Related-party transfers of inventory; write-downs should precede transfers to minimize related-party loss limitations.

Write-Downs Should Precede Transfers to Minimize Related-Party Loss Limitations

Inventory sometimes does not sell easily. For example, it may be obsolete, discontinued, overpriced or mismarketed. Perhaps the competition is keen. Or maybe the business is simply feeling the effects of an overall downturn in the economy. Whatever the reason, management's task is to assure maximum sale opportunities for the inventory. This goal is often achieved by transferring inventory between related parties (a "controlled sale"). The transferee, identified by management as a more efficient sale outlet, then offers the inventory for resale to the general public (an "uncontrolled sale").

This article will identify and discuss the various tax issues arising from an intercompany related-party transfer of inventory, and explain how, depending on the way the transfer is structred, adverse tax consequences may result.

Inventory Method and Write-Down

* Inventory cost flow procedure Inventory must be properly accounted for, both for tax and accounting purposes. In determining the cost of inventory, taxpayers are required to identify which of the costs of beginning inventory and purchases should be included in the cost of goods sold and which should be included in the cost of ending inventory. This identification requirement necessitates adopting a procedure for assigning costs to ending inventory and to cost of goods sold.(1)

Generally, to account for inventory properly, a taxpayer's method must conform as nearly as may be to the best accounting practice in the trade or business, and clearly reflect income.(2) For tax purposes, two assumptions of cost flow are specifically approved in the regulations: FIFO and LIFO.(3) Additionally, authorization of the specific identification method is implied. However, a taxpayer is not necessarily restricted to these cost flow methods. As stated, any method that is determined to be the best accounting practice in the particular trade or business and that clearly reflects income is acceptable. For example, if this test is satisfied, a taxpayer may use average cost flow (rather than FIFO or LIFO) in accounting for its inventory for income tax purposes. Average costing is also an acceptable cost flow assumption for accounting purposes.(4)

* Bases of inventory valuation In addition to assigning costs to ending inventory and to costs of goods sold, taxpayers must properly value the costs so assigned. As a general rule, the bases of valuation most commonly used by business concerns and which meet the requirements of Sec. 471 are --cost; and --cost or market, whichever is lower.(5) However, if the LIFO cost flow procedure is used, inventory must be valued at cost.(6)

* Inventory write-down After adopting a cost flow procedure and determining the inventory's initial basis, the practitioner must determine whether the inventory's basis may be subsequently written down. Such a write-down serves as a tax-deductible item.

Cost or market general rule: When valuing items of inventory for tax purposes under the lower of cost or market value method, the determination of cost or market is made for each item of inventory on hand at the inventory valuation date.(7) For purchased inventory items, "cost" generally means the invoice price less trade or other discounts, plus transportation or other charges incurred in acquiring possession of the goods.(8) For produced inventory items, "cost" means the cost of raw materials and supplies entering into or consumed in connection with the product, expenditures for direct labor; and indirect production costs incident to and necessary for the production of the particular inventory item.(9)

Under ordinary circumstances and for normal goods in an inventory, "market" means the "current bid price prevailing at the date of the inventory...."(10) Further, the courts have uniformly interpreted "bid price" to mean "replacement cost," which, in turn, is the price the taxpayer would have to pay on the open market to purchase or reproduce the inventory items.(11)

Exceptions: Two exceptions to the general rule exist, and only then may taxpayers value inventory lower than the "market" (i.e., "replacement cost") price (assuming such "market" is lower than "cost"). First, if no open market exists, the taxpayer must use such evidence of a fair market price at the date or dates nearest the inventory as may be available, such as specific purchases or sales by the taxpayer or others in reasonable volume and made in good faith....(12) Accordingly, when, in the regular course of business, the taxpayer offers inventory for sale at prices lower than "market," the inventory may be valued at the offered price less direct costs of disposition. The correctness of the offered price is determined by reference to the actual sales occurring within a reasonable period before and after the inventory valuation date. However, prices materially varying from the actual sales prices are disregarded in making this determination.

The question of whether an open market exists has been construed quite strictly. For example, the Court of Claims has held that the phrase in the regulations "or where quotations are nominal, due to inactive market conditions"(13) does not refer to the volume of sales but to quoted prices for the merchandise.(14) Thus, as long as there is an established and existing price for the particular merchandise on the inventory date, market is ascertainable.

This valuation issue was examined by the Supreme Court in Thor Power Tool Co.(15) There, the Court disallowed the write-down because the taxpayer provided no objective evidence of the reduced value of its "excess" inventory. The Court held that when a taxpayer seeks to depart from "market," it must "substantiate its lower inventory valuation by providing evidence of actual offerings, actual sales, or actual contract cancellations."(16) The Court reasoned that hard evidence of actual sales and records of actual dispositions must be kept, since if the "taxpayer could write down its inventories on the basis of management's subjective estimates of the goods' ultimate salability, the taxpayer would be able ... |to determine how much tax it wanted to pay for a given year'."(17)

The second exception is the write-down of "subnormal goods." Subnormal goods are any goods in inventory that are unsalable at normal prices or unusable in the normal way because of damage, imperfections, shop wear, changes of style or other similar causes. Such goods are to be valued at their bona fide selling prices less direct cost of disposition.(18) Bona fide selling price means the actual offering of goods during a period ending not later than 30 days after the inventory valuation date. The taxpayer has the burden to prove such value through records of the disposition of the goods.

The requirements of the subnormal goods exception are not easily satisfied. For example, the excess inventory at issue in Thor Power did not come within the definition of subnormal goods, since the taxpayer was merely maintaining "liberal quantities of each part to avoid subsequent production runs."(19)

Method must clearly reflect income: Whether a taxpayer's write-downs of inventory are in compliance with these rules is a question of fact, depending in large part on the extent of its objective evidence regarding sales of such inventory to third parties. Further, the Code grants the Service much discretion in determining whether the taxpayer's accounting method clearly reflects income,(20) which serves as another limitation to an inventory write-down. Taxpayers should be aware of these limitations in writing down their inventory. Taxpayers may believe their inventory is obsolete and discontinued, or that they can provide third-party solicitations for similar items at similar prices. If substantiated, such evidence may satisfy the Thor Power objective evidence criteria and may further satisfy the subnormal goods standard. However, any sale ultimately resulting from such third-party solicitations must be in substance a sale, rather than merely a transaction attempting to circumvent the objective evidence requirement.(21) With these limitations in mind, taxpayers need to gather and organize the necessary documentation to substantiate their position.

Reallocation of Income and Expense Items of Related Parties

Sec. 482 generally provides that gross income, deductions, credits and other allowances of related taxpayers may be reallocated by the Service in order to prevent the evasion of taxes or to reflect clearly the income of the related organizations. The major function of Sec. 482 is to prevent the artificial shifting or distorting of the true taxable incomes of commonly controlled enterprises by placing a controlled taxpayer on a tax parity with an uncontrolled taxpayer.(22)

Sec. 482 applies only if the organizations, trades or businesses are "owned or controlled directly or indirectly by the same interests." In determining indirect control, the courts have applied attribution principles in determining whether ownership or control existed in a particular situation.(23) Thus, the provisions of Sec. 482 are often applicable since the stock attribution principles broadly define ownership.

* Pricing methods Regs. Sec. 1.482-2(e)(1), which addresses sales of tangible property (which would include sales of inventory) between controlled entities, states: Where one member of a group of controlled entities ... sells or otherwise disposes of tangible property to another member of such group ... at other than an arm's length price (such a sale being referred to in this paragraph as a "controlled sale"), the district director may make appropriate allocations between the seller and the buyer to reflect an arm's length price for such sale or disposition. An arm's length price is the price that an unrelated party would have paid under the same circumstances for the property involved in the controlled sale. Since unrelated parties normally sell products at a profit, an arm's length price normally involves a profit to the seller. (Emphasis added.) The regulation further provides taxpayers with three methods that may be used in determining an arm's-length price.

1. The comparable uncontrolled price method. 2. The resale price method. 3. The cost plus method.(24)

Certain ordering rules exist in determining which method applies. First, if comparable uncontrolled sales exist, the comparable uncontrolled price method must be used because it is the method likely to result in the most accurate estimate of an arm's-length price, since it is based on the price actually paid by unrelated parties for the same or similar products. Second, if no comparable uncontrolled sales exist, the resale price method must be used if the standards for its application are satisfied because it is the method likely to result in the next most accurate estimate. Third, if all the standards for the mandatory application of the resale price method are not satisfied, either that method or the cost plus method may be used, depending on which method is more feasible and is likely to result in a more accurate estimate of an arm's-length price.

If the standards for applying one of the three pricing methods are met, that method must be used unless the taxpayer can establish that, considering all the facts and circumstances, some other method of pricing is "clearly more appropriate."(25)

Comparable uncontrolled price method: Under this method, the arm's-length price of a controlled sale is equal to the price paid in comparable uncontrolled sales with certain adjustments.(26) "Uncontrolled sales" are sales in which the sellers and the buyers are not members of the same controlled group. However, uncontrolled sales do not include sales at unrealistic prices, as for example when a member makes uncontrolled sales in small quantities at a price designed to justify a nonarm's-length price on a large volume of controlled sales.(27)

Uncontrolled sales are considered comparable to controlled sales "if the physical property and circumstances involved in the uncontrolled sales are identical to the physical property and circumstances involved in the controlled sales, or if such properties and circumstances are so nearly identical that any differences either have no effect on price, or such differences can be reflected by a reasonable number of adjustments to the price of uncontrolled sales."(28) For this purpose, differences can be reflected by adjusting prices only when the differences have a definite and reasonably ascertainable effect on price. If the differences can be reflected by the adjustment, the price of the uncontrolled sale as adjusted constitutes the comparable uncontrolled sales price. Whether and to what extent differences in the various properties and circumstances affect the price, and whether differences render sales noncomparable, depends on the particular circumstances and property involved.

The examples in Regs. Sec. 1.482-2(e)(2)(ii) address the issue of whether differences between the controlled and uncontrolled sales are material enough to render such sales noncomparable. See the summary chart above.

The critical factor is whether the differences between the controlled and uncontrolled sales have a definite and reasonably ascertainable effect on price. If so, the comparable uncontrolled price method applies. If not, the comparable uncontrolled price method does not apply. Generally speaking, if the differences may be measured in dollars, it follows that such differences have a reasonably ascertainable effect on price.

Resale price method: Under the resale price method, the arm's-length price of a controlled sale is equal to the applicable resale price reduced by an appropriate markup.(29) An appropriate markup is computed by multiplying the applicable resale price by the appropriate markup percentage. Example 1: One member of a group of controlled entities sells properties to another member, which resells the property in uncontrolled sales. If the applicable resale price of the property involved in the uncontrolled sale is $100 and the appropriate markup percentage for resale by the buyer is 20%, the arm's-length price of the controlled sale is $80 ($100 - (0.20 x $100)).(30) A typical situation in which the resale price method may be required occurs when a manufacturer sells products to a related distributor, which, without further processing, resells the products in uncontrolled transactions.

The resale price method must be used to compute an arm's-length price of a controlled sale if all of the following circumstances exist. * There are no comparable uncontrolled sales. * An applicable resale price is available for resales made within a reasonable time before or after the time of the controlled sale. * The buyer (reseller) has not added more than an insubstantial amount to the value of the property by physically altering the product before resale. * The buyer (reseller) has not added more than an insubstantial amount to the value of the property by using intangible property.(31)

The "applicable resale price" is the price "at which it is anticipated that property purchased in the controlled sale will be resold by the buyer in an uncontrolled sale."(32)

The appropriate markup percentage is equal to the percentage of gross profit (expressed as a percentage of sales) earned by the buyer (reseller) on the property's resale that is most similar to the applicable resale of the property involved in the controlled sale.(33) Further, in determining an arm's-length price, an appropriate adjustment must be made to reflect any material differences between the uncontrolled purchases and resales used as the basis for calculating the appropriate markup percentage and resales of property involved in the controlled sale.(34)

Cost plus method: Under the cost plus pricing method, the arm's-length price of a controlled sale of property is computed by adding to the cost of producing the property an amount equal to that cost multiplied by the appropriate gross profit percentage.(35) The appropriate gross profit percentage is equal to the gross profit percentage (expressed as a percentage of cost) earned by the seller on the uncontrolled sale that is most similar to the controlled sale in question.(36) A typical situation in which the cost plus method may be appropriate occurs when a manufacturer sells products to a related entity that performs substantial manufacturing, assembly or other processing of the product, or adds significant value through its use of intangible property before the resale in uncontrolled transactions.

Related-Party Loss Limitations

Related-party loss limitations may also apply to a sale of inventory. If taxpayers are members of a controlled group, as defined in Sec. 267(f)(1), any loss sustained in the sale of inventory would be deferred(37) until the property is transferred outside the group and the loss would be recognized under consolidated return principles "or until such other time as may be prescribed in regulations."(38)

* Applying the lower of cost or market and arm's-length price principles Even assuming the taxpayer has properly written down its inventory in compliance with the regulations and Thor Power, the Sec. 267 loss limitations may still apply to a certain extent since the taxpayer's basis in the inventory (after the proper write-down) and the arm's-length price for such inventory may not be equal. The standards for determining the inventory write-down and the arm's-length price are not necessarily the same, because the inventory write-down is determined by reference to the inventory's "replacement cost." By contrast, the inventory's arm's-length price (as defined by one of the three above methods) takes into account expenses associated with the sale and generally imputes a profitability factor, depending on market conditions. The following example illustrates that the amounts resulting from these two standards are not necessarily equal. Example 2: Corporations A and B are members of a controlled group. A has inventory with a cost of $35 and a market value (i.e., "replacement cost") of $25, therefore entitling it to a $10 inventory write-down. In its sale of the same inventory to B, the arm's-length price is more than likely to be greater than $25, since the arm's-length price, in the Sec. 482 reallocation context, generally includes some built-in profit factor in its computation, depending on market conditions. Such profit, therefore, generally results in the arm's-length price of the inventory being higher than its replacement cost.

* Write-down preceding related-party transfer Despite the above limitations, taxpayers may still attempt to minimize their exposure to the loss limitation rules, to the extent it may be proven by the facts, by writing down their inventory before the sale to the related party. In Example 2, if the $10 loss had not been written down before the sale to B, it would have been deferred under Sec. 267(f) and not accounted for until the inventory was disposed of outside the controlled group.(39) Conversely, if a loss is properly written down before the sale, the taxpayer immediately recognizes the inventory write-down. However, it may be the case that the inventory is not properly priced at $25 in the sale to B, since a seller in a comparable uncontrolled sale context will attempt to earn a profit on its sale. To the extent the comparable uncontrolled price method does not apply, both the resale price method and the cost plus method also include profit factors. Therefore, taxpayers should be aware of the two separate accounting entries that must be made regarding the inventory: (1) The amount of inventory write-down, if any, determined under the lower of cost or market principles; and (2) the proper value of the inventory in the sale to the related party, determined under the arm's-length price principles, which generally include a profit factor.

Further, a taxpayer's objective evidence must prove it is qualified for such a presale write-down by including the dates of the applicable events and supporting facts. The correctness of a write-down based on the "no open market exception," as, for example, when a taxpayer offers inventory for sale at a price less than "market," is determined by referring to the taxpayer's actual sales for a reasonable period before and after the inventory date.(40) Further, write-downs based on the subnormal goods exception must be proven by actually offering the goods for sale at the price to which they are written down during a period ending not later than 30 days after the inventory date.(41)

Other Valuation Issues--Transaction Realignment 

Other valuation issues may arise if the sales price of the transferred excess inventory is not an arm's-length price. Such transactions between two corporations under common control can result in constructive distributions to their controlling shareholder, even though nothing passes directly to the controlling shareholder.(42) Example 3: Although the arm's-length price of corporation A's inventory is $25, corporation B buys it for $10. The IRS may take the position that this transaction should be realigned as follows.

* Constructive distribution: The benefit ($15 difference between sales price and arm's-length price) ostensibly moving directly from A to B could be treated as having been distributed first by A to its shareholders. This constructive distribution would be a taxable dividend to the shareholders(43) and could trigger gain to A.(44) * Gift: Second, if the transfer takes place in a closely held business and family context, the $15 benefit could be treated as a taxable gift by A's shareholders to B's shareholders. * Capital contribution: Third, the $15 benefit could be treated as a contribution by B's shareholders to B's capital. Because this transaction realignment could potentially apply in the context of sales of inventory between related parties if the sales are not at arm's-length, meeting the arm's-length standard is critical.

Imputed Interest 

Another issue that arises is whether interest may be imputed by the Service to inventory sale transactions. The following Code provisions may potentially apply in imputing such interest.

* Sec. 7872 treatment of loans with below-market interest rates The proposed regulations under Sec. 7872 state that if a below-market loan subject to that section would also be subject to Sec. 482--if the IRS chose to apply Sec. 482 to the loan transaction--Sec. 7872 will be applied first.(45) Further, the Service may argue that the inventory sale transaction meets the definition of a "loan" for Sec. 7872 purposes. The proposed regulations broadly interpret the term "loan" "to implement the anti-abuse intent of the statute."(46) Therefore, an integrated series of transactions that is the equivalent of a loan is treated as a loan. Transactions will be characterized for tax purposes according to their economic substance, rather than the terms used to describe them.

In applying Sec. 7872, however, certain loans are exempted. For example, loans that are made available by the lender to the general public on the same terms and conditions and that are consistent with the lender's customary business practice are exempt.(47)

* Sec. 482 allocation of income and deductions among taxpayers If the stated rate of interest on a loan or advance between controlled entities is subject to adjustment under Sec. 482 and is also subject to adjustment under any other Code section (e.g., Sec. 483, 1274 or 7872), Sec. 482 may be applied to the loan or advance in addition to the other Code section.(48)

Generally speaking, for Sec. 482 purposes, the period for which interest will be charged with respect to a bona fide indebtedness between controlled entities begins on the day after the day the indebtedness arises and ends on the day indebtedness is satisfied.(49) However, certain exemptions limit the period for which interest will be charged.

* Intercompany transactions in the ordinary course of business: Interest is not required to be charged on an intercompany trade receivable until the first day of the third calendar month following the month in which the intercompany trade receivable arises.(50) * Regular trade practice of creditor: If the creditor (or unrelated persons in the creditor's industry) allows, as a regular trade practice, unrelated parties a longer period without charging interest than that described in the exception for transactions that are similar to transactions giving rise to intercompany trade receivables, the longer interest-free periods will be allowed.(51)

* Sec. 483 interest on certain deferred payments Sec. 483 applies only to payments on account of the sale or exchange of property that are due more than six months after the sale or exchange date.(52) Therefore, if the taxpayer requires payments from the inventory sales to be due within six months of the sale date, Sec. 483 may not be used to treat a portion of the sales price as interest.

* Sec. 1274 determination of issue price when certain debt instruments are issued for property While Sec. 1274 determines the issue price of certain debt instruments, its provisions do not apply to

--debt instruments arising from the sale or exchange of property if the sum of the payments due and any other consideration to be received does not exceed $250,000;(53) and --debt instruments under which none of the payments are due more than six months after the date of the sale or exchange.(54) Therefore, assuming the taxpayer can satisfy the requirements of either exception, Sec. 1274 will not apply to its inventory sale transactions.

Conclusion

The sales price for a sale of inventory between related parties must be equal to an arm's-length price. The critical inquiry in determining the arm's-length price is whether comparable uncontrolled sales exist. Further, an inventory write-down is determined by the lower of cost or market principles, which do not necessarily provide the same result as the arm's-length price principles. To the extent allowed by these rules, taxpayers should write down inventory before transferring it to related parties in order to minimize the related-party loss limitations. [Tabular Data Omitted]

(1)Sec. 471. (2)Regs. Sec. 1.471-2(a). (3)Regs. Sec. 1.471-2(d). Assuming a general rise in prices, LIFO results in a lower net income. (4)FASB Accounting Standards, Section 178.107. (5)Regs. Sec. 1.471-2(c). (6)Sec. 472(b)(2). (7)Regs. Sec. 1.471-4(c). The taxpayer may not simply compare the aggregate cost to aggregate market value. (8)Regs. Sec. 1.471-3(b). (9)Regs. Sec. 1.471-3(c). (10)Regs. Sec. 1.471-4(a). (11)See, e.g., D. Loveman & Son Export Corp., 34 TC 776 (1960), aff'd, 296 F2d 732 (6th Cir. 1961)(9 AFTR2d 303, 62-1 USTC [P] 9147), cert. denied. (12)Regs. Sec. 1.471-4(b). (13)Id. (14)Elder Manufacturing Co., 10 F Supp 125 (Ct. Cl. 1935)(15 AFTR 454, 35-1 USTC [P] 9190). (15)Thor Power Tool Co., 439 US 522 (1979)(43 AFTR2d 79-362, 79-1 USTC [P] 9139). (16)Id., at 79-1 USTC 86,132. (17)Id., at 79-1 USTC 86,132-86,133. (18)See Regs. Sec. 1.471-2(c). (19)Thor Power Tool Co., note 15, at 79-1 USTC 86,128. (20)See Sec. 446(b). (21)See e.g., Clark Equipment Company and Consolidated Subsidiaries, TC Memo 1988-111. See, also, Rexnord, Inc., No. 90-2903 (7th Cir. 1991); Paccar, Inc. and Subsidiaries, 849 F2d 393 (9th Cir. 1988)(62 AFTR2d 88-5021, 88-1 USTC [P] 9380). (22)Regs. Sec. 1.482-1(b)(1). (23)See. e.g., Jesse E. Hall, Sr., 294 F2d 82 (5th Cir. 1961)(8 AFTR2d 5161, 61-2 USTC [P] 9582). (24)Regs. Sec. 1.482-2(e)(1)(ii). (25)Regs. Sec. 1.482-2(e)(1)(iii). (26)Regs. Sec. 1.482-2(e)(2)(i). (27)Regs. Sec. 1.482-2(e)(2)(ii). (28)Id. (29)Regs. Sec. 1.482-2(e)(3)(i). (30)Id. (31)Regs. Sec. 1.482-2(e)(3)(ii). (32)Regs. Sec. 1.482-2(e)(3)(iv). (33)Regs. Sec. 1.482-2(e)(3)(vi). (34)Regs. Sec. 1.482-2(e)(3)(ix). (35)Regs. Sec. 1.482-2(e)(4)(i). (36)Regs. Sec. 1.482-2(e)(4)(iii). (37)Cf. Losses to which Sec. 267(a)(1) applies are permanently disallowed. (38)Sec. 267(f)(2). The Sec. 267(f)(3)(B) exception regarding a loss on the sale or exchange of inventory applies when the transferee or transferor is a foreign corporation. (39)See Regs. Sec. 1.1502-13(f)(1)(i). (40)See Regs. Sec. 1.471-4(b). (41)See Regs. Sec. 1.471-2(c). (42)See, e.g., Gilbert L. Gilbert, 74 TC 60 (1980). (43)See Sec. 301(c) (the taxable amount of a distribution). (44)See Sec. 311(b) (distributions of appreciated property). (45)Prop. Regs. Sec. 1.7872-2(a)(2)(iii). (46)Prop. Regs. Sec. 1.7872-2(a)(1). (47)Temp. Regs. Sec. 1.7872-5T(b)(1). (48)Regs. Sec. 1.482-2(a)(3). (49)Regs. Sec. 1.482-2(a)(1)(iii)(A). (50)Regs. Sec. 1.482-2(a)(1)(iii)(B). (51)Regs. Sec. 1.482-2(a)(1)(iii)(D). (52)Sec. 483(c)(1). (53)Sec. 1274(c)(3)(C). (54)Prop. Regs. Sec. 1.1274-1(b)(1).

Steven D. Erdahl, J.D., LL.M., CPA Meadows, Owens, Collier, Reed & Coggins Dallas, Tex.