IRS continues challenge of the components-of-cost LIFO method.

• Author: Conjura, Carol

In Letter Ruling (TAM) 9405005, the IRS disallowed a manufacturer's use of the components-of-cost method to compute its dollar-value LIFO inventories and cost of goods sold. Based on this ruling, it appears that the Service will continue its challenge to the use of this method on examination, and will not permit taxpayers to change from a product-cost to a components-of-cost LIFO method. However, some manufacturers may be willing to challenge the IRS position in court on the basis that the method is supported by regulations.

General description

The components-of-cost LIFO method may provide additional tax benefits to manufacturers who experience technological or other efficiencies in the cost of manufacturing a product. Under this method, the LIFO index is computed on the basis of the price changes in the individual elements of the product (i.e., raw materials, labor and overhead). Under the product-cost method, a manufacturer will compute its LIFO inflation index by comparing current-year prices with base-year prices of the total product. Although the prices of the individual elements of the product may increase from inflation, efficiency gains will be reflected in lower current costs, thereby showing less inflation. Similarly, less efficient production will increase the current cost and reflect more inflation.

Under the components-of-cost method, the LIFO index is computed by comparing the currentyear prices of current-year inputs with the base-year prices of the same current-year inputs. This method prevents efficiency gains from being treated as price deflation (and inefficient production from being treated as price inflation) in the product.

Current IRS position

In TAM 9405005, a manufacturer of various products had originally adopted the specific goods LIFO method in 1939, but only with respect to raw materials, including the raw material content of work-in-process and finished goods. Some time later, the taxpayer expanded its LIFO election to all components of inventory. The taxpayer also requested and had approved a change in its LIFO method to use the dollar-value method, natural business unit pooling and the link-chain index method. At the time the change was requested, the taxpayer may have clearly represented to the IRS that it intended to use the components-of-cost method and the consent letter may have described this aspect of the taxpayer's proposed method. However, the letter ruling apparently did not specifically discuss...