Tax-free basis step-up for LIFO bargain purchases.
Under Hamilton and Kohler, goods acquired at a substantial discount from current cost, even though physically identical to goods subsequently purchased or produced, must be accounted for as separate items under the dollar-value LIFO method, because of their substantially different cost characteristics. The result of treating subsequently purchased items as separate items results in triggering the discount into income to the extent the bargain-purchased items are sold first and do not remain physically on hand at year-end.
After purchasing substantially all the assets of another corporation (including inventory), LaCrosse adopted the double-extension, dollar-value LIFO inventory accounting method and the method Of earliest acquisitions during the year for valuing goods in closing inventory in excess of those in opening inventory, under Regs. Sec. 1.472-8(e)(2). LaCrosse allocated a portion of the purchase price to the inventory, resulting in an opening inventory value of approximately 33% of FMV.
Base-Year LIFO Items May Be Valued at FMV
The Claims Court dismissed the requirement under Regs. Sec. 1.472-2(c) that goods on LIFO must be valued at cost regardless of FMV, because the regulation specifically excepts computations otherwise provided under Regs. Sec. 1.472-8, with respect to the dollar-value method. Instead, the Claims Court superimposed on that regulation the underlying philosophy of the double-extension, dollar-value LIFO method--an item's base-year cost should approximate FMV, even when FMV exceeds cost. The court arrived at this conclusion by determining that the dollar-value LIFO regulations do "otherwise provide" for a valuation at other than cost:
* Base-year cost would be based either on an approximation of current FMV, determined by actual current-year purchase cost (whether first acquisition, average cost or latest purchase) or on an historical (reconstructed) FMV.
* Regs. Sec. 1.472-8(e)(2)(iii) presumes that the higher cost (in a time of rising costs, such as would prompt a LIFO election in the first instance) is the taxpayer's current-year cost, and that this presumptively will be imposed in lieu of a lower cost, unless the taxpayer can reconstruct the lower cost.
* The use of the inventory's FMV as its base-year cost was the approach most consistent with generally accepted accounting principles and, therefore, was ordinarily the most accurate method for clear reflection of income; see Regs. Sec. 1.446-1(a)(2).
Under the Claims Court's decision, the taxpayer's basis in the bargain-purchased goods is stepped up from the bargain purchase price to the replacement cost of subsequently purchased items. The court likened the stepped-up basis for a bargain purchase of inventory to the stepped-up basis provided in Sec. 1014(a)(1) for property acquired from a decedent. Surprisingly, the Claims Court allowed the basis step-up to occur without any offsetting income recognition or basis reduction in another asset. The end result is that the bargain element is never subject to tax. Thus, even though the bargain-purchased items may be sold and do not physically remain on hand at year-end (which would result in recognition of the discount as income under Kohler and Hamilton), the taxpayer's cost of goods sold under LaCrosse is increased by the basis step-up. Assuming a relatively constant level of inventories and no increasing costs, the Claims Court stated that there should be little difference between the LIFO value of the opening inventory (comprising bargain goods at FMV) and that of the dosing inventory (consisting of subsequently purchased goods valued at current cost).
The decision is currently pending on appeal before the Federal Circuit. Both the taxpayer and the IRS have filed briefs that include a discussion of the proper standard of review. The Service's position is that the court can only change the decision if it is clearly unlawful or plainly arbitrary, while the taxpayer's position is that the proper standard of review of the Claims Court decision is whether such decision is dearly erroneous. In response to the taxpayer's claim, the IRS has asserted in its reply brief that, because no evidence was presented at trial to support the use of an FMV basis for the bargain-purchased inventory, the Claims Court's decision is dearly erroneous.
Addressing the merits of the Claims Court's decision, the Service stated that the court "was on the right track when it held that the taxpayer's bargain-purchased inventory was to be treated as an `item' separate from its later-manufactured goods, but then it went off course in holding that the bargain-purchased inventory was to be valued at its FMV, rather than its cost." The IRS also stated that the decision was "plainly wrong" and continued its argument that using FMV to measure the base-year cost of the taxpayer's bargain-purchased inventory conflicts with the general rule of Sec. 1012 that property's basis is its cost. (Bargain-purchased inventory is not one of the exceptions to this rule. In fact, the Service stated that the LIFO regulations require that "inventory shall be taken at cost regardless of FMV." In addition, Regs. Sec. 1.472-8(e)(2)(iii) does not sanction the use of FMV as the basis of inventory; it refers to cost.)
The taxpayer continued its earlier argument that the Claims Court "erred in Kohler on the `item' issue." Nevertheless, the taxpayer stated that the decisions are not in conflict, because the issue of base-year cost was not addressed in Kohler. The taxpayer acknowledged that current-year cost is defined under Regs. Sec. 1.472-8(e) (2)(ii) as the actual cost of the goods purchased or produced, but then summarily stated that "[t]here is no comparable reference to `actual' cost for base-year cost purposes in the Regulations." In addition, the taxpayer took issue with the IRS's use of the term "basis" and distinguished it from the LIFO concept of base-year cost. Interestingly, too, the taxpayer attempted to discount the conclusion that the taxpayer's step-up in basis in the bargain-purchased inventory is tax-free, by noting that it would expect the Service to tax such amount on complete liquidation of the taxpayer's inventory.
The IRS finally appears to focus on the major deficiency in the holding in LaCrosse--the bargain purchase is not the taxpayer's beginning inventory (a statement with which the taxpayer concurs in its brief). (See Rev. Rul. 85-172, which held that goods acquired in a bulk purchase must be treated as goods acquired during the tax year, and that the first purchase of inventories was not a beginning inventory.) As a result, the discourse over whether base-year cost may be FMV is likely irrelevant to the case at hand; the increase in the taxpayer's inventory during the year (from zero) needs to be valued at actual cost in order of acquisition as elected by the taxpayer. In so doing, the value of the inventory at base-year cost, however determined, needs to be converted to actual cost, to the extent it exceeds the prior year's base-year cost.
If the bulk purchase is valued at FMV and treated as beginning inventory, the approach in LaCrosse results in a permanent difference (as the bargain element is never subject to tax). If a practice permanently affects the taxpayer's lifetime income, it does not involve timing and, therefore, is not a method of accounting; see Rev. Proc. 91-31. Therefore, a change to such practice is not an accounting method change, and a taxpayer is, therefore, not required to file Form 3115, Application for Change in Accounting Method. Taxpayers that have previously complied with the Kohler and Hamilton results for prior-bargain purchases may be tempted to file amended returns to request the application of the result in LaCrosse. Such an action would be premature, based on the IRS'S appeal of that decision. In the interim, however, LaCrosse does provide substantial authority for a taxpayer that made a bargain purchase of inventory in a tax year for which it has not yet filed a tax return, to value the bargain-purchased inventory at FMV and treat it as beginning inventory.
FROM FRANK J. KALIS, JR., CPA AND PAUL K. GIBBS, CP, WASHINGTON, DC
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|Title Annotation:||last-in-first-out inventory accounting|
|Author:||Gibbs, Paul K.|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 1999|
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