate, Rulings such as Letter Ruling (TAM) 9632001 reflect the IRS position that LIFO items should be maintained at a more detailed level, taking the view that differences (such as disparate cost characteristics for identical inventory goods) are significant enough to warrant separate-item treatment.

Businesses that do not keep their inventory item books and records at acceptable Service levels can use IPIC, as that method removes much of the item definition uncertainty and leads to fewer items than an internal calculation. For instance, a tire manufacturer may produce many tire types in terms of size, performance, construction materials and cost. If a taxpayer aggregates all of these tire types into just a few LIFO items, its prior-year LIFO calculations could be subject to adjustment. If the IRS raises the issue, the taxpayer may have difficulty reconstructing base-year costs for additional items the Service identifies, and still retain its full LIFO reserve. However, if the taxpayer voluntarily adopts the IPIC method, it may be able to do so on a cut-off basis (i.e., without a Sec. 481(a) adjustment). Moreover, a voluntary filing change will likely preclude the IRS from making adjustments to prior-year LIFO calculations. The appropriate PPI report lists just two categories for passenger car tires. Thus, by using the IPIC method, the taxpayer would not have to compute internal inflation on each of its many tire types.

Use of External Inflation Figures

Taxpayers that are cost leaders in their industry and are aggressively achieving better-than-average cost reductions have also become interested in switching to IPIC. When cost pressures are deflationary, internal index calculations create income through recapturing previous LIFO charges. Taxpayers concerned about this may consider adopting IPIC for tax purposes, while, at the same time, retaining internal index calculations for book purposes.

A switch to IPIC means that a taxpayer must completely rely on BLS external index figures. These figures may make it difficult for the taxpayer to estimate the LIFO impact throughout the year, as the necessary external reports are not obtainable until after year-end. Further, the PPI and CPI reports show deflation for some items and inflation for others; thus, the taxpayer could find itself in the position of experiencing internal inflation, while the underlying PPI or CPI reports show deflation for the taxpayer's inventory.

Peculiar Mechanics of LIFO

Regs. Sec. 1.472-8(e)(3) and Rev. Proc. 84-57 provide guidance for performing an IPIC LIFO calculation. There are IPIC mechanical weaknesses that can produce results that are difficult to explain. The most common weaknesses are the following:

* In most cases, IPIC requires reducing the external inflation factor by 20%.

* Changes in wholesale prices determine PPI external inflation factors. Manufacturers must adjust these factors for changes in the company's gross profit margins.

* IPIC often requires that a taxpayer compute the overall external inflation by factoring in BLS "weights," rather than solely using its actual inventory mix. Because the BLS weights do not take into account the company's inventory mix, they can potentially distort the overall inflation factor.

* Other than department stores, retailers must still take a detailed accounting of inventory to "map" to the proper PPI or CPI category. Under the present rules, only a department store retailer may apply a single external inflation factor to department inventory without first determining the department's inventory mix.

Change to IPIC

A change to IPIC is a change in accounting method requiring IRS permission. Fortunately, Rev. Proc. 97-37 states that, in general, taxpayers can automatically switch to IPIC, provided they timely file Form 3115, Application for Change in Accounting Method. For most other accounting method changes, taxpayers must file Form 3115 in the year of change; a change to IPIC does not have to be filed until after year-end. Rev. Proc. 97-37 does have special rules whereby taxpayers currently under examination may file Form 3115 only in a specified "window period." However, Rev. Proc. 97-37 gives taxpayers enough time to analyze whether IPIC will meet their goals for simplifying the LIFO calculations and/or generating an inflationary index beneficial for tax purposes.