Accounting Methods & Periods
Dollar-Value LIFO Pooling for Automobile Resellers
In Rev. Proc. 2008-23, the IRS provides retail dealers and wholesale distributors of cars and light-duty trucks (collectively, automobile resellers) the option to use an alternative dollar-value last-in, first-out (LIFO) pooling method. Under the vehicle-pool method, automobile resellers may establish one new-vehicle pool for most new vehicles and one used-vehicle pool for most used vehicles. This taxpayer-favorable IRS guidance alters previously upheld IRS positions that required automobile resellers to use separate pools for cars and light-duty trucks.
Background
Under Regs. Sec. 1.472-8(a), a taxpayer may use the dollar-value LIFO method to account for inventories, with items grouped into a pool or pools. Regs. Sec. 1.472-8(c)(1) requires that resellers establish dollar-value pools based on major lines, types, or classes of goods.
Previous case law and IRS guidance required automobile resellers to establish two separate pools—one for cars and one for light-duty trucks. In Fox Chevrolet, Inc., 76 TC 708 (1981), the Tax Court noted that cars and light-duty trucks did not constitute a single class of goods because cars appealed to the general public, while trucks often were bought for business use; also, the registration and other legal requirements for the operation of trucks were more stringent than those for cars. In Richardson Investments, Inc., 76 TC 736 (1981), the Tax Court rejected a Ford dealer’s argument that cars and light-duty trucks should be assigned to a single pool, noting that Ford’s advertising campaign distinguished the commercial nature of Ford trucks and the personal nature of Ford cars.
Based on this case law, the IRS required automobile resellers to maintain separate pools for cars and light-duty trucks. For example, under the alternative LIFO method provided in Rev. Proc. 97-36, automobile resellers were required to establish one pool for all new cars and a separate pool for all new light-duty trucks. Likewise, under the used-vehicle alternative LIFO method provided in Rev. Proc. 2001-23, automobile resellers were required to establish separate pools for used cars and used light-duty trucks.
As a result of a submission to the IRS Industry Issue Resolution Program on behalf of the automobile industry, the IRS announced that it would publish guidance on dollar-value LIFO pooling for crossover vehicles (IR-2007-39). Crossover vehicles include SUVs, minivans, and pickup trucks used as substitutes for cars. The IRS acknowledged that the line between cars, light-duty trucks, and crossover vehicles had blurred since the 1981 decisions in Fox Chevrolet and Richardson Investments.
Vehicle-Pool Method
Rev. Proc. 2008-23 allows automobile resellers subject to the dollar-value LIFO pooling rules of Regs. Sec. 1.472-8(c)(1), Rev. Proc. 97-36, or Rev. Proc. 2001-23 to use the vehicle-pool method. Under this method, an automobile reseller with new vehicles (i.e., new cars, new light-duty trucks, and new crossover vehicles, including SUVs, vans, minivans, and other similar vehicles) may establish a new-vehicle pool for all new vehicles. Similarly, an automobile reseller may establish a used-vehicle pool for all used vehicles. Rev. Proc. 2008-23 specifically notes that the new- and used-vehicle pools may not include a vehicle with a gross vehicle weight that exceeds 14,000 pounds, thereby excluding many commercial trucks from the pools.
Rev. Proc. 2008-23 provides additional guidance to automobile resellers that use the alternative LIFO method under Rev. Proc. 97-36 or the used-vehicle alternative LIFO method under Rev. Proc. 2001-23 and that decide to continue maintaining separate pools for new cars and new trucks or used cars and used trucks (in lieu of the vehicle-pool method). Section 4.02(1) of Rev. Proc. 2008-23 states that automobile resellers must assign new crossover vehicles to either the new-car pool or the new-truck pool, whichever is more reasonable based on the facts and circumstances. Similar rules apply for used crossover vehicles.
Changing to the Vehicle-Pool Method
Rev. Proc. 2008-23 grants an automobile reseller automatic consent to change to the vehicle-pool method provided that the taxpayer follows the provisions of Rev. Proc. 2002-9. The change is made on a cutoff basis (i.e., without a Sec. 481(a) adjustment) and must comply with Regs. Sec. 1.472-8(g).
Also, instead of using the earliest tax year for which the taxpayer adopted the LIFO method for any items in the pool, the taxpayer must use the year of change as the base year when determining the LIFO value of the pool for the year of change and subsequent tax years. The taxpayer must restate the base-year cost of all layers of increments in a pool at the beginning of the year of change in terms of the new base-year cost. If a taxpayer is changing concurrently to the alternative LIFO method under Rev. Proc. 97-36 or the used-vehicle alternative LIFO method under Rev. Proc. 2001-23, the taxpayer should file only one Form 3115, Application for Change in Method of Accounting.
Impact on Automobile Resellers
The theoretical justification for the LIFO method is that income is reflected more clearly by matching current costs with current revenues. However, when a decrease (decrement) in the pool occurs during the year because sales exceed purchases, older costs flow into cost of goods sold. In many instances, the decrement will result in higher taxable income to the taxpayer. Therefore, it usually is advantageous for a taxpayer to establish the fewest number of pools permitted by the IRS to prevent a decrement from occurring (i.e., a decrease in one pool can be offset by an increase in another pool).
Rev. Proc. 2008-23 permits automobile resellers to use one pool for all new cars, new light-duty trucks, and new crossover vehicles (and one pool for all used cars, used light-duty trucks, and used crossover vehicles). As a result, decrements that otherwise might occur with separate pools can be avoided.
From Jim Martin, CPA, and Louis Lazar, CPA, Washington, DC
A mistake made in a taxpayer’s last-in, first-out (LIFO) computation may repeat in later year returns if staff preparing the computation take a “same as last year” approach. When the mistake ultimately is detected, there is a question of whether the mistake represents a method of accounting or an error.
Huffman Decision
The Sixth Circuit recently affirmed a Tax Court decision holding that a taxpayer that consistently had omitted a step in its LIFO computation (for 10–20 years) had adopted a method of accounting (Huffman, 518 F3d 357 (6th Cir. 2008), aff’g 126 TC 322 (2006)). Thus, the IRS could impose a Sec. 481(a) adjustment representing the entire amount of income that had been omitted as a result of using the improper LIFO method, including the portion that had arisen in closed years.
This result hinged on the court’s determination that the mistake was a method of accounting as opposed to an error. Under Regs. Sec. 1.446-1(e)(2)(ii)(b), the correction of a mathematical or posting error is not a change in method of accounting and thus does not involve a Sec. 481(a) adjustment, whereas a change in accounting method generally requires a Sec. 481(a) adjustment.
Method of Accounting or Error
Whether a mistake involves an accounting method or an error may not be clear. In Huffman, the mistake might be viewed as an “error” in the ordinary sense of that word. Within the LIFO computation, the court stated, the accountant consistently had failed to extend the base-year cost of LIFO increments by the current-year cumulative index, which effectively valued inventory at base-year prices (some 10–20 years prior), instead of properly valuing each increment at the applicable price for the year in which it was created. As a result, the accountant did not compute the proper LIFO value of the inventory under the dollar-value method.
The taxpayer argued that the IRS adjustment was the “correction of an error,” which would avoid Sec. 481(a) treatment and limit the adjustment to open years only. The taxpayer cited Regs. Sec. 1.446-1(e)(2)(ii)(b), which provides that “[a] change in method of accounting does not include correction of mathematical or posting errors.” The Tax Court, however, found that “[t]he regulations give no guidance as to the meaning of the term ‘mathematical error.’” The Tax Court concluded that the accountant “reached an erroneous result not because he made a mistake in arithmetic (multiplication) but because he omitted the critical step of multiplication altogether.”
The Sixth Circuit agreed and cited, as “sufficiently analogous,” Regs. Sec 1.446-1(e)(2)(iii), Example 6, in which a taxpayer for many years had excluded overhead costs in valuing inventories at cost. The example concludes that allocating overhead is a change in method of accounting “because it involves a change in the treatment of a material item used in the overall practice of identifying or valuing items in inventory.”
It is at this point where error and method become fused into the concept of erroneous methodology. In essence, a consistently repeated error becomes a method of accounting.
Consistency
Consistency may play a significant role in answering the “error or method” question. Regs. Sec. 1.446-1(e)(2)(ii)(a) states that “in most instances a method of accounting is not established for an item without such consistent treatment.” Since the facts in Huffman reflected that the taxpayer used the improper method from the beginning and continued for 10–20 years, the court ruled that consistency had been established.
Consistency is not always clear cut. Some taxpayers may properly elect and use a LIFO methodology in the first year and subsequent years but inadvertently (often by way of spreadsheet error) migrate to an improper method. The Tax Court in Huffman only briefly discussed this issue, noting that “a short-lived deviation from an already established method of ac-counting need not be viewed as establishing a new method of accounting.” The IRS sought to define consistency in Rev. Rul. 90-38 and Rev. Proc. 2002-18. However, that guidance stops short of addressing a situation in which a taxpayer properly has elected and used a method of accounting for a number of years, but then subsequently used a different method in two or more consecutively filed returns.
Observations
If a taxpayer discovers an error with respect to its LIFO computation that results in the understatement of income, the item is an exposure until the statute of limitation expires. The taxpayer should eliminate the exposure through an amended return.
If a taxpayer discovers an error with respect to its LIFO computation that results in the overstatement of income, the taxpayer should request a refund through amended returns. However, if the IRS believes the error is a method of accounting, the request for refund may be disallowed.
If a taxpayer presently is using an erroneous LIFO methodology (such as skipping or misapplying a step in the LIFO computation) that results in an understatement of income, the taxpayer is at risk for the IRS to impose a Sec. 481(a) adjustment and recover the entire understatement as in Huffman. However, if that taxpayer requests a change to a proper method by filing a Form 3115, Application for Change in Accounting Method, it should receive audit protection for all years before the year of change. In addition, since most LIFO method changes are made on a cutoff basis, no Sec. 481(a) adjustment may be required.
If a taxpayer is presently using an erroneous LIFO methodology that results in an overstatement of income, the taxpayer should file Form 3115 to request a change to a proper method. Unfortunately, the requirement that most LIFO changes be made on a cutoff basis likely will prevent the taxpayer from obtaining a favorable Sec. 481(a) adjustment. Even so, a taxpayer may benefit by changing to a proper LIFO method that does not overstate income going forward. If there is uncertainty as to whether the mistake is an error or an improper method, the taxpayer also should file an amended return to prevent the statute of limitation from expiring. This will allow the taxpayer to obtain a refund on the overstatement of income from open years if the IRS National Office concludes that the mistake is an error.
While the implications of Huffman reach further than LIFO, taxpayers using LIFO should take a closer look at their present calculations to determine whether any mistakes might have been made and, if so, whether the mistakes would be considered errors or improper methods.
From Tom Sehman, CPA, Minneapolis, MN
