163 13 IRS Inventory Rules 13-1 Introduction The inventory accountant is primarily concerned with preparing accounting records that fall under the guidelines of Generally Accepted Accounting Principles (GAAP). However, the Internal Revenue Service (IRS) has its own set of rules related to inventory, which do not always match GAAP. This chapter contains the text of the IRS’s inventory rules, along with commentary from the author (shown next to the “Commentary” headers). The text of the IRS rules has been truncated by the author 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 within the Internal Revenue Code: Title 26—Internal Revenue Code Subtitle A—Income Taxes Chapter 1—Normal Taxes and Surtaxes Subchapter E—Accounting Periods and Methods of Accounting Part II—Methods of Accounting Subpart D—Inventories Section 471—General Rule for Inventories Section 472—Last-in, First-Out Inventories Section 473—Qualified Liquidations of LIFO Inventories Section 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 is necessary in order clearly to determine the income of any taxpayer, c13_4353.qxd 11/29/04 9:29 AM Page 163 inventories shall be taken by such taxpayer on such basis as the Sec- 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 reflecting the income. 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. IRS Text: (a) Authorization A taxpayer may use the method provided in subsection (b) in inventorying goods specified in an application, to use such method filed at such time and in such manner as the Secretary may prescribe. The change to, and the use of, such method shall be in accordance 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 (b) describes a modified form of LIFO inventory, whereby one layer includes inventory existing before the taxable year and one subsequent 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 the order of acquisition) to the extent thereof; and second, those acquired in the taxable year; (2) Inventory them at cost; and (3) Treat those included in the opening inventory of the taxable year in which such method is first used as having been acquired at the same time and 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 financial reporting. (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 spec- ified in paragraphs (1) and (3) of subsection (b) in inventorying such goods to ascertain the income, profit, or loss of the first taxable year for which the method described in subsection (b) is to be used, for the purpose of a report or statement covering such taxable year – 164 / Inventory Accounting c13_4353.qxd 11/29/04 9:29 AM Page 164 (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 de- 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 be taken into account ratably in each of the 3 taxable years beginning with the first 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 a LIFO 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 all subsequent taxable years unless – (1) with the approval of the Secretary a change to a different method is au- thorized; or, (2) the Secretary determines that the taxpayer has used for any such subse- 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 year for the purpose of a report or statement covering such taxable year (A) to shareholders, partners, or other proprietors, or beneficiaries, or (B) for credit purposes; and requires a change to a method different from that prescribed in subsection (b) beginning with such subsequent taxable year or any taxable year thereafter. If paragraph (1) or (2) of this subsection applies, 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 pub- lished governmental indexes in such manner and circumstances as determined 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 com- bines its financial results must also use the LIFO method. The complete text of the IRS rule for the “section 1504” referred to in this section is listed later in Section 13-6 of this chapter. IRS Inventory Rules / 165 c13_4353.qxd 11/29/04 9:29 AM Page 165 (g) Conformity rules applied on controlled group basis (1) In general Except as otherwise provided in the regulations, all members of the same group of financially related corporations shall be treated as one taxpayer for purposes of subsections (c) and (e)(2). (2) Group of financially related corporations For purposes of paragraph (1), the term ‘’group of financially related cor- porations’’ means – (A) any affiliated group as defined in section 1504 determined by substi- tuting ‘’50 percent’’ for ‘’80 percent’’ each place it appears in section 1504(a) and without regard to section 1504(b), and (B) any other group of corporations which consolidate or combine for purposes 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 inventories under the LIFO method, and (2) the taxpayer elects to have the provisions of this section apply with re- spect to such liquidation, then the gross income of the taxpayer for such taxable year shall be adjusted as provided in subsection (b). 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 replace- ment year and such replacement is reflected in the closing inventory for such year, then the gross income for the liquidation year shall be – (1) decreased by an amount equal to the excess of – (A) the aggregate replacement cost of the liquidated goods so replaced during 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. 166 / Inventory Accounting c13_4353.qxd 11/29/04 9:29 AM Page 166 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 ref- erenced again in section 473(e)(2). (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 the opening inventory of such year, but only if (B) the taxpayer establishes to the satisfaction of the Secretary that such decrease 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) but only to the extent provided in the notice published pursuant to sub- paragraph (B). (B) Determination by Secretary Whenever the Secretary, after consultation with the appropriate Federal officers, 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 foreign trade interruption, has made difficult or impossible the re- placement during the liquidation year of any class of goods for any class of taxpayers, and (ii) that the application of this section to that class of goods and taxpayers is necessary to carry out the purposes of this section, he shall publish a notice of such determinations in the Federal Register, together with the period to be affected by such notice. Commentary: Section 473 (d) defines the terms “liquidation year,” “replace- ment year,” “replacement period,” “LIFO method,” and “election.” (d) Other definitions and special rules For purposes of this section – (1) Liquidation year The term ‘’liquidation year’’ means the taxable year in which occurs the qualified liquidation to which this section applies. IRS Inventory Rules / 167 c13_4353.qxd 11/29/04 9:29 AM Page 167 (2) Replacement year The term ‘’replacement year’’ means any taxable year in the replacement period; except that such term shall not include any taxable year after the taxable 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 the Federal 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 the Federal Register. (4) LIFO method The 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 con- ditions, and in such manner and form and at such time, as the Secre- tary may prescribe by regulation. (B) Irrevocable election An election under this section shall be irrevocable and shall be bind- ing for the liquidation year and for all determinations for prior and subsequent taxable years insofar as such determinations are affected 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, the goods reflecting such increase shall be considered, in the order of their acquisition, 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 para- graph (1) as having been acquired in replacement of the goods liquidated in such liquidation shall be taken into purchases and included in the clos- ing inventory of the taxpayer for the replacement year at the inventory cost basis of the goods replaced. 168 / Inventory Accounting c13_4353.qxd 11/29/04 9:29 AM Page 168 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 by reason of the replacement of liquidated goods during any replacement year, 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 tax- able year, is otherwise prevented by the operation of any law or rule of law (other than section 7122, relating to compromises), then such deficiency may be assessed, or credit or refund allowed, within the period prescribed for assessing a deficiency or allowing a credit or refund for the replacement year if a notice for deficiency is mailed, or claim for refund is filed, within such period. (2) Interest Solely for purposes of determining interest on any overpayment or un- derpayment attributable to an adjustment made under this section, such overpayment 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-value method 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 Pro- ducer Price Index or Consumer Price Index. (b) Simplified dollar-value method of pricing inventories For purposes of this section – (1) In general The simplified dollar-value method of pricing inventories is a dollar- value method of pricing inventories under which – (A) the taxpayer maintains a separate inventory pool for items in each major category in the applicable Government price index, and IRS Inventory Rules / 169 c13_4353.qxd 11/29/04 9:29 AM Page 169 (B) the adjustment for each such separate pool is based on the change from the preceding taxable year in the component of such index for the major category. (2) Applicable Government price index The term ‘’applicable Government price index’’ means – (A) except as provided in subparagraph (B), the Producer Price Index published by the Bureau of Labor Statistics, or (B) in the case of a retailer using the retail method, the Consumer Price Index published by the Bureau of Labor Statistics. (3) Major category The 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 section 448(c)(3) covers the following points: • If the business has not yet been in operation for three years, then the reg- ulation shall be applied for the period of its existence. • If any of the three preceding taxable years include a short year, that year shall 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 any taxable 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, all persons which are component members of such group shall be treated as one taxpayer for purposes of determining the gross receipts of the taxpayer. 170 / Inventory Accounting c13_4353.qxd 11/29/04 9:29 AM Page 170 (B) Controlled group defined For purposes of subparagraph (A), persons shall be treated as being component members of a controlled group if such persons would be treated as a single employer under section 52. (2) Election (A) In general The election under this section may be made without the consent of the Secretary. (B) Period to which election applies The 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 the Secretary to the revocation of such election. (3) LIFO method The term ‘’LIFO method’’ means the method provided by section 472(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 election applies, 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 regula- tions under section 472; (ii) the aggregate dollar amount of the taxpayer’s inventory as of the beginning of the year of change shall be the same as the aggregate dollar 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 year after such election ceases to apply. IRS Inventory Rules / 171 c13_4353.qxd 11/29/04 9:29 AM Page 171 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 Sec- tion 1504 (a)(2) with 50%. (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 stock ownership with a common parent corporation which is an includible corporation, 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 corpora- tions, and (ii) stock meeting the requirements of paragraph (2) in each of the includible corporations (except the common parent) is owned directly 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 this paragraph if it – (A) possesses at least 80 percent of the total voting power of the stock of such 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 year which 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 re- turn filed by the affiliated group (or by another affiliated group with the same common parent or a successor of such common parent) before the 61st month beginning after its first taxable year in which it ceased to be a member of such affiliated group. 172 / Inventory Accounting c13_4353.qxd 11/29/04 9:29 AM Page 172 [...]... for the Physical Inventory Count3 The physical inventory counting process is highly dependent on a stationary inventory This means that there can be no movement of inventory into or out of the warehouse area during the counting process, nor can there be a movement of any 3 Adapted with permission from p 1098 of Roehl-Anderson and Bragg, Controllership 7E, John Wiley & Sons, 2004 184 / Inventory Accounting... counters shall continually review inventory accuracy and identify related problems This policy is intended for perpetual inventory systems and results in a much higher level of inventory accuracy and attention to the underlying problems that cause inventory errors 14-3 Setting up an Inventory Tracking System1 A physical inventory count can be eliminated if accurate perpetual inventory records are available... incorporate accurate inventory records into its inventory valuations, external auditors can review the system at any time, because there is no need to conduct a year-end physical inventory count, and the material planning staff can utilize the inventory database with confidence 14-4 Taking the Physical Inventory2 Most companies still use a physical inventory system that only reconciles inventory to actual... should approve and support, as well as procedures for setting up inventory tracking systems, conducting physical inventory counts, ensuring a proper inventory cutoff, reconciling inventory variances, running successful cycle counting programs, and reducing the need for inventory tracking 14-2 Inventory Counting Policies Creating and running inventory tracking systems can require a considerable upfront... approach for organizing the inventory in preparation for a count, creating and managing counting teams, and properly using counting forms and inventory release teams to ensure that counts have been completed as accurately as possible This section provides that information 2 Adapted with permission from pp 56–57 of Bragg, GAAP Implementation Guide, John Wiley & Sons, 2004 180 / Inventory Accounting The... layout It is much easier to move racks before installing a perpetual inventory system, because no inventory locations must be changed in the computer system Create aisles that are wide enough for forklift operation 1 Adapted with permission from pp 159–161 of Bragg, Accounting Reference Desktop, John Wiley & Sons, 2002 Counting Inventory / 177 4 5 6 7 8 if this is needed for larger storage items,... Counting Inventory 14-1 Introduction An accountant can have the finest costing system in the world and still waste time recording inventory transactions if the record accuracy level of those transactions is poor Because the accounting department is often held responsible if recorded inventory costs are wrong, one should have a clear idea of how to set up an inventory tracking system, conduct physical inventory. .. complete physical inventory count shall be conducted at the end of each reporting period This policy ensures that an accurate record of the inventory is used as the basis for a cost of goods sold calculation The materials manager is responsible for inventory accuracy This policy centralizes control over inventory accuracy, thereby increasing the odds of it being kept at a high level 175 176 / Inventory Accounting... assigned inventory and the problems causing specific transactional errors 15 Initiate inventory audits The inventory should be audited frequently, perhaps as much as once a week This allows the accountant to track changes in the inventory accuracy level and initiate changes if the accuracy drops below acceptable levels In addition, frequent audits are an indirect means of telling the staff that inventory. .. improvement in inventory record accuracy The long list of requirements to fulfill before achieving an accurate perpetual inventory system makes it clear that this is not a project that yields immediate results Unless the inventory is small or the conversion project is heavily staffed, it is likely that a company faces many months of work before it arrives at the nirvana of an extremely accurate inventory . the clos- ing inventory of the taxpayer for the replacement year at the inventory cost basis of the goods replaced. 1 68 / Inventory Accounting c13_4353.qxd 11/29/04 9:29 AM Page 1 68 Commentary:. physical inventory counts, ensuring a proper inventory cutoff, reconciling inventory variances, running successful cycle counting programs, and reducing the need for inventory tracking. 14-2 Inventory. means of telling the staff that inventory accuracy is important and must be maintained. The minimum ac- 1 78 / Inventory Accounting c14_4353.qxd 11/29/04 9:30 AM Page 1 78 ceptable accuracy level is