Time is of the Essence

The Last-In-First-Out (LIFO) method of inventory accounting provides significant tax benefits and improves cash flow for many manufacturers. Unfortunately, the IRS has increased its scrutiny of LIFO, which can result in expensive audits for manufacturers using the popular method of accounting.

LIFO is a method of valuing inventory in which the items acquired last are treated as the ones sold first. This is in contrast to the First-In-First-Out (FIFO) method, which values goods sold by using the cost of the oldest items in inventory first.

For more than 50 years, LIFO has produced significant tax savings for all types of businesses. It essentially allows a company to expense inflation build up in inventory and provides a better matching of current costs with current revenues. Although your company can still realize significant savings from the LIFO method, it has recently become an IRS audit target so you must be careful about meeting the requirements under tax law.

One recent Tax Court case is a painful reminder of the complexity of LIFO calculations.

Facts of the case: A group of corporations sold new and used automobiles in Kentucky. For a period of between 10 and 20 years, the corporations omitted a step required by the LIFO inventory method. The omissions resulted in an accounting method change and costly adjustments for the business.

The case also showed that the normal statue of limitations does not apply to LIFO. Since LIFO accounting involves a cumulative calculation, the IRS can go back to the date of adoption, correct errors, and bring the resulting correction into the earliest open year. (Huffman et al, 126 TC 17)

IRS Guidance

In addition to the Tax Court case described above, the IRS also recently issued Legal Advice to its field agents relating to LIFO. The guidance looks at a company that produces a significant number of bottled wines. However, for purposes of determining its LIFO inventory value, the wine manufacturer places all of its products into a single pool including two items: bulk wine and case goods.

The inventory, according to the IRS, results in different costs for each item due to:

• The various grapes used in production,
• A number of locations where grapes were grown,
• An assortment of bottles, seals or corks, labels and packaging,
• Aging costs for different wines.

Despite these unique characteristics, the IRS notes, "the winery summarizes all costs into either case goods or bulk wine and makes no attempt to identify individual stock keeping units within the inventory." Field agents were instructed to terminate LIFO due to the taxpayer's noncompliance with the regulations and the winery's inability to correct the LIFO calculations due to a lack of historical cost data. (IRS LAFA 20064301F)

This example illustrates how IRS agents are scrutinizing what constitutes an "item." LIFO calculations are being closely investigated to determine whether or not they are in compliance with Treasury Regulations.

What's more, failure to use proper item accounting could be viewed by the IRS as grounds for retroactively terminating a taxpayer's LIFO election.

How Should Your Business Proceed?

The issue of what an "item" includes can cause potential problems for many companies using internal index LIFO calculations, not just wineries and auto dealers. The recent court case and IRS guidance should serve as a reminder that your company's inventory methods should be periodically reviewed to determine that they are still the best available option and ensure that the underlying calculations are accurate.

Due to the complexity of LIFO calculations, Moss Adams uses centralized LIFO processing to ensure accurate, efficient calculations. We have reviewed hundreds of calculations prepared by clients and tax professionals' and have assisted in correcting many large conceptual and mechanical errors in the calculations.

Smart Steps  Periodic review  Voluntary corrections  Good records

Based on this experience, we advise all taxpayers to take a fresh look at their inventory methods and calculations.

It is important to voluntarily correct any errors in your inventory methods or calculations. Generally, if you voluntarily make corrections, an unfavorable adjustment is spread over four years and a favorable adjustment is deductible in the year of correction. If the IRS finds an unfavorable adjustment, it will be added to your earliest open year (typically three years back). Plus, interest and penalties will likely apply.

Time is of the essence. Once you have been contacted by the IRS for an audit, it is typically too late to implement any prospective changes to your company's inventory methods.

Also important: It is critical for your company to maintain comprehensive records of related LIFO computations. Good records can help withstand IRS challenges and avoid expensive tax penalties.

Contact your local Moss Adams office to arrange a review of your inventory methods, calculations and record keeping. We can be reached online at www.mossadams.com, or by phone at 888-MADE AT MOSS to be directed to a LIFO tax professional near you.

The material appearing in this newsletter is for informational purposes only and is not legal advice. Communication of this information is not intended to create, and receipt does not constitute a legal relationship, including, but not limited to, an attorney-client or accountant-client relationship. The information provided herein is intended only as general information which may or may not reflect the most current developments. Although these materials may be prepared by professionals, they should not be used as a substitute for professional services. If legal, accounting, or other professional advice is required, the services of a professional should be sought.