2006 U.S. Tax Ct. LEXIS 17">*17 The sole issue for decision is whether a correction to the
inventory method employed by S corporations owned by certain of
the petitioners constitutes an accounting method change that
requires an adjustment pursuant to
ranging from 10 to 20 years, the corporations' accountant, in
applying the link-chain, dollar-value method of valuing LIFO
inventory, omitted a step required by that method.
Held: R's revaluations of the corporations' inventories,
to correct for the accountant's omissions, constituted changes
in a method of accounting employed by the corporations,
requiring adjustments pursuant to
amounts of income from being omitted solely on account of the
changes.
126 T.C. 322">*322 OPINION
HALPERN, Judge: These cases have been consolidated for purposes of trial, briefing, and opinion. By notices of deficiency dated December 19, 2003 (the2006 U.S. Tax Ct. LEXIS 17">*18 notices), respondent determined deficiencies in Federal income taxes as follows:
Taxable (Calendar) Year
_______________________
Deficiency
? __________
Petitioners (Husband and Wife) 1997 1998 1999
______________________________ ____ ____ ____
Dow A. and Sandra E. Huffman -- $ 36,757 $ 9,413
James A. and Dorothy A. Patterson -- 35,542 --
Douglas M. and Kimberlee H. Wolford -- 33,422 1,966
Neil A. and Ethel M. Huffman $ 131,408 535,065 304,033
Petitioners have conceded some of the adjustments made by respondent that give rise to the deficiencies in question, and other adjustments are merely computational and do not require our attention. The sole issue for decision is whether2006 U.S. Tax Ct. LEXIS 17">*19 a correction to the inventory method employed by corporations 126 T.C. 322">*323 owned by certain of the petitioners constitutes an accounting method change that requires an adjustment pursuant to
Some facts have been stipulated and are so found. The stipulation of facts, with accompanying exhibits, is incorporated herein by this reference. We need find few facts in addition to those stipulated and shall not, therefore, separately set forth our findings of fact. We shall make additional findings of fact as we proceed.
Background
All petitioners except for James A. and Dorothy A. Patterson resided in Kentucky at the time they filed their respective petitions. The Pattersons resided in Florida at the time they filed their petition.
The Huffman Group
The Huffman group of corporations2006 U.S. Tax Ct. LEXIS 17">*20 (Huffman group) consists of four members (sometimes, the members): Neil Huffman Nissan, Inc. (Nissan); Neil Huffman Volkswagen, Inc. (Volkswagen); Neil Huffman Enterprises, Inc., d.b.a. Neil Huffman Dodge (Dodge); and Neil Huffman, Inc., d.b.a. Huffman Chrysler Plymouth (Chrysler). The members sell new and used automobiles in Kentucky. At least one of each married pair of petitioners owns stock in one or more of the members. Each of the members has elected to be treated as an S corporation under the provisions of
Use of Inventories
The members of the Huffman group all sell merchandise (new and used automobiles). Each, therefore, computes its gross income from sales during a year by subtracting from sales revenue the cost of the goods sold. See Cost of beginning inventory + Purchases and2006 U.S. Tax Ct. LEXIS 17">*22 other acquisition or production costs = Cost of the goods available for sale - Cost of ending inventory = Cost of goods sold
Various cost-flow assumptions are used to allocate the cost of goods available for sale between goods sold during the year and goods remaining on hand at the end of year. Two assumptions generally used for financial accounting and tax purposes are first-in, first-out (FIFO) and last-in, first-out (LIFO). 3 Id. par. 6.08[2], at 6-84. Under FIFO, it is assumed that the first goods acquired or produced are the first goods sold and that the goods remaining in ending inventory are the last goods acquired or produced. Id. Under LIFO, it is assumed that the last goods acquired or produced are the first goods sold. 4
2006 U.S. Tax Ct. LEXIS 17">*23 Id. We are concerned here with certain aspects of LIFO.
126 T.C. 322">*325 The LIFO Method
--Introduction
We have said "the overriding purpose of * * * LIFO * * * is to match current costs against current income."
For a taxpayer whose ending inventory computed under LIFO reflects the lower prices of antecedent purchases (rather than the higher price of current purchases), the income tax advantage of LIFO is obvious: a reduction in current income, leading, generally, to a reduction in current income tax. The potential for increased gain on account of the allocation of the lower costs of antecedent purchases to ending inventory is not eliminated, however; it is simply deferred until, in time, there is a liquidation of the items to which those lower costs have been allocated. See2006 U.S. Tax Ct. LEXIS 17">*25 id. at 7-5. The term "LIFO reserve" refers to the amount by which the FIFO value (e.g., the current replacement cost) of inventory exceeds the LIFO value shown in the accounting records of the taxpayer. See id. par. 7.03[2], at 7-15. 6 It is a measure of the potential gain in a store of inventoried items on account of the use of the LIFO method.
2006 U.S. Tax Ct. LEXIS 17">*26 There is more than one method for computing the value of a LIFO inventory. Id. par. 7.04[1], at 7-30. Nevertheless, all LIFO computational methods involve essentially three determinations: (1) The LIFO inventory must be segmented into groups or "pools" of similar items; (2) a determination must be made as to whether there has been a quantitative change in the inventory of each pool during the period in question, and (3) there must be a determination of the manner in which increments to (i.e., increases in the quantity of) each pool are to be valued. Id. We are here concerned mainly with the third of those determinations.
Two basic LIFO computational methods are permitted by the income tax regulations: the specific goods method, a measure of inventory in terms of physical units of individual 126 T.C. 322">*327 items, see
--Dollar-Value Method2006 U.S. Tax Ct. LEXIS 17">*27 of Valuing LIFO Inventories
Gertzman explains the dollar-value method as follows: Under the dollar-value method, the common denominator for measuring items within a pool is not units, such as pounds or yards, but dollars as of a particular date. Thus, a reduction in the number of inventory items within a pool will not reduce the LIFO value of the inventory as long as the total inventory stated in base-year dollars (i.e., the base [year] cost of the inventory) is not reduced. The base [year] cost of an item is generally what the item cost or would have cost at the beginning of the year for which LIFO was first adopted.
Id. par. 7.04[3], at 7-36 (fn. ref. omitted). The dollar-value method is described similarly in
2006 U.S. Tax Ct. LEXIS 17">*28 126 T.C. 322">*328 Under the dollar-value method, once items have been grouped into pools, the next step is to determine whether there has been any change in the quantity of dollars invested in the pools over the year. See Gertzman par. 7.04[3][b], at 7-44. Those changes are determined by comparing the aggregate base-year cost of the items in a pool at the beginning of the year to the aggregate base-year cost of the items in the pool at the end of the year. See id. par. 7.04[3][b], at 7-44 to 7-45. If the latter exceeds the former, there has been an increment in the pool; if the former exceeds the latter, there has been a liquidation of all or part of the pool. Id. par. 7.04[3][b], at 7-45. The base-year cost of an item in a pool is the cost of the item (or what would have been the item's cost if it had been added to the pool) as of the base date. See id. "Base date" is the first day of the first year for which LIFO is adopted. Id. A similar description of the procedure for measuring the change in the size of a pool is found in
Under any application of the dollar-value method, it is necessary to have a means for computing2006 U.S. Tax Ct. LEXIS 17">*29 the base-year costs of the items in a pool and for computing the value of any increment in, or liquidation of, the pool. Gertzman par. 7.04[3][b], at 7-45. As stated by the regulations, with respect to an increment: "In determining the inventory value for a pool, the increment, if any, is adjusted for changing unit costs or values by reference to a percentage, relative to base-year cost, determined for the pool as a whole."
Example (1): T elects, beginning with calendar year2006 U.S. Tax Ct. LEXIS 17">*30 1, to compute its inventory by use of the dollar-value LIFO method. T creates Pool No. 1 for items A, B, and C. The composition of the inventory for Pool No. 1 at the base date, January 1 of year 1, is as follows:
Items Units Unit Cost Total Cost
_____ _____ _________ __________
A 1,000 $ 5.00 $ 5,000
B 2,000 4.00 8,000
C 500 2.00 1,000
______
Total base year cost, Jan. 1, yr. 1 14,000
At December 31, year 1, the closing inventory of Pool No. 1 contains 3000 units of A, 1,000 units of B, and 500 units of C. T computes the current-year cost of the items making up the pool by reference to the actual cost of the goods most recently purchased. The most recent purchases of items A, B, and C are as follows:
Quantity Unit
Items Purchase Date Purchased Cost
_____ _____________ _________ ?____
A2006 U.S. Tax Ct. LEXIS 17">*31 Dec. 15, yr. 1 3,500 $ 6.00
B Dec. 10, yr. 1 2,000 5.00
C Nov. 1, yr. 1 500 2.50
The inventory of Pool No. 1 at December 31, year 1, shown at base-year and current-year costs is as follows:
Dec. 31, yr. 1,
inventory at Dec. 31, yr. 1,
Jan. 1, yr. 1, inventory at
base-year cost current-year cost
__________________ ______________________
Items Quantity Unit Cost Amount Unit Cost Amount
_____ ________ __________________ ______________________
A 3,000 $ 5.00 $ 15,000 $ 6.00 $ 18,000
B 1,000 4.00 4,000 5.00 5,000
C 500 2.00 1,000 2.50 1,250
_______ 2006 U.S. Tax Ct. LEXIS 17">*32 _______
Totals 20,000 24,250
If the amount of the December 31, year 1, inventory at base-year cost were equal to, or less than, the base-year cost of $ 14,000 at January 1, year 1, that amount would be the ending LIFO inventory at December 31, year 1. However, since the base-year cost of the ending LIFO inventory at December 31, year 1, amounts to $ 20,000, and is in excess of the $ 14,000 126 T.C. 322">*330 base-year cost of the opening inventory for that year, there is a $ 6,000 increment in Pool No. 1 during that year. That increment must be valued at current-year cost; i.e., multiplied by the ratio of $ 24,250 to $ 20,000 (24,250/20,000), or 121.25 percent. The LIFO value of the inventory in Pool No. 1 at December 31, year 1, is $ 21,275, computed as follows:
Ratio(as a
percentage)
Dec. 31, yr. 1 of total
inventory at current-year Dec. 31, yr. 1,
Jan. 1, yr. 1, cost to total inventory2006 U.S. Tax Ct. LEXIS 17">*33 at
base-year cost base-year cost LIFO value
_______________ ______________ _______________
Jan. 1, yr. 1,
base cost $ 14,000 100.00% $ 14,000
Dec. 31, yr. 1,
increment 6,000 121.25% 7,275
_______ _______
Totals 20,000 21,275
The LIFO reserve for Pool No. 1 as of December 31, yr. 1, is $ 2,975, computed as follows:
Dec. 31, yr. 1, inventory at current-year cost $ 24,250
Less: LIFO value of ending inventory 21,275
_______
Equals: LIFO reserve 2,975
--Link-Chain Method
Where use of either an index or double-extension method is impractical or unsuitable due to the nature of the inventory in a dollar-value pool, a taxpayer may use a link-chain method2006 U.S. Tax Ct. LEXIS 17">*34 of computing the LIFO value of the pool. [T]he link-chain method is comparable to the double-extension method, except that the base year is rolled forward each year. Thus, instead of comparing the current-year cost and the base-year cost of each item in the ending inventory, under the link-chain method, the current-year cost and the preceding year's cost (referred to as the item's "prior-year cost") of each item are compared. This comparison is used to compute a one-year index, referred to as the current years' index. Each year's current-year index is multiplied (or "linked") to all preceding year's [sic] current-year indexes to arrive at a cumulative price index that relates back to the taxpayer's base year.
1 Schneider, Federal Taxation of Inventories, sec. 14.02[3][b], at 14-100.7 - 100.8 (2006) (fn. refs. omitted). 9
2006 U.S. Tax Ct. LEXIS 17">*35 126 T.C. 322">*331 The following example,
Dec. 31, yr. 2, Dec. 31, yr. 2,
inventory at inventory at
prior-year cost current-year cost
__________________ ___________________
Items Quantity Unit Cost Amount Unit Cost Amount
_____ ________ 2006 U.S. Tax Ct. LEXIS 17">*36 __________________ ___________________
B 2,000 $ 5.00 ? $ 10,000 $ 6.00 $ 12,000
C 500 2.50 1,250 3.00 1,500
D 2,500 6.00 15,000 8.00 20,000
_______ _______
Totals 26,250 33,500
(33,500/26,250 = 127.62%)
Cumulative index:
Base-year cost of Dec. 31, yr. 2, inventory:
1st year percentage link 121.25%
2nd year percentage link 127.62%
Product: chain percentage, Dec. 31, yr. 2, relative
to Jan. 1, yr. 1, base date (121.25% x 127.62%) 154.74%
Base-year cost ($ 33,500/154.74%) $ 21,649
The LIFO value of the inventory in Pool No. 1 at December 31, year 2, is $ 23,379, computed as follows:
Ratio (as a
2006 U.S. Tax Ct. LEXIS 17">*37 percentage) of
Dec. 31, yr. 2, current-year Dec. 31, yr. 2,
inventory at cost to Inventory at
base-year cost base-year cost LIFO value
_______________ _______________ _______________
Jan. 1, yr. 1,
base cost $ 14,000 100.00% $ 14,000
Dec. 31, yr. 1,
increment 6,000 121.25% 7,275
Dec. 31, yr. 2,
increment 1,649 154.74% 2552
______ ______
Totals 21,649 23,827
The LIFO reserve for Pool No. 1 as of December 31, yr. 2, is $ 9,673, computed as follows:
126 T.C. 322">*332 Dec. 31, yr. 2, inventory at current-year cost $ 33,500
Less: LIFO value of ending inventory 23,379
2006 U.S. Tax Ct. LEXIS 17">*38 _______
Equals: LIFO reserve $9,673
Dec. 31, yr. 3, Dec. 31, yr. 3,
inventory at inventory at
prior-year cost current-year cost
__________________ __________________
Items Quantity Unit Cost Amount Unit Cost Amount
_____ ________ _________ ______ _________ ______
B 1,500 $ 6.00 $ 9,000 $ 6.00 $ 9,000
C 600 3.00 1,800 4.00 2,400
D 2006 U.S. Tax Ct. LEXIS 17">*39 2,500 8.00 20,000 7.00 17,500
Totals 30,800 28,900
(28,900/30,800 = 93.83%)
Cumulative index:
Base-year cost of Dec. 31, yr. 3, inventory:
1st year percentage link 121.25%
2nd year percentage link 127.62%
3rd year percentage link 93.83%
Product: Chain percentage, Dec. 31, yr. 3,
relative to Jan. 1, yr. 1, base date
(121.25% x 127.62% x 93.83%) 145.19%
Base-year cost ($ 28,900/145.19%) $ 19,905
The LIFO value of the inventory in Pool No. 1 at December 31, year 3, is $ 21,161, computed as follows:
Ratio of
Dec. 31, yr. 3, current-year Dec. 31, yr. 3,
inventory at cost to inventory2006 U.S. Tax Ct. LEXIS 17">*40 at
base-year cost base-year cost LIFO value
________________ ______________ _______________
Jan. 1, yr. 1,
base cost $ 14,000 100.00% $ 14,000
Dec. 31, yr. 1,
increment 5,905 121.25% 7,160
______ ______
Totals 19,905 21,160
The LIFO reserve for Pool No. 1 as of December 31, yr. 3, is $ 9,739, computed as follows:
126 T.C. 322">*333 Dec. 31, yr. 3, inventory at current-year cost $ 28,900
Less: LIFO value of ending inventory 21,161
_______
Equals: LIFO reserve 7,740
--Preconditions to Use of LIFO Method
Use of the LIFO method for income tax purposes is dependent on certain conditions being satisfied and a proper election to adopt and use the method being2006 U.S. Tax Ct. LEXIS 17">*41 made. See
Huffman Group Elections
The parties have stipulated that, prior to the tax years at issue, each member of the Huffman group filed an election to use the link-chain, dollar-value LIFO inventory method (the link-chain method). 10 The parties have further stipulated that those elections were effective for the members as of the close of their taxable years ending as follows: Nissan, June 30, 1979; Volkswagen, Dec. 31, 1979; Dodge and Chrysler, Dec. 31, 1989.
2006 U.S. Tax Ct. LEXIS 17">*42 The Accountant's Method
The Huffman group employed an accountant (the accountant) to compute the values of the respective inventories of each member using the link-chain method. The accountant was consistent in his method (the accountant's method) of making those computations each year, for each member, beginning with the year of each member for which it elected the link-chain method (the election year) and continuing thereafter, without exception, until the actions of respondent that led to this litigation (together, and without distinguishing among members, the election and following years). The parties have stipulated that, for each of the election and following years, the accountant omitted a computational step required by
Under the accountant's method, for years in which he determined that there had been an increment to an inventory pool, his failure to index the increment resulted in his understating the yearend LIFO value of the pool (assuming that the cumulative index, expressed as a percent, was greater than 100%), which, in turn, resulted in (1) an unwarranted increase in his computation of the cost of the goods sold from the pool, (2) an understatement of the gross income attributable to those sales, and (3) an overstatement of the LIFO reserve attributable2006 U.S. Tax Ct. LEXIS 17">*44 to the pool. 11 For years in which he determined that an inventory pool had been liquidated in whole or in part, his past failures to have indexed any increments remaining in the pool at the beginning of the year resulted in his computing too low a cost of goods sold from the pool, which, in turn, resulted in an overstatement of the gross income attributable to those sales. The accountant's error did not result in the permanent omission of any amount of gross income by any member.
The distortion resulting from the accountant's error can be seen in the following example: T, a merchant, elects to compute her LIFO inventory using a dollar-value method and 126 T.C. 322">*335 begins her first year under the dollar-value method (year 1) with 100 units of an inventoriable2006 U.S. Tax Ct. LEXIS 17">*45 item with a base-year cost of $ 1.00 a unit. Later that year, after the wholesale price of the item has increased to $ 2.00 a unit, T purchases 100 units more. Unfortunately, T makes no sales during that year. Applying the accountant's method, nevertheless, T computes a cost of goods sold of $ 100. She reaches that result by determining the value of her ending inventory (200 units, comprising an opening inventory of 100 units plus an increment of 100 units), at base-year unit cost ($ 1.00) to be $ 200 (200 x $ 1.00). Since the base-year cost of her opening inventory of 100 units is $ 100, and she purchased 100 units during the year for $ 200, her cost of goods available for sale is $ 300, which, after subtracting the value determined for her yearend inventory ($ 200), results in a cost of goods sold (and a loss) of $ 100. Assume further that, in the next year (year 2), T decides to liquidate her inventory (200 units) and retire. She sells her inventory in bulk for $ 300. Her cost of goods sold is her year 2 opening inventory of $ 200, which results in T realizing a year 2 gain of $ 100. Of course, T realizes neither a loss in year 1 nor a net gain in year 2. T's failure to index the2006 U.S. Tax Ct. LEXIS 17">*46 100 unit increment included in her year 1 ending inventory distorts her income for both years 1 and 2. 12 The distortion is only matter of timing, however, since the understatement of income in year 1 is rectified by the overstatement of income in year 2. The following table illustrates the distortions:
LIFO inventory LIFO inventory
undistorted distorted
______________ ______________
Yr. 1 Yr. 2 Yr. 1 Yr. 2
1. Opening inventory $ 100 $ 300 $ 100 $ 200
2. Plus: Purchases 200 0 200 0
____ ____ ____ ____
3. Equals: Cost of goods
available for sale 300 300 300 200
4. Less: Closing inventory 300 0 200 0
____ ____ ____ ____
5. Equals: Cost of goods sold2006 U.S. Tax Ct. LEXIS 17">*47 0 300 100 200
6. Sales 0 300 0 300
==== ==== ==== ====
7. Less: Cost of goods sold
(line 5.) 0 300 100 200
____ ____ ____ ____
8. Equals: Gross Income
from sales 0 0 (100) 100
It should be noted that, if T's failure to index the year 1 increment were corrected as of the beginning of year 2 126 T.C. 322">*336 (increasing her year 2 opening inventory to $ 300), without any concomitant increase in her year 1 ending inventory, then $ 100 of gross income would go unreported (T would have a phantom loss of that amount in year2006 U.S. Tax Ct. LEXIS 17">*48 1 with no offsetting gain in year 2), unless an offsetting
Respondent's Examination and Adjustments
--The Examination
Sometime after the members of the Huffman group filed their 1999 Federal income tax returns, respondent commenced an examination of those and prior returns. Respondent identified mistakes in the members' beginning and ending inventory values shown on those returns due to the accountant's error. Respondent revalued the members' inventories for the election and following years (beginning for Nissan and Volkswagen with 1979 and for Dodge and Chrysler with 1990 and ending for all four corporations with 1999). Those revaluations caused respondent to make adjustments to the members' gross incomes for those years. For each inventory pool, for each year, respondent proceeded as follows: He first calculated the correct yearend LIFO inventory value. Based on the correct yearend LIFO inventory value, he next calculated the correct yearend LIFO reserve. He then subtracted the correct yearend LIFO reserve from the yearend LIFO reserve calculated by the accountant. The difference, generally a positive2006 U.S. Tax Ct. LEXIS 17">*49 number (the adjustment to ending inventory), is the amount that he calculated would have to be added to or subtracted from (generally added to) the yearend LIFO inventory value computed by the accountant to conform that value with the correct yearend LIFO value. To calculate any necessary adjustment to gross income for the year, respondent subtracted from the adjustment to ending inventory the similarly calculated adjustment that he had made for the prior year (except, of course, for the first year he commenced making adjustments). The difference was usually positive and would, thus, increase gross income (by, in effect, decreasing the cost of goods sold from the pool).
The following table illustrates respondent's adjustments with respect to Nissan for 1997 through 1999 (all dollar figures in thousands):
126 T.C. 322">*337 1997 1998 1999
______ _______ _______
LIFO inventory value as corrected $ 1,829 $ 1,848 $ 1,910
====== ======= =======
LIFO reserve as corrected 2006 U.S. Tax Ct. LEXIS 17">*50 (1,048) (1,032) (1,009)
Less: LIFO reserve as reported (1,843) (1,844) (1,862)
Equals: Adjustment to ending ______ _______ _______
inventory 795 812 853
Less: Adj. to beginning inventory n.1 /441 795 812
______ _______ _______
Equals: Yearly adjustment to income 354 17 41
Cumulative Adjustment to income 795 812 854
n.1 Adjustment to 1996 ending inventory.
Respondent's adjustment to ending inventory is a measure of the improper net increase in cost of goods sold (and net reduction in gross income) through the end of the year due to the accountant's error. It is, by definition, equal to the accountant's overstatement of the LIFO reserve as of that yearend (which overstatement is a measure of the gain in the inventory pool that should already have been recognized under the LIFO method). In appendices attached to his brief, respondent calculates the required adjustment to inventory for2006 U.S. Tax Ct. LEXIS 17">*51 each member of the Huffman group for each year for which he recalculated the member's inventories and, additionally, describes the required adjustment as the "cumulative adjustment to income" for the year.
Petitioners agree that respondent's calculations of the beginning and ending inventories of each member of the Huffman group are correct.
--The Adjustments
Apparently because the expiration of the period of limitations on assessment and collection of tax (see
Member 1997 1998 1999
______ 2006 U.S. Tax Ct. LEXIS 17">*52 ____ ____ ____
Nissan --- $ 17,251 $ 41,273
Volkswagen $ 49,056 35,484 575,137
Dodge --- (37,752) 256,315
Chrysler --- 76,402 (88,687)
Petitioners do not contest those portions of the deficiencies that result from those adjustments.
In addition, for the earliest year of each member open to adjustment by respondent (the first year in issue), respondent made an additional adjustment under
Member 1997 1998
______ ____ ____
Nissan --- $ 794,993
Volkswagen $ 273,115 ---
Dodge --- 2006 U.S. Tax Ct. LEXIS 17">*53 348,762
Chrysler --- 337,423
The parties vigorously dispute whether the
Change in Method of Accounting
No member of the Huffman group requested respondent's permission to change its method of accounting.
Discussion
The parties are in agreement that, in computing the LIFO values of the Huffman group's yearend inventories, the accountant employed by the group omitted a computational step required by
2006 U.S. Tax Ct. LEXIS 17">*55 Before addressing that question, we shall discuss the relevant provisions of
A change in the method of accounting 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. Although a method of accounting may exist under this definition without the necessity of a pattern of consistent treatment of an item, in most instances a method of accounting is not established for an item without such consistent treatment. A material item is any item which involves the proper time for the inclusion of the item in income or the taking of a deduction. Changes in method of accounting include * * * a change involving the method or basis used in the valuation of inventories * * *
A change in method of accounting does not include correction of mathematical or posting errors, or errors in the computation of tax liability (such as errors in computation of the foreign tax credit, net operating loss, percentage depletion or investment credit). Also, a change in method of accounting does not include adjustment of an item of income2006 U.S. Tax Ct. LEXIS 17">*57 or deduction which does not involve the proper time for the inclusion of the item of income or the taking of a deduction. For example, corrections of items that are deducted as interest or salary, but which are in fact payments of dividends, and of items that are deducted as business expenses, but which are in fact personal expenses, are not changes in method of accounting. * * *
126 T.C. 322">*341 B.
The distinction between a change in method of accounting and the correction of a mathematical error is especially significant because of
A notable feature of
To distinguish between error correction and an accounting method change, we must examine both the pertinent Treasury regulation and caselaw.
B.
As we described supra in giving the background of this case, the accountant erred in applying the link-chain method, he did so consistently for each member, beginning in the year the member elected the link-chain method and ending only when respondent found the error, the error resulted in income being under-reported for some (most) years and over-reported 126 T.C. 322">*343 for other years, and, if not corrected, the error would not result in the permanent omission of income by the taxpayers. The accountant's error was an error in allocating the cost of goods available for sale during a year between the items sold during the year and the items on hand at the end of the year. Generally, under a system of inventory accounting, the value assigned to the items on hand at the end of one year establishes the value of the items on hand at the beginning of the next year. Consequently, 2006 U.S. Tax Ct. LEXIS 17">*62 the accountant's error would, if applied consistently (as, in fact, it was), self correct, at least in the sense that, if the error were continued over the life of any inventory pool, the total gain reported on account of the sale of items in the pool would be correct. See, e.g.,
Nevertheless,
The accountant did not make a mathematical error because he did not make an error in arithmetic. He neither divided when he should have multiplied nor multiplied 2 x 2 and found the product to be 5. The accountant erred in that, after deflating the current-year cost of each inventory pool to determine whether, at base-year costs, there had been an increment in the pool, and finding an increment, he failed to multiply the increment by the cumulative index in order to determine the yearend LIFO value of the pool. The accountant reached an erroneous result not because he made a mistake in arithmetic (multiplication) but because he omitted 126 T.C. 322">*345 the critical step of multiplication altogether. That kind of error no more lends itself to being classified as an arithmetical (mathematical) error than does the error of the baker who, having intended to double the recipe for a2006 U.S. Tax Ct. LEXIS 17">*66 cake he has baked, finds that the cake has only risen half way because he failed to double the measure of baking powder called for by the recipe. Petitioners cannot avoid respondent's
Nor can petitioners avail themselves of the exceptions in
Although
1. Introduction
In considering the caselaw dealing with what constitutes a change in method of accounting, we must distinguish2006 U.S. Tax Ct. LEXIS 17">*67 between cases decided before and after 1970. Before 1970, courts were mostly left to their own devices to resolve whether an accounting adjustment rose to the level of a change in method of accounting. In 1970,
2. Petitioners' Argument
Petitioners' argument is as follows: "It has long been held that where a taxpayer properly elects a particular accounting method, the making by the taxpayer of an error in the use of that accounting method is an error. Thus, it logically follows that the correction of that error is not a change of accounting method." Petitioners' argument rests on the premise that a taxpayer does not change its method of accounting by deviating from it. If the premise is sound, then the taxpayer does not change its method of accounting by correcting that deviation, since before, during, and after the deviation, the taxpayer used the same method of accounting.
Petitioners can find some support for their premise in cases holding that a taxpayer does not change its method of accounting2006 U.S. Tax Ct. LEXIS 17">*69 when it does no more than conform to a prior accounting election or some specific requirement of the law. Many of the cases that petitioners rely on, however, were decided before the 1970 revisions to
3. Post-1970 Decisions
a. Primo Pants Co. v. Commissioner
This Court has generally agreed with
Because the accountant's error in the instant case had precisely the same effect as did the taxpayer's discounting practices in Primo Pants Co. -- viz, it served merely to alter the distribution of a lifetime income among taxable periods -- that case would seem to govern us here, requiring us to conclude that respondent's adjustments to the members' inventories constituted a change in the members' methods of accounting. Petitioners attempt to distinguish Primo Pants Co. and the cases of the Court that follow it, but their2006 U.S. Tax Ct. LEXIS 17">*73 reading of those cases is flawed. For example, on brief, petitioners discount the relevance of our holding in Primo Pants Co. because, they suggest: "No contention was made that the undervalued inventory was the result of a mathematical error." On the contrary, our report in Primo Pants Co. states: "Petitioner characterizes the various adjustments to inventory as the mere correction of its application of its lower of cost or market method of valuing inventory."
b. Cases Cited by Petitioners
i. Korn Indus., Inc. v. United States
Petitioners rely heavily on
Taxpayers on other occasions have brought Korn Indus., Inc. to our attention. See, e.g.,
ii. Evans v. Commissioner
Petitioners also refer us to
iii. Gimbel Brothers; Standard Oil
Petitioners cite two additional cases for the proposition that a taxpayer does not change its method of accounting when it corrects a deviation from a previously elected method of accounting:
We agree with respondent that the facts of
4. Discussion
There is an evident incongruity between
The notion that a taxpayer does not change its method of accounting when it merely conforms to a prescribed (but ignored) method of accounting is contradicted by at least one example in
Consider a taxpayer that elects a method of accounting and, for some time, adheres to the method (thereby adopting it). The taxpayer then, for some time, deviates from the method before, again, adhering to it. The notion that the taxpayer did not change its method of accounting when it either, first, deviated from the method or, thereafter, adhered to the method is a notion that is narrower than the previously described notion, and it is one we have supported. See, e.g.,
Our inconsistency in holding that a taxpayer does not change its method of accounting when it does no more than conform to a prior accounting election is not necessarily inconsistent with
126 T.C. 322">*355 D. Conclusion
We affirm the conclusions that, tentatively, we reached supra in section III.B. of this report. The accountant erred in applying the link-chain method. He did so consistently, 2006 U.S. Tax Ct. LEXIS 17">*87 and his error was an error in timing. It was not, within the meaning of
For the first year in issue of each member, respondent's revaluation of the member's inventory constituted a change in the member's method of accounting. Therefore, respondent's
To reflect the foregoing,
Decisions will be entered for respondent.
1. Cases of the following petitioners are consolidated herewith: James A. and Dorothy A. Patterson, docket No. 2846-04; Douglas M. and Kimberlee H. Wolford, docket No. 2847-04; and Neil A. and Ethel M. Huffman, docket No. 2848-04.↩
2. Hereafter, all section references are to the Internal Revenue Code of 1986, as amended and in effect for the years in issue.↩
3. FIFO is authorized by
4. The following example is based on an example in Gertzman, Federal Tax Accounting, par. 7.02, at 7-4 (2d. ed. 1993) (cited hereafter as Gertzman par. __, at __):
Example: Assume that, in its first year of operation, a retailer acquires identical products at the following times and costs:
Date Number Unit Cost Total
____ ______ _________ _____
Jan. 1 10 $ 1.00 $ 10.00
Apr. 1 15 1.02 15.30
July 1 15 1.04 15.60
Oct. 1 10 1.06 10.60
__ _____
50 51.50
Assuming that 12 units remain on hand at the end of the year, it is necessary to determine what portion of the $ 51.50 aggregate cost of goods available for sale should be allocated to those 12 units. The balance will be allocated to the 38 units sold and will be deemed the cost of goods sold.
Under FIFO, the ending inventory would be deemed to cost $ 12.68 (consisting of a layer of 10 units at $ 1.06 a unit and a layer of 2 units at $ 1.04 a unit). The balance of the cost of goods available for sale, $ 38.82, would be allocated to the 38 units sold and would be deemed the cost of goods sold.
Under LIFO, the ending inventory would be deemed to cost $ 12.04 (consisting of a layer of 10 units at $ 1.00 a unit and a layer of 2 units at $ 1.02 a unit). The balance of the cost of goods available for sale, $ 39.46, would be allocated to the 38 units sold and would be deemed the cost of goods sold.↩
5. In the example supra in note 4, the use of LIFO instead of FIFO increased the cost of goods sold by $ 0.64 (from $ 38.82 to $ 39.46). That $ 0.64 represents the inflation that had occurred during the year in the cost of the 12 items that remained on hand at the end of the year ((10 units x increase in price of $ 0.06 a unit) + (2 units x increase in price of $ 0.02 a unit)).↩
6. In the example supra note 4, assuming LIFO, the LIFO reserve at the end of the year would be $ 0.64, calculated as follows:
FIFO value (current replacement cost)
of ending inventory:
2 units at $ 1.04 = $ 2.08
10 units at $ 1.06 = 10.60
$ 12.68
LIFO value of ending inventory:
10 units at $ 1.00 = $ 10.00
2 units at $ 1.02 = 2.04
12.04
______
Difference (LIFO reserve): 0.64↩
7. Consider the following example of the dollar-value method, based on Gertzman par. 7.04[3], at 7-37.
Assume that T (a manufacturer) began operations a number of years ago with 4 pounds of item A that cost $ 0.10 a pound. Its total inventory was thus valued at $ 0.40. Normal operations require the taxpayer to purchase and consume 4 pounds of A each year. The LIFO value of its closing inventory would, thus, have remained $ 0.40 notwithstanding that the cost of A increased to $ 0.50 a pound in the interim. Assume further, that, because of technical advantages, an equal quantity of item B may now be used in lieu of item A. The current price of B is $ 0.40 a pound, and, because of the price advantage of B over A ($ 0.10), T, this year, purchases 4 pounds of B and consumes its remaining stock of A. Like A, B has a base-year cost of $ 0.10. Under those facts, if T follows the dollar-value method with a single inventory pool that includes both items A and B, its cost of goods sold and ending inventory will be as follows:
Quantitative change in base-year cost of inventory:
Beginning inventory at base-year cost
(4 pounds of A at $ 0.10) $ 0.40
(0 pounds of B at $ 0.10) 0.00
_____
0.40
Ending inventory at base-year cost
(0 pounds of A at $ 0.10) 0.00
(4 pounds of B at $ 0.10) 0.40
______
0.40
Increase in inventory cost 0.00
LIFO value of inventory:
Beginning inventory 0.40
Ending inventory 0.40
Cost of goods sold:
Beginning inventory 0.40
Purchases (4 pounds of B at $ 0.40/lb) 1.60
____
2.00
Less: Ending inventory 0.40
____
Cost of goods sold 1.60
LIFO reserve at end of year:
Replacement cost of ending inventory
(4 pounds of B at $ 0.40/lb) 1.60
Less: LIFO value of ending inventory 0.40
____
LIFO reserve 1.20
The dollar-value method allowed T to take full advantage of the current cost of B in determining its cost of goods sold. By focusing solely on the change in the dollar value of T's total inventory investment, rather than the specific mix of items constituting that investment, the dollar-value method allowed T to liquidate its investment in A without incurring a tax on past inflation. The LIFO reserve measures the potential gain built into the inventory pool.↩
8.
9. The computational procedures for the link-chain method are described by the Commissioner in
10. The parties have attached documentation to the stipulation of facts evidencing those elections. The documentation is inconsistent with the described elections with respect to (1) Neil Huffman Enterprises, Inc., d.b.a. Neil Huffman Dodge, and (2) Neil Huffman, Inc., d.b.a. Huffman Chrysler Plymouth, in that it indicates that those corporations elected to adopt "an index method as provided in
11. The yearend LIFO value of the pool was understated because, even under the LIFO method, inventory cannot be carried at a cost lower than the actual cost of purchasing the inventory. Cf.
12. For the 100 units purchased during year 1, the index would be 200%, reflecting the doubling during the year in the unit cost of the inventoriable item.↩
13. In citing
14. SEC. 481. ADJUSTMENTS REQUIRED BY CHANGES IN METHOD OF ACCOUNTING. (a) General Rule. -- In computing the taxpayer's taxable income for any taxable year (referred to in this section as the "year of the change") -- (1) if such computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding taxable year was computed, then (2) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted, except there shall not be taken into account any adjustment in respect of any taxable year to which this section does not apply unless the adjustment is attributable to a change in the method of accounting initiated by the taxpayer.↩
15. We have held that consistent treatment of an item is shown by two or more taxable years of application.
16. Though adhering to the holding of its predecessor in
17.
18. See supra note 10.↩
19. Nor in reaching that conclusion would a court have to find that the taxpayer committed a posting or mathematical error. See
20. It is worth mentioning that the use of price indexes in applying the dollar-value method is a matter to which Congress in