IRS Revenue Ruling
1997-42

Code Sec. 472

<<FULL TEXT>>

26 CFR 1.472-2(e): LIFO conformity requirement.


REV. RUL. 97-42

ISSUE

Whether a franchised automobile dealer that elected the last-in,
first-out (LIFO) inventory method for federal income tax purposes violates
the LIFO conformity requirement of section 472(c) or (e)(2) of the
Internal Revenue Code by providing certain monthly income statements to
the credit subsidiary of its franchisor (an automobile manufacturer).


FACTS

A, B, and C are franchised automobile dealers engaged in the purchase,
sale, and service of automobiles manufactured by X. A, B, and C regularly
finance their purchases of new automobiles through Y, a subsidiary of X.

For federal income tax purposes, A, B, and C use the accrual method of
accounting and a calendar taxable year. Each dealer elected to use the
LIFO inventory method to account for its automobile inventory beginning
with its taxable year ended December 31, 1970.

Pursuant to the terms of the franchise agreements with X and the
financing agreements with Y, X and Y must receive balance sheets and
income statements from A, B, and C within 10 days after the end of each
month. The income statements are prepared in a format required by X or on
pre-printed forms supplied by X and present the dealers' operating results
for both the month and the calendar year-to-date.

During 1996, A, B, and C's monthly financial statements were received
by X and Y. In the January through November income statements, A, B, and C
calculated their Cost of Goods Sold using the specific identification
inventory method instead of the LIFO inventory method. Under the specific
identification method, the cost of the dealers' beginning and ending
inventories is determined by reference to X's actual invoice price for the
automobiles on hand.

Situation 1 -- LIFO Reflected in Gross Profit. A provided the following
income statement to X and X for the month of December:

INCOME STATEMENT

December 1996

Month Year-to-Date
----- ------------
Sales of Automobiles $300x $3,600x
Cost of Goods Sold (255x) (2,400x)
------ --------
Gross Profit $45x $1,200x
Variable Expenses (12x) (144x)
Fixed Expenses (18x) (216x)
------ --------
Net Income $15x $840x
====== ========


A calculated its Cost of Goods Sold for the year and the month as
follows. First, A used the specific identification inventory method to
calculate a tentative cost of goods sold for the year ($2,340x) and the
month ($195x). Then, A made an adjustment of $60x (representing a $60x
increase in A's LIFO reserve for 1996) to the tentative cost of goods sold
to arrive at Cost of Goods Sold for the year ($2,400x) and the month
($255x), respectively.

Situation 2 -- LIFO Reflected in Net Income. B provided the following
income statement to X and Y for the month of December:

INCOME STATEMENT

December 1996

Month Year-to-Date
----- ------------
Sales of Automobiles $300x $3,600x
Cost of Goods Sold (195x) (2,340x)
------ --------
Gross Profit $105x $1,260x
Variable Expenses (12x) (144x)
Fixed Expenses (18x) (216x)
------ --------
Operating Profit $75x $900x
Other Income & Expenses (60x) (60x)
------ --------
Net Income $15x $840x
====== ========


B used the specific identification inventory method to calculate its
Cost of Goods Sold and Gross Profit for both the year and month without
adjusting for a $60x increase in B's LIFO reserve for 1996. On the Other
Income and Expenses line, B reduced Operating Profit in the Year-to-Date
column by $60x (representing the $60x increase in B'B LIFO reserve for
1996) and in the Month column by $60x to arrive at B's Net Income for the
year ($840x) and the month ($15x), respectively.

Situation 3 -- LIFO Not Reflected on the Income Statement. C provided
the following income statement to X and Y for the month of December:

INCOME STATEMENT

December 1996

Month Year-to-Date
----- ------------
Sales of Automobiles $300x $3,600x
Cost of Goods Sold (195x) (2,340x)
------ --------
Gross Profit $105x $1,260x
Variable Expenses (12x) (144x)
Fixed Expenses (18x) (216x)
------ --------
Operating Profit $75x $900x
Other Income & Expenses -0- -0-
------ --------
Net Income $75x $900x
====== ========


C used the specific identification inventory method to calculate its
Cost of Goods Sold, Gross Profit, and Net Income for the year and month
without adjusting for a $60x increase in C's LIFO reserve for 1996. Thus,
the December 1996 income statement does not reflect C's use of the LIFO
inventory method.


LAW AND ANALYSIS

Section 472(a) authorizes a taxpayer to use the LIFO inventory method
in accordance with regulations prescribed by the Secretary.

Section 472(c) provides that a taxpayer may not elect to use the LIFO
inventory method unless it establishes to the satisfaction of the
Commissioner that it used no method other than the LIFO method in
inventorying goods to ascertain the income, profit, or loss of the first
taxable year for which the LIFO method is to be used, for the purpose of a
report or statement covering that taxable year to shareholders, partners,
other proprietors, or beneficiaries, or for credit purposes.

Section 472(e) provides that a taxpayer electing to use the LIFO
inventory method must continue to use the LIFO inventory method unless the
taxpayer: (1) obtains the consent of the Commissioner to change to a
different method; or (2) is required by the Commissioner to change to a
different method because the taxpayer has used some inventory method other
than LIFO to ascertain the income, profit, or loss of any subsequent
taxable year in a report or statement covering that taxable year (a) to
shareholders, partners, other proprietors, or beneficiaries, or (b) for
credit purposes.

Section 1.472-2(e)(1) of the Income Tax Regulations provides that a
taxpayer electing to use the LIFO inventory method must establish to the
satisfaction of the Commissioner that the taxpayer, in ascertaining the
income, profit, or loss of the taxable year for which the LIFO inventory
method is first used, or for any subsequent taxable year, for credit
purposes or for purposes of reports to shareholders, partners, other
proprietors, or beneficiaries, has not used any inventory method other
than LIFO.

Section 1.472-2(e)(1) generally provides exceptions to the LIFO
conformity requirement. Under section 1.472-2(e)(1)(iv), a taxpayer is not
at variance with the LIFO conformity requirement if it uses an inventory
method other than LIFO in a report or statement covering a period of less
than an entire taxable year. However, section 1.472-2(e)(6) provides that
a series of credit statements or financial reports is considered a single
statement or report covering an entire taxable year if the statements or
reports in the series are prepared using a single inventory method and can
be combined to disclose the income, profit, or loss for the entire taxable
year. For this purpose a taxable year includes any one-year period that
both begins and ends in a taxable year for which the taxpayer used the
LIFO inventory method. Section 1.472-2(e)(2). Thus, income statements
prepared on the basis of a calendar year may be subject to the LIFO
conformity requirement even though the taxpayer employs a fiscal year for
federal income tax purposes.

Under section 1.472-2(e)(2)(vi), a taxpayer is not at variance with the
LIFO conformity requirement if it uses costing methods or accounting
methods to ascertain income, profit, or loss in financial statements for
credit purposes if such methods are not inconsistent with the LIFO
inventory method. The use of cost estimates is an example of a costing
method that is not inconsistent with the LIFO inventory method. Section
1.472-2(e)(8)(ix).

The financial statements received by Y are "for credit purposes" within
the meaning of sections 472(c) and (e)(2) because they were issued to a
creditor with whom A, B, and C maintain continuing credit relationships.
Thus, under sections 472(c), 472(e)(2), and section 1.472-2(e)(1), A, B,
and C violated the LIFO conformity requirement if they used a method other
than LIFO in inventorying goods to ascertain the income, profit, or loss
for the taxable year covered by the financial statements provided to Y.

In Situations 1 and 2, A and B did not violate the LIFO conformity
requirement in their statements to Y because they used the LIFO method in
inventorying goods to ascertain their net income in the Month and
Year-to-Date columns of the December income statement. The results in
Situations 1 and 2 would be the same if the $60x LIFO adjustment reflected
in the Month and Year-to-Date columns of the December 1996 income
statement had been a reasonable estimate of the change in LIFO reserve for
the year. Further, if A or B had employed a fiscal taxable year, the
results in Situations 1 and 2 would be the same if A or B made either an
adjustment for the change in the LIFO reserve that occurred during the
calendar year in the Month and Year-to-Date column of the December income
statement or an adjustment for the change in the LIFO reserve that
occurred during the fiscal year in the Month and Year-to-Date columns of
the income statements provided for the last month of the fiscal year.

In Situation 3, C violated the LIFO conformity requirement in its
statements to Y because C used a method other than LIFO in inventorying
goods to ascertain its net income in the Year-to-Date column of the
December income statement. Further, C violated the LIFO conformity
requirement because the January through November income statements can be
combined with the December income statement to ascertain C's net income
for the year using a single inventory method other than LIFO. The result
in Situation 3 would be the same even if C's December 31, 1996 Balance
Sheet had reflected a 1996 adjustment to C's LIFO reserve.


HOLDING

A franchised automobile dealer that elected the LIFO inventory method
for federal income tax purposes violates the LIFO conformity requirement
of S 472(c) or (e)(2) by providing to the credit subsidiary of its
franchisor (an automobile manufacturer) an income statement for the
taxable year that fails to reflect the LIFO inventory method in the
computation of net income.


DRAFTING INFORMATION

The principal author of this revenue ruling is Jeffery G. Mitchell of
the Office of Assistant Chief Counsel (Income Tax and Accounting). For
further information regarding this revenue ruling, contact Mr. Mitchell on
(202) 622-4970 (not a toll free call).

<<END RULING>>

 

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