Dec. 31, yr. 2, inventory at current-year cost Equals: LIFO reserve $33,500 23,827 9,673 Example (3) continues the facts of Example (2). At baseyear costs, year 3 closing inventory is less than year 2 closing inventory, indicating that a liquidation of inventory has occurred during year 3. That liquidation is reflected by the elimination of the year 2 layer of inventory and a reduction in the year 1 layer of inventory. Product: Chain percentage, Dec. 31, yr. 3, relative to Jan. 1, yr. 1, base date (121.25% x 127.62% × 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: The LIFO reserve for Pool No. 1 as of December 31, yr. 3, is $9,739, computed as follows: 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 being made. See sec. 472(a), (c); sec. 1.472-3, Income Tax Regs. ("Time and manner of making election."). 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. 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 section 1.472-8, Income Tax Regs., which 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 [sec. 1.472-8(e)(1), Income Tax Regs., *** which] will be developed by double extending *** a representative portion of inventory at beginning of year cost and current cost." Such an index method is distinct from the link-chain method purportedly adopted. We address the significance of that fact infra sec. III.C.3.b.iii of this report. addresses the dollar-value method of pricing LIFO inventories. Pursuant to his method, the accountant first determined the items in each dollar-value pool at the end of each year. He then determined the current-year cost of each pool and divided that current-year cost by a cumulative index to determine the base-year cost of the pool. He compared the baseyear cost so determined to the base-year cost of the pool as of the beginning of the year. When the end-of-the-year baseyear cost exceeded the beginning-of-the-year base-year cost, the accountant determined that there had been an increment to the pool, but he did not multiply the increment by the cumulative index (he failed to "index" the increment) to determine a LIFO value for the increment (sometimes, the accountant's error). He assumed the LIFO value of the increment to be the difference between the end-of-the-year and beginning-of-the-year base cost of the pool. That assumption led him to conclude that the yearend LIFO value of each pool was its value determined at base-year costs. 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 attributable 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 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. Fox Chevrolet, Inc. v. Commissioner, 76 T.C. 708, 732 n.15 (1981). begins her first year under the dollar-value method (year 1) with 100 units of an inventoriable item with a base-year cost of $1 a unit. Later that year, after the wholesale price of the item has increased to $2 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) to be $200 (200 × $1). 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's 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 the 100unit 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: It should be noted that, if T's failure to index the year 1 increment were corrected as of the beginning of year 2 12 For the 100 units purchased during year 1, the index would be 200 percent, reflecting the doubling during the year in the unit cost of the inventoriable item. (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 year 1 with no offsetting gain in year 2), unless an offsetting section 481 adjustment were made in year 2 to correct that apparent windfall. 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 positive 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): |