Dow A. AND SANDRA E. HUFFMAN, ET AL.,1 PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 2845-04, 2846-04,

Filed May 16, 2006.

2847-04, 2848-04.

The sole issue for decision is whether a correction to the inventory method employed by S corporations owned by certain of petitioners constitutes an accounting method change that requires an adjustment pursuant to sec. 481, I.R.C. For periods 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 sec. 481, I.R.C., to prevent amounts of income from being omitted solely on account of the changes.

Charles Fassler, Mark F. Sommer, Jennifer S. Smart, and Brett S. Gumlaw, for petitioners.

Mark D. Eblen, for respondent.

OPINION

HALPERN, Judge: These cases have been consolidated for purposes of trial, briefing, and opinion. By notices of deficiency dated December 19, 2003 (the notices), respondent determined deficiencies in Federal income taxes as follows:

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 whether a correction to the inventory method employed by corpora

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.

tions owned by certain of petitioners constitutes an accounting method change that requires an adjustment pursuant to section 481 of the Internal Revenue Code of 1986, as amended and in effect for the years in issue.2

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 corporations (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 section 1361.

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 sec. 1.61–3(a), Income Tax Regs. Because each is a merchant, each must also use inventories and an accrual method of accounting to determine the cost of the goods sold and to match that cost against sales revenue. See secs. 1.471-1 (merchants must use inventories) and 1.446–1(c)(2)(i) (generally, where inventories

2 Hereafter, all section references are to the Internal Revenue Code of 1986, as amended and in effect for the years in issue.

necessary, accrual method must be used with regard to purchases and sales), Income Tax Regs. As explained by Stephen F. Gertzman (Gertzman) in his treatise, Federal Tax Accounting, par. 6.02[2], at 6-5 & 6-6 (2d ed. 1993) (cited hereafter as Gertzman par. at), in the case of a merchant that sells a large number of essentially similar or fungible items, the cost of the goods sold during any period is computed in steps, using inventories and an accrual method of accounting, along with various assumptions as to the manner in which the actual costs incurred in acquiring or producing items of inventory are allocated among the items so acquired or produced. To compute the cost of goods sold during a year, the steps are as follows. First, the costs of the items acquired or produced during the year are aggregated. That total is then combined with the aggregate cost of the items on hand at the beginning of the year to produce the total cost of the goods available for sale during the year. That last total is then allocated among items on hand at the end of the year (cost of ending inventory) and items sold during the year (cost of goods sold). The formula for determining cost of goods sold is essentially as follows:

+

Cost of beginning inventory

Purchases and other acquisition or production costs

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 Id. We are concerned here with certain aspects of LIFO.

3 FIFO is authorized by sec. 1.471-2(d), Income Tax Regs., and LIFO is authorized by sec. 472. 4 The following example is based on an example in Gertzman, Federal Tax Accounting, par.

The LIFO Method

Introduction

We have said "the overriding purpose of * * * LIFO * * * is to match current costs against current income." UFE, Inc. v. Commissioner, 92 T.C. 1314, 1322 1314, 1322 (1989). Gertzman describes the objective of the LIFO method similarly: "The objective of the LIFO method is to match relatively current costs against current revenues to compute a meaningful gross profit." Gertzman par. 7.02[1], at 7-4. Gertzman posits that businesses have a continuing need for a certain level of inventory, and he justifies LIFO on the ground that the changing costs associated with maintaining that level of inventory should be expensed in the year incurred. Id. Gertzman believes that the LIFO objective of matching is achieved because the costs associated with changing prices are generally reflected in the cost of goods sold. Id. at 7-5. To the extent so reflected, those costs (when increasing) are, in effect, treated as deductible expenses.5 See id. Because the LIFO method matches current revenues against relatively current costs, Gertzman views the LIFO method of accounting as

at

7.02, at 7-4 (2d. ed. 1993) (cited hereafter as Gertzman par. Example: Assume that, in its first year of operation, a retailer acquires identical products at the following times and costs:

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 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 > increase in price of $0.06 a unit) + (2 units × increase in price of $0.02 a unit)).

producing a "meaningful" or "true" measure of the gross profit from sales for a period. Id. at 7-4 & 7–5.

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. See 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.

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

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: