Related-party transfers of inventory; write-downs should precede transfers to minimize related-party loss limitations.

• Author: Erdahl, Steven D.

Write-Downs Should Precede Transfers to Minimize Related-Party Loss Limitations

Inventory sometimes does not sell easily. For example, it may be obsolete, discontinued, overpriced or mismarketed. Perhaps the competition is keen. Or maybe the business is simply feeling the effects of an overall downturn in the economy. Whatever the reason, management's task is to assure maximum sale opportunities for the inventory. This goal is often achieved by transferring inventory between related parties (a "controlled sale"). The transferee, identified by management as a more efficient sale outlet, then offers the inventory for resale to the general public (an "uncontrolled sale").

This article will identify and discuss the various tax issues arising from an intercompany related-party transfer of inventory, and explain how, depending on the way the transfer is structred, adverse tax consequences may result.

Inventory Method and Write-Down

* Inventory cost flow procedure Inventory must be properly accounted for, both for tax and accounting purposes. In determining the cost of inventory, taxpayers are required to identify which of the costs of beginning inventory and purchases should be included in the cost of goods sold and which should be included in the cost of ending inventory. This identification requirement necessitates adopting a procedure for assigning costs to ending inventory and to cost of goods sold.(1)

Generally, to account for inventory properly, a taxpayer's method must conform as nearly as may be to the best accounting practice in the trade or business, and clearly reflect income.(2) For tax purposes, two assumptions of cost flow are specifically approved in the regulations: FIFO and LIFO.(3) Additionally, authorization of the specific identification method is implied. However, a taxpayer is not necessarily restricted to these cost flow methods. As stated, any method that is determined to be the best accounting practice in the particular trade or business and that clearly reflects income is acceptable. For example, if this test is satisfied, a taxpayer may use average cost flow (rather than FIFO or LIFO) in accounting for its inventory for income tax purposes. Average costing is also an acceptable cost flow assumption for accounting purposes.(4)

* Bases of inventory valuation In addition to assigning costs to ending inventory and to costs of goods sold, taxpayers must properly value the costs so assigned. As a general rule, the bases of valuation most commonly used by business concerns and which meet the requirements of Sec. 471 are --cost; and --cost or market, whichever is lower.(5) However, if the LIFO cost flow procedure is used, inventory must be valued at cost.(6)

* Inventory write-down After adopting a cost flow procedure and determining the inventory's initial basis, the practitioner must determine whether the inventory's basis may be subsequently written down. Such a write-down serves as a tax-deductible item.

Cost or market general rule: When valuing items of inventory for tax purposes under the lower of cost or market value method, the determination of cost or market is made for each item of inventory on hand at the inventory valuation date.(7) For purchased inventory items, "cost" generally means the invoice price less trade or other discounts, plus transportation or other charges incurred in acquiring possession of the goods.(8) For produced inventory items, "cost" means the cost of raw materials and supplies entering into or consumed in connection with the product, expenditures for direct labor; and indirect production costs incident to and necessary for the production of the particular inventory item.(9)

Under ordinary circumstances and for normal goods in an inventory, "market" means the "current bid price prevailing at the date of the inventory...."(10) Further, the courts have uniformly interpreted "bid price" to mean "replacement cost," which, in turn, is the price the taxpayer would have to pay on the open market to purchase or reproduce the inventory items.(11)

Exceptions: Two exceptions to the general rule exist, and only then may taxpayers value inventory lower than the "market" (i.e., "replacement cost") price (assuming such "market" is lower than "cost"). First, if no open market exists, the taxpayer must use such evidence of a fair market price at the date or dates nearest the inventory as may be available, such as specific purchases or sales by the taxpayer or others in reasonable volume and made in good faith....(12) Accordingly, when, in the regular course of business, the taxpayer offers inventory for sale at prices lower than "market," the inventory may be valued at the offered price less direct costs of disposition. The correctness of the offered price is determined by reference to the actual sales occurring within a reasonable period before and after the inventory valuation date. However, prices materially varying from the actual sales prices are disregarded in making this determination.

The question of whether an open market exists has been construed quite strictly. For example, the Court of Claims has held that the phrase in the regulations "or where quotations are nominal, due to inactive market conditions"(13) does not refer to the volume of sales but to quoted prices for the merchandise.(14) Thus, as long as there is an established and existing price for the particular merchandise on the inventory date, market is ascertainable.

This valuation issue was examined by the Supreme Court in Thor Power Tool Co.(15) There, the Court disallowed the write-down because the taxpayer provided no objective evidence of the reduced value of its "excess" inventory. The Court held that when a taxpayer seeks to depart from "market," it must "substantiate its lower inventory valuation by providing evidence of actual offerings, actual sales, or actual contract cancellations."(16) The Court reasoned that hard evidence of actual sales and records of actual dispositions must be kept, since if the "taxpayer could write down its...