Prohibition against use of replacement cost by LIFO taxpayers clarified.

In Mountain State Ford Truck Sales, Inc., 112 TC No. 7 (1999), the Tax Court held that the taxpayer was not allowed to use replacement cost in valuing its LIFO inventory, because it (1) violated elections made by the taxpayer on Form 970, Application to use LIFO Inventory Method, and (2) is an improper method of valuing current-year inventory for dollar-value LIFO taxpayers. This decision affects all LIFO taxpayers to the extent they use (or are considering the use of) replacement cost, as the options for determining current-year inventory value are the same under both the specific goods and dollar-value LIFO methods. Further, this decision provides the first unambiguous rejection of the use of the replacement cost valuation method by a LIFO taxpayer. Prior to this decision, the courts had not addressed the issue; the only authority was provided by a series of conflicting letter rulings.

Background

Sec. 472(b) (2) requires taxpayers using the LIFO method to "inventory [goods] at cost." Regs. Sec. 1.4728 (e) (2) (ii) allows dollar-value LIFO taxpayers to select one of four optional methods for determining the costs to be assigned to any current-year inventory increment:

1. Most recent purchases or production;

2. Earliest purchases or production during the tax year in order of acquisition;

3. Average of all goods purchased or produced during the tax year; or

4. Any other proper method that, in the IRS's opinion, clearly reflects income.

While these options are specifically provided to dollar-value LIFO taxpayers using the double-extension method, they are generally held also to be available to dollar-value taxpayers using the link-chain method. Virtually identical provisions are found in Regs. Sec. 1.472-2(d)(1)(i), addressing the determination of current-year inventory value by a specific-goods LIFO taxpayer.

In Letter Ruling 750313035013, the taxpayer requested permission to use the current replacement cost in computing its parts and accessories LIFO inventory, in lieu of actual invoice price. The Service allowed the use of current replacement cost, finding that it was an "other proper method" within the meaning of Regs. Sec. 1.4728(e) (2)(ii)(d). Subsequently, the IRS issued several rulings addressing the use of current replacement cost, but declined in each of them to specifically state that such use constituted an improper LIFO method.

In Letter Ruling (TAM) 8906001, the Service limited itself to determining that use of current replacement cost was not grounds for terminating the taxpayer's LIFO election, while noting that use of current replacement cost "may not in some instances represent `actual cost' incurred during the year." In Letter Ruling (TAM) 9433004, the IRS held that the taxpayer could not use replacement cost to value its current-year increment, because it had specifically elected to value such increment based on the most recent purchases. The Service went on to indicate that any valuation method qualifying as an "other proper method" under Regs. Sec. 1.4728(e)(2)(ii)(d) would have to "satisfy the requirement under Sec. 472(b)(2) of the Code that LIFO inventories be stated at cost," and that replacement cost may be more analogous to the market value used in the lower of cost or market inventory method.

Mountain State: The Courts Finally Speak

Mountain State filed Form 970 with its 1980 income tax return. On the Form 970, Mountain State adopted the LIFO inventory method for its parts inventory and its new heavy trucks inventory. Specifically, with respect to its parts inventory, Mountain State disclosed its intent to (1) value its inventory "at actual cost regardless of market value" (2) use the dollar-value LIFO method for its parts inventory, (3) use the link-chain method of calculating the price index for its parts inventory (which it was pooling in one LIFO pool) and (4) use the "most recent purchases method" of valuing its LIFO increments. In actuality, Mountain State used replacement cost to value its LIFO increments,just as it had previously used replacement cost to value its ending inventory under its non-LIFO inventory method.

The Tax Court was faced with two questions: (1) does the use of a replacement cost valuation method by a LIFO taxpayer clearly reflect income and (2) if it does, could Mountain State use such method when it filed Form 970, adopting the most recent purchases inventory valuation method? The IRS argued that "cost" refers only to actual cost, while Mountain State argued that the term clearly encompasses "replacement cost." The Tax Court agreed with the Service, based on the definition of "cost" provided in Regs. Sec. 1.471-3, which defines the cost of purchased inventory as invoice price net of certain adjustments.

The Tax Court first considered the second issue--whether Mountain State's specific election on Form 970 to determine its ending parts inventory on the basis of most recent purchases dictated that it use only the actual cost of the most recent purchases, and whether Mountain State's failure to have requested or received permission to change to a different method precluded it from using any method other than the most recent purchases method of determining current-year cost for its parts pool. The Tax Court concluded that, regardless of the different meanings of "cost" Mountain State had selected a method that explicitly required the use of actual cost.

The Tax Court then considered Mountain State's argument that, notwithstanding its election to use the most recent purchases method on the Form 970, the method should not be disallowed, because Mountain State's actual method of determining cost was a proper "other reasonable method" as contemplated by the regulations. The Tax Court found no merit in Mountain State's contention that "cost" may refer to replacement cost as well as to actual cost; the court reasoned that "[i]f Congress had intended for the term `cost' in LIFO inventory tax accounting to have a meaning different from th[e] regulatory definition [of Regs. Sec. 1.471-3], it would have so stated."

In so holding, the Tax Court gave no credence to the argument that "any other reasonable method" can refer to something other than actual cost, even though the regulations fail to explicitly qualify the term "cost" with the adjective "actual." The Tax Court rejected Mountain State's contention that use of replacement cost constituted a proper "other" method under Regs. Sec. 1.472-8(e)(2)(ii)(d), finding no basis for a holding that such a method is not required to be based on actual cost.

The IRS's decision to litigate this issue is somewhat surprising, in light of its ruling history of not having definitely disallowed the use of the method, while expressing some degree of tolerance for the method. This being a case of first impression, however, the issue is still far from a final resolution.

FROM CAROL CONJURA, J.D., CPA, AND LYNN AFEMAN, CPA, WASHINGTON, DC