When bargain purchase inventory exists, the effect of LIFO should not be disregarded.

When the LIFO method of accounting for inventory was promulgated, it was believed that a better matching of current revenues and expenses would be achieved, to properly reflect net income for any given period. As expected, what worked in theory worked as well in practice; both taxpayers and the IRS were pleased. The purpose of the LIFO method, however, has been ignored in a recent Tax Court case and in Ann. 91-173, which provided for a voluntary accounting method change when the taxpayer had made a bulk bargain purchase of inventory.

In Hamilton Industries, Inc., 97 TC No. 9 (1991), the Tax Court held that dollar-value LIFO inventory items purchased or produced subsequent to a bargain purchase transaction were different from those items acquired in the bargain purchase. This decision prevented the taxpayer from freezing the bargain purchase price into its LIFO inventory layers and passing the higher cost of producing subsequent inventory items through cost of goods sold. The court also held that the Service's treatment of the subsequently produced inventory items as "new items" constituted a change in accounting method. Thus, Sec. 481 applied and permitted the IRS to reconstruct the cost of the opening inventory (even though one of the bargain purchases occurred in a year barred by the statute of limitations).

The court reasoned that the taxpayer's good should be placed into separate item categories for the taxpayer's single natural business unit pool when they have substantially dissimilar characteristics, whether in terms of their physical nature or in terms of their cost. The bargain element gave the inventory a materially different cost characteristics from inventory purchased or produced after the bargain purchases. As such, even though the two classes of inventory were physically the same, the significant difference in their costs warranted their separation into different items to avoid a distortion of income. Thus, the court concluded that the goods purchased or produced subsequent to the bargain purchase and on hand at the end of the year of the LIFO election should be valued at their current-year cost.

However, since the earliest acquisition considered occurred in a closed year, it would only be possible to trigger the gain from that year if the treatment of subsequently produced items as new items was a change in accounting method. Sec. 481(a) would then permit a positive (income increasing) adjustment, and the opening inventory for the year of change would be revalued as though the taxpayer had treated subsequently purchased and produced goods as new items. The court rejected the taxpayer's argument that the failure to treat subsequently purchased or produced items as new items did not establish a method of accounting because such acquisitions were isolated transactions effected by separate taxable entities and that the determination of whether a new item comes into existence is merely a question of fact.

The court reasoned that, since the taxpayer consistently did not differentiate between the bargain purchase items and subsequently produced items, and because the Service's adjustment affected the timing of the inclusion of income, a change in accounting method resulted. Therefore, Sec. 481 permitted the IRS to make an adjustment even though the year was closed.

While this was a case of first impression, there are a number of arguments that the court failed to address or that could be used to distinguish this case. Also, the holding in this case raises a number of computational issues not addressed by the court.

The court's conclusion on the change in accounting method issue seems to conflict with its recent opinion in Coulter Electronics, Inc., TC Memo 1990-186. The Service argued that Coulter attempted to change its accounting method for alleged sales of property under its equipment lease program. Prior to such program, Coulter sold its equipment outright and recognized income at the time of sale. Under its newly established program, the equipment was leased and income recognized ratably over the lease term. However, Coulter assigned its leases to a bank in exchange for cash in the amount of a discounted value of each lease. The taxpayer initially reported these assignments as sales of the lease contracts. Later, however, it took the position that the assignments were pledges and not sales. Because of this change, the IRS asserted that the taxpayer was improperly changing its accounting method. The court agreed with Coulter in that the issue was one of characterization, not timing, i.e., whether the transfer by Coulter of the leases to the bank constituted sales or pledges for loans. As such, the court ruled that the determination of timing would follow from the resulting characterization of the assignments.

A similar argument could have been made in Hamilton. The issue was the characterization of the inventory produced subsequent to the bargain purchase, not whether the timing of income recognition is changed. As in Coulter, the determination of the character of such inventory determines the timing of the gain recognition.

Another case worth noting is Korn Industries, 532 F2d 1352 (Ct. Cl. 1976), nonacq. In that case, a manufacturer had inadvertently omitted three of the 14 elements of material costs in its finished goods for four consecutive years. On discovery, the taxpayer corrected its mistake by adjusting both the beginning and ending inventories. The Service took the position that this was a change in accounting method, the correction of which would cause a Sec. 481(a) adjustment. The court held that there had not been any change in method, but only the correction of an inventory error.

Korn is significant because it supports the proposition that not all changes in the valuation of inventory are accounting method changes. The costs were consistently omitted for four years and resulted in the understatement of ending inventory and taxable income. Under the rationale of Hamilton, the recognition of income would be considered to have been merely postponed until the undertated inventory is sold. Thus, a change in the valuation of the inventory would involve timing. The court in Korn, however, held that a change in accounting method had not occurred.

Whether or not Hamilton applies could also depend on the degree of a bargain purchase. For instance, if a taxpayer's bargain purchase results in a 10% discount, this is far different from the 60% and 96% discounts present in Hamilton. Because Hamilton involved such deep discounts on the purchased inventory, the argument that they are different items was more appealing than it would be in situations with smaller discounts. The IRS and the court were sensitive to this issue in Hamilton. In situations with less of a difference, the authorities may be more prone to attributing the deferral to the LIFO system (the true catalyst of the deferral), rather than to the bargain purchase.

Those taxpayers who had a bargain purchase and who subsequently updated their base year to comply with Sec. 263A may have another way of distinguishing Hamilton. Under Temp. Regs. Sec. 1.263A-1T(e)(6)(iv)(A), by updating the base-year cost, the "year prior to the year of change becomes a new base year, and all costs are restated in new base year costs for purposes of extending such costs in future years." As previously stated, the Service was successful in reaching back to closed years since it was able to convince the court that the taxpayer was using an improper method of accounting and, therefore, was able to impose a Sec. 481(a) adjustment to recapture the deferred income from the sale of the bargain purchased inventory.

Initially, under the double extension method, Hamilton priced items produced subsequent to the bargain purchase transaction at their current-year cost and the bargain purchase base-year cost to determine whether an increment occurred and to calculate an inflation index. Next, it would price any increment using such index. The court held that it was improper to price the produced items at the base-year cost of the bargain purchased items to determine whether an increment occurred under the double extension method. Accordingly, Sec. 481(a) applied and the opening inventory was revalued as though items produced subsequent to the bargain purchase were new items and priced at current-year cost (instead of pricing such items at their bargain purchase base-year cost under the old method of accounting) to determine the inflation index and whether an increment occurred and to value the increment. However, once a taxpayer updates its base year, the older costs will no longer be used in computing indexes and valuing ending inventory. In effect, updating the base year has removed the use of the improper method of first pricing goods at their improper bargain purchase base-year cost to determine the inflation index and whether an increment has occurred.

As noted earlier, the Hamilton court still needs to address a number of computational issues. Regs. Sec. 1.472-8(e)(2)(ii) provides that the base-year cost for new items may be determined either by using as the base-year cost the item's current-year cost for the year the item first enters the pool or by determining what the item would have cost in the base year or an earlier year. Thus, if inventory items produced after the acquisition of the businesses (i.e., work-in-process and finished goods produced using the inventory acquired in the bargain purchase) are held to be new items, the base-year cost of such items arguably could be similar to the cost of some of the items purchased in the acquisition. For example, the items produced after the acquisition included the cost of raw materials and work-in-process acquired in the bargain purchase along with the additional costs incurred to bring the items to their current year-end state. The cost of these items should constitute the base-year cost.

Conclusion

Hamilton neglects the theory on which the LIFO method of carrying inventory was based. LIFO, by definition, defers prior-year lower costs by running the most current costs through cost of goods sold. The deferral of the recognition of base-year costs would occur whether or not inventory was discounted. Accordingly, in cases in which the discount is not as deep, the Service and the courts may not be as sensitive to the issue.

The Hamilton decision should not affect retailers using the retail inventory method. Under this method, inflation is determined at retail prices or through the use of an external index (either the Bureau of Labor Statistics Department Store Index or the Consumer Price Index). Therefore, the bargain element would not be reflected in the index calculation. Further, reconstruction of a new item is not necessary when using external indexes. However, the bargain element is preserved because the cost complement used to reduce ending inventory at retail to cost would be lower than the customary cost complement. This would reduce ending inventory to the true cost.