Inventory acquisition and dollar-value LIFO - the effect of bargain prices.

• Author: Turner, Mark A.

Companies that use LIFO to minimize the taxation of illusory inventory profits should never forget that LIFO can turn around and bite them when inventory levels decline. Recently, the Tax Court handed down a decision that could cause LIFO companies to be hit with a large tax bill even when inventory levels do not decline. If any part of the LIFO base can be construed as having been acquired in a bargain purchase, under the precedent of Hamilton Industries, Inc. v. Commissioner, (1*) the Internal Revenue Service may require income retained in the LIFO layer to be immediately recognized. Thus, many companies could have a bomb buried in their LIFO inventory that could be detonated by an IRS audit. In addition, companies that anticipate acquiring inventory through means other than normal purchasing channels (such as business acquisitions) need to be aware of the implications of this Tax Court decision.

Development of Dollar-Value LIFO

After the Revenue Act of 1939 granted all taxpayers the right to use LIFO, the IRS argued that LIFO should be limited to situations where it would be easy to measure units. Thus, the IRS expressed a preference for a narrow specific-goods approach and opposed the use of the dollar-value method. In 1947, however, the Tax Court in Hutzler Brothers Co. (2) approved the dollar-value method and the IRS retreated to fight the battle on a different front. It continued to oppose the very innovation made possible by dollar-value LIFO -- applying LIFO to a broad pool of dissimilar items. The primary benefit of dollar-value LIFO is that goods can be expressed in terms of dollars regardless of the dissimilarity of the items. Theoretically, a change in the mix of items should not necessary change the value of the inventory as long as the total inventory in base-year dollars is unchanged. The accompanying example illustrates the effects on inventory when a taxpayer changes the inventory mix.

In this example, the value of the ending inventory is the same as the beginning inventory because the inventory stated in base-year dollars has not changed. Using a single pool dollar-value system allowed the taxpayer to utilize current costs of both Muck and Yuck to determine cost of goods sold. If the IRS requires the establishment of separate pools for Muck and Yuck, the taxpayer will be forced to liquidate low-base Muck inventory and replace it with a higher base for Yuck. The results of treating Muck and Yuck as separate pools is shown below:

Beginning inventory $100 (100 barrels of Muck at $1 Purchases (50 barrels of Muck at $5, plus 50 barrels of Yuck at $4 450 550 Less: Ending inventory (50 barrels of Muck at $1 plus 50 barrels of Yuck at $4 250 Cost of Goods Sold $300 Once items have been grouped into pools, each pool is evaluated to determine changes in quantity of that pool only. In the example, overall quantity has not changed: there are 100 barrels of material in both beginning and ending inventories. If Yuck is a separate pool, however, the first barrels of Yuck that are bought will be used to establish a LIFO pool for Yuck that necessitates liquidating part of the low-cost Muck pool.

The Inventory Pooling Issue

The example demonstrates that the establishment of multiple pools may be at odds with the LIFO objective of matching current costs with current revenues. Accordingly, the dollar-value regulations that were promulgated in 1961 allowed pooling on the basis of "natural business units." The purpose of the natural business unit concept is to ensure that no gain or loss results from shifting inventory dollars from one item to another within a naturally related group of activities. Under Treas. Reg. [section] 1.472-8(b)(2), the determination of what constitutes a natural business unit is to be resolved on a case-by basis.

Under the regulations, the facts and circumstances are to be reviewed in light of some general considerations. Divisions formed for internal management purposes, separate and distinct production facilities and processes, and maintenance of separate profit and loss records are significant indicators of natural business units. In contrast, differences attributable solely to geographical location are not sufficient to identify separate natural business units. If only one natural business unit exists, raw materials, work-in-process, and finished goods may be combined. If more than one natural business unit exists, however, the Commissioner may require that separate pools be established for raw materials, work-in-process, and finished goods. Manufacturing units that also engage in wholesaling or retailing of purchased goods must use separate pools to account for their purchased goods.

In Amity Leather Products Co. v. Commissioner, (3) a business sold leather products, some that it manufactured and other identical goods which it purchased from a Puerto Rico subsidiary. The cost of producing the goods domestically was substantially different from producing them in Puerto Rico. The Tax Court required Amity to form separate pools for manufactured and purchased inventory even though the parent exercised considerable control over the subsidiary and the goods were similar in quality. The court observed that the subsidiary was a separate entity that kept separate books, filed separate tax returns, and produced a product with substantially different costs.

Will a manufacturer that makes a single, isolated bulk purchased of inventory for resale be required to segregate such goods into a separate pool? In UFE, Inc. v. Commissioner, (4) the Tax Court rebuffed the IRS's attempt to separate inventory that was part of an acquisition of a manufacturing business from the subsequent identical products produced. In other words, UFE, a manufacturer, was not deemed to also become a wholesaler or retailer on the basis of a single isolated initial purchase but was allowed to use one pool for the acquired and subsequently manufactured inventory. This enabled the initially purchased inventory to be "frozen" into a low-cost LIFO base because the acquisition was accomplished at a bargain price.

Recently, the Tax Court reconsidered the issue in Hamilton Industries. On very similar facts, the court technically reached the same on the pooling issue. Nevertheless, it required Hamilton to treat its bargain purchase as a separate "item" which resulted in matching the costs of the bargain purchase against current sales. This decision had the effect of requiring a LIFO company to...