Business Ebook John Wiley Sons Inventory Accounting_8 potx

Commentary: Section 472 b describes a modified form of LIFO inventory, whereby one layer includes inventory existing before the taxable year and onesubsequent layer includes inventory ac

13 IRS Inventory Rules

13-1 Introduction

The inventory accountant is primarily concerned with preparing accounting recordsthat fall under the guidelines of Generally Accepted Accounting Principles (GAAP).However, the Internal Revenue Service (IRS) has its own set of rules related toinventory, which do not always match GAAP This chapter contains the text of theIRS’s inventory rules, along with commentary from the author (shown next tothe “Commentary” headers) The text of the IRS rules has been truncated by theauthor near the end of some sections where the content does not relate to inventory

In order to locate the original IRS text, please refer to the following headings withinthe Internal Revenue Code:

Title 26—Internal Revenue Code

Subtitle A—Income TaxesChapter 1—Normal Taxes and SurtaxesSubchapter E—Accounting Periods and Methods of AccountingPart II—Methods of Accounting

Subpart D—InventoriesSection 471—General Rule for InventoriesSection 472—Last-in, First-Out InventoriesSection 473—Qualified Liquidations of LIFO InventoriesSection 474—Simplified Dollar-Value LIFO Method for Certain Small Businesses

13-2 Section 471—General Rule for Inventories

Commentary: This section is an authorization for the IRS to develop its own

in-ventory rules in order to determine a taxpayer’s taxable income

Whenever in the opinion of the Secretary the use of inventories isnecessary in order clearly to determine the income of any taxpayer,

inventories shall be taken by such taxpayer on such basis as the retary may prescribe as conforming as nearly as may be to the best ac-counting practice in the trade or business and as most clearly reflectingthe income.

Sec-13-3 Section 472—Last-In, First-Out Inventories

Commentary: Section 472 (a) is a general statement that anyone using the LIFO

method shall follow IRS rules in doing so

Commentary: Section 472 (b) describes a modified form of LIFO inventory,

whereby one layer includes inventory existing before the taxable year and onesubsequent layer includes inventory acquired during the taxable year.(b) Method applicable

In inventorying goods specified in the application described in subsection (a),the taxpayer shall:

(1) Treat those remaining on hand at the close of the taxable year as being:First, those included in the opening inventory of the taxable year (in theorder of acquisition) to the extent thereof; and second, those acquired inthe taxable year;

(2) Inventory them at cost; and(3) Treat those included in the opening inventory of the taxable year inwhich such method is first used as having been acquired at the same timeand determine their cost by the average cost method

Commentary: Section 472 (c) states that taxpayers can only use LIFO for tax

reporting purposes if the company already uses LIFO for its regular financialreporting

(c) Condition

Subsection (a) shall apply only if the taxpayer establishes to the satisfaction

of the Secretary that the taxpayer has used no procedure other than that ified in paragraphs (1) and (3) of subsection (b) in inventorying such goods toascertain the income, profit, or loss of the first taxable year for which themethod described in subsection (b) is to be used, for the purpose of a report orstatement covering such taxable year –

spec-(1) to shareholders, partners, or other proprietors, or to beneficiaries, or(2) for credit purposes.

Commentary: Section 472 (d) describes the costing method to be used for

LIFO layering

(d) 3-year averaging for increases in inventory value

The beginning inventory for the first taxable year for which the method scribed in subsection (b) is used shall be valued at cost Any change in the in-ventory amount resulting from the application of the preceding sentence shall

de-be taken into account ratably in each of the 3 taxable years de-beginning with thefirst taxable year for which the method described in subsection (b) is first used

Commentary: Section 472 (e) states that a company cannot switch from LIFO

to some other method once it has begun reporting taxable income with aLIFO inventory valuation, without permission from the IRS

(e) Subsequent inventories

If a taxpayer, having complied with subsection (a), uses the method described

in subsection (b) for any taxable year, then such method shall be used in allsubsequent taxable years unless –

(1) with the approval of the Secretary a change to a different method is thorized; or,

au-(2) the Secretary determines that the taxpayer has used for any such quent taxable year some procedure other than that specified in paragraph(1) of subsection (b) in inventorying the goods specified in the applica-tion to ascertain the income, profit, or loss of such subsequent taxable yearfor the purpose of a report or statement covering such taxable year (A) toshareholders, partners, or other proprietors, or beneficiaries, or (B) forcredit purposes; and requires a change to a method different from thatprescribed in subsection (b) beginning with such subsequent taxable year

subse-or any taxable year thereafter If paragraph (1) subse-or (2) of this subsectionapplies, the change to, and the use of, the different method shall be in ac-cordance with such regulations as the Secretary may prescribe as necessary

in order that the use of such method may clearly reflect income

Commentary: Section 472 (f) states that government price indexes can be

used to value LIFO inventory layers

(f) Use of government price indexes in pricing inventory

The Secretary shall prescribe regulations permitting the use of suitable lished governmental indexes in such manner and circumstances as determined

pub-by the Secretary for purposes of the method described in subsection (b)

Commentary: Section 472 (g) states that if a company is to use the LIFO

method for tax reporting purposes, all of the companies with which it bines its financial results must also use the LIFO method The complete text

com-of the IRS rule for the “section 1504” referred to in this section is listed later

in Section 13-6 of this chapter

(g) Conformity rules applied on controlled group basis

(1) In generalExcept as otherwise provided in the regulations, all members of the samegroup of financially related corporations shall be treated as one taxpayerfor purposes of subsections (c) and (e)(2)

(2) Group of financially related corporationsFor purposes of paragraph (1), the term ‘’group of financially related cor-porations’’ means –

(A) any affiliated group as defined in section 1504 determined by tuting ‘’50 percent’’ for ‘’80 percent’’ each place it appears in section1504(a) and without regard to section 1504(b), and

substi-(B) any other group of corporations which consolidate or combine forpurposes of financial statements

13-4 Section 473—Qualified Liquidations of LIFO Inventories

Commentary: Section 473 (a) states that liquidated LIFO layers cannot be

re-placed with newly acquired goods

(a) General rule

If, for any liquidation year –(1) there is a qualified liquidation of goods which the taxpayer inventoriesunder the LIFO method, and

(2) the taxpayer elects to have the provisions of this section apply with spect to such liquidation, then the gross income of the taxpayer for suchtaxable year shall be adjusted as provided in subsection (b)

re-Commentary: Section 473 (b) states again that liquidated LIFO layers cannot

be replaced with newly acquired goods; the cost of the liquidated layers must

be reflected in current taxable income

(b) Adjustment for replacements

If the liquidated goods are replaced (in whole or in part) during any ment year and such replacement is reflected in the closing inventory for suchyear, then the gross income for the liquidation year shall be –

replace-(1) decreased by an amount equal to the excess of –(A) the aggregate replacement cost of the liquidated goods so replacedduring such year, over

(B) the aggregate cost of such goods reflected in the opening inventory

of the liquidation year, or(2) increased by an amount equal to the excess of –(A) the aggregate cost reflected in such opening inventory of the liqui-dated goods so replaced during such year, over

(B) such aggregate replacement cost

Commentary: Section 473 (c) states that a LIFO inventory layer can be

liqui-dated and then reinstated if it is caused by a Department of Energy request or

is the result of a specific type of foreign trade interruption This section is erenced again in section 473(e)(2)

ref-(c) Qualified liquidation defined

For purposes of this section –(1) In general

The term ‘’qualified liquidation’’ means –(A) a decrease in the closing inventory of the liquidation year from theopening inventory of such year, but only if

(B) the taxpayer establishes to the satisfaction of the Secretary that suchdecrease is directly and primarily attributable to a qualified inven-tory interruption

(2) Qualified inventory interruption defined(A) In general the term ‘’qualified inventory interruption’’ means a reg-ulation, request, or interruption described in subparagraph (B) butonly to the extent provided in the notice published pursuant to sub-paragraph (B)

(B) Determination by SecretaryWhenever the Secretary, after consultation with the appropriate Federalofficers, determines –

(i) that –(I) any Department of Energy regulation or request with respect

to energy supplies, or(II) any embargo, international boycott, or other major foreigntrade interruption, has made difficult or impossible the re-placement during the liquidation year of any class of goodsfor any class of taxpayers, and

(ii) that the application of this section to that class of goods andtaxpayers is necessary to carry out the purposes of this section,

he shall publish a notice of such determinations in the FederalRegister, together with the period to be affected by suchnotice

Commentary: Section 473 (d) defines the terms “liquidation year,”

“replace-ment year,” “replace“replace-ment period,” “LIFO method,” and “election.”

(d) Other definitions and special rules

For purposes of this section –(1) Liquidation yearThe term ‘’liquidation year’’ means the taxable year in which occurs thequalified liquidation to which this section applies

(2) Replacement yearThe term ‘’replacement year’’ means any taxable year in the replacementperiod; except that such term shall not include any taxable year after thetaxable year in which replacement of the liquidated goods is completed.(3) Replacement period

The term ‘’replacement period’’ means the shorter of –(A) the period of the 3 taxable years following the liquidation year, or(B) the period specified by the Secretary in a notice published in theFederal Register with respect to that qualified inventory interruption.Any period specified by the Secretary under subparagraph (B) may

be modified by the Secretary in a subsequent notice published in theFederal Register

(4) LIFO methodThe term ‘’LIFO method’’ means the method of inventorying goods de-scribed in section 472

(5) Election(A) In general

An election under subsection (a) shall be made subject to such ditions, and in such manner and form and at such time, as the Secre-tary may prescribe by regulation

con-(B) Irrevocable election

An election under this section shall be irrevocable and shall be ing for the liquidation year and for all determinations for prior andsubsequent taxable years insofar as such determinations are affected

bind-by the adjustments under this section

Commentary: Section 473 (e) defines inventory acquired to replace earlier

in-ventory layers

(e) Replacement; inventory basis

For purposes of this chapter –(1) Replacements

If the closing inventory of the taxpayer for any replacement year reflects

an increase over the opening inventory of such goods for such year, thegoods reflecting such increase shall be considered, in the order of theiracquisition, as having been acquired in replacement of the goods most re-cently liquidated (whether or not in a qualified liquidation) and not previ-ously replaced

(2) Amount at which replacement goods taken into account

In the case of any qualified liquidation, any goods considered under graph (1) as having been acquired in replacement of the goods liquidated

para-in such liquidation shall be taken para-into purchases and para-included para-in the ing inventory of the taxpayer for the replacement year at the inventory costbasis of the goods replaced

clos-Commentary: Section 473 (f) describes the periods within which tax credits or

liabilities and related interest charges can be assessed as a result of adjustments

to inventory layers

(f) Special rules for application of adjustments

(1) Period of limitations

If –(A) an adjustment is required under this section for any taxable year byreason of the replacement of liquidated goods during any replacementyear, and

(B) the assessment of a deficiency, or the allowance of a credit or refund

of an overpayment of tax attributable to such adjustment, for any able year, is otherwise prevented by the operation of any law or rule

tax-of law (other than section 7122, relating to compromises), then suchdeficiency may be assessed, or credit or refund allowed, within theperiod prescribed for assessing a deficiency or allowing a credit orrefund for the replacement year if a notice for deficiency is mailed,

or claim for refund is filed, within such period

(2) InterestSolely for purposes of determining interest on any overpayment or un-derpayment attributable to an adjustment made under this section, suchoverpayment or underpayment shall be treated as an overpayment or un-derpayment (as the case may be) for the replacement year

13-5 Section 474—Simplified Dollar-Value LIFO Method

for Certain Small Businesses

Commentary: Section 474 (a) allows a simplified LIFO valuation for small

businesses

(a) General rule

An eligible small business may elect to use the simplified dollar-valuemethod of pricing inventories for purposes of the LIFO method

Commentary: Section 474 (b) describes the simplified dollar-value method,

including the use of inventory pools and cost adjustments based on the ducer Price Index or Consumer Price Index

Pro-(b) Simplified dollar-value method of pricing inventories

For purposes of this section –(1) In general

The simplified value method of pricing inventories is a value method of pricing inventories under which –

dollar-(A) the taxpayer maintains a separate inventory pool for items in eachmajor category in the applicable Government price index, and

(B) the adjustment for each such separate pool is based on the changefrom the preceding taxable year in the component of such index forthe major category.

(2) Applicable Government price indexThe term ‘’applicable Government price index’’ means –(A) except as provided in subparagraph (B), the Producer Price Indexpublished by the Bureau of Labor Statistics, or

(B) in the case of a retailer using the retail method, the Consumer PriceIndex published by the Bureau of Labor Statistics

(3) Major categoryThe term ‘’major category’’ means –(A) in the case of the Producer Price Index, any of the 2-digit standard in-dustrial classifications in the Producer Prices Data Report, or(B) in the case of the Consumer Price Index, any of the general expen-diture categories in the Consumer Price Index Detailed Report

Commentary: Section 474 (c) defines what types of businesses are eligible

to use the simplified dollar-value LIFO method The reference to section448(c)(3) covers the following points:

• If the business has not yet been in operation for three years, then the ulation shall be applied for the period of its existence

reg-• If any of the three preceding taxable years include a short year, that yearshall be annualized

• Gross receipts shall be reduced by any returns and allowances

(c) Eligible small business

For purposes of this section, a taxpayer is an eligible small business for anytaxable year if the average annual gross receipts of the taxpayer for the 3 pre-ceding taxable years do not exceed $5,000,000 For purposes of the preced-ing sentence, rules similar to the rules of section 448(c)(3) shall apply

Commentary: Section 474 (d) covers several special rules related to LIFO,

such as the applicability of controlled groups, the ability to use LIFO, and how

to transition to its use

(d) Special rules

For purposes of this section –(1) Controlled groups(A) In general

In the case of a taxpayer which is a member of a controlled group, allpersons which are component members of such group shall be treated

as one taxpayer for purposes of determining the gross receipts of thetaxpayer

(B) Controlled group definedFor purposes of subparagraph (A), persons shall be treated as beingcomponent members of a controlled group if such persons would betreated as a single employer under section 52.

(2) Election(A) In generalThe election under this section may be made without the consent ofthe Secretary

(B) Period to which election appliesThe election under this section shall apply –(i) to the taxable year for which it is made, and(ii) to all subsequent taxable years for which the taxpayer is an eligi-ble small business, unless the taxpayer secures the consent of theSecretary to the revocation of such election

(3) LIFO methodThe term ‘’LIFO method’’ means the method provided by section472(b)

(4) Transitional rules(A) In general

In the case of a year of change under this section –(i) the inventory pools shall –

(I) in the case of the 1st taxable year to which such an electionapplies, be established in accordance with the major cate-gories in the applicable Government price index, or(II) in the case of the 1st taxable year after such election ceases

to apply, be established in the manner provided by tions under section 472;

regula-(ii) the aggregate dollar amount of the taxpayer’s inventory as of thebeginning of the year of change shall be the same as the aggregatedollar value as of the close of the taxable year preceding the year

of change, and(iii) the year of change shall be treated as a new base year in accor-dance with procedures provided by regulations under section 472.(B) Year of change

For purposes of this paragraph, the year of change under this section

is –(i) the 1st taxable year to which an election under this section ap-plies, or

(ii) in the case of a cessation of such an election, the 1st taxable yearafter such election ceases to apply

13-6 Section 1504 (a)—Affiliated Group Definition

Commentary: This section contains the complete IRS text referring to an

affil-iated group, as referenced earlier in Section 472 (g) For the purposes of Section

472 (g), replace all references to 80% in the voting and value tests noted in tion 1504 (a)(2) with 50%

Sec-(a) Affiliated group defined

For purposes of this subtitle –(1) In general

The term ‘’affiliated group’’ means –(A) 1 or more chains of includible corporations connected through stockownership with a common parent corporation which is an includiblecorporation, but only if –

(B)(i) the common parent owns directly stock meeting the requirements

of paragraph (2) in at least one of the other includible tions, and

corpora-(ii) stock meeting the requirements of paragraph (2) in each of theincludible corporations (except the common parent) is owneddirectly by one or more of the other includible corporations.(2) 80-percent voting and value test

The ownership of stock of any corporation meets the requirements of thisparagraph if it –

(A) possesses at least 80 percent of the total voting power of the stock ofsuch corporation, and

(B) has a value equal to at least 80 percent of the total value of the stock

of such corporation

(3) 5 years must elapse before reconsolidation(A) In general

If –(i) a corporation is included (or required to be included) in a con-solidated return filed by an affiliated group for a taxable yearwhich includes any period after December 31, 1984, and(ii) such corporation ceases to be a member of such group in a tax-able year beginning after December 31, 1984, with respect to pe-riods after such cessation, such corporation (and any successor

of such corporation) may not be included in any consolidated turn filed by the affiliated group (or by another affiliated groupwith the same common parent or a successor of such commonparent) before the 61st month beginning after its first taxableyear in which it ceased to be a member of such affiliated group

re-(B) Secretary may waive application of subparagraph (A)The Secretary may waive the application of subparagraph (A) to anycorporation for any period subject to such conditions as the Secre-tary may prescribe.

(4) Stock not to include certain preferred stockFor purposes of this subsection, the term ‘’stock’’ does not include anystock which –

(A) is not entitled to vote,(B) is limited and preferred as to dividends and does not participate incorporate growth to any significant extent,

(C) has redemption and liquidation rights which do not exceed the issueprice of such stock (except for a reasonable redemption or liquida-tion premium), and

(D) is not convertible into another class of stock

(5) RegulationsThe Secretary shall prescribe such regulations as may be necessary or ap-propriate to carry out the purposes of this subsection, including (but notlimited to) regulations –

(A) which treat warrants, obligations convertible into stock, and othersimilar interests as stock, and stock as not stock,

(B) which treat options to acquire or sell stock as having been exercised,(C) which provide that the requirements of paragraph (2)(B) shall betreated as met if the affiliated group, in reliance on a good faith de-termination of value, treated such requirements as met,

(D) which disregard an inadvertent ceasing to meet the requirements ofparagraph (2)(B) by reason of changes in relative values of differentclasses of stock,

(E) which provide that transfers of stock within the group shall not betaken into account in determining whether a corporation ceases to be

a member of an affiliated group, and(F) which disregard changes in voting power to the extent such changesare disproportionate to related changes in value