La Crosse Footwear Further Limits Benefit of Bargain Inventory Purchases.

The Federal Circuit has reversed the Court of Federal Claims in interpreting the proper accounting method for the bargain purchase of inventory using LIFO (La Crosse Footwear, Inc., 191 F3d 1372 (1999), rev'g Ct. Fed. Cl. (1998)). The Court of Federal Claims had held that the base-year cost of inventory acquired in a bargain purchase was its fair market value (FMV), thereby allowing a stepped-up basis without a corresponding reduction in the basis of other assets acquired in a bulk purchase. The decision of the lower court did not make sense, in that the total basis allocated in the bulk purchase of assets exceeded the purchase price of those assets, thus avoiding the recognition of taxable income that would have related to the bargain-purchased inventory on its eventual sale.

Although the Federal Circuit followed the Court of Federal Claims in holding that the bargain-purchased inventory must be accounted for separately from subsequently purchased similar goods, it reversed the lower court on the question of basis by deciding that the base-year cost of the bargain-purchased goods was the acquisition cost, not the FMV. The Federal Circuit reasoned that the regulations require that reconstructed cost be established to the IRS's satisfaction, and that the LIFO method cannot be used to postpone the realization of gains associated with the bargain purchase of inventory, pursuant to Kohler Co., 124 F3d 1451 (Fed. Cir. 1997).

This decision was not unexpected. Unfortunately, it eliminates the only judicial support for using the LIFO method to defer gain associated with the bargain purchase of inventory. The lower court's decision had provided substantial authority in cases when the application of Hamilton Industries, 97 TC 120 (1991), and Kohler may have required the recognition of taxable income or proper disclosure to avoid penalties.

Where does this decision leave a taxpayer that acquires inventory in a bargain purchase? Both Hamilton and Kohler, and now La Crosse, require that the discount associated with the bargain purchase of inventory not be deferred by use of the LIFO method. However, these cases do not apply to all discounts. Both the Hamilton and Kohler courts specifically stated that the decision does not apply in all cases. In Hamilton, the bargain element was substantial (over 90%), while in Kohler, the bargain element was approximately 50%. Thus, if necessary, the IRS will attack and litigate discounts in excess of 50%, with the outcome probably unfavorable to the taxpayer. The Service will probably challenge discounts less than 50%, unless strong factors indicate a reason to distinguish the situation from the decided cases. For example, if a taxpayer regularly acquires inventory in bulk at a discount, a case could possibly be made for distinguishing the situation. However, the closer the discount approaches 50%, the tougher it will be to distinguish the situation from the decided cases.

La Crosse affects all LIFO taxpayers that have made bargain purchases in prior years, regardless of whether the year is open or closed under the statute of limitations, or whether the issue has been previously raised on examination. Based on the Hamilton and Kohler decisions, the IRS can now attack the accounting for such transactions as an accounting method change and make an adjustment in an open year.

FROM FRANK DEVLIN, CPA, J.D., WASHINGTON, DC, ROBERT ROSSELLI, CPA, NEW YORK, NY, AND JuDI BRUCE, CPA, WASHINGTON, DC