Voluntary LIFO method change can forestall IRS challenge.

Over the last few years, the IRS Industry Specialization Program (ISP) has identified certain LIFO inventory methods that it believes are improper. Companies using a LIFO method that the Service believes is erroneous should consider voluntarily changing to a method it will accept, thereby precluding the IRS from raising the issue for earlier years.

Estimating Earliest Acquisitions Cost

A company must determine the current-year method that it will use to value its LIFO increments (i.e., LIFO layers). The most common methods are the earliest acquisitions, the latest acquisitions and the average cost of acquisitions methods.

Because the earliest acquisitions method is not used for internal management purposes, many LIFO companies have developed shortcuts for estimating earliest acquisitions cost. One common shortcut for companies using the link-chain method is a dual-index method that eliminates the need to compute earliest acquisitions cost, unless there is a current-year increment.

Under a dual-index method, a cumulative deflator index is computed, employing year-end FIFO costs, and then is used to determine base-year cost. If an increment occurs, a cumulative inflator index is used to state the increment at its current-year earliest acquisitions cost. The inflator index is computed by extending the current year's ending inventory at its current year's earliest acquisitions cost and its prior year's FIFO cost; see Exhibit 1, on page 461.

A taxpayer must compute the current year's inflator index based on actual earliest acquisitions cost (see Example 1).The following methods are not acceptable: (1) use of the prior year's cumulative deflator index to value the current year's increment, assuming there is no inflation at the beginning of the current year or (2) use of a method that estimates the earliest acquisitions cost based on inventory turns.

Example 1: Company A computed the base-year cost of its 1998 increment as follows:

FIFO value of 12/31/98 inventory                $208,000
1997 cumulative deflator index         2.00
1998 deflator index                  x 1.04
1998 cumulative deflator index                /     2.08

Base-year cost of 1998 inventory                $200,000
Base-year cost of 1997 inventory              - $150,000

Base-year cost of 1998 increment                 $50,000

A's inventory turned over four times in 1998. Using an
inventory-turnover method to compute its yearly inflator
index, A showed 1% inflation for the year:

1998 deflator index inflation 4%/1998 inventory turns 4 =
1% 1998 inflator index inflation

Using the 1% inflator index, the 1998 increment would have a
$101,000 LIFO value:

FIFO value of 12/31/98 inventory   $208,000
1997 cumulative deflator index         2.00
1998 deflator index                  x 1.04

1998 cumulative deflator index                                2.08
Base-year cost of 1998 inventory                $200,000
Base-year cost of 1997 inventory              - $150,000

Base-year cost of 1998 increment                           $50,000
1997 cumulative deflator index         2.00
1998 inflator index                  x 1.01

1998 cumulative deflator index                                2.02

LIFO value of 1998 increment                    $101,000

On audit, the IRS could attempt to revalue the 1998 layer using
the 1998 cumulative deflator index (2.08). This would result in a
potential $3,000 adjustment:

Base-year cost of 1998 increment                 $50,000
1997 cumulative deflator index         2.00
1998 deflator index                  x 1.04

1998 cumulative deflator index                                2.08

Revised LIFO value of 1998
 increment                                      $104,000
Original LIFO value of 1998
 increment                                      $101,000

Potential adjustment to 1998
 increment                                                  $3,000

Because the Service believes that a change in the method of valuing LIFO layers is a Sec. 446 accounting method change, it could seek to revalue all prior years' LIFO layers using the cumulative deflator index for those years. Years otherwise barred by the statute of limitations could be required to be restated.

Replacement Cost Used to Value LIFO Layers

The IRS has challenged the use of LIFO methods by manufacturers, wholesalers and retailers that do not value LIFO layers using actual inventory cost. For example, it has attacked the use of costs published in trade magazines to value the raw material content of a manufacturer's inventory as well as the use of catalog prices by a car dealer to value its parts and accessories.

The Tax Court recently upheld the Service's position in Mountain States Ford Truck Sales, 112 TC No. 7 (1999). Mountain States, a truck dealer, adopted the latest acquisitions method to determine the cost of its parts and accessories, but used replacement cost (i.e., year-end catalog price) as the current-year cost of its LIFO inventory. The court held that Mountain States had to use the latest acquisitions method, because it had adopted that method. In addition, replacement cost could not be used, even if the method was adopted, because a LIFO calculation must be based on the "actual cost" of inventory. Looking to Sec. 471, the court concluded that replacement cost was not an acceptable method of determining inventory cost.

Because Mountain States did not attempt to recompute its LIFO inventory value using actual cost, the Tax Court concluded the IRS could trigger the taxpayer's LIFO reserve into income. Further, the taxpayer was required to continue using the LIFO inventory method in future years, because its LIFO election had not been terminated.

All LIFO companies should review their LIFO methods to determine if they are using actual cost to value their LIFO inventory. If replacement cost or a similar method not specifically allowed by Sec. 471 is being used, the company should consider voluntarily changing to an actual cost method that the Service will accept. If a voluntary change is not requested, the company should retain records for all years (even barred years) that will enable it to show the IRS that its method values its LIFO inventory at actual cost.

Broad Item Definition

To simplify LIFO inventory calculations, many companies use a broad item definition that computes a single item cost for a group of related items (see Example 2). The use of a narrower item definition may increase or decrease income when the inventory mix changes. When challenging a broad item definition, the Service attempts to make the taxpayer recompute its LIFO value for all LIFO years (even barred years) using a narrower item definition.

Example 2: Company A adopted the dollar-value, double extension LIFO method in 1995. On Dec. 31, 1994, A had the following items in its inventory:

                      Base-year   Total base-year
Item          Units   unit cost        cost

Low cost       100       $10          $1,000
Medium cost    100       $15          $1,500
High cost      100       $20          $2,000
                                      $4,500
                      Total units  /     300
                      Per item
                      base-year cost     $15

During 1995, A's inventory cost remained
constant; however, the inventory mix changed.
On Dec. 31,1995, A had the following ending inventory:

                       Current       Total
Item          Units   unit cost   current cost

Medium cost    100       $15        $1,500
High cost      200       $20        $4,000

                                    $5,500

                Base        Total
Item          unit cost   base cost

Medium cost    $15         $1,500
High cost      $15         $3,000

                           $4,500

Using a broad item definition, the 1995 LIFO index
would show 22% inflation during 1995 when there was
no rise in the unit cost of low-cost, medium-cost
or high-cost inventory.

$5,500 1995 inventory at 1995 current-year cost
/$4,500 1995 inventory at 1994 base-year cost
= 1.22 1995 LIFO index

In the past, an Automobile Industry ISP has challenged use of a broad item definition by automobile dealers. More recently, a Petroleum Industry ISP has attacked use of a broad item definition by refiners (e.g., when refiners treat all crude as a single item). The IRS also may question the treatment of different grades of metals, chemicals or lumber as a single item.

Use of a broad item definition may present significant audit exposure if the current-year costs of items with the same base-year costs vary significantly. If the current-year costs differ significantly, the use of a broad item definition could distort the LIFO inventory value when the mix of the inventory changes.

Use of a broad item definition can be identified in the LIFO workpapers by looking at the current-year and base-year costs used to compute the current-year LIFO index. If the same base-year cost is used for items with different current-year costs, this is an indication that a broad item definition is being used.

A quick screening mechanism to determine whether use of a broad item definition has distorted LIFO value is to review the yearly inflation shown by the LIFO method and determine whether the yearly inflation is reasonable in light of the types of inventory in the LIFO pool. The yearly inflation is computed by dividing the current-year LIFO index by the prior-year LIFO index.

[ILLUSTRATION OMITTED]

FROM RICHARD W. GARRETT, CPA, WASHINGTON, DC, SHARON ABSHEER, CPA, WASHINGTON, DC, AND JOHN E. SEELAND, CPA, SYRACUSE, NY3