When the automatic change procedure of Rev. Proc. 94-49 applies.

Rev. Proc. 94-49 offers most companies a one-time opportunity to make modifications to their Sec. 263A uniform capitalization rules (UCR) methodologies without the advance consent of the IRS National Office.

This important opportunity is available for the first tax year beginning in 1994. The general deadline for using it is the filing date of the 1994 tax return. However, companies under examination have an earlier deadline - in many cases, as early as Dec. 27, 1994.

This important opportunity allows most companies to - correct erroneous UCR methods with audit protection for prior tax years, and/or - improve their allocation methodologies to simplify their UCR calculation or achieve more favorable tax results.

The following examples illustrate situations in which the automatic change procedure of Rev. Proc. 94-49 applies.

Example 1: XYZ Company, a calendar-year taxpayer, is treating certain handling costs relating to raw materials as period costs. XYZ is not under IRS examination.

Handling costs are subject to the capitalization rules. Thus, XYZ is using an erroneous UCR method. The company should request a change in accounting method under the automatic change provision of Rev. Proc. 94-49. This filing will give XYZ a maximum four-tax year spread of the resulting adjustment, and audit protection for its earlier years.

Example 2: A Company is recording its inventory gross of discounts and recognizing discount income currently when discounts are earned.

Trade and other discounts are required by Regs. Sec. 1.471-3(b) to be accounted for as a reduction to the purchase price of goods. Interest-type discounts (e.g., 2/10, net 30) can be accounted for as a reduction to the purchase price of goods; alternatively, purchases are recorded at their gross purchase price with discounts recognized currently in income when they are taken.

It is unclear whether the Service will allow taxpayers to use the automatic method change procedure of Rev. Proc. 94-49 for trade, interest or other discounts, since it can be argued that this is not a pure Sec. 263A change.

Note that if a company uses either the simplified resale or the simplified production method to allocate UCR costs to ending inventory, it may not use the automatic change procedure to change its definition of "Sec. 471 costs" to record purchases at their net value.

If a change is made, the beginning inventory for the year of change is reduced to its net purchase price. When a company is on LIFO, all prior LIFO layers must be restated. A LIFO taxpayer may use the three-year average method to compute an estimated adjustment.

Example 3: ABC Company, a calendar-year taxpayer using the FIFO method, has substantially undervalued its inventories. Rev. Rul. 89-107 held that a taxpayer with substantially undervalued inventory is required to change its erroneous method when it implements the UCR. Accordingly, ABC can use the automatic change procedure of Rev. Proc. 94-49 to correct its understated inventory.

Example 4: Z Company, a LIFO taxpayer, capitalized its 1993 UCR costs in its 1993 ending inventory even though its one LIFO pool had a decrement during 1993. Over the years Z has experienced inflation in its UCR costs.

Under the LIFO method, the UCR costs associated with a LIFO layer should be the UCR costs incurred in the year the layer was added to inventory. Assuming UCR costs rise over time, this will result in LIFO layers having lower prior years' UCR cost associated with them. if Z has regularly capitalized current-year UCR costs to all LIFO layers regardless of whether its LIFO pools have had a decrement, it has established a method of accounting that can be corrected under the automatic change procedure.

If 1993 is the first year in which Z capitalized current-year costs when the LIFO pool had a decrement, the excess capitalization of UCR costs in 1993 is not an accounting method, but rather an error in calculation. Z should amend its 1993 return to deduct the UCR costs erroneously capitalized.

Example 5: V Company is a wholesaler of paper goods and also runs a catalog operation. It has several warehouses, and it treats costs relating to pulling goods, packing them and transporting them to the loading dock as period costs. Included in these costs is 20% of the depreciation on the warehouse.

The final UCR regulations allow pick and pack costs to be currently expensed. However, the occupancy cost of a facility must be treated as an inventoriable cost. V should file for a method change under Rev. Proc. 94-49 to comply with the final regulations.

Example 6: E Company, a manufacturer, elected to use the simplified production method. However, on review it is discovered that for simplicity it has consistently used an estimated absorption ratio of 5% to determine the capitalizable UCR costs.

E is using a method that estimates the amount of UCR costs that should be allocated to its ending inventory. Although its method is erroneous, E may believe it does not have any audit exposure, since the method closely approximates the UCR costs that would be allocated to ending inventory under a proper method. If audit protection is desired, E may change its UCR method under Rev. Proc. 94-49 and disclose the erroneous method. E would have to change from an estimated to an actual method of determining the total amount of its UCR costs. As part of the change, E would have to determine whether it wanted to use any of the simplified methods. if the simplified production is chosen, E could elect on its 1994 return the historical absorption ratio method. Since under the historical absorption ratio method E would not have to do a yearly UCR calculation (the historical absorption ratio only requires a UCR calculation to be done every six years), this method would give the company the simplicity it desires.

Example 7: Company R adopted dollar-value, double-extension LIFO in 1973. It has been experiencing difficulty recreating the base year of new items entering the LIFO pool. R does not use a simplified method to allocate UCR costs to ending inventory.

Under the LIFO inventory method, a company must extend its ending inventory at its current-year and base-year costs. When a new item enters a LIFO inventory pool, a company must use the current-year cost of the new item as the base-year cost, unless it can reconstruct an earlier cost. Not reconstructing the base-year cost of new items will normally increase a company's income.

When a company using the double-extension or index method has been on LIFO for many years, it often has problems with reconstructing the base-year cost of new items. R will have trouble reconstructing the 1972 base cost of new items that entered its inventory in 1993. In practice, companies use many short-cut methods that approximate the base-year cost of new items.

Rev. Proc. 94-49 requires LIFO companies to update the base year in connection with changing their Sec. 263A method if they use the three-year average revaluation method and are not using the simplified production or resale method. If R were to identify some component of its UCR methodology to change (which would then qualify it to use Rev. Proc. 94-49), it would alleviate R's problems with finding base-year cost data, since as part of making the Sec. 263A change, the base year would be updated from 1972 to 1993.

Example 8: Company B, a manufacturer, allocates its officers' salaries between inventory and noninventory activities. Because of the nature of B's inventory operations, it has only a small amount of ending inventory.

An expense account, such as officers' salaries, may relate to both inventory and noninventory operations. A company may inventory the entire amount of such an expense account, provided this treatment does not provide a significant tax advantage. in order to reduce the recordkeeping associated with the UCR, B may want to consider treating the entire amount of the officers' salaries account as an inventory cost. B can use the automatic change procedure to change its treatment of officers' salaries.