Separate-item treatment for bargain-purchased inventory.

Taxpayers may not use the LIFO method to preserve the tax benefit of a bargain purchase of inventory by treating each inventory item so purchased as identical to inventory subsequently acquired or produced, according to the Federal Circuit (Kohler Co., 9/17/97).

In 1984, Kohler Co. acquired Sterling Plumbing Group, Inc., which used the LIFO method of accounting for its inventory. Sterling's entire opening inventory consisted of finished merchandise purchased in 1978 at a bargain price. Sterling treated each bargain-purchased item and the identical subsequently produced goods as the same item. On examination of Kohler's 1984 consolidated return, the IRS determined that Sterling's method of inventory accounting failed to clearly reflect income.

The Service changed Sterling's method of accounting to treat the bargain-purchased inventory items as separate items from subsequently produced goods, effectively increasing the value of Sterling's inventory as of the end of the 1984 tax year by the bargain element in the 1978 inventory purchase; Kohler's 1984 taxable income was increased accordingly under Sec. 481(a).

Kohler challenged the IRS's determination. Applying the rationale of Hamilton Industries, 97 TC 120 (1991), the Court of Federal Claims held that the Service had a reasonable basis for determining that separate-item treatment was required for bargain-purchased inventory.

The Federal Circuit upheld the Court of Federal Claims. Relying on Hamilton, the court held that the IRS's determination that separate-item treatment for bargain-purchased inventory was necessary to clearly reflect income. The court stated that LIFO was a permitted method of accounting for inventory for tax purposes, because it protected taxpayers from recognizing profits that resulted merely from the "bloating of inventory values due to inflation."

The court then found that the taxpayer's LIFO system was not only compensating for inflation, but also was permitting it to postpone gains associated with the bargain-price inventory. Similar to the taxpayer's situation in Hamilton, Kohler sought to "fill its inventory with goods purchased at a steep discount, and replace them with goods purchased and produced at higher cost." The court noted that "if factors other than inflation enter into the cost of inventory items, a reliable index cannot be computed."

The court rejected Kohler's argument that the adjustment to 1984 income based on a change in Sterling's accounting method in 1978 was barred by the three-year statute of limitations under Sec. 6501 (a). According to the court, the fact that the challenged LIFO application related to a single transaction did not preclude the Service from imposing an adjustment under Sec. 481(a); the transaction affected the LIFO index, which in turn affected the recognition of income in subsequent tax years.

Additionally, the court relied on language in Hamilton, in which the Tax Court noted that "[t]o avoid omissions or duplications occurring solely by reason of an accounting method change, section 481 permits the Commissioner to include in the required adjustment amounts attributable to taxable years with respect to which assessment is barred by the statute of limitations."

FROM DIANE P. HERNDON, WASHINGTON, DC.