Change in accounting method vs. correction of an error.

• Author: Schuth, Michael R.

The Tax Court recently decided, in Huffman, 126 TC No. 17 (2006), that the correction of an inventory error was an accounting-method change that required a Sec. 481(a) adjustment, and not a mathematical error, as the taxpayer had argued.

In this consolidated case, the taxpayers owned a group of four S corporations that had used the link-chain, dollar-value method of valuing LIFO inventory for at least 10 previous tax years. The corporations' accountant had omitted a computational step required by the LIFO method for all tax years since the S corporations had elected the LIFO method, until discovery by the IRS. The Service determined the omission was an error in timing and not a mathematical or posting error.

Background

Accountant's method: The taxpayers' accountant began the inventory calculation by determining the current-year cost of each pool and divided it by a cumulative index to determine the pool's base-year cost. He then compared this base-year cost with the base-year cost calculated at the beginning of the year. When the end-of-year base-year cost exceeded the beginning-of-year base-year cost, he determined there had been an increment to the pool. However, he failed to multiply this increment by the cumulative index to determine a LIFO value for the increment, as required by the link-chain, dollar-value method. As a result, the taxpayers' LIFO reserve was overstated, and cumulative taxable income understated, over the life of the LIFO election.

Correct method: Temp. Regs. Sec. 1.446-IT(e)(2)(ii)(a) sets forth the basic framework for determining whether an accounting-method change has been made; consistency and timing are crucial to this determination. Under the regulation, a change in method includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. A "material" item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. It also states that although an accounting method may exist without a pattern of consistent treatment of an item, in most instances, consistent treatment of such item will be considered an accounting method.

Temp. Regs. Sec. 1.446-1T(e)(2) (ii)(b) describes when a correction or adjustment does not constitute an accounting-method change, such as a correction of mathematical or posting errors, or errors in the computation of tax liability. The term "mathematical...