Three IRS papers on LIFO inventory.

Author:Rosselli, Robert V.
Position:Last-in, first-out accounting

The IRS has released three Industry Specialization Program (ISP) papers in the LIFO inventory area. The first concludes that a taxpayer may not use an index developed by double-extending one segment of its inventory to apply to a segment of inventory not included in the determination of the index. The second concludes that, for purposes of determining the annual index, inventories purchased in bulk at discounted amounts are separate items from goods subsequently purchased or produced. The third paper concludes that a taxpayer that elects the earliest acquisition method to price increments may not use shortcut methods to price any such increment.

Two common examples of improper methods cited in the first paper are (1) excluding new items in the computation of the index and (2) using an index developed from warehouse data to apply to stores. The Service believes that a representative portion of the inventory requires that "every item in the population must have an equal not zero chance of selection." New items are generally excluded because of the administrative cost to reconstruct or otherwise establish a base-year cost. For taxpayers using the linkchain method, indexing new items at 1.0 has the effect of eliminating inflation for one year. For other taxpayers, the effect is generally much more dramatic, depending on the number of years on LIFO.

The second paper reflects the IRS's long-standing battle against LIFO and bargain bulk purchases of inventory. The Service has been successful in contesting this issue. In Hamilton Industries, Inc., 97 TC 120 (1991), the taxpayer purchased the assets of a business. In the allocation of the purchase price, inventories were valued on a residual basis at an amount approximating 4% of the FIFO cost to the seller. The facts clearly indicate that the allocation of the purchase price was distortive. Unfortunately, bad facts sometimes make bad law. The IRS argued successfully that the items purchased were not the same as those subsequently manufactured. Thus, base-year cost of the items manufactured was not the same as the bargain purchase price. As a result, the amount of the bargain purchase was not locked up in the value of the inventory, but rather entered into the determination of taxable income as the inventory was sold.

Hamilton also held that the adjustment to treat the subsequent manufactured items as new or different items was a "method of accounting." Thus, even though the bargain purchase of...

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