Inventory price index computation method for LIFO inventories.

The inventory price index computation (IPIC) method described in Regs. Sec. 1.4728(e)(3) is designed to simplify the computation of a taxpayer's LIFO inventories. Although adopted with smaller taxpayers in mind, the IPIC method is often a more favorable LIFO computation method for larger taxpayers Because the IPIC method is mechanical in nature and relies on published price indexes to compute inflation (versus a taxpayer's actual inflation experience), its use can result in inflation (and a potential tax benefit) when none might otherwise exist.

Use of the method can be advantageous in a number of situations. For example, the method might be considered when a taxpayer's costs are being reduced as a result of manufacturing efficiencies (e.g., from reengineering) or outsourcing (e.g., buying parts or materials from less expensive sources).

Under the IPIC method, a taxpayer's inventory items are assigned to categories in the producer (PPI) or consumer (CPI) price index. PPI tables must be used by manufacturers and wholesalers; CPI tables may be used by retailers. As with other LIFO methods, taxpayers must establish inventory pools. However, retailers and wholesalers may establish inventory pools for any group of inventory items included in one of the 11 general CPI categories. Also, manufacturers may use one or more natural business unit pools.

Except for eligible small businesses (as defined in Sec. 474(b)), Regs. Sec. 1.472-8(e)(3)(u) provides that in computing the annual LIFO index, taxpayers must use only 80% of the percentage change in the applicable selected price indexes; eligible small businesses may use 100%. As shown beIow, the use of the IPIC method may still be favorable, even with the 80% limit.

Example 1: T manufactures widgets. Due to reengineering and outsourcing, the cost to manufacture widgets has decreased from $100 per widget to $90 per widget. The categorization rules under the IPIC method result in nominal inflation being computed for the year; for this purpose, assume that the allowable inflation is 2% (i.e., 80% of the inflation rate computed). T has 15 widgets on hand at the end of the year; it had 10 on hand at the beginning of the year.

The first-year LIFO computation would be as follows:

                                         LIFO        FIFO

Year-end inventory
at FIFO (15 @ $90)                      $1,350      $1,350

Deflator index
(100% + 2% inflation)                   / 1.02

Inventory at
base-year cost
(rounded down)                           1,323

Inventory at beginning
of year (10 @ $100) (A)                  1,000

Increase in base-year
cost                                     1,000

LIFO layer
(323 x 1.02) (B)                           323

Year-end inventory
(A + B)                                    329

Difference                              $1,329       1,329

                                                    $   21

The year-end inventory is $21 less than if FIFO had been used.

A benefit can also result under the IPIC method when inventories are shrinking.

Example 2: The facts are the same as in
Example 1, except that only 5 widgets are
included in year-end inventory.

                                         LIFO          FIFO

Year-end inventory
(5 @ $90)                               $  450         $450

Deflator index                          / 1.02

Inventory at base-year cost                441

Inventory at beginning
of year (10 @ $100) (A)                  1,000

Decrease in base-year
cost (B)                                   559

Year-end inventory
(A - B)                                 $  441          441

Difference                                             $  9

The year-end inventory is $9 less than if FIFO had been used.

As these examples illustrate, a tax benefit occurs under the IPIC method because the deflator index is overstated relative to actual inflation, resulting in a beneficial conclusion with respect to quantity increases and decreases. Therefore, the use of the IPIC method can be beneficial when the published inventory price indexes overstate inflation vis-a-vis the actual costs of producing or purchasing inventory. More over, for taxpayers using the dollar value double extension LIFO method, the IPIC method generally simplifies the annual computation of the ending LIFO inventory value.

As with other accounting method changes, taxpayers wanting to change to the IPIC method from another LIFO method must secure IRS consent by filing Form 3115,Application for Change in Accounting Method. Initial LIFO elections adopting the IPIC method are made by filing Form 970, Application To Use LIFO Inventory Method, with the tax return for the year of the election.

FROM MARK A. HAJDUCH, CPA, OAK BROOK, ILL.