Method change from LIFO inventory method under Rev. Proc. 97-37.

Once the LIFO inventory method is adopted, IRS approval is needed to change to another inventory method. The rules governing how a taxpayer makes an automatic accounting method change from the LIFO inventory method were modified in 1997 by the issuance of a mass automatic method change procedure in Rev. Proc. 97-37 (the new procedure). Taxpayers who did not request a LIFO method change on or before Dec. 31, 1997 can no longer use Rev. Proc. 88-15 (the old procedure) to make an automatic method change from the LIFO method. In many respects, Rev. Proc. 97-37 simplifies or modifies the requirements for this automatic method change, as well as some of the terms and conditions. Now that the transitional rules of Rev. Proc. 97-37 are no longer applicable, it is a good time to review this automatic method change to ensure that taxpayers understand the rules that win apply if they qualify for (and decide to file) an automatic method change to discontinue the use of the LIFO inventory method.

Who Can Use the New Procedure?

As with Rev. Proc. 88-15, the new procedure only applies to taxpayers that want to change from the LIFO inventory method for tax purposes for all of their inventory currently accounted for under the LIFO method. If a taxpayer desires to change from the LIFO method for only a portion of its inventory currently accounted for under the LIFO method, it win need to request prior approval for the method change under Rev. Proc. 97-27.

In addition, restrictions apply if the taxpayer is under examination, before an Appeals office or before a Federal court. For example, taxpayers under examination may still file under Rev. Proc. 97-37 if they are within various window periods or if they obtain the consent of the district director. Taxpayers before an Appeals office or a Federal court may still be able to file under Rev. Proc. 97-37 if they certify that the same accounting method is not an issue under consideration by Appeals or the Federal court.

Further, if the applicant is treated as a partnership or an S corporation for Federal income tax purposes, it may not use the new procedure if, on the date a copy of the application is filed with the IRS, the LIFO method is under consideration in an examination of a partner, member or shareholder's Federal income tax return or is an issue under consideration by an Appeals office or by a Federal court with respect to a partner's, member's, or shareholder's Federal income tax return.

In the past, taxpayers may have been precluded from making an automatic change; the old procedure contained a restriction that an automatic change could not be made if the company had requested to change or had changed from the LIFO inventory method within the past six tax years. The new procedure reduces this restriction to four tax years. A taxpayer is treated as applying for a change if an application was withdrawn, not perfected, not granted or denied.

A taxpayer cannot use the automatic procedure if it engages in, or expects to engage in, a transaction to which Sec. 381 (a) applies within the proposed year of change.

Another change in Rev. Proc. 97-37 from the old procedure relates to LIFO terminating events. The new procedure does not have any restrictions on its use due to LIFO terminating events. However, Rev. Proc. 88-15 could not be used if a taxpayer had a terminating event at the time it filed under the procedure in any year not barred by the statute of limitations. A terminating event includes: (1) the taxpayer did not properly adopt (or extend) the LIFO method, (2) the taxpayer issued non-LIFO primary income statements to its creditors or shareholders or (3) the taxpayer wrote down its tax LIFO inventory below cost. For purposes of Rev. Proc. 88-15, the issuance of Non-LIFO statements was ignored if they were the first non-LIFO statements ever issued and were issued in the year of change.

Comply with Rev. Proc. 97-37

A taxpayer using Rev. Proc. 97-37 must comply with the following terms and conditions.

Adjustment period. Under the old procedure, the spread period for the net Sec. 481(a) adjustment depended on whether the adjustment was positive or negative, how many tax years the LIFO method had been used, and what the adjustment would have been if the method change had been made in the first preceding year or over the three preceding years. The rules with respect to the spread period have been simplified. Under the new procedure, there is typically a four-tax-year spread period for both positive adjustments (i.e., adjustments that increase income) and negative adjustments (i.e., adjustments that decrease income). However, cooperatives must include the entire adjustment in income in the year of change.

Accelerate the spread period. Similar to the old procedure, Rev. Proc. 97-37 allows the normal spread period rules to be ignored if the adjustment (positive or negative) is less than $25,000 and the taxpayer elects to take the adjustment into income entirely in the year of change.

The old procedure contained a condition that provided that if, on the last day of any year of the adjustment period, the inventory value to which the adjustment related was reduced by more than 33 1/3% of the inventory value at the beginning of the year of change and was so reduced by at least such percentage at the end of the following tax year, the balance of the adjustment was taken into account in the year succeeding the year of the reduction. Rev. Proc. 97-37 does not contain this inventory reduction condition.

Under Rev. Proc. 97-37, certain subsequent events may shorten the initial four tax-year spread period:

* A taxpayer that ceases to engage in a trade or business or that terminates its existence must take the balance of the adjustment related to the trade or business into account in computing income in the tax year of the cessation or termination.

* If a C corporation elects to be treated as an S corporation after the year of change, the balance of any positive adjustment must be included in the last C return. If the positive adjustment increases the C corporation's tax, the increase is payable in four equal installments, starting with the last C tax year. If a corporation elects to be treated as an S corporation in the year of change, the IRS feels that the Sec. 1363 rules operate to recapture the LIFO reserve before the Sec. 481 (a) adjustment is computed.

Limitation on the use of NOLs. Rev. Proc. 88-15 provided that no part of any net operating loss (NOL) carryover or other carryover available at the beginning of the year of change could be used as an offset against the portion of the positive net Sec. 481 (a) adjustment taken into account in the year of change. The new procedure does not contain this restriction.

Change to permitted method. The taxpayer must change to a "permitted method" under Rev. Proc. 97-37. A permitted method is a method under which:

* The identification method is either the FIFO inventory method or the specific identification inventory method.

* The valuation method is cost; cost or market, whichever is lower; market (but only if the taxpayer is a dealer in securities, as defined in Regs. Sec. 1.471-5); the "farm price method" or the "unit-livestock-price method" (but only if the taxpayer is a farmer permitted to use such methods); or the retail method, reduced to either approximates cost or approximate cost or market. whichever is lower (but only if the taxpayer is a retail merchant).

Note: The average cost method is not a permitted method.

The new procedure also provides a set of rules that a taxpayer must use to determine which permitted method it must use:

* If the taxpayer has both LIFO and non-LIFO inventory, the taxpayer must change to the method used for the non-LIFO inventory, provided that the non-LIFO inventory is accounted for using a permitted method.

* If the taxpayer uses the LIFO method for an of its inventory, the taxpayer must change to the method used prior to the adoption of the LIFO method, provided that the prior method is a permitted method.

* If the taxpayer adopted the LIFO method in its first year and uses the LIFO method for an of its inventory, the taxpayer may change to any permitted method.

Financial and credit report conformity. Rev. Proc. 88-15 also provided that the NON-LIFO method that was used for tax purposes also had to be used in all reports to shareholders, partners or other proprietors, or beneficiaries, including financial statements and statements for credit purposes. That conformity requirement did not apply to Sec. 263A costs not required to be inventoried for financial statement purposes, or market write-downs allowed for book, but not, purposes. The financial statement and credit report conformity condition of Rev. Proc. 88-15 is not contained in Rev. Proc. 97-37. Therefore, taxpayers that change from the LIFO inventory method for tax purposes under the new procedure can continue to use the LIFO method in their financial statements.

Limitation on the readoption of LIFO. The taxpayer may not reelect the LIFO inventory method for at least five tax years, beginning with the year of change. The taxpayer may be able to shorten this period of limitation if it can show unusual and compelling circumstances to the Service, and thereby receive permission to change the method of accounting earlier.

Procedural Requirements

A taxpayer must comply with the following procedural requirements of Rev. Proc. 97-37.

Due date. An automatic method change under the new procedure is made by filing two copies of Form 3115, Application for Change in Accounting Method. While there is still no user fee associated with making an automatic method change from the LIFO inventory method, the due dates have changed. One copy must be filed with the IRS National Office during a period of time that starts on the first day of the year of change and ends on the day a timely filed return for the year of change is filed. In addition, the original application must be attached to a timely filed return for the year of change. The new due dates provide taxpayers with considerably more time to decide whether they want to make the change from the LIFO method. For example, a calendar-year taxpayer considering a change from the LIFO method for tax purposes in 1998 will typically have from Jan. 1, 1998 through Sept. 15, 1999 (including extensions) to make a decision. Previously, the taxpayer would have had to make a decision and apply by the 270th day of the year of change.

Even though the taxpayer has a considerable amount of time to make this decision on a possible accounting method change, there may be instances in which the taxpayer should file the copy of the application with the IRS National Office as soon as possible for the year of change. For example, it may be advisable for the taxpayer to obtain audit protection for the tax years prior to the year of change (see Rev. Proc, 97-37 for the specific rules relating to audit protection). In addition, the taxpayer may want assurance that it will not be precluded from making the intended automatic change for any reason, such as being contacted for examination by the IRS before it files the application.

Required statements on the application. A taxpayer is required to indicate certain information and attach various statements to its application to auto-dramatically continue the LIFO method. First, the taxpayer must indicate on the application that the automatic method change to discontinue the LIFO inventory method is being made under Section 10.01 of the Appendix of Rev. Proc. 97-37. Second, the taxpayer must indicate that it agrees to all of the terms and conditions of Rev. Proc. 97-37. Third, the taxpayer must indicate the period over which the net Sec. 481(a) adjustment will be taken into account ratably, and why the spread period is appropriate. Fourth, the taxpayer must make various representations regarding the permitted method. There are additional requirements if the taxpayer is filing while it is under examination, before Appeals or before a Federal court. Michelle R. Koroghlanian, CPA, and Richard W. Garrett, CPA, Washington, D.C.