21 T.C. 147">*148 The respondent determined a deficiency in income tax for the year 1947 in the amount of $ 7,867.95. Two issues are involved: (1) Whether the petitioner was authorized to report its inventories on the last-in, first-out method computed under the provisions of section 22 (d) (1) of the Internal Revenue Code; and (2) if not, can the respondent require that the valuation of petitioner's inventories on January 1, 1947, remain on the last-in, first-out method, as reported by the petitioner, even though the respondent has changed the method for the computation of the closing inventory at December 31, 1947, to the first-in, first-out method?

Some of the facts were stipulated.

FINDINGS OF FACT.

The stipulated facts are so found and are incorporated herein.

Textile Apron Company, Inc. (hereinafter referred to as petitioner), is a Georgia corporation with its principal office at LaGrange, Georgia. The returns for the calendar year 1947 were filed with the collector of internal revenue for the district of Georgia. Petitioner succeeded to the business of the Textile Apron Company, East Point, Georgia; East Point Roller Covering Company, East Point, Georgia; and Textile Roller1953 U.S. Tax Ct. LEXIS 35">*38 Covering Company, LaGrange, Georgia, on January 2, 1946. These companies were owned and operated by J. B. Kennington, Sr., of LaGrange, Georgia, as sole proprietorships from 1941 until January 2, 1946. On December 19, 1945, petitioner was organized and incorporated under the laws of Georgia, authorized 21 T.C. 147">*149 by its charter to issue 1,000 shares of stock. On January 2, 1946, a tax-free exchange under section 112 (b) (5) of the Internal Revenue Code was effected whereby J. B. Kennington, Sr., transferred the assets of the above-mentioned companies to petitioner in consideration of the entire 1,000 shares of stock which it was authorized to issue.

In reporting his income from the predecessor companies, J. B. Kennington, Sr., had since 1942 followed the last-in, first-out inventory method set forth in section 22 (d) (1) of the Internal Revenue Code (hereinafter called "Lifo"). He had filed Form 970 in 1941 requesting permission to change from the "cost or market" method of section 22 (c) to the Lifo method beginning January 1, 1942. His individual income and victory tax return for the year 1943, in which the reported inventories were computed under the Lifo method, was audited1953 U.S. Tax Ct. LEXIS 35">*39 by an agent for the Bureau of Internal Revenue, and that agent took no exception to such method.

The petitioner continued to employ the Lifo method both in its income tax returns for 1946 through 1949 and on its ledger account for inventories, using the same inventory ledger sheet which had previously been used by the proprietorships. However, it failed to file Form 970 requesting permission to use this method. On its corporation income tax return for the calendar year 1946, it answered question 15 as to the method of inventory valuation employed by stating that it used "Lifo."

In a notice of deficiency dated February 14, 1951, the respondent asserted that petitioner's failure to file Form 970, requesting permission to use the Lifo method, prevented the use of such method by the petitioner in reporting its income. The respondent accordingly recomputed the petitioner's income on the basis of the first-in, first-out method of inventory valuation prescribed by section 22 (c) (hereinafter called "Fifo"). No recomputation was made for petitioner's initial year, 1946, since the statute of limitation had already expired as to that year.

In determining the deficiency for 1947, the respondent1953 U.S. Tax Ct. LEXIS 35">*40 employed both the Lifo and Fifo methods of inventory valuation. Respondent calculated petitioner's January 1, 1947, inventory on a Lifo basis and the inventory at December 31, 1947, on a Fifo basis. By this use of different methods of inventory valuation for the opening and closing inventories, an additional $ 20,705.16 would be added to petitioner's income in 1947. If the respondent had used Fifo in calculating both the opening and closing inventories, only $ 7,928.37 would be added to petitioner's income for 1947.

The inventory valuations as calculated according to the two methods are: 21 T.C. 147">*150

The inventory reported by petitioner at December 31, 1946, consisted of raw materials and 27,800 units of finished "textile aprons." In its inventory reported at December 31, 1947, there were raw materials but no finished "textile aprons." Gross sales of the petitioner in 1946 were $ 463,939.06.

OPINION.

The first issue is whether the petitioner is entitled to use the Lifo method of inventory valuation without having specifically requested and obtained1953 U.S. Tax Ct. LEXIS 35">*41 the permission of the respondent, on the theory that such permission had previously been secured by the predecessor proprietorships; and that, because of the tax-free exchange out of which the petitioner was formed, it has a continuing effect. Respondent's contention is that the petitioner is a new taxpaying entity and, as such, must obtain the approval of the Commissioner of Internal Revenue before adopting the Lifo method. ¹

1953 U.S. Tax Ct. LEXIS 35">*42 In the statutory scheme, the Congress recognized that the general terms of the Lifo method, as stated in section 22 (d), should be subject to additional qualifications in order that the income of various types of taxpaying entities be accurately reflected under this method and to prevent its use in instances which would be inappropriate. It provided that the taxpayer must make specific application to use this method. Further, it provided in section 22 (d) (3) that:

The change to, and the use of, such method shall be in accordance with such regulations as the Commissioner, with the approval of the Secretary, may prescribe as necessary in order that the use of such method may clearly reflect income.

The Commissioner was thus given the right to promulgate regulations restricting the use of this method to those taxpayers who supplied 21 T.C. 147">*151 information showing that this method of inventory valuation would be proper under the circumstances of their particular business.

It has been established that the regulations issued by the Commissioner must be upheld unless they are plainly inconsistent with the law itself. Commissioner v. South Texas Co., 333 U.S. 496">333 U.S. 496 (1948),1953 U.S. Tax Ct. LEXIS 35">*43 rehearing denied 334 U.S. 813">334 U.S. 813 (1948). Congress has thus delegated broad discretion to the Commissioner to control the adoption and use of this method by the promulgation of restrictive regulations, and we are unable to say that they are in conflict with the statute.

The petitioner has failed to conform to the requirements of the statute and regulations, and it is, therefore, not entitled to use the Lifo method of inventory valuation. It filed no application and it cannot rely on that filed by its predecessor. The regulations require ² that an application be filed by "the taxpayer." When organized and incorporated on December 19, 1945, petitioner became a new taxpayer, entirely separate and distinct from the proprietorships whose assets it subsequently acquired. It was, therefore, required to file an application of its own if it wished to use the Lifo method. It would not be reasonable to attribute a meaning to the word "taxpayer" which would encompass a predecessor composed of individual proprietorships and also a successor corporation.

1953 U.S. Tax Ct. LEXIS 35">*44 Our holding on this issue also disposes of petitioner's alternative argument that section 22 (d) (5) (A)³ compelled it to use the same system of inventory valuation employed by the proprietorships. This paragraph requires that a taxpayer, once having used the Lifo method of inventory valuation, must continue its use in subsequent years. This paragraph would have barred the proprietorships from changing their method of inventory valuation without the consent of the Commissioner, but it could in no way affect the choice of inventory method by the petitioner, an entirely new and separate taxpayer. Further, although petitioner continued the business of the predecessor proprietorships, it was not compelled to employ the same accounting methods. Section 29.22(d)-3 of the regulations provides that a taxpayer must file, if he is a manufacturer, in addition to a statement of intent to use the Lifo method, "an analysis of all inventories" 21 T.C. 147">*152 showing "in detail the manner in which costs are computed with respect to raw materials, goods in process, and finished goods * * *." The Commissioner can then decide whether the use of the Lifo method is appropriate, taking into consideration1953 U.S. Tax Ct. LEXIS 35">*45 the particular accounting methods employed by the manufacturer in the computation of costs. Since the petitioner was under no obligation to use the same method of computing costs as that employed by its predecessors, it is obvious that permission granted to its predecessors on the basis of stated methods of cost computation should not extend to the petitioner, who was free to employ an entirely different method of cost computation.

The petitioner argues that since it was required, as a transferee in a 112 (b) (5) tax-free exchange, to record its opening inventory in 1946 at the transferor's basis, ⁴ it was also required to use the transferor's method of valuing1953 U.S. Tax Ct. LEXIS 35">*46 inventories. This is clearly not the case. The transferor's method of computing inventory valuation had no continuing effect on the petitioner. It merely served as a means of determining the basis of the transferred assets. ⁵Section 113 (a) (8) of the Internal Revenue Code requires that the assets received by the transferee retain the basis which they had in the hands of the transferor in order to prevent income from escaping taxation. Section 112 (b) (5) exempts any increase in value of the transferred assets from taxation at the time of the transfer, but this is merely a postponement and not a forgiveness. When the transferee sells these assets, such appreciation in value is taxed by requiring that the transferee use the transferor's basis in computing the gain. The transfer to petitioner on January 2, 1946, took place during a period of rising prices. The inventory transferred to the petitioner by the proprietorships appeared on their books at considerably less than its replacement cost, since it was calculated according to the Lifo method. This was the result of the assumption on which Lifo is based, namely, that the merchandise purchased last during the year is the1953 U.S. Tax Ct. LEXIS 35">*47 first to be sold. Petitioner thus acquired an inventory with a basis substantially less than its then current market value. Having failed to make application for the use of Lifo, petitioner should have computed its inventories according to the Fifo method in 1946. Therefore, the merchandise first to be sold was that acquired in inventory from the transferor. Since the petitioner was required to use the transferor's basis in arriving at his gain from the sale of this inventory, his income 21 T.C. 147">*153 for 1946 should have been increased by the difference between the Lifo valuation and the Fifo valuation at the date of the transfer.

1953 U.S. Tax Ct. LEXIS 35">*48 Petitioner's citations of Boyne City Lumber Co., 7 B. T. A. 36 (1927), and The Buss Co., 2 B. T. A. 266 (1925), holding that the valuation of opening and closing inventories must be computed uniformly, are not in point. They refer to situations where the taxpayer has acquired its inventory by purchase in the ordinary course of business, whereas petitioner acquired its inventory by means of a tax-free exchange. Petitioner has no option in determining the value of its initial opening inventory under section 22 (c) or (d). That value is fixed by section 113 (a) (8) which requires that it employ the transferor's basis.

This brings us to the second issue: Whether the respondent, having failed to require the use of Fifo in determining petitioner's income for 1946, and now barred by the statute of limitation from doing so in that year's return, may make a compensatory adjustment in petitioner's income for 1947. Thus, the respondent would require the petitioner to use, for the year 1947, an opening inventory calculated on the Lifo method and a closing inventory calculated on the Fifo method.

The respondent relies, in his brief, 1953 U.S. Tax Ct. LEXIS 35">*49 on William Hardy, Inc. v. Commissioner, 82 F.2d 249 (C. A. 2, 1936). This case held that in requiring a change from the cash to accrual method of accounting, the Commissioner may make a "retroactive" adjustment by adding to the taxpayer's income for the year of change the amount of its opening inventory. This was to prevent the value of that inventory, which had "escaped taxation" in previous years, from escaping taxation in the year of change.

However, since the submission of the parties' briefs, this case has been overruled. Commissioner v. Dwyer, 203 F.2d 522 (C. A. 2, 1953). That court has now brought its treatment of tax adjustments resulting from a change in accounting method into accord with its own prior opinions, ⁶ and those of other circuits, ⁷ in holding that the Commissioner is barred by the statute of limitation from making compensatory adjustments after the prescribed period has terminated. The court, in Commissioner v. Dwyer, supra, stated, p. 524:

Although there have been exceptions, it is established by the great weight of authority that, if a taxpayer1953 U.S. Tax Ct. LEXIS 35">*50 has not misrepresented or suppressed the facts, the statute of limitations not only prevents any reassessment of the tax after the prescribed period has passed; but that the Treasury may not assess a tax for a later year to make up for a credit erroneously allowed, or a charge erroneously omitted, in an earlier year. * * *

21 T.C. 147">*154 The respondent was given due notice that the petitioner was using the Lifo method of inventory valuation in 1946 since the petitioner stated so on the face of its income tax return. The respondent should have required1953 U.S. Tax Ct. LEXIS 35">*51 that the necessary adjustment be made in the 1946 return. Having failed to do so, he cannot now rectify his previous error by distorting the petitioner's 1947 income.

Approaching this compensatory inventory adjustment from an arithmetical standpoint, we find that it must almost certainly result in inequity to either the taxpayer or the Commissioner. The amount which has escaped taxation here is the difference between the low Lifo valuation and the higher Fifo valuation of the inventory at the time it was transferred to the petitioner. It is most improbable that petitioner's inventories in a later year would be exactly the same value as its 1946 inventories, either on a Lifo or Fifo basis. Ordinary changes in business activity will affect the amount of inventory being carried. Therefore, the amount which would be added to petitioner's income by making this adjustment in a subsequent year would bear little relation to the amount which should have been taxed in 1946.

Petitioner may be required to use the Fifo method of inventory computation, but this shall apply uniformly to both its opening and its closing inventories.

Decision will be entered under Rule 50.

Murdock, 1953 U.S. Tax Ct. LEXIS 35">*52 J., dissenting: This petitioner, successor in a nontaxable exchange to three other businesses all entitled and permitted to use Lifo and itself fully qualified to use Lifo, continued the use of Lifo in carrying on the same business. It used the Lifo method during 1946, its first year, with the knowledge of and without the objection of the Commissioner, but is denied the right to use Lifo in 1947 and is required to make adjustments to another system for that year, adjustments which cannot do exact justice. The denial is solely upon the technicality that the petitioner, upon succeeding to the business in 1946, failed to apply for permission to use Lifo, as had its predecessors. Such a strict application of a reasonable regulation is unreasonable, arbitrary, bureaucratic, and accomplishes no sensible purpose, but merely serves to cause inconvenience and expense to the taxpayer. A proper sensible result is more desirable than a literal application of a law or regulation. Cf. Church of the Holy Trinity v. United States, 143 U.S. 457">143 U.S. 457; Diamond A Cattle Co., 21 T.C. 1. I think the Tax Court should not approve such1953 U.S. Tax Ct. LEXIS 35">*53 narrow action by the Commissioner but should allow the petitioner to continue the use of Lifo and should regard it, if necessary, as having obtained the permission.