Introduction
The information that follows
concerns dollar value LIFO
computations using the
conventional definition of an
item, including full
comparability of items. This
section also applies to an auto
dealership that was eligible to
elect 97-36 and did not exercise
that election. A separate
section discussing "Alternative
LIFO," as defined in Rev. Procs.
92-79, 97-36 and 2001-23 is
found later in this ATG.
This information focuses on the
application of LIFO to new
vehicles in ending inventory.
The application of LIFO to used
cars and parts is similar.
The information that follows is
an attempt to explain the basic
concepts of LIFO. This
compendium not only addresses
the technical principles to
apply, but provides an in-depth
case study featuring precise
computations and definitions of
what is being computed. It is
our wish to make the revenue
agent comfortable with these
concepts so they will have the
necessary confidence to complete
this issue that may arise during
an auto dealership examination.
LIFO
Concepts
This section is arranged in a
question and answer format
addressing issues most often
encountered in this area.
Why do we need to compute
LIFO indices?
We need to compute LIFO
indices to determine the
annual reserve increment (or
decrement) known as the LIFO
layer. This amount is added
to or subtracted from the
reserve on an annual basis.
The LIFO reserve is the
difference between the LIFO
valuation of ending
inventory and its non-LIFO
(i.e. first-in, first-out,
specific identification or
average cost) valuation. By
computing the annual index
we can determine this
inflationary rate, which is
added to the non-LIFO value.
The result of inflation
being added to ending
inventory creates the layer
that adds to the reserve
balance and increases the
current year cost of goods
sold deduction. The reserve
balance creates a tax
deferral for the dealership.
How do we measure the value
of LIFO inventories?
There are two methods: the
Unit Method (also known as
the Specific Goods Method)
and the Dollar Value Method.
The unit method is used
where an inventory consists
of specific items or goods
that may be considered
fungible. This method
measures inventory changes
in quantity of items. The
unit method is rarely used
by the auto dealership
industry. The dollar value
method measures inventory
changes in terms of dollars
instead of in terms of
changes in quantity of
items. This method is
properly used when measuring
an inventory that contains
similar specific items such
as vehicles. This method
groups items into separate
pools. See Treas. Reg.
section 1.472-8. Most auto
dealerships use the dollar
value method.
What are the Dollar Value
methods of pricing a LIFO
inventory?
Treas. Reg. section
1.472-8(e)(1) states there
are four:
Double Extension Method
Link Chain Method
Index Method
Retail Method (not
discussed at this time)
Whatever method is used must
consistently and clearly
reflect the income of the
taxpayer. See IRC section
446(b). The dollar value
method of valuing LIFO
inventories is a method of
determining cost by using
"base year" cost expressed
in terms of total dollars
rather than quantity and
price of specific goods as a
unit of measurement. See
Treas. Reg. section 1.472-8.
This Guide will primarily
focus on the Link Chain
Method and touch upon the
Double Extension Method
because these methods are
more commonly elected by
auto dealers to value their
inventories. The index
method has not been
encountered in an auto
dealership setting, but is
mentioned because it is an
acceptable method that may
be used. The retail method
is technically an acceptable
method to use, but it would
be unlikely to be
encountered because it uses
external indexes that may
produce indices
significantly lower than
those the auto dealer can
generate internally.
a.
Double Extension Method
Under the double extension
method, the quantity of each
item in the inventory pool
at the close of the taxable
year is extended (priced) at
both base year unit cost and
current year unit cost.
(Pools are discussed below.)
The respective extensions
(pricing) of the two costs
are each totaled. The first
total gives the amount of
such inventory in terms of
current year costs. (See
below, for a discussion of
determining current year
costs). The second total
gives the amount of such
inventory expressed in base
year costs.
Under the double extension
method, a base year cost
must be ascertained for each
item entering a pool for the
first time subsequent to the
beginning of the base year.
In such a case, the base
year unit cost of the
entering item shall be the
current year cost of that
item, unless the taxpayer is
able to reconstruct or
otherwise establish a
different cost.
The double extension index
formula is as follows:
Current year
quantity (CYQ) x Current
year costs (CYC)
Index =
—————————————————————
Current year
quantity (CYQ) x Base year
costs (BYC)
b. Link Chain Method
The link chain method is a
cumulative index that
considers all annual indices
dating back to the year of
election. It is used to
restate current year
inventory to base year
costs. This cumulative index
is also used to value
increments of base
year cost when they occur.
This cumulative index is
called the link chain method
because it is derived by a
multiplication process that
involves the "linking" of
annual indices back to base
year. For example, if the
year of the LIFO election is
1991, and the current year
is 1993, the 1993 link chain
index is computed as
follows:
1991 index times 1992 index
times 1993 index = 1993
cumulative link chain index.
c. Index Method
Under the index method,
indices are developed by
double extending a
representative portion of
inventory in a LIFO pool or
by using other sound and
consistent statistical
methods. The formula for
calculating the sample index
is identical to the one used
in the double extension
method.
In order to determine total
base year costs, total
current year cost is divided
by a weighted average index
derived for the sample. This
calculation technique is
necessary because the index
method does not double
extend the entire current
year inventory. This index
is also used to value
increments.
The dollar value indices
determined under the double
extension and index methods
measure inflation from "day
1" of the LIFO election,
through the current year.
The annual inflation index
is determined according to
this formula:
End of year
quantity (EQ) x End of year
costs (EC)
Index =
——————————————————————
End of year
quantity (EQ) x Beginning of
year cost (BC)
How does reconstruction of
base year costs affect
Dollar Value pricing?
The double extension method
is the "preferred method" to
compute base year costs as
stated in Treas. Reg.
section 1.472-8(e)(1).
However, in the auto
dealership context, using
the double extension method
to reconstruct base year
costs raises concerns and
hence is more susceptible to
error than other known
methods.
LIFO - Reconstruction of New
Item Cost
Treas. Reg. section
1.472-8(e)(2) states in
part; "Double-extension
method. —(i) Under the
double-extension method the
quantity of each item in the
inventory pool at the close
of the taxable year is
extended at both base-year
unit cost and current-year
unit cost (emphasis
added)."
Under the double-extension
method a base-year unit cost
must be ascertained for new
items entering a pool for
the first time. The
base-year unit cost of the
new item shall be the
current-year cost of that
item unless the taxpayer is
able to reconstruct or
otherwise establish a
different cost.
If the new item is a product
or raw material not in
existence on the base date,
its cost may be
reconstructed, that is, the
taxpayer using reasonable
means may determine what the
cost of the item would have
been had it been in
existence in the base-year.
If the item was in existence
on the base date but not
stocked by the taxpayer, he
or she may establish, by
using available data or
records, what the cost of
the item would have been to
the taxpayer had he or she
stocked the item.
If the base-year unit cost
of the entering item is
either reconstructed or
otherwise established to the
satisfaction of the
Commissioner, such cost may
be used as the base-year
unit cost in applying the
double-extension method. If
the taxpayer does not
reconstruct or establish to
the satisfaction of the
Commissioner a base-year
unit cost, but does
reconstruct or establish to
the satisfaction of the
Commissioner the cost of the
item at some year subsequent
to the base-year, he or she
may use the earliest cost
which he or she does
reconstruct or establish as
the base-year unit cost.
It is clear from the
language used in the
regulations that this issue
is highly factual. The
regulations state the
taxpayer "using reasonable
means may determine what the
cost of an item would have
been had it been in
existence in the base year."
The regulations place the
burden of reconstruction on
the taxpayer by creating a
presumption that base-year
cost equals current-year
cost for new items unless
the taxpayer can demonstrate
otherwise. This burden
should not be taken lightly.
The Supreme Court, in Burnet
v. Houston, 283 U.S. 223
(1931) stated, "The
impossibility of proving a
material fact upon which the
right to relief depends,
simply leaves the claimant
upon whom the burden rests
with an unenforceable claim,
a misfortune to be borne by
him, as it must be borne in
other cases, as the result
of a failure of proof."
A number of techniques have
been developed to make
reconstruction easier. One
technique is to elect the
link-chain method. This
method, which has generally
been permitted,
substantially reduces the
task of reconstruction. This
is so, because reconstructed
costs only have to be
established as of the
beginning of the current
year and generally there
will be fewer completely new
items.
Another technique used is to
broadly define the inventory
item. If a car dealer treats
all cars as one item, there
would probably never be a
new item in the car pool.
The technique probably used
most often is to develop an
index for comparable items
and then use that index to
determine the base-year cost
(beginning of the year cost
for a link-chain taxpayer)
for new items. Whether or
not this reconstruction
technique is reasonable has
been the subject of two
recent private letter
rulings.
Chief Counsel recently
commented on retail
automobile dealerships with
essentially the same facts
and arguments. Each
dealership had reconstructed
the beginning-of-the-year
costs of new vehicles in
ending inventory utilizing
an index derived only from
comparable vehicles. The
dealers argued they had used
a reasonable method of
reconstruction because the
cost increases for
comparable vehicles should
be used as a guide for the
new vehicles. They stated
that it would be reasonable
to assume that
non-comparables (new
vehicles) would have
increased in price at the
same rate as other vehicles
produced by that same
manufacturer. The same
administrative staff, raw
material suppliers, union
contracts, and depreciation
schedules, etc., would
influence the price of both
comparables and
non-comparables. One dealer
argued that a new vehicle as
a percentage of the total
inventory was not material
and therefore, it had
double-extended a
representative portion of
its inventory. The facts
showed that comparable
vehicles represented
anywhere from 73 to 100
percent of the value of the
vehicles in the various
pools and years.
The National Office defines
"comparables" as items that
exist in both beginning and
ending inventory.
Non-comparables are items
that only exist in the
ending inventory.
The National Office
concluded that the
reconstruction methods used
by these dealers were not
reasonable and provided the
following reasons:
Comparable and
non-comparable vehicles
may vary in their
characteristics and
costs.
This method is not
supported by the
regulations. It is
inappropriate to apply
an index derived from
one subset of items in a
pool to another subset
of items. An index
computed that excludes
new models does not
clearly reflect income.
The method has the
potential to produce
distortions in the
dollar-value
computations. These
inaccuracies would then
cause distortions in
computations in
subsequent years due to
the use of the
link-chain method.
Even if a dealer could
substantiate its claim
that the effect of
inflation on comparable
vehicles is reflective
of the effect on
non-comparable vehicles,
there is no reasonable
assurance that this
relationship would
continue in the future.
A price index for a
dollar-value LIFO pool
must be computed based
on all the items in
ending inventory for
that pool.
The National Office stated,
"Whether a taxpayer's
particular method is
reasonable is a
determination that should be
left to the district
director because such a
determination requires a
facts-and-circumstances
analysis [emphasis added]."
In a PLR the National Office
stated "A taxpayer's method
of reconstruction should be
considered reasonable if the
taxpayer can demonstrate
that the method used is an
accurate measure of what the
rate of inflation would have
been had the new item been
in existence in the prior
year, or had the item been
stocked by the taxpayer in
the prior year. For example,
had X used an index derived
from a portion of its
vehicles in ending inventory
that X could demonstrate
were comparable to a
particular new model,
application of that index to
derive a reconstructed
beginning-of-the-year cost
for that new model should be
acceptable."
If the taxpayer's method of
reconstruction is an issue,
develop the issue by first
determining how the taxpayer
computes its index for new
items. Consider following
these steps;
Interview the
individual(s) who did
the LIFO computations
and ask them how they
handled new items. If
the method used does not
appear to be reasonable
you need more
information.
Submit an Information
Document Request for
either a list of the new
items or an
identification of the
new items on the
double-extension
schedules or inventory
records.
Request the taxpayer to
identify new items that
existed in the base year
(beginning of the year
for a link-chain method)
but were not stocked.
Start with the tax years
under examination.
If items existed but not
stocked, the taxpayer
should be able to obtain
a proper cost either
from existing price
sheets or from its
suppliers. Ask the
taxpayer to obtain the
cost prices.
Give the taxpayer the
opportunity to
demonstrate that the
index derived for an
existing item is
comparable to a
particular new item.
For the remaining items
that are completely new,
ask the taxpayer to
either reconstruct the
cost using reasonable
means or accept the
current price as the
base or
beginning-of-the-year
price.
Depending on the results
of the revised
computations for the
current year(s) under
examination, consider
either applying the
steps above to prior
years or adjusting the
prior years using error
rates for the current
year(s).
Keep in mind that the
regulations place the burden
of reconstruction squarely
upon the taxpayer. It is not
the examiner's
responsibility to either do
the reconstruction or even
to do a statistical sample
to establish whether or not
the taxpayer's short cut
method is accurate and
reliable. The examiner only
has to demonstrate with
supporting workpapers using
the taxpayer's records
(double-extension schedules
and inventory listings) that
the comparable (existing
items) and non-comparable
items vary in their
characteristics and cost.
Since this is a
facts-and-circumstances
issue and the taxpayer is
allowed to use reasonable
means to reconstruct, the
examiner should make every
effort to resolve this type
of issue.
Another issue that has come
up in this area is whether a
taxpayer may retroactively
reconstruct the cost of a
new item where the current
year cost was used for that
item as the base-year cost
when the returns were filed.
In the particular case where
this issue arose, the
taxpayer proposed this and
requested a large refund
during the examination. How
an item is valued would
appear to be a method of
accounting and any change in
how that item is valued
would be a change in method
of accounting. Treas. Reg.
section 1.446-1(e)(2)(ii)(a)
states in part, "* * *
Changes in method of
accounting include * * * a
change involving the method
or basis used in the
valuation of inventories * *
*."
A taxpayer in the business
of manufacturing diamond
rings reconstructed the
base-year cost of new
diamonds by comparing them
to a higher quality diamond.
The Service held that the
correction of the base-year
cost of an item constitutes
a change in method of
accounting that could only
be done prospectively. See
IRC section 446 and the
corresponding regulations,
Hamilton Industry, Inc.,
Successor of Mayline
Company, Inc. and Subsidiary
v. Commissioner, 97 T.C.
120 (1991) and Rev. Rul.
90-38, 1990-1 C.B. 57.
For Dollar Value LIFO
what is the definition of an
item?
The next few paragraphs
reference the Motor Vehicles
Industry Specialization
Program's coordinated issue
paper "Dollar Value LIFO –
Definition of an Item". For
more detail please refer to
the full text.
An item of inventory is
defined, for purposes of
calculating the value of the
taxpayer's inventory under
the dollar-value LIFO method
as authorized by Treas. Reg.
section 1.472-8, is defined
by reference to a particular
vehicle as to make, year,
model, body style, standard
equipment, options, and
other factors.
Treas. Reg. section
1.472-8(e)(2)(i) provides
that under the
double-extension method, the
quantity of each item in the
inventory pool at the close
of the taxable year is
extended at both base-year
unit cost and current-year
unit cost. Under the
link-chain method, the
quantity of each item in the
inventory pool at the close
of the taxable year is
extended at both the
beginning-of-the year unit
cost and the end-of-the-year
unit cost. Neither the Code
nor the regulations define
what constitutes an item.
The tax court in Wendle
Ford Sales, Inc. v.
Commissioner, 72 T.C.
447(1979), determined that
1975 Fords with solid-state
ignitions and catalytic
converters were not new
items when compared to 1974
Fords that did not have
solid-state ignitions and
catalytic converters. The
manufacturer determined
whether or not a Ford had
either of these features.
Their cost was never
separately stated on the
dealer's invoice. The court
decided that the entire car
was the item and not the
individual components or
parts.
Vehicles on hand at the end
of 2 different taxable year
should be compared
considering differences in
make, year, model, body
style, standard equipment,
options, and other factors,
appropriate adjustments
should be made to the cost
of the vehicles on hand at
the end of the prior taxable
year to account for as many
of these factors as
possible. The prices of all
factory installed options
are readily available to
distributors and dealers.
For body style, standard
equipment, options and other
features that are available
at one point and not
another, the adjustment
should be based on the
stated or implied price when
available and factored in as
a percentage of the base
vehicle cost.
Under full comparability
LIFO when a vehicle cannot
be compared to a similarly
equipped vehicle in the
prior year, beginning and
ending cost are the same,
resulting in an index of
1.00.
Reconstruction is a
fundamental issue for all
three methods. The base year
cost of an item will be the
current year cost of the
item unless the taxpayer is
able to reconstruct or
otherwise establish a
different cost to the
satisfaction of the agent.
If the taxpayer originally
elects on their Form 970 the
double extension method, but
applies the link chain
method without requesting
permission, the taxpayer has
an unauthorized change in
accounting method. The
taxpayer should recalculate
their LIFO by applying the
double extension method as
originally filed. If the
taxpayer wishes to change
their method, then a Form
3115 should be filed under
the provisions of Rev. Proc.
97-27, 1997-1 C.B 680 (May
8, 1997).
How many ways are there to
compute a dollar value
index?
There are two general
classes of indices, the
internal and the
external. The
internal method
generates indexes from
information derived and
maintained by the
dealership. The external
method indices are taken
from the Consumer Price
Index (CPI) or the Producer
Price Index (PPI).
These classes of indices
should not be confused with
different LIFO methods
previously discussed.
Remember, an index is a
subpart of an overall LIFO
method tracking the
inflation or deflation of a
particular item (pool) in
ending inventory at a
certain yearend.
The external indices are
used with the Inventory
Price Index (IPI) Method and
are seldom used for two
reasons. The Government
generated indices are
generally lower than those
produced internally by the
dealers. Second, a
dealership or group with
gross receipts over
$5,000,000 does not qualify,
under IRC section 474, and
under the IPI method can
only take 80 percent (100%
after for tax years ending
after 12/31/2001 per Treas.
Reg. 1.472-8) of the annual
change in IPI Method CPI or
PPI for the index. The use
of the external indices is
an election made with the
adoption of LIFO or if this
represents a change in
method, then a Form 3115
should be filed under the
provisions of Rev. Proc.
97-27, 1997-1 C.B. 680 (May
8, 1997).
What methods can be used to
determine the current-year
costs that can be used in
the index calculations to
price units in the yearend
inventory?
The current-year costs that
can be used in the index
calculations are:
Cost based on the most
recent purchases.
Cost based on the
average cost of
purchases during the
year.
Cost based on the
earliest acquisitions
during the year.
Remember, each item in the
inventory pool at yearend is
priced at current-year cost.
See Treas. Reg. section
1.472-(2)(i).
In addition to these three
methods, the regulations
authorize the use of any
other proper method that, in
the opinion of the
Commissioner clearly
reflects income. Whatever
method is adopted, it must
be adhered to in all
subsequent years. See Treas.
Reg. section 1.472-8(e).
We will focus our
concentration on the
Earliest Acquisitions Method
and the Latest Acquisitions
Method (most recent
purchases) because these are
the most prevalent in the
auto dealership industry.
The earliest acquisitions
method encompasses pricing
the inventory items on hand
at the yearend with the
actual cost of goods
purchased during the taxable
year in the order of
acquisition. This
theoretical position assumes
that pricing is being done
in chronological order to
the actual purchases.
Note, in dollar-value LIFO,
the indices are used to
ascertain the amount of the
LIFO reserve. However, in
using the earliest
acquisitions method, not
only is the index creating
the reserve, in addition
there is an amount created
called a "Hidden Reserve."
If we compare the result of
the pricing of yearend
inventory using the earliest
acquisitions method to the
general ledger amount of the
inventory at yearend, the
difference is this
additional amount of
"reserve." This difference
is not obtained in using the
most recent purchases
method.
An example of these
comparisons follows:
Example 1
There are 40 units of X
in ending inventory that
are to be valued at
their earliest
acquisition cost.
Purchases of X during
the year were as
follows:
Date
Quantity
Amount
1/21
10 @
$2.00
2/15
10 @
2.10
3/25
15 @
2.15
4/08
30 @
2.25
5/10
100 @
2.30
10/11
150 @
2.50
12/10
200 @
2.45
The current year cost of
X computed according to
the earliest acquisition
cost method would be
$84.50:
10 x $2.00 = $20.00
10 x 2.10 = 21.00
15 x 2.15 = 32.25 05 x 2.25 =
11.25
40
$84.50
In contrast the FIFO
amount (cost) = 40 x
2.45 = $98.00
The difference between the
current-year cost pricing of
the inventory being $84.50
and the FIFO amount of $98
results in a difference of
$13.50, which is the "Hidden
Reserve" obtained in
earliest acquisition without
considering the indices.
This is an example of the
hidden reserve referred to
earlier.
If we want to use the most
recent purchases (latest
acquisition), the current
year pricing will equal the
amount using the FIFO
amount. Therefore, the
hidden reserve is not
present under this method.
Forty units at $2.25 equals
$98 which is equal to the
FIFO amount.
If an inventory contains a
large number of different
items, such as with auto
dealerships, the pricing
procedure just described
could involve quite a few
calculations and most, if
not all, taxpayers do not
price all items in their
inventory using the earliest
acquisition method. For this
reason, the theoretical
method of pricing ending
inventory quantities under
LIFO is not used and the
taxpayers who elect this
method use a shortcut method
to determine the earliest
acquisition cost. The IRS
has not approved any short
cut method. See coordinated
issue "Segment of Inventory
Excluded from the
Computation of the LIFO
Index."
In practice, using example 1
above, some taxpayers apply
the earliest acquisition
method of pricing quantities
by using the $2 purchase
price on January 21 to price
all 40 units of X in ending
inventory. Current-year
costs of X would, therefore,
be $80 (40 x $2). Even under
this shortcut method a
hidden reserve would result
in the amount of $18.
In periods of inflation, the
earliest acquisition cost
generally produces the
lowest LIFO inventory value.
Use of the latest
acquisition cost usually
results in the highest LIFO
inventory value.
Pooling
Introduction
One of the central points of
LIFO valuation is the
requirement to compare only like
kind items. A unique aspect of
the dollar value method is
pooling, allowing the dealer to
combine like kind items into a
group where inflation is
computed on these like kind
items. If non-comparable items
were pooled together there would
be a fundamental problem with
the indices causing a material
distortion of income.
Assuming the dealership elects
LIFO for its inventory, under
the full comparability LIFO
method, a dealer may have a pool
for:
New cars
New trucks
Parts
Used cars
Used trucks
Other items such as
recreational vehicles
Proper pooling must be
determined for each trade or
business. Some of the factors
Chief Counsel has relied upon
are based upon the particular
facts and circumstances of the
dealership include the
following:
The dealership is engaged in
the same type of activities
(i.e., those related to new
and used vehicle sales and
service).
Employees including
upper-level management,
accounting personnel and
administrative personnel can
work at other locations, for
example, the same employee
is the general manager of
multiple locations that sell
automobiles and the used car
manager manages all used
vehicle sales for all
locations and purchases all
used vehicles that are not
acquired through trade-in
sales.
The dealership only has one
checking account out of
which all payrolls and other
expenses are paid. The
dealership has one line of
credit that is secured by
all inventories, regardless
of location or manufacturer.
Importance of Pooling
The first and probably the most
important problem involved in
the dollar-value method is
determining the character of the
inventory items which may be
grouped into a pool. Two pools
are required, one for cars and
one for trucks. The reason this
question is so important is that
the goods grouped in one pool
are treated as fungible under
the dollar-value method. Hence,
inventory decreases in one item
may be offset by increases in
another item contained in the
same pool. Under the specific
goods method, if you have a
quantity increase in an item of
inventory, that increase is
valued at the cost prevailing
for that item in the year of the
increase, absolutely separate
from any other item in the
inventory. Each item retains its
own unique history of cost.
Under the dollar-value method,
quantity increases or decreases
are determined looking at the
pool as a whole with the unit of
measure the dollar. Treas. Reg.
section 1.472-8(a) states in
part "* * * new items which
properly fall within the pool
may be added, and old items may
disappear from the pool, all
without necessarily effecting a
change in the dollar value of
the pool as a whole." If there
is a quantity increase, in terms
of dollars, that increase is
valued at the cost prevailing
for the year of the increase
considering all of the items in
the pool. Under this concept,
historical cost for items
decreasing or disappearing can
be substituted for the cost of
items increasing in quantity or
new items entering the pool.
This is the major difference
between the dollar-value method
and the specific goods method.
If the pooling requirements were
such that a pool had to be
established for each item in the
inventory, the results under
dollar-value would not be much
different than under the
specific goods method. The
results would be more accurate
in that historic costs
attributable to items liquidated
could not be substituted for
other items.
The Tax Court in Fox
Chevrolet, Inc. v. Commissioner,
76 T.C. 708 (1981) (a new car
and truck dealer with one pool)
stated where "* * * a pool of
inventory is depleted because
sales exceed purchases during
the year, the LIFO reserve is
invaded and older "historic"
costs flow into costs of sales.
It is self-evident that the
greater number of pools the
greater the likelihood of such a
liquidation occurring. [Emphasis
added]." In Fox Chevrolet the
Service wanted a pool for each
model line of new cars. The
Court noted that model lines
change very rapidly and
consequently pools would be
liquidated each time a model
line was discontinued.
The Tax Court in Richardson
Investments, Inc. and
Subsidiaries (Formally
known as Rich Ford Sales, Inc.),
a New Mexico Corporation v.
Commissioner, 76 T.C. 736
(1981) [a new car and truck
dealer] stated "[the Service's]
24-pool method, [pools by model
line], would, in substance,
place petitioner on the specific
goods LIFO method."
What is interesting in the
Richardson Investment case are
the reasons stated why a second
pool was required for new
trucks. The Court stated:
[t] he use of two pools
would not, as a
practical matter,
prevent petitioner from
employing the
dollar-value method. * *
*; the two-pool approach
succeeds in matching
revenues from truck
sales with the costs of
producing such trucks,
and revenues from the
sale of cars with the
costs of producing such
cars. In addition,
petitioner's income, for
income tax purposes,
would be clearly
reflected because of
this matching of
revenues and costs.
Thus, the objections
found with respect to
[the Service's] 24-pool
approach and
petitioner's 1-pool
approach are not
applicable to a 2-pool
approach. To the
contrary, the
fundamental purposes of
the dollar-value method
are enhanced.
Rules for pooling that apply to
dealers:
Wholesalers, Retailers, etc.
Treas. Reg. section 1.472-8(c)
provides the rules for
establishing pools for
wholesalers, retailers, jobbers
and distributors. Basically they
must pool by major lines, types,
or classes of goods. In
determining such groupings
customary business
classifications of the
particular trade in which the
taxpayer is engaged is an
important consideration. The
regulations mention department
stores as an example of the
customary business
classification.
Cases on this part of the law
have involved new car and truck
dealers, two of which have been
noted above. The Tax Court's
reasoning in the Richardson
Investments, Inc. case brings
another factor into the
determination of the proper
number of pools under this
section of the regulations. Near
the end of its opinion, the
Court stated:
The two-pool [one for
new cars and one for new
trucks] approach
succeeds in matching
revenues from truck
sales with the costs of
producing such trucks,
and revenues from the
sale of cars with the
costs of producing such
cars. In addition,
petitioner's income, for
income tax purposes,
would be clearly
reflected because of
this matching of
revenues and costs.
Thus, the objections
found with respect to
[the Service's] 24-pool
approach and
petitioner's 1-pool
approach are not
applicable to a 2-pool
approach. To the
contrary, the
fundamental purposes of
the dollar-value method
are enhanced. Therefore,
notwithstanding our
earlier determination
that one pool for new
cars and new trucks is
the customary business
classification, this
factor is outweighed by
the clear reflection of
income obtained by
utilizing two pools.
[emphasis added] See
Thor Power Tool Co. v.
Commissioner, 439
U.S. 522, (1979).
This passage illustrates why
requiring pools for unlike items
is appropriate where customary
practices are not firmly
established.
Inventory Price Index (IPI)
Method
Be aware that there are special
pooling rules for taxpayers
electing to use the Consumer
Price Index (CPI) or the
Producer Price Index (PPI)
method provided for by Treas.
Reg. section 1.472-8(e)(3). If
the CPI tables are used, pools
may be established based on the
11 general categories of
consumer goods described in the
CPI detailed report. If the PPI
tables are used pools may be
established based on the 15
general categories of producer
goods described in Table 6 of
the Producer Prices and Price
Indexes. See Rev. Proc. 84-57,
superceded by TD 8975, for
additional explanations of the
pooling requirements for
taxpayers who use this method.
Under this method a new car and
new truck dealer could have one
pool that would include both new
cars and new trucks.
"Transportation Equipment" is
one of the 15 categories.
However, not all of a car
dealer's inventory falls into
this one pool. Car radios, car
batteries, metal stampings,
tires, and engine components are
some examples of dealer
inventory that are in another
PPI pool.
What constitutes a new item?
Another issue is that of a "new
item." In Wendle Ford Sales,
Inc. v. Commissioner, 72
T.C. 447 (1979), the judge
alluded to perhaps classifying
new vehicles as new items after
a period of 5, 10, or 15 years.
Auto dealers maintain that
technological changes are
frequent and revolutionary. A
1995 Ford Thunderbird does not
even closely resemble a
Thunderbird of the early
sixties, for all practical
purposes only the name remains
the same.
There was a television
commercial comparing a 1965
Mustang to a 1995 Mustang. The
theme of the commercial stated
these cars have the same name,
but everything else is new.
Therefore, in lieu of everything
else, most new vehicle inventory
should be reclassified as new
items periodically. This
reclassification assumes that
dealers will not be able to
reconstruct the base period cost
of the items. This issue would
be applicable no matter what
LIFO method is used.
Reconstruction is available
under both the double extension
and link chain methods. For the
double extension method, the
reconstruction would be for a
period from the current year
back to the base year. The base
year is the year of election.
For the link chain method, the
period would be from the current
year to
the prior year only.
The calculation of the current
inflation is derived from
comparisons within each pool.
For the double extension and the
index method, the current
inflation is derived by dividing
the Base Year Cost into the
Current Cost and subtracting the
cumulative index for the prior
year. As for the link chain
method the current
inflation is derived by taking
the Current Cost and dividing by
the Beginning of Year Cost.
For a further discussion of the
definition of an item, refer to
the coordinated issue paper
"Dollar Value LIFO-Definition of
an Item".
Foundation Principles
IRC section 472(a), in
substance, authorizes a taxpayer
to elect the LIFO method,
provided the method clearly
reflects income. A method
clearly reflects income only if
the method conforms to the
regulations prescribed by the
Secretary of the Treasury. The
LIFO regulations are legislative
and carry the full force of law.
To
further enhance our
understanding, it would be
useful to provide a general
background of how the LIFO rules
are arranged in the regulations.
There are eight applicable
subparagraphs:
Treas. Reg. section 1.472-1,
authorizes the use of the LIFO
method and provides general
rules for the use of the
specific goods method.
Treas. Reg. section 1.472-2,
sets forth the requirements
incident to the adoption and use
of LIFO. A taxpayer adopting
LIFO must file an application
and specify with "particularity"
the goods to which LIFO is to
apply. The cost of goods in
ending inventories over those in
beginning inventories must be
valued at a cost that is, at the
option of the taxpayer, the most
recent, average, or latest
acquisition cost. Inventories
valued at LIFO must be reported
in the same manner for financial
purposes. This last rule is
frequently referred to as the
"conformity requirement."
Treas. Reg. section 1.472-3
provides instructions on the
time and manner of making the
election. A taxpayer must attach
a completed Form 970 or
equivalent statement to the tax
return for the first year LIFO
is adopted. Form 970 provides
the Service with detailed
information about the LIFO
method adopted by the taxpayer.
The regulation states that the
taxpayer's application to use
LIFO is subject to the
Commissioner's approval upon
examination of the taxpayer's
tax return. Audit adjustments
are subject to the appellate
process.
Treas. Reg. section 1.472-4
states that the taxpayer in
electing LIFO agrees to any
audit adjustments that the
Commissioner might require in
order to have the taxpayer's
LIFO method clearly reflect
income.
Treas. Reg. section 1.472-5
stipulates that the LIFO
election is irrevocable unless
written permission is secured
from the Commissioner.
Treas. Reg. section 1.472-6
provides the inventory
methodology a taxpayer must use
if permission is received to
discontinue the use of LIFO or
if the IRS terminates the LIFO
election for failure to conform
with the LIFO regulations.
Treas. Reg. section 1.472-7
provides cross-references for
valuing LIFO inventories of an
acquiring corporation. The
language in this regulation is
identical to the language in
Treas. Reg. section 1.471-9.
Both of these regulations state
that IRC section 381(c)(5) and
the regulations thereunder
prescribe the rules for valuing
inventories acquired in certain
corporate reorganizations.
Treas. Reg. section 1.472-8
contains the rules for the use
of the dollar value method.
These rules are relegated to
eight subparagraphs in the
regulations. Below is a summary
of these eight subparagraphs:
Paragraph (a) provides for
the election of dollar value
LIFO and then explains the
conceptual basis underlying
the method.
Paragraph (b) contains the
pooling rules for taxpayers
engaged in manufacturing.
Paragraph (c) contains the
pooling rules for retailers
and wholesalers.
Paragraph (d) reserves for
the Commissioner the right
to determine the appropriate
number and composition of
the dollar value pools.
Paragraph (e) describes and
explains the various dollar
value methods available to
the taxpayer.
Paragraph (f) prescribes the
rules for changing from
another LIFO method to
dollar value (i.e., from
specific goods to dollar
value).
Paragraph (g) sets forth the
rules for combining or
splitting up dollar value
pools.
The
LIFO Election
In adopting LIFO, an election
must be made to use the method.
Such election is not
automatically granted. To make
the election, the following must
be done:
Form 970, "Application to
Use LIFO Method," or its
equivalent must be
completed, signed and
attached to the return filed
for the year of election.
Its equivalent means that if
the taxpayer does not file a
Form 970, but attaches a
schedule supplying all the
necessary information, the
taxpayer will be deemed to
be in compliance.
A 3-year inventory analysis
must be made for any
increase in inventory value.
Restatement of any other
inventory value being used
to state actual cost must be
disclosed.
A statement describing
computations and calculation
of the index must be made.
If electing the Index
method, or the use of the
Link Chain method is
employed, an additional
statement with justification
must be submitted.
A
taxpayer adopting the LIFO
method is bound by the election.
An amended return cannot be
filed to revoke the election.
Terminating or modifying the use
of an elected LIFO method
requires the advance approval of
the Commissioner although some
changes are automatic under Rev.
Proc. 88-15, 1988-1 C.B. 683.
Form 3115 should be used to make
such changes. A taxpayer
terminating LIFO generally
cannot re-elect the method for 5
taxable years following the
termination. See Rev. Procs.
88-15, 1988-1 C.B. 683
(superceded by RP 97-37, RP
98-60, RP 99-49 and RP 2002-9)
and 92-20, 1992-1 C.B. 685,
section 9.03(1).
The adoption of LIFO on Form 970
is tentative and is subject to
the Commissioner’s approval upon
audit. See Treas. Reg. section
1.472-3(d). Furthermore, the
taxpayer agrees to any
adjustments the Commissioner may
deem necessary in order to have
the elected method clearly
reflect income. See Treas. Reg.
section 1.472-4.
The LIFO election requires
adherence to "conformity
requirements" by the taxpayer to
maintain its viability which are
discussed as follows:
Situations that do not
warrant termination, but
which may cause problems.
These situations usually
contemplate problems such as
computational errors or
applications. If a taxpayer
elects the double extension
method, but applies the link
chain method without filing
a Form 3115, this does not
constitute a termination.
The LIFO computations must
be recomputed from the time
of the election under the
double extension method as
originally elected.
There are two methods that a
taxpayer can elect on the
Form 970, the unit method
and the dollar value method.
If a taxpayer elects the
dollar value method of
computing LIFO and is using
the unit method or visa
versa, without filing a Form
3115, then the taxpayer
should be placed on the
elected method as reflected
on Form 970 from the time of
the election of LIFO. See
Rev. Proc. 79-23, 1979-1
C.B. 564, 1979.
What are the conformity
requirements?
IRC section 472(c) states a
taxpayer on the LIFO method
for tax purposes must also
use the same method for
financial reporting. The
application of this section
primarily concerns
statements affecting a full
year's operation, whether
the same as the taxable year
or any other 12 month
period.
No violation occurs if the
taxpayer issues non LIFO
reports or credit statements
covering a period of
operations that is less than
the whole of the taxable
year and less than 12
months.
If the interim report
contains annual financial
data, the report must be on
LIFO basis. Where the
taxpayer presented its
fourth quarter report to its
shareholders on a FIFO basis
and also included its
results of operation for the
entire 12-month period on a
FIFO basis, the Service may
terminate the use of LIFO.
The conformity requirement
will not be considered
violated as long as the
series of interim reports,
when combined, do not
present operating results
for the year on a non LIFO
basis.
A franchised automobile
dealer that elected the LIFO
inventory method for federal
income tax purposes violates
the LIFO conformity
requirement of IRC section
472(c) or (e)(2) by
providing to the credit
subsidiary of its franchisor
(an automobile manufacturer)
an income statement for the
taxable year that fails to
reflect the LIFO inventory
method in the computation of
net income.
IRC section 472(e) provides
that a taxpayer electing to
use the LIFO inventory
method must continue to use
the LIFO inventory method
unless the taxpayer: (1)
obtains the consent of the
Commissioner to change to a
different method; or (2) is
required by the Commissioner
to change to a different
method because the taxpayer
has used some inventory
method other than LIFO to
ascertain the income,
profit, or loss of any
subsequent taxable year in a
report or statement covering
that taxable year (a) to
shareholders, partners,
other proprietors, or
beneficiaries, or (b) for
credit purposes.
Section 1.472-2(e)(1) of the
Income Tax Regulations
provides that a taxpayer
electing to use the LIFO
inventory method must
establish to the
satisfaction of the
Commissioner that the
taxpayer, in ascertaining
the income, profit, or loss
of the taxable year for
which the LIFO inventory
method is first used, or for
any subsequent taxable year,
for credit purposes or for
purposes of reports to
shareholders, partners,
other proprietors, or
beneficiaries, has not used
any inventory method other
than LIFO.
Treas. Reg. section
1.472-2(e)(1) generally
provides exceptions to the
LIFO conformity requirement.
Under Treas. Reg. section
1.472-2(e)(1)(iv), a
taxpayer is not at variance
with the LIFO conformity
requirement if it uses an
inventory method other than
LIFO in a report or
statement covering a period
of less than an entire
taxable year. However,
Treas. Reg. section
1.472-2(e)(6) provides that
a series of credit
statements or financial
reports is considered a
single statement or report
covering an entire taxable
year if the statements or
reports in the series are
prepared using a single
inventory method and can be
combined to disclose the
income, profit, or loss for
the entire taxable year. For
this purpose a taxable year
includes any 1-year period
that both begins and ends in
a taxable year for which the
taxpayer used the LIFO
inventory method. See Treas.
Reg. section 1.472-2(e)(2).
Thus, income statements
prepared on the basis of a
calendar year may be subject
to the LIFO conformity
requirement even though the
taxpayer employs a fiscal
year for federal income tax
purposes.
Under Treas. Reg. section
1.472-2(e)(2)(vi), a
taxpayer is not at variance
with the LIFO conformity
requirement if it uses
costing methods or
accounting methods to
ascertain income, profit, or
loss in financial statements
for credit purposes if such
methods are not inconsistent
with the LIFO inventory
method. The use of cost
estimates is an example of a
costing method that is not
inconsistent with the LIFO
inventory method. See Treas.
Reg. section
1.472-2(e)(8)(ix).
A taxpayer subject to these
conformity requirements may
have the LIFO election
terminated for a conformity
violation. In determining
whether there exists a LIFO
conformity violation, it is
important to examine the
automobile dealer's
financial statement
disclosures to the
manufacturer and to the
entities (creditors) that
"floor plan" the dealer's
inventory, regardless of
whether a particular
creditor is an affiliate of
the manufacturer or outside
party. Refer to Rev. Proc.
79-23.
In Rev. Proc. 97-44, I.R.B.
1997-41, (September 25,
1997), the IRS provided
relief for franchised
automobile dealers that have
violated the LIFO conformity
requirement. This revenue
procedure provides relief
for automobile dealers that
elected the last-in,
first-out (LIFO) inventory
method and violated the LIFO
conformity requirement of
section 472(c) or (e)(2) of
the Internal Revenue Code by
providing, for credit
purposes, an income
statement prepared in a
format required by the
franchisor or on a
pre-printed form supplied by
the franchisor (an
automobile manufacturer),
covering any taxable year
ended on or before October
14, 1997, that fails to
reflect the LIFO inventory
method. See, e.g., Rev. Rul.
97-42, 1997-41 I.R.B.
(Situation 3). Automobile
dealers that comply with
this revenue procedure will
not be required to change
from the LIFO inventory
method to another inventory
method as a result of such
LIFO conformity violation.
Taxpayers that elected this
relief were required to make
three catch up payments to
avoid being terminated.
Revenue agents should at a
minimum, inquire if the
taxpayer elected the above
relief. If the taxpayer did
elect the above relief,
verify the required three
payments were made. If the
taxpayer did not elect the
relief, the agent must check
to see if the taxpayer is in
violation of the LIFO
conformity requirements
under IRC section 472. Even
if they did elect the
relief, taxpayers are
required to continue to
comply with the requirements
of the regulations. Rev.
Proc. 98-46 extended the
relief in Rev. Proc. 97-44
to medium and heavy truck
dealers.
What are the record keeping
requirements?
A taxpayer electing LIFO
agrees to maintain adequate
records to comply with the
regulations. Treas. Reg.
section 1.472-2(h) requires
a taxpayer electing LIFO to
maintain records supporting
the LIFO computations and
compliance with the LIFO
regulations. Treas. Reg.
section 1.472-2(h) places a
substantial responsibility
on the taxpayer since, under
the LIFO reverse order
principle, the costs in
ending inventories relate to
years all the way back to
the year of the initial LIFO
election. A taxpayer may
have the LIFO election
terminated for
non-compliance. See H.E.
Boecking, Jr. and Sally
Boecking v. Commissioner,
T.C. Memo. 1993-497, CCH
49,362(M). See Treas. Reg.
section 1.472-8(e)(1).
How do write-downs affect
the LIFO election?
LIFO is a cost method.
Write-downs from cost are
not permitted. A taxpayer as
part of the election must
restore to the base year
inventories all cost write
downs to items on hand. This
means restoration must be
made to the beginning
inventory in the first year
covered by the LIFO
election.
The write downs that must be
restored (and that cannot be
subsequently claimed as long
as the LIFO election is in
effect) include "lower of
cost or market" write downs,
Treas. Reg. section 1.471-4,
as well as "subnormal goods"
write-downs. See Treas. Reg.
section 1.471-2, Rev. Rul.
76-282, and Rev. Proc.
76-28, 1976-2 C.B. 645.
Under elections made prior
to December 31, 1981, the
restoration had to be made
on an amended return for the
tax year immediately
preceding the year of the
LIFO election. See Rev.
Proc. 76-6. For elections
made after December 31,
1981, IRC section 472(d)
requires the restoration to
be made pro rata over 3 tax
years beginning with the
year of the LIFO election.
The 3-year analysis that is
required to be attached to
the Form 970 provides the
information for the
restoration.
The use of the lower of LIFO
or cost or market for
financial statements is not
a violation of the
conformity requirement
although the write-down must
be restored for tax
purposes. See TAM 8402015.
How can the LIFO election be
terminated?
The service can terminate
the use of the LIFO method
by a taxpayer who has
adopted LIFO without filing
Form 970. There may be an
exception to this rule if
the taxpayer includes all of
the information on the tax
return that is required on
the Form 970. Fischer
Industries Inc. and
Subsidiaries v.
Commissioner, 87 T.C. 116
(1986).
The method may also be
terminated if the financial
reporting requirements are
not complied with (see
above), or adequate records
are not maintained (see
above).
The 1987 Revenue Act added
IRC section 1363(d), which
requires that a
C-Corporation using the LIFO
method who converts to an
S-Corporation must recapture
its LIFO reserve and pay the
tax over a 4 year period.
This provision was effective
after December 17, 1987.
For more information, refer
to Rev. Proc. 79-23, 1979-1
C.B. 564, 1979.
Computations
Index
The examination of an auto
dealership's LIFO begins with a
determination of the
appropriateness of the
taxpayer's indices. A complete
examination of the taxpayer's
computations would require a
great deal of both the
Government's and taxpayer's time
and resources. The agent should
determine if issues are likely
to exist, before embarking upon
a complete examination of these
indices.
The first thing the agent needs
to do is to secure the Form 970
and determine which Dollar Value
method the taxpayer has elected
to price its inventory. In the
auto dealership context, there
are three such pricing methods;
the Double Extension Method, the
Link Chain Method and the Index
method. The Link Chain Method is
the most prevalent in this
industry and will be the focus
of this discussion.
The LIFO years should be
determined by reviewing the Form
970. From this form, the agent
can ascertain the method the
taxpayer has elected to
determine current year costs of
the units in ending inventory in
order to compute the index.
Recall many auto dealerships
elect the Earliest Acquisitions
Method, also known as the First
Purchases Method or the Most
Recent Purchases, also known as
the Latest Acquisitions Method.
Taxpayers may elect the most
recent Purchases method but, in
fact, may be using the specific
identification method. This is
not an unauthorized change in
method of accounting if it has
been consistently used from the
date of election.
To
compute the LIFO index, both the
latest acquisition and earliest
acquisition methods require
comparison of each vehicle in
the current year's ending
inventory to a similarly
equipped vehicle in the prior
year. The difference between the
two methods lies in which
purchase cost is used in the
computation.
Dealers that elect to use the
latest acquisition method must
determine the last purchase
(latest acquisition), during the
current year, of each vehicle in
ending inventory. (For latest
acquisition, generally the
vehicle on hand at the end of
the year is the latest
acquisition.) The cost of the
latest acquisition of the
vehicle must be compared to the
cost of the latest purchase in
the prior year of a similarly
equipped vehicle.
Dealers that elect to use the
earliest acquisition method must
determine the first purchase
(earliest acquisition), during
the current year, of each
vehicle in ending inventory. The
earliest acquisition must be
determined for a vehicle
similarly equipped to the
vehicle in ending inventory. The
cost of the first purchase of
the vehicle must then be
compared to the cost of the
first purchase of a similarly
equipped vehicle in the prior
year.
For example: the dealer has in
ending inventory a fully loaded
Dodge Intrepid. Review of
purchase invoices indicates that
the dealer first purchased a
similarly equipped Intrepid in
May of the current year. The
cost of the May purchase is the
current year cost for purposes
of computing the LIFO index. The
dealer must then analyze vehicle
purchases for the prior tax year
and determine the first purchase
of a similarly equipped Dodge
Intrepid. The cost of the first
purchase in the prior year is
the prior year cost for the
purpose of the LIFO
computation.
Regardless of which method is
elected, if the vehicle is
determined to be a new item for
purposes of the LIFO
computation, the prior year cost
is the same as the current year
cost, i.e. 1.00 index. (Current
year cost is determined as noted
above.)
From these invoices, the indices
will be created. The agent needs
to determine the manufacturer,
model year and model type of the
various distinct vehicles the
dealership has in ending
inventory, separated into two
pools, cars and trucks. This is
necessary to insure the same
vehicles are being "compared"
during the applicable measuring
periods. To illustrate this
concept consider the following:
The current year and year of
examination is 9312. The first
year of the dealership LIFO
election was for the year ending
December 31, 1991. The Form 970
indicates this taxpayer has
elected to use the Link Chain,
Latest Acquisitions Method to
value the inventory. Review of
the general ledger indicates the
9112 dealership ending inventory
has a dollar value of $224,000.
This dollar value was
represented by the following
vehicles:
Model Year 1992
- December 31,
1991
Model
Quantity
Cost
Extended Cost
Car
A
1
$22,000
$
22,000
Car
B
2
23,000
46,000
Car
C
6
26,000
156,000
Base Year Cost 9112
$224,000
You have obtained the necessary
general ledger entries and
invoices and have determined the
following apply to 9212 and 9312
regarding this election:
Model Year 1993
- December 31,
1992
Extended Model
Quantity
Cost
Cost
Car
A
5
$22,880
$114,400
Car
B
6
23,920
143,520
Car
C
9
27,040
243,360
Current Year Cost
9212
$501,280
Model Year 1994 -
December 31, 1993
Extended Model
Quantity
Cost
Cost
Car A
6
$24,024
$144,144
Car B
7
25,116
175,812
Car C
10
28,392
283,920
Current
Year Cost 9312
$603,876
From this information the
indices for each of the 3 years
of this election can be computed
as follows:
The 1991 LIFO Index is 1.000.
This is the Base Year of the
election. There are no prior
items in the inventory.
The 1992 LIFO Index is 1.040.
This was determined as follows:
