Inventory acquisition and dollar-value LIFO - the effect of bargain prices.

Companies that use LIFO to minimize the taxation of illusory inventory profits should never forget that LIFO can turn around and bite them when inventory levels decline. Recently, the Tax Court handed down a decision that could cause LIFO companies to be hit with a large tax bill even when inventory levels do not decline. If any part of the LIFO base can be construed as having been acquired in a bargain purchase, under the precedent of Hamilton Industries, Inc. v. Commissioner, (1*) the Internal Revenue Service may require income retained in the LIFO layer to be immediately recognized. Thus, many companies could have a bomb buried in their LIFO inventory that could be detonated by an IRS audit. In addition, companies that anticipate acquiring inventory through means other than normal purchasing channels (such as business acquisitions) need to be aware of the implications of this Tax Court decision.

Development of Dollar-Value LIFO

After the Revenue Act of 1939 granted all taxpayers the right to use LIFO, the IRS argued that LIFO should be limited to situations where it would be easy to measure units. Thus, the IRS expressed a preference for a narrow specific-goods approach and opposed the use of the dollar-value method. In 1947, however, the Tax Court in Hutzler Brothers Co. (2) approved the dollar-value method and the IRS retreated to fight the battle on a different front. It continued to oppose the very innovation made possible by dollar-value LIFO -- applying LIFO to a broad pool of dissimilar items. The primary benefit of dollar-value LIFO is that goods can be expressed in terms of dollars regardless of the dissimilarity of the items. Theoretically, a change in the mix of items should not necessary change the value of the inventory as long as the total inventory in base-year dollars is unchanged. The accompanying example illustrates the effects on inventory when a taxpayer changes the inventory mix.

In this example, the value of the ending inventory is the same as the beginning inventory because the inventory stated in base-year dollars has not changed. Using a single pool dollar-value system allowed the taxpayer to utilize current costs of both Muck and Yuck to determine cost of goods sold. If the IRS requires the establishment of separate pools for Muck and Yuck, the taxpayer will be forced to liquidate low-base Muck inventory and replace it with a higher base for Yuck. The results of treating Muck and Yuck as separate pools is shown below:

Beginning inventory                        $100
  (100 barrels of Muck at $1
Purchases (50 barrels of Muck at $5,
  plus 50 barrels of Yuck at $4              450      550
Less: Ending inventory (50 barrels of
  Muck at $1 plus 50 barrels of Yuck at $4           250
Cost of Goods Sold                                 $300

Once items have been grouped into pools, each pool is evaluated to determine changes in quantity of that pool only. In the example, overall quantity has not changed: there are 100 barrels of material in both beginning and ending inventories. If Yuck is a separate pool, however, the first barrels of Yuck that are bought will be used to establish a LIFO pool for Yuck that necessitates liquidating part of the low-cost Muck pool.

The Inventory Pooling Issue

The example demonstrates that the establishment of multiple pools may be at odds with the LIFO objective of matching current costs with current revenues. Accordingly, the dollar-value regulations that were promulgated in 1961 allowed pooling on the basis of "natural business units." The purpose of the natural business unit concept is to ensure that no gain or loss results from shifting inventory dollars from one item to another within a naturally related group of activities. Under Treas. Reg. [section] 1.472-8(b)(2), the determination of what constitutes a natural business unit is to be resolved on a case-by basis.

Under the regulations, the facts and circumstances are to be reviewed in light of some general considerations. Divisions formed for internal management purposes, separate and distinct production facilities and processes, and maintenance of separate profit and loss records are significant indicators of natural business units. In contrast, differences attributable solely to geographical location are not sufficient to identify separate natural business units. If only one natural business unit exists, raw materials, work-in-process, and finished goods may be combined. If more than one natural business unit exists, however, the Commissioner may require that separate pools be established for raw materials, work-in-process, and finished goods. Manufacturing units that also engage in wholesaling or retailing of purchased goods must use separate pools to account for their purchased goods.

In Amity Leather Products Co. v. Commissioner, (3) a business sold leather products, some that it manufactured and other identical goods which it purchased from a Puerto Rico subsidiary. The cost of producing the goods domestically was substantially different from producing them in Puerto Rico. The Tax Court required Amity to form separate pools for manufactured and purchased inventory even though the parent exercised considerable control over the subsidiary and the goods were similar in quality. The court observed that the subsidiary was a separate entity that kept separate books, filed separate tax returns, and produced a product with substantially different costs.

Will a manufacturer that makes a single, isolated bulk purchased of inventory for resale be required to segregate such goods into a separate pool? In UFE, Inc. v. Commissioner, (4) the Tax Court rebuffed the IRS's attempt to separate inventory that was part of an acquisition of a manufacturing business from the subsequent identical products produced. In other words, UFE, a manufacturer, was not deemed to also become a wholesaler or retailer on the basis of a single isolated initial purchase but was allowed to use one pool for the acquired and subsequently manufactured inventory. This enabled the initially purchased inventory to be "frozen" into a low-cost LIFO base because the acquisition was accomplished at a bargain price.

Recently, the Tax Court reconsidered the issue in Hamilton Industries. On very similar facts, the court technically reached the same on the pooling issue. Nevertheless, it required Hamilton to treat its bargain purchase as a separate "item" which resulted in matching the costs of the bargain purchase against current sales. This decision had the effect of requiring a LIFO company to use FIFO with regard to an initial bargain purchase of inventory. How did the Tax Court reach such a result?

Hamilton Industries

In March 1975 Mayline, Inc., the assests of its parent company, Old Mayline. Both companies manufactured identical drafting equipment and related furniture and accessories. Using FIFO, Old Mayline valued the inventory on the aquisition date at approximately $2 million. Mayline, however, allocated only $79,000 of the total purchase price to inventory. Since this transaction involved neither a subsidiary liquidation nor a corporate reorganization, Mayline was not obligated to use the same inventory valuation method. The use of FIFO would have triggered recognition of most of the inventory profit created by this bargain purchase.

Mayline elected on its initial return to use dollar-value LIFO with all inventory placed into a single pool as a single natural business unit. This election effectively froze inventory profits by treating the purchase price it had allocated to Old Mayline's inventory as the base-year cost for inventoriable items it purchased and manufactured. The frozen profit would remain in that condition until such time as that initial inventory layer was liquidated.

Mayline's wholly owned subsidiary, Hamilton Industries, Inc., followed similar steps when it accquired the LIFO valued inventory of an American Hospital Supply division in May 1982. In that instance, inventory with a FIFO value of $17 million was carried over at its LIFO value of $7 million. As with the Old Mayline asset acquisition, Hamilton acquired inventory that was co-mingled with subsequently produced inventory. Hamilton also elected to use dollar-value LIFO with a single natural business unit pool.

The Tax Court focused on the following issues: (5)

1. Whether section 481 is applicable, permitting the Commissioner to include in income amounts attributable to taxable years barred by the statute of limitations.

2. Whether taxpayer's method of accounting clearly reflects income, which requires a determination whether taxpayer's bargain purchase of inventory constitutes a separate pool, a separate item within a pool, or both.

Applicability of Section 481

Section 481 allows the Commissioner to open tax years barred by the statute of limitations where omissions or duplication of income occurs solely by reason of an accounting method change. For this section to apply in Hamilton Industries, the court needed to conclude that requiring a bargain purchase of inventory to be treated as a separate pool or as a separate item constituted a change in accounting method.

Treas. Reg. [section] 1.481-1(a)(1) states that section 481 applies to changes in the overall method of accounting for gross income or deductions or to change in the treatment of a material item. According to Treas. Reg. [section] 1.446-1(e)(2)(ii)(a), a material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. Therefore, if Mayline relied on a method of accounting for the acquired inventory that resulted in income postponement, the Commissioner had grounds for invoking section 481. In the case of Mayline, application of section 481 would permit the IRS to include in taxable income for 1981 -- the first open year -- an adjustment that would have otherwise fallen into 1976.

Whether Mayline's method of valuing altered the timing of income recognition was conditioned upon a finding that the bargain purchase of inventory constituted a separate pool or a separate item within a single pool Combining the bargain inventory with subsequently manufactured products resulted in a lower value than would have occurred if separate pools were formed or if the bargain inventory were treated as a separate item within the pool. Therefore, since separate pool or item treatment affects the timing of income recognition, the court determined that a change in method of accounting occurred.

Application of Sections 446 and 471

Since the manner in which Mayline accounted for inventory represented an accounting method, the Court turned to whether Mayline's choice clearly reflected income. Whether a particular method of accounting clearly reflects income is a question of fact and the issue must be decided on a case-by-case basis. (6) Section empowers the Commissioner to select a proper method of accounting, and section 471 requires taxpayers to account for inventories whenever necessary to clearly reflect in income.

Under the dollar-value LIFO method, the proper grouping of goods into and items is central to an accurate measure of ending inventory. It is, therefore, essential that only goods with like characteristics be grouped. This produces a more accurate measure of the effect of inflation. Inventory groups that are homogeneous more effectively screen out cost increases attbributable to factors other than inflation.

The "Item" Issue

In the simple Muck and Yuck example, separate pools caused acquisition items to get closed out in the year following acquisition. If Muck is established as a separate pool, it is simply not replaced when we begin buying Yuck. If Muck were purchased at a bargain, those bargain costs would be matched against current sales. The same results occur if Muck and Yuck are treated as separate items whithin a single pool. In the double extension procedure used in Hamilton Industries, each item is extended to create a separate price index. If the item is not in the ending inventory, it drops out of the calculation. Any bargain purchase element reflected in the beginning inventory will be increased to current cost. The resulting increase in inventory increases taxable income. Thus, whether bargain inventory is treated as a separate pool or a separate item, the bargain element is soon reported in income. The "item" issue was not addressed in UFE, but the government raised the issue in Hamilton Industries and found the Tax Court to be responsive.

Neither the Code nor the regulations define the term "item." The Tax Court, however, has previously reasoned that the term should be flexible enough to include minor technical and stylistic changes made in a product over time. (7) The term should also not be so narrow that it causes use of dollar-value LIFO to become administratively impracticable. In Amity Leather Co., the Tax Court established that the term should be characterized "in a manner that most clearly satisfies the purpose of maintaining inventories, i.e., the clear reflection of income."

Within the boundaries of administrative practicability and clear reflection of income, taxpayers must find the meaning of "item" for purposes of indexing ending inventory. Items should be substantially distinguishable on either physical characteristics or cost. Differences attributable to either feature can result in failure to clearly reflect income when dollar-value LIFO is employed. In the case of Hamilton Industries, the FIFO value of inventory acquired was judged by the Tax Court to be more representative of the cost or value than the amount of purchase price allocated to it under purchase and sale agreements.

The Tax Court has definitely broadened the concept of "item" in Hamilton Industries. It is one thing to hold that similar products produced in different countries under different cost structures should be distinguished (as in Amity); it is quite another thing to hold that identical goods produced by the same company before and after an ownership change are different "items." Should a bargain purchase constitute a separate item? It depends on how you view the purpose of LIFO.

The avowed purpose of LIFO has always been to eliminate inventory profits in a period of rising prices. In Hamilton Industries, a price rise did occur but over a very compressed time period. The cost of production in the year following the ownership change substantially exceeded the costs assigned to the original inventory. If the purpose of LIFO is to match the most recent costs against revenues, the bargain purchase should be frozen. But the IRS's and the Tax Court's real complaint with this approach is that the difference in costs did not result from inflation but rather to the "artificially low value" assigned to the base-year inventory.

If the problem is the artificially low value assigned to inventory, then the allocation of the purchase price could have been questioned. That option was not avialable to the IRS, however, because the acquisition was affected in a closed year. Consequently, the IRS chose to raise the accounting method issue in order to capture the total inventory "under-evaluation" with section 481. In effect, the low inventory value is allowed but is costed out on a FIFO basis through separate item treatment. How much does inventory have to be understated before it will be considered a separate item? The Tax Court stopped short of saying that every bargain purchase will be treated as a separate item. Rather, each case should be considered separately under the "clear reflection" standard. (8)

Implications for Past Transactions

Where businesses have layers of LIFO inventory acquired at prices substantially below market value, significant exposure to IRS attack exists. Even though inventory was purchased as long ago as 1954, Hamilton Industries supports IRS authority to make appropriate adjustments to income. Absent a reversal of Hamilton Industries (or an expession of self-restraint by the IRS), there is no way to reduce this exposure.

Implications for Future Transactions

Business taxpayers should be aware that Hamilton Industries may affect future inventory acquisitions. Inventory acquired through normal purchasing channels will not normally be affected. When inventory is acquired in bulk as part of merger, acquisition, and liquidation activity, however, inventory could be acquired at prices below market value. The following sections discuss such possibilities.

Inventory Acquisitions in Sections 351 and 721 Transactions. Under section 351 and section 721, taxpayers who transfer property to a corporation or partnership do not recognize gain or loss on the transfer. Tax-free treatment to shareholders is conditioned upon receiving only stock in exchange for property. Tax-free treatment for partners is contingent upon receiving only a partnership interest. The basis of the property in the hands of the transferee entity is the same as the contributor's basis.

If the transferor utilized LIFO, the transferee company (under the rationale of section 351 and section 721) arguably should be able to step into the shoes of the transferor and maintain the low value LIFO base. Indeed, this is the conclusion of the Second Circuit in Seagram where the transferee was an existing company that had used the LIFO method for many years. (9) But where the transferor used another method or the newly formed transferee adopts LIFO at the time of the transfer, the rationale in Seagram may not hold. In any case, if the new corporation wants to try to freeze a bulk purchase of inventory at a bargain price, the purchase should be timed to occur just prior to the end of its taxable year. Otherwise, the IRS will take the position that the initial purchase is not a beginning inventory but a current year's purchase.

Therefore, unless the tax-free exchange involves a LIFO-to-LIFO situation, the bargain inventory is subject to treatment as a separate item under Hamilton Industries. This will generally require reporting the bargain element as income during the first year. Thus, any inventory acquired since 1954 in a section 351 transaction may be subject to the outcome in Hamilton Industries when the IRS appears for the next audit.

Inventory Acquisitions in Section 332 Liquidations. When a parent corporation liquidates a subsidiary in which it owns an interest of at least 80 percent, section 332 prohibits the recognition of gai or loss on the receipt of property by the parent. When section 332 applies, the parent retains a carryover basis in the assets acquired. If the assets include inventory recorded at bargain prices by the former subsidiary and the parent uses dollar-value LIFO, the new inventory may consitute a separate item under the Hamilton Industries rationale. As that inventory is consumed, the bargain element of the inventory would be recognized as income.

Inventory Acquisitions in Section 338 Liquidations. Section 338 applies to certain stock purchases that are treated as asset acquisitions. When section 338 applies, any newly acquired inventory will take on a value as indicated by the portion of the "adjusted grossed-up basis" allocated to inventory. The rules of section 338 require that the adjusted grossed-up basis be allocated among four classes of assets at fair market value rates. Inventory, a Class III asset, could receive an allocation substantially below the market value of similar inventory owned or subsequently acquired by the acquiring corporation. This newly acquired inventory will not cause the corporation to be treated as a wholesaler/retailer for purposes of inventory pooling, (10) but the inventory itself may be treated as a separate item under Hamilton Industries. As that item is liquidated, the bargain element will be recognized as income.

Purchase of a Subsidiary. When a business acquires a subsidiary, inventory may be involved. The acquiring corporation should be concerned about how the newly acquired subsidiary's inventory may affect accounting for the parent's inventory. Generally, if the subsidiary tracks its own income and is required to file its own tax return, the subsidiary's inventory will not become part of the natural business unit of the parent. This is so despite the presence of significant parental contorl over the activities of the subsidiary. (11)

If the parent regularly acquires inventory from the subsidiary that it then wholesales or retails, that inventory must be separately indexed under dollar-value LIFO according to Treas. Reg. [section] 1.472-8(b)(2). Any inherent cost savings therefore will flow into income as that inventory is liquidated.

If the parent uses the subsidiary's inventory as an input into the production process, the acquisition is either controlled by the natural business unit concept or the item concept, depending upon the presence of a substantially different cost of existing versus newly acquired inventory. If there are no substantially different cost features, the subsidiary's inventory can be co-mingled with existing inventory without distorting income. If material has substantially different cost characteristics, however, the item must be separately treated to prevent deferral of recognition of the bargain element of the purchased inventory.

Corporate Reorganizations. Section 361(a) provides that no gain or loss is to be recognized to a corporation if such corporation is party to a reorganization and exchanges property (according to a plan of reorganization) and receives solely stock or securities in the exchange. Section 381(a) further provides when section 361 is applicable to a Type A, C, D, F, or G reorganization as described in section 368, section 381(c)(5) controls treatment of acquired inventories. Section 381(c)(5) provides that the acquiring corporation take a carryover basis in the inventory received if the same inventory method is used. If a different method is used, the acquiring corporation is to use the method as prescribed in Treas. Reg. [section] 1.381(c)(5)-1. Consequently, taxpayers should recognize that if a corporate reorganization results in the preservation of the bargain element in inventory and dollar-value LIFO is used by the acquiring corporation, the kind of situation found in Hamilton Industries may be present.

Planning

The decision in Hamilton Industries is a threat to any business that retains bargain element inventory. An IRS audit could trigger immediate tax consequences. In addition, businesses that anticipate acquisition of inventory containing a bargain element should be wary of the potential tax cost of acquiring inventory at bargain prices.

Although the Hamilton Industries decision has potentially disastrous consequences for many companies, there is a reasonable possibility it could be overturned. In the first place, there is a statutory right to use LIFO. The IRS position, in effect, forces a taxpayer with bargain inventory to use FIFO or specific identification. Only a few years ago, the government used the clear reflection argument to try to deny the use of LIFO to long-term contractors but was rebuffed by the courts. (12) Secondly, the function of LIFO is to match current costs against revenue. Just because the price change occurred quickly for the taxpaer in Hamilton Industries, it does not follow that a taxpayer should be precluded from using LIFO to keep the price rise from appearing in taxable income when replacement is necessary. If replacement of a portion of the bargain inventory is not necessary, then the inventory profit in the liquidated portion should be reported.

The other primary reason Hamilton Industries could be overturned is that it does not square with UFE. Although the government did not raise the "item" issue in UFE, this technical issue should not be permitted to obscure the real issue -- the tension between the matching philosophy of LIFO and the clear reflection standard. The Tax Court's digression into the distinction between a pool and an item does not promote clarity. Income was clearly reflected in both UFE and Hamilton Industries or in neither.

The Tax Court in Hamilton Industries, in a footnote, suggested that not all bargain purchases will create new items in a LIFO pool. The issue is to be decided on a case-by-case basis. Apparently the Tax Court felt that income was not clearly reflected in Hamilton Industries because of both price and quantity considerations. Not only was the inventory carried at an "artificially low price" but the entire bargain purchase was equal to the minimal quantity required to operate the business. The uncertainty leaves some room for planning. There is nothing in the opinion indicating that inventory cannot be valued at a bargain price so long as the price is not artificially low. In other words, if an existing business is acquired at a bargain, a reasonable portion of that bargain should be reflected in inventory. Furthermore, such an argument may be strengthened if the quantity of the bulk purchase of inventory is somewhat less than the minimum quantity required to operate the business.

In conclusion, a taxpayer wishing to preserve an inventory bargain element by electing LIFO may find some of the following suggestions helpful in light of the Hamilton Industries decision.

1. If the transaction could be structured so that only inventory is acquired, the court's objection to an artificial price should be moot since no "artificial" allocation could be present.

2. If other assets are acquired along with the inventory, an attempt should be made to allocate the bargain element over all the assets in an even-handed manner. The extremely low value for inventory in Hamilton Industries virtually begged the Tax Court to see a violation of the clear reflection of income standard.

3. The acquiring company should, if possible, adopt a tax year that ends shortly after the date of acquisition. Otherwise, the IRS will take the position that a bulk purchase should be treated as a current year's purchase and not as beginning inventory.

4. If, contrary to 3 above, the bulk purchase occurs at the beginning of a year, the taxpayer should preserve the low basis of the bargain purchase by electing to value increments on the basis of earliest costs incurred.

5. If the acquired company uses LIFO, the bargain element could be preserved by making an acquisition' that would fall within the ambit of section 381. In Hamilton Industries the LIFO value of the 1982 acquisition presumably could have been preserved with a tax-free reorganization because the acquired company used LIFO.

6. Specific-goods LIFO could be used rather than dollar-value LIFO. This should avoid the "item" question which arises under the dollar-value approach. Interestingly, the IRS should not be able to drop back and argue that bargain purchases constitute a separate "pool" because both UFE and Hamilton Industries cases establish the clear precedent to the contrary.

Afterword

The IRS gave quick response to Hamilton Industries. In Announcement 91-173, (13) the IRS stated that taxpayers who use the LIFO method of accounting may voluntarily change their method if the cost of inventory items acquired in a bulk purchase are combined with similar items that are subsequently acquired or purchased. Form 3115, Application for Change in Accounting Methods, must be filed. Moreover, if the application is filed on or after November 7, 1991, a section 481(a) adjustment is required.

Rev. Proc. 92-20, (14) which was issued on March 2, 1992, provides detailed instructions for filing Form 3115. This procedure, in part, is "designed to encourage prompt compliance with proper tax accounting principles, and to discourage taxpayers for delaying the filing of form 3115." The procedure generally provides a graduated set of favorable terms and conditions based upon how quickly a request for change is filed. Generally, up to a six-year spread of the section 481(a) adjustment will be allowed if the requirements are not met.

Announcement 91-173 identifies Hamilton Industries-type LIFO inventory changes as Category B methods. Rev. Proc. 92-20 describes different section 481(a) adjustment periods for Category B methods, depending upon whether a change is requested before, during, or after a 90-day window period beginning after contanct for examination. Thus, tax-payers should promptly evaluate the effect of Hamilton Industries and then determine the most advantageous time for requesting a change in accounting method.

-- Notes --

(1) 97 T.C. No. 9 (1991).

(2) 8 T.C. 14 (1947).

(3) 82 T.C. 726 (1984).

(4) 92 T.C. 1314 (1989).

(5) The court also considered the issue of the company's method of accounting for long-term contracts.

(6) Peninsula Steel Products & Equipment Co. v. Commissioner, 78 T.C. 1029, 1045 (1982).

(7) Wendle Ford Sales, Inc. v. Commissioner, 72 T.C. 447 (1979).

(8) See note 6 of the decision in Hamilton Industries.

(9) Commissioner v. Joseph E. Seagram & Sons, Inc., 394 F.2d 738 (2d Cir. 1968), rev'g 46 T.C. 698 (1966); and Rev. Rul. 70-565, 1970-2 C.B. 110.

(10) UFE, Inc. v. Commissioner, 92 T.C. 1314 (1989).

(11) Amith Leather Products Co. v. Commissioner, 82 T.C. 776 (1984).

(12) See, e.g., Spang Industries v. United States, 791 F.2d 906 (Fed. Cir. 1986) (reversing 1984 Claims Court decision)

(13) 1991-47 I.R.B. 29 (November 25, 1991).

(14) 1992-12 I.R.B. (March 23, 1992).

MARK A TURNER is an Associate professor of Accounting at Stephen F. Austin State University in Nacogdoches, Texas. He is a certified public accountant, a certified management accountanta, and holds a doctorate in business administration. His primary teaching and research interests lie in the tax field and he has previously published articles in a wide variety of tax and accounting journals, including Journal of Accountancy, Taxation for Accountants, and Taxes -- The Tax Magazine.

LARRY MAPLES is a Professor of Accounting at Tennessee Technological University in Cookeville, Tennesses. He is a certified public accountant and holds a doctorate in business administration. He has contributed frequently to The Tax Executive and other tax journals.