Three IRS papers on LIFO inventory.

The IRS has released three Industry Specialization Program (ISP) papers in the LIFO inventory area. The first concludes that a taxpayer may not use an index developed by double-extending one segment of its inventory to apply to a segment of inventory not included in the determination of the index. The second concludes that, for purposes of determining the annual index, inventories purchased in bulk at discounted amounts are separate items from goods subsequently purchased or produced. The third paper concludes that a taxpayer that elects the earliest acquisition method to price increments may not use shortcut methods to price any such increment.

Two common examples of improper methods cited in the first paper are (1) excluding new items in the computation of the index and (2) using an index developed from warehouse data to apply to stores. The Service believes that a representative portion of the inventory requires that "every item in the population must have an equal not zero chance of selection." New items are generally excluded because of the administrative cost to reconstruct or otherwise establish a base-year cost. For taxpayers using the linkchain method, indexing new items at 1.0 has the effect of eliminating inflation for one year. For other taxpayers, the effect is generally much more dramatic, depending on the number of years on LIFO.

The second paper reflects the IRS's long-standing battle against LIFO and bargain bulk purchases of inventory. The Service has been successful in contesting this issue. In Hamilton Industries, Inc., 97 TC 120 (1991), the taxpayer purchased the assets of a business. In the allocation of the purchase price, inventories were valued on a residual basis at an amount approximating 4% of the FIFO cost to the seller. The facts clearly indicate that the allocation of the purchase price was distortive. Unfortunately, bad facts sometimes make bad law. The IRS argued successfully that the items purchased were not the same as those subsequently manufactured. Thus, base-year cost of the items manufactured was not the same as the bargain purchase price. As a result, the amount of the bargain purchase was not locked up in the value of the inventory, but rather entered into the determination of taxable income as the inventory was sold.

Hamilton also held that the adjustment to treat the subsequent manufactured items as new or different items was a "method of accounting." Thus, even though the bargain purchase of inventory occurred in a closed year, the Service could require an adjustment. This means that the LIFO effect of a bargain purchase may be challenged upon audit at any time even though the purchase was made in a closed year.

The result in Hamilton was recently applied in Kohler Co., Ct. Fed. Cl., 11/3/95. In this case, the discount amount approximated 50%. The court also held that the treatment of the bargain purchased items as new items was a method of accounting.

The third paper deals with the determination of an incremental index for taxpayers using the earliest acquisition method. Most taxpayers that use the earliest acquisition method use a dual index, a deflation index to measure changes in inventory levels and an inflation index to price increments. Although the regulations do not specifically sanction the use of a dual index, the paper recognizes that such method is in common use. Many taxpayers use shortcut methods to calculate the increment index. The paper points out that such methods include using the prior year's deflator index and an application of inventory turnover to the current year deflator index (e.g., if inventory turnover is 12, using 1/12 of the current year deflator index). The paper concludes that (1) the use of a prior year's deflator index is not permitted and (2) the use of a shortcut approach using inventory turnover is not permitted unless it results in a clear reflection of income.

It is safe to assume that examining agents will be looking for these types of situations and proposing adjustments, if applicable. Taxpayers in violation of the conclusions of the papers may either continue their method and defend it in the appeals process or change the method prospectively. With respect to the omission of new items from the determination of the annual index, taxpayers could:

* File a Form 3115, Application for Change in Accounting Method, to request a change from using an index that excludes new items to an index method that includes new items. For taxpayers currently double-pricing 100% of the old items, the change could be to a method of a statistical sample of all items, or possibly a continuation of 100% of the old items and a statistical sample of the new items. By requesting such a change, a taxpayer receives audit protection for all filed years. The change would be made on a cut-off basis; i.e., there would be no Sec. 481 (a) adjustment.

* On an ongoing basis, reconstruct or redetermine base-year cost for new items coming into the pool(s) during the current year. This approach would not provide any audit protection for prior year.

Taxpayers with a Hamilton-type issue need to evaluate their risk primarily based on the significance of the discount percentage. It seems that anything in excess of a 50% discount may be hard to defend. Any discount below such an amount would need to be evaluated based on all the facts. Taxpayers may want to file Form 3115 to protect prior years and spread the adjustment.

Taxpayers that use a "shortcut" approach to determine an earliest acquisition index need to review its effect to see if it meets the clear reflection of income standard. If not, the taxpayer should consider filing Form 3115 and making a change to possibly the latest acquisition method. Such change would be made prospectively, provide audit protection and be done on a cut-off basis.

From Robert V. Rosselli, CPA, New York, N.Y.