Service scrutinizes inventory.

During the past few years, the IRS appears to have been paying greater attention to inventory. It has litigated cases, issued several technical advice memoranda (TAMs) and, in the 2004-2005 Treasury/IRS Priority Guidance Plan, identified a number of inventory concerns for which it expects to issue guidance. Several of these concerns have appeared on prior plans, suggesting that the Service is either having difficulty resolving complex inventory matters or facing emerging issues (such as issuing Sec. 199 guidance).

This item discusses the IRS's views on inventory issues, including purchased and produced goods pooling under the LIFO inventory price-index computation (IPIC) method, maintaining required inventory records and reporting trade discounts and allowances.

Background

Notwithstanding currently pending inventory issues, the Tax Court agreed with the IRS in Mountain State Ford Truck Sales, Inc., 112 TC 58 (1999), that an auto dealer using LIFO could not value its parts inventory at replacement cost, which was the most recent cost information available to the taxpayer. That decision's effect on auto dealers was widespread. As a result, the Service provided a safe harbor in Rev. Proc. 2002-17, under which automobile dealers can approximate the cost of their vehicle parts inventory, using replacement cost in accordance with the procedure's method (for details on Mountain State, see Gaffaney, Tax Clinic, "Automobile Dealers May Use Replacement-Cost Method to Approximate Vehicle-Parts Inventory Cost," TTA, March 2003, p. 128).

An IRS inventory specialist recently took the position in a pending examination that a retailer that contracts for merchandise to be produced to specification is a producer for purposes of the Sec. 263A uniform capitalization rules. Such a retailer will not be able to use the simplified resale method for allocating additional Sec. 263A costs, but will be required to use one of the producer cost-allocation methods to allocate direct and indirect costs to property produced and acquired for resale. Obviously, this position affects large retailers involved in so-called contract manufacturing. The position was likely adopted by the IRS after its successful litigation in Suzy's Zoo, 114TC 1 (2000), aff'd, 273 F3d 875 (9th Cir. 2001). Clearly, the Service intends to scrutinize contract manufacturing once it finalizes Sec. 199 guidance.

In another questionable stance, the IRS held in Letter Ruling 200144003 that a distributor of certain component products used in the manufacture of vehicles had to allocate storage and handling costs to merchandise in transit, but not yet received. The in-transit inventory (shipped via boat from outside the U.S.) approximated 26%-28% of the taxpayer's ending inventory. In its defense, the taxpayer argued that because it had not yet incurred storage and handling costs for this merchandise (the taxpayer properly allocated freight costs), allocating such costs would have been a distortion, violating the clear-reflection-of-income doctrine. The IRS disagreed.

Are Separate IPIC Pools Required for Purchased and Produced Goods?

Contrary to many taxpayers' beliefs, manufacturers and processors (collectively, "manufacturers") must use separate LIFO IPIC pools for purchased and produced goods.

Under the natural-business-unit (NBU) method of pooling (described in Regs. Sec. 1.472-8(b)(1) and (b) (2)(i)), a manufacturer also engaged in wholesaling or retailing cannot include purchased goods in the manufacturing NBU pool. The regulations are interpreted very strictly by the IRS: goods purchased for resale that are not processed further by the taxpayer cannot be included with like goods manufactured and included in the taxpayer's NBU pool.

The concept of separating purchased and produced goods for LIFO pooling purposes is based on differences in the costing configuration, which might distort income. According to Rev. Rul. 82-192, income distortions could occur if manufactured and purchased goods are put into the same LIFO pool, because the cost of manufactured goods is determined under the full absorption method, whereas the cost of purchased goods is limited to direct material costs.

This argument's underlying assumption is that the different cost characteristics have a different effect on LIFO indexes. Further, in Amity Leather Products Co., 82 TC 726 (1984), the Tax Court ruled that the restriction in Regs. Sec. 1.472-8(b) (2) against the inclusion of manufactured and purchased goods in the same NBU pool was not ambiguous. Accordingly, in Amity, the taxpayer was required to separately pool goods manufactured in its own facilities from related goods acquired from its wholly owned subsidiaries, notwithstanding the fact that the goods at issue were identical, produced by an affiliate and sold as part of a single trade or business, and the taxpayer exercised significant control over the production of the purchased goods.

IPIC pooling method: In contrast, the IPIC pooling method, as described in Regs. Sec. 1.472-8(b) (4), does not bar including wholesaling and manufacturing operations in the same pool. Rather, it allows manufacturers that elect the IPIC method for a trade or business, to establish dollar-value pools based on the major commodity groups in Table 6 (producer price indexes (PPI) and percent changes for commodity groupings and individual items, not seasonally adjusted) of the "PPI Detailed Report," for items for which they account by the IPIC method. Consequently, manufacturers should be permitted to pool manufactured and purchased goods, as long as the goods are included in the same trade or business and are appropriately categorized using the same two-digit PPI commodity code.

When the LIFO IPIC method was enacted, it varied from the historic dollar-value LIFO method. For example, retailers, wholesalers, jobbers and distributors were allowed under former Regs. Sec. 1.472-8(e) (3)(iv) to establish inventory pools according to the 11 general categories of consumer goods described in the "CPI Detailed Report." The IPIC pooling method was expanded by Rev. Proc. 84-57, to include the 15 general categories of producer goods described in Table 6 of the PPI Detailed Report. Taxpayers that elected the IPIC pooling method were also allowed to aggregate inventory pools that comprised less than 5% of the inventory value, into one miscellaneous IPIC pool. If that pool still comprised less than 5% of the inventory value, it could be combined with the largest inventory pool.

These special pooling rules were only allowed for certain taxpayers that were using the IPIC method, which clearly demonstrates that pooling under that method is different from pooling under the regular or historic-dollar-value LIFO regulations. In furthering this approach, revised IPIC regulations, issued pursuant to TD 8976 (1/8/02), expanded the special pooling methods available to taxpayers using the IPIC method. For example, manufacturers and processors, which formerly were allowed to pool only under the NBU pooling rules or the multiple-pooling rules, are now permitted to pool according to the major commodity groups in Table 6 of the PPI Detailed Report.

Further, different cost characteristics contained in manufactured and purchased goods are not an issue for taxpayers computing LIFO indexes under the IPIC method. They will have no effect on the LIFO indexes, because the IPIC regulations allow taxpayers to calculate a LIFO index based on the indexes contained in Table 6 of the PPI Detailed Report, and disregard any differences in actual taxpayer price changes. Accordingly, the restriction against including purchased goods in a manufacturing NBU pool should not apply to taxpayers pooling via the IPIC pooling method.

Guidance under Regs. Sec. 1.472-8 on the IPIC method was listed on the 2004-2005 Treasury/IRS Priority Guidance Plan. Because this topic is rather broad, it is anyone's guess which issues this impending tax guidance will address. However, clarity on whether separate IPIC pools are required for purchased and produced goods would resolve a significant matter affecting many taxpayers and some controversy in an area that was meant to "simplify" rather than complicate, the LIFO method.

Maintaining Contemporaneous, Purchase-Related Records

In TAM 200445026, a taxpayer had previously been granted permission to change its accounting method to the retail inventory method under Regs. Sec. 1.471-8. On examination, the IRS asserted that the taxpayer did not (1) apply the retail method properly and (2) maintain the required inventory records.

After a lengthy analysis of the history and application of the retail method, the IRS ruled that the method will correctly compute inventories at retail lower-of-cost-or-market (LCM), only if the merchant uses contemporaneous retail prices when computing the cost complement and ending inventories (at retail). Thus, the retail method will not correctly compute retail LCM if the merchant computes the cost complement and/or ending inventories (at retail) using any of the following methods:

1. An artificially high or nominal retail price (with or without an artificial markdown);

2. The permanent retail price of identical units prevailing on the first day of the tax year (with or without an artificial markdown);

3. An artificially low retail price; or

4. A temporarily reduced retail price.

Holding: In the taxpayer's case, the IRS found that inappropriate amounts were in fact used to compute inventory under the retail method. Further, a merchant must maintain records that document (1) the cost and retail value of beginning inventories, (2) the unit cost and original retail price of all purchases (as well as their respective totals) and (3) its markups, markdowns, vendor discounts, etc. The merchant must also be able to show that it used the data properly when computing the cost complement, ending inventories (at retail) and retail LCM (or retail cost). If software was used to apply the retail method, the merchant has to establish audit trails between the retained electronic records and its books, and between the retained electronic records and its tax returns. In addition, it must show that its software used all the relevant data properly when computing the cost complement, ending inventories (at retail), and retail LCM (or retail cost). In the taxpayer's case, the IRS found that the taxpayer's software did not maintain adequate contemporaneous records (thus precluding corrections of the taxpayer's computations).

Based on this, the IRS revoked the taxpayer's ruling as of the beginning of the year of change, because it did not comply with the ruling's terms and conditions. The IRS noted that the taxpayer could request consent to return to the retail method in the tax year that it established to the IRS's satisfaction that it is able to comply with all the computational and recordkeeping requirements of the retail method.

Note: Kegs. Sec. 1.471-8 requires keeping accurate accounts, and Sec. 446(b) seems to be broad enough to permit the IRS to change a taxpayer's accounting method (albeit a permitted method), if the taxpayer does not maintain adequate records to support using the method. The Service's position in this TAM may be viewed by some as being extremely bold; however, for the IRS to accept a particular method (e.g., the retail inventory method or the LIFO method), taxpayers must maintain adequate books and records.

When Will the IRS Alter Its Position on Cooperative Advertising Reimbursements?

Many manufacturers and vendors offer a variety of trade discounts, including allowances for advertising. Generally, these inducements depend on the volume or quantity of purchases. Under Regs. Sec. 1.471-3(b), trade or other discounts must be treated as a reduction in the purchase price of the inventory to which they relate; however, the regulation does not define a "trade or other discount." According to Rev. Rul. 84-41, a trade discount is a vendor reduction to the purchase price, which varies depending on the volume or quantity purchased. If a discount is always allowed regardless of time of payment, it is deemed a trade discount.

Because most vendors offer cooperative advertising allowances through their trade discount programs, and taxpayers generally view such payments no differently from other discounts, there have been disputes over the correct tax treatment of such amounts. The treatment of cooperative advertising allowances was discussed in Field Service Advice (FSA) 199915011, in which the IRS stated that it viewed such allowances as reimbursements for services, rather than as trade discounts. FSA 199915011's issuance has resulted in the Service taking a very narrow approach on this issue; see Woehrle and Leib, Tax Clinic, "Tax Implications on the Financial Accounting Treatment of Cooperative Advertising Reimbursements," TTA, June 2003, p. 321, which addresses the inconsistency between the Financial Accounting Standards Board's (FASB's) and the IRS's treatment of cooperative advertising allowances.

The FASB's Emerging Issues Task Force (EITF) reached a consensus that cash consideration received by a reseller from a vendor for cooperative advertising is presumed to be a reduction of the price of the vendor's products or services and, thus, should be classified as a reduction of cost of sales; see EITF Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Certain Cash Consideration Received from a Vendor." This presumption is overcome only if the consideration is either a (1) payment for assets or services delivered to the vendor or (2) reimbursement of costs the reseller incurred to sell the vendor's products.

Dilemma: The IRS's current position on this issue is that taxpayers must report cooperative advertising reimbursements as an item of income (or, possibly, a reduction of advertising expenses), thus creating a book-tax reporting difference, because taxpayers have to comply with EITF Issue No. 02-16 for financial reporting purposes. For some taxpayers, this annual reporting difference would be substantial. To date, there has been no guidance to help resolve this dilemma.

Impracticality of Tracing Trade Discounts

Citing Rev. Rul. 69-619, the IRS has recently proposed in a pending ruling request to disallow trade discounts allocated to ending inventory if the goods to which the discounts relate are not in ending inventory. This proposal presents taxpayers with a bit of a quandary. If the taxpayer receives uniform discounts throughout the year, this proposal may not be a problem. However, if the discounts were received for purchases made only within a certain timeframe (e.g., from January through March), this proposal would require taxpayers to trace trade discounts to specific items of inventory. For most taxpayers, this would be an arduous task; for retailers it would be nearly impossible.

Inconsistency: The Service and the courts have not been consistent as to the method of adjusting ending inventory for cash discounts. In Rev. Rul. 69-619, the IRS held that a taxpayer could not adjust its ending inventory by an average cash discount received during the year on merchandise purchases. In essence, the actual invoice price for the respective goods must be reduced. The courts, however, have been more lenient, depending on the facts and circumstances. Several of the older court decisions permitted taxpayers to reduce the cost of merchandise by the average cash discount allowed during the year; see, e.g., James Edgar Co., 16 BTA 120 (1929), nonacq., 1929-2 CB 62, and Leedom & Worrall Co., 10 BTA 825 (1928).

The question as to the precision with which discounts must be determined has also arisen with trade discounts. Similar to cash discounts, several older cases have permitted taxpayers to deduct average trade discounts from inventory; see e.g., Blumberg Bros. Co., 12 BTA 1021 (1928), nonacq., 1929-1 CB 51, and Torlicht-Duncker Carpet Co., 22 BTA 466 (1931), acq., 1931-2 CB 71. Arbitrary determinations, however, have not been permitted; see C.E. Longley Co., 4 BTA 246 (1926). According to Regs. Sec. 1.471-3(b), in the case of merchandise purchased since the beginning of the tax year, "cost" means invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the taxpayer's option, provided a consistent course is followed. Thus, trade discounts (unlike cash discounts) are required to be treated as reductions in the purchase price of the inventory to which it relates; hence, some sort of consistently applied method must be used.

While the regulations require inventory cost to be reduced by trade discounts, they are silent as to any specific methods for doing so. Because it is impracticable (or impossible) to trace and allocate each individual discount through the system, some sort of allocation method should be allowed as long as such method clearly reflects income and is consistently applied.

Rev. Rul. 69-619 was published before the uniform capitalization roles. Presumably, the same methods of allocating costs between ending inventory and cost of goods sold should be acceptable when allocating trade discounts. If not, it seems rather inconsistent that this level of accuracy would be appropriate for Sec. 263A, but not for the determination of cost under Sec. 471.

Regs. Sec. 1.471-2(a) provides two tests to which inventory must conform: it must (1) conform as nearly as may be to the best accounting practice in the trade or business; and (2) clearly reflect income, Regs. Sec. 1.471-2(b) further states:

It follows, therefore, that inventory rules cannot be uniform but must give effect to trade customs which come within the scope of the best accounting practice in the particular trade or business. In order to clearly reflect income, the inventory practice of a taxpayer should be consistent from year to year, and greater weight is to be given to consistency than to any particular method of inventorying or basis of valuation....

Allocating discounts to all inventory generally conforms to the best accounting practice in various trades or businesses.

Most taxpayers do not have the ability to determine which specific goods remain in ending inventory or which vendor allowances are allocable thereto. This fact was seemingly acknowledged by the EITF in Issue No. 02-16 (discussed above). In the consensus, the Task Force noted that many resellers have programs with more than one supplier or more than one program with the same supplier, and that payments are based on more than one measure. As a result, it concluded that many of these programs may be blended to include current purchases, annual purchases and some level of retail merchandising activity. This would seem to suggest that the Task Force has acknowledged that at some point, companies cannot account for each program individually. When will the IRS follow suit?

FROM CHRISTINE J. WOEHRLE, CPA, MINNEAPOLIS, MN, AND IRWIN A. LEIB, CPA, WASHINGTON, DC