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 for 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 sec. 6501, respondent is limited in the number of years open to adjustment by him. The earliest year open to an adjustment by respondent is 1998 for Nissan, Dodge, and Chrysler, and it is 1997 for Volkswagen. For the earliest and each succeeding year of a member open to adjustment by him, respondent increased or, in two cases, decreased the taxable income of the member to reflect respondent's recalculation of the member's beginning and ending inventories for the year. The amounts of the adjustments in taxable income resulting from

those recalculations, and the taxable years to which they correspond, are as follows:

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 section 481. That adjustment increased the taxable income of the member for that year to reflect the cumulative adjustments to income revealed by respondent's recalculations for all years of the member's up until that year. Those adjustments (the section 481 adjustments) are as follows:

The parties vigorously dispute whether the section 481 adjustments (cumulatively, $1,709,293) are permissible, and it is that question that is the primary issue before us.

Change in Method of Accounting

No member of the Huffman group requested respondent's permission to change its method of accounting.

Discussion

I. Introduction

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 section 1.472-8, Income Tax Regs. (addressing the dollar-value method of pricing LIFO inventories). The

consequence of the accountant's error was that, generally, he understated the LIFO value of those inventories (which, generally, resulted in an underreporting of income from sales). Respondent corrected the accountant's error, and petitioners accept respondent's adjustments to the inventories of the members of the Huffman group for all of the years in issue. Petitioners do not accept, however, respondent's determination that, in making those adjustments for the first year in issue of each member, he was implementing a change that he had made in the members' methods of accounting, which necessitated his making additional adjustments for those years pursuant to section 481(a). Petitioners argue that respondent's adjustments were merely the result of his correction of a mathematical error made by the accountant. They point out that, pursuant to section 1.446–1(e)(2)(ii)(b), Income Tax Regs.,13 the correction of a mathematical error is explicitly excluded from constituting a change in method of accounting. Because, they argue, there was no change in any member's method of accounting, no section 481 adjustments were warranted. They concede, however, that if section 481 adjustments were warranted, respondent has correctly computed those adjustments. Our sole task is to determine whether the section 481 adjustments were warranted, which requires us to determine whether, in revaluing the members' inventories, respondent corrected a mathematical error or changed the members' methods of accounting for those inventories.

Before addressing that question, we shall discuss the relevant provisions of sections 446 and 481.

II. Sections 446 and 481

A. Section 446

Section 446 prescribes certain rules with respect to methods of accounting: A taxpayer computes its taxable income in accordance with its method of accounting, see sec. 446(a), and has some discretion in choosing a permissible method of accounting, see sec. 446(c). Nevertheless, no method of

13 In citing sec. 1.446-1(e)(2)(ii)(a) and (b), Income Tax Regs., we refer to that section as in effect before its revision by T.D. 9105, 2001-4 C.B. 419, 423, which replaced much of the content of that section with the substantially similar content of sec. 1.446-1T(e)(2)(ii)(a) and (b), Temporary Income Tax Regs., 69 Fed. Reg. 42 (Jan. 2, 2004).

accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. Sec. 1.446-1(a)(2), Income Tax Regs.; see sec. 446(b). The regulations interpret the term "method of accounting" to include not only the taxpayer's overall method of accounting but also the taxpayer's accounting treatment of "any item." Sec. 1.446-1(a)(1), Income Tax Regs. In general, a taxpayer wishing to change its method of accounting must obtain the prior approval of the Commissioner. See sec. 446(e); sec. 1.446-1(e)(2)(i), Income Tax Regs. The regulations give guidance, but no comprehensive definition, as to what constitutes a change in method of accounting. The regulations provide a rule of inclusion:

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 * * ** [Sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs.]

The regulations also provide certain rules of exclusion; e.g., 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 income 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. * * * [Sec. 1.446-1(e)(2)(ii)(b), Income Tax Regs.]

The regulations give no guidance as to the meaning of the term "mathematical error".

B. Section 481

The distinction between a change in method of accounting and the correction of a mathematical error is especially significant because of section 481. "Section 481 prescribes the rules to be followed in computing taxable income in cases where the taxable income of the taxpayer is computed under a method of accounting different from that under which the taxable income was previously computed." Sec. 1.481-1(a)(1), Income Tax Regs. For purposes of section 481, a change in method of accounting includes a change in the taxpayer's overall method of accounting or a change in the taxpayer's treatment of a material item. See id. Section 481(a) specifies that, in computing the taxpayer's income for the taxable year of the change in method of accounting (year of change), there shall be taken into account those adjustments that are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted.14

III. Discussion

A. Introduction

A notable feature of section 481 is that the adjustments called for by the section may be made notwithstanding that the period of limitations on assessment and collection of tax may have closed on the years (closed years) in which the events giving rise to the need for an adjustment occurred. See Superior Coach of Fla., Inc. v. Commissioner, 80 T.C. 895, 912 (1983). While section 481 may not necessarily conflict with the statute of limitations found in section 6501, see id., it does place a premium on distinguishing between the correction of errors (which is limited to open years) and a change in a method of accounting (which implicates section

14 Sec. 481(a) provides:

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.