TAM links scope of LIFO election to LIFO pooling method.

In Technical Advice Memorandum (TAM) 200603027, the JRS concluded the scope of a LIFO election is "linked" to a taxpayer's LIFO pooling method; thus, the taxpayer's LIFO election must extend to all items that fall within the LIFO pools.

Facts

The taxpayer used the dollar-value, inventory price index computation (IPIC) LIFO method. It had received ISS consent (through an automatic method change) to use the IPIC pooling method for its LIFO inventory. Prior to the change, the taxpayer had received IRS advance consent to use a non-LIFO method to account for certain inventory departments or categories. Generally, its non-LIFO inventory items experienced deflation rather than inflation. If the taxpayer had used the LIFO method to account for these inventory items, the items would have fallen within its IPIC pools.

Background

Under Regs. Sec. 1.472-8(a), the dollar-value LIFO method is a way to determine the cost of a pool of goods. A taxpayer using this method treats all goods inventoried under the LIFO method that fall within a pool as fungible. Instead of measuring quantity changes based on the number of units of specific goods in ending inventory, the taxpayer computes, for the pool as a whole, the net change in inventory investment measured in terms of equivalent value dollars.

The IPIC pooling method requires grouping LIFO inventory according to (1) the two-digit commodity codes in Table 6 of the Producer Price Index Detailed Report or (2) the general expenditure categories in Table 3 of the Consumer Price Index Detailed Report.

In the TAM, the IRS concluded the taxpayer's use of the IPIC pooling method did not clearly reflect income, because the taxpayer employed a non-LIFO method for items that would be included in its IPIC pools had it used the LIFO method to account for those items.

As a result of this holding, the IRS revoked the method change that had given the taxpayer consent to use a non-LIFO method to account for certain departments or categories of inventory. In addition, it revoked the automatic method change that had given the taxpayer consent to use the IPIC pooling method for LIFO inventory.

Technical Observations

The conclusion reached in TAM 200603027 is significant. It introduces the "linkage" concept, which means a taxpayer's LIFO method will not clearly reflect income without a link between the scope of the LIFO election and the LIFO pooling method. Further, the TAM concluded that the linkage requirement underlies the rules covering LIFO pools.

However, while Regs. Sec. 1.472-8(b) provide a linkage concept for natural business unit pools, this concept is not mentioned elsewhere in the LIFO regulations. To the contrary, according to Regs. Sec. 1.471-1(i), the LIFO election can be limited to salable products that are further processed into finished goods. In addition, under Regs. Sec. 1.471-1(c), the LIFO election can be limited to only raw material content, and Regs. Sec.1.471-1(j) provides the LIFO election can be limited to any one raw material. The regulations do not prohibit the use of the IPIC pooling method with these elections. In fact, the IPIC pooling regulations allow taxpayers to establish IPIC pools "for those items accounted for using the IPIC method," suggesting the scope of the LIFO election is established first, with IPIC pools then established for those items.

Practical Observations

Many taxpayers using the IPIC pooling method may have limited their LIFO elections to only a portion of their inventory. For example, retail grocers using the IPIC pooling method for LIFO inventory may not be using the LIFO method to account for their produce, bakery and deli departments; these departments would usually fall within the IPIC pools used by retail grocers. Similarly, retail department stores using the IPIC pooling method for LIFO inventory may not be using the LIFO method to account for their electronics and apparel departments. In some cases, these departments could fall within the IPIC pools used by retail department stores. As discussed in more detail below, a taxpayer can now face the risk of the IRS requiring it to (1) use the LIFO method to account for departments or goods that have been excluded from the LIFO method, (2) change from LIFO for one or more pools or (3) change to a different LIFO pooling method. Alternatively, the taxpayer could voluntarily pursue one or more of these options.

If the IRS requires the taxpayer to extend the LIFO method to deflationary departments or goods that have been excluded from the LIFO pools, the change would result in an increase in taxable income. Typically, the change would be implemented with a Sec. 481(a) adjustment that would be taken into account entirely in the earliest open year under examination. If the taxpayer voluntarily makes this change by filing Form 970, Application to Use LIFO Inventory Method, there is no guarantee of eliminating exposure in prior years (i.e., audit protection may not apply).

When the IRS initiates a change from the LIFO method for one or more pools, the LIFO reserve associated with the pool(s) will be recaptured through a Sec. 481(a) adjustment. In most cases, this change would result in an increase in taxable income generally taken into account entirely in the earliest open year under examination. If the taxpayer voluntarily makes this change by filing Form 3115, Application for Change in Accounting Method, the change generally would qualify as an automatic change under Section 10.01 of the Appendix to Rev. Proc. 2002-9, with the resulting Sec. 481(a) adjustment taken into account prospectively (beginning with the year of change) over a four-year period.

If the IRS or the taxpayer initiates a change from the IPIC pooling method to a different LIFO pooling method, the taxpayer most likely would have to change the number and composition of its LIFO pools. As a result, it would have to separate or combine LIFO layers associated with the pools. If this change is required by the IRS, it would be implemented with a Sec. 481(a) adjustment taken into account entirely in the earliest open year under examination. If the taxpayer voluntarily makes this change by filing Form 3115, the change would be implemented using a cut-off method (i.e., with no Sec. 481(a) adjustment), and the taxpayer would receive audit protection for prior years. The voluntary change must be filed under the nonautomatic consent procedures provided in Rev. Proc. 97-27.

The rules for LIFO pooling methods other than the IPIC pooling method are very subjective. Thus, taxpayers requesting to change to a different LIFO pooling method should be prepared to deal with these subjective rules while Form 3115 is being processed. The IRS National Office might conclude that a different LIFO pooling method (requiring a significant increase in the number of pools) is appropriate, creating an additional administrative burden and diluting the LIFO expense over time in most cases. Moreover, the IRS might use the position stated in TAM 200603027 to require the taxpayer to link the new LIFO pools and the items accounted for under the LIFO method.

Conclusion

In TAM 200603027, the IRS acknowledged Regs. Sec. 1.472-8 "does not explicitly link the scope of the taxpayer's LIFO election and the method of pooling selected by the taxpayer ('linkage')." However, it stated the LIFO method will not clearly reflect income without this linkage, so taxpayers with facts similar to those in the TAM should be prepared to face IRS challenges to their LIFO method.

FROM TOM SEHMAN, CPA, MINNEAPOLIS, MN, AND JIM MARTIN, CPA, WASHINGTON, DC