Accounting Methods & Periods

Change in Accounting Method vs. Correction of an Error

The Tax Court recently decided, in Huffman, 126 TC No. 17 (2006), that the correction of an inventory error was an accounting-method change that required a Sec. 481(a) adjustment, and not a mathematical error, as the taxpayer had argued.

In this consolidated case, the taxpayers owned a group of four S corporations that had used the link-chain, dollar-value method of valuing LIFO inventory for at least 10 previous tax years. The corporations’ accountant had omitted a computational step required by the LIFO method for all tax years since the S corporations had elected the LIFO method, until discovery by the IRS. The Service determined the omission was an error in timing and not a mathematical or posting error.

 

Background

Accountant’s method: The taxpayers’ accountant began the inventory calculation by determining the current-year cost of each pool and divided it by a cumulative index to determine the pool’s base-year cost. He then compared this base-year cost with the base-year cost calculated at the beginning of the year. When the end-of-year base-year cost exceeded the beginning-of-year base-year cost, he determined there had been an increment to the pool. However, he failed to multiply this increment by the cumulative index to determine a LIFO value for the increment, as required by the link-chain, dollar-value method. As a result, the taxpayers’ LIFO reserve was overstated, and cumulative taxable income understated, over the life of the LIFO election.

Correct method: Temp. Regs. Sec. 1.446-1T(e)(2)(ii)(a) sets forth the basic framework for determining whether an accounting-method change has been made; consistency and timing are crucial to this determination. Under the regulation, a change in method includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. A “material” item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. It also states that although an accounting method may exist without a pattern of consistent treatment of an item, in most instances, consistent treatment of such item will be considered an accounting method.

Temp. Regs. Sec. 1.446-1T(e)(2) (ii)(b) describes when a correction or adjustment does not constitute an accounting-method change, such as a correction of mathematical or posting errors, or errors in the computation of tax liability. The term “mathematical error,” however, is not defined. Also, a change in accounting method does not include an adjustment of any item of income or deduction that does not involve the proper timing for the inclusion of income or the taking of the deduction. Whether the treatment of an item is an accounting-method change or the correction of an error determines whether the IRS can apply Sec. 481(a), which may allow it to include in or exclude from income the cumulative difference between the erroneous and proper method for all tax years closed by statute, in the earliest open year.

       

Taxpayers’ Arguments

Pre-1970 revisions: In contending that the accountant committed merely a mathematical or posting error, the taxpayers relied on cases decided before important 1970 revisions to Regs. Sec. 1.446-1(e). These modifications in-cluded the addition of the term “material item,” as defined above, as well as the language regarding a pattern of consistent treatment described above. Because the earlier cases did not address the regulations’ timing and consistency considerations, the court gave them little weight.

Korn: The taxpayers also unsuccessfully relied on Korn Indus., Inc., 532 F2d 1352 (Cl. Ct. 1976), to support their mathematical-error position. In Korn, the Court of Claims agreed that the taxpayer had not properly accounted for its inventory by omitting certain costs, yet reasoned that such omissions were “inadvertent” and similar to mathematical or posting errors, and were not a change in accounting method. The court in the instant case stated that the inadvertent or good-faith exception created by Korn is not authorized by statute, and that such exception would render the regulations moot. It also found the instant facts distinguishable.

Other cases: Further, the taxpayers unsuccessfully relied on Gimbel Bros., Inc., 535 F2d 14 (Cl. Ct. 1976), and Standard Oil Co., 77 TC 349 (1981), stating that a method change does not result when one corrects a deviation from a previously elected method. In Gimbel, the taxpayer had used the accrual method, which was impermissible given the installment method election it had made. The subsequent application of the installment method was a correction of the error. In Standard Oil, to deduct intangible drilling and development costs, the taxpayer reversed costs previously capitalized. The changes in both cases were determined not to be accounting-method changes, but corrections of errors made within the broader context of the taxpayer’s proper accounting method. In the instant case, however, the court agreed with the IRS, stating that even though the Huffman companies elected the link-chain method, no member actually adopted it until the corrections were made, because the method was not properly applied until then.

The Tax Court cited Wayne Bolt & Nut Co., 93 TC 500 (1989), which interpreted a “posting error” to be an error in “the act of transferring an original entry to a ledger.” In the court's opinion, this interpretation did not describe Huffman’s accountant’s error.

       

Holding

The Tax Court held the error to be a consistent application of method involving the proper timing of the recognition of income. If the error was continued over the life of the inventory pool, the total gain reported from the sale of inventory items would be correct. The court acknowledged that when a taxpayer deviates from a previously established accounting method, and the deviation does not have the time to become a method on its own, there exists the possibility of an accounting error. However, the fact that the accountant consistently applied the improper method for over 10 years ruled out this possibility.

       

Strategy

The result in Huffman may give practitioners the opportunity to review their clients’ inventory calculations to determine if there exists years of consistent application of a method that deviates from the rules prescribed by the statute. Existence of such a deviation and identification before discovery in an IRS examination, will allow a taxpayer to consider whether a voluntary change in accounting method (with the ability to spread a positive Sec. 481(a) adjustment over a four-year period) may be worthwhile.

From Michael R. Schuth, CPA, Oak Brook, IL