IRS Revenue Ruling
2001-8

Code Secs. 471, 61, 111, 472

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26 CFR 1.471-3: Inventories at cost.
(Also sections 61, 111, 472; 1.472-2.)


REV. RUL. 2001-8

ISSUE

What is the proper method of accounting for payments made or received
with respect to "floor stocks"?


BACKGROUND

A floor stocks provision, which applies to a designated type of goods
held in inventory (floor stocks) on a particular date (the "floor stocks
date"), is sometimes enacted in conjunction with a tax, change in tax
rate, or subsidy that is imposed upon similar goods purchased or produced
on or after that date. The purpose of a floor stocks provision is to
ensure that all goods sold on or after the floor stocks date are subjected
to the same total amount of tax or subsidy, regardless of whether the
items sold were goods held as floor stocks on the floor stocks date or
goods purchased or produced after that date. This equal treatment is
achieved by imposing with respect to goods held on the floor stocks date
an amount, to be either paid or received, that will serve to eliminate any
differential in total tax or subsidy that would otherwise exist relative
to goods subsequently purchased or produced.

The Internal Revenue Service, in two previous revenue rulings, has
addressed the proper tax treatment of payments received with respect to
floor stocks. Rev. Rul. 88-95, 1988-2 C.B. 28, and Rev. Rul. 85-30, 1985-1
C.B. 20, generally provide that payments received with respect to floor
stocks should be treated as either an item of gross income or a reduction
in inventory, depending on whether the cost of the goods to which the
payments relate remains in ending inventory under the taxpayer's cost flow
assumption. However, questions continue to arise about how the "goods to
which the payments relate" should be determined, particularly when the
last-in, first-out (LIFO) inventory method is used.

The purpose of this revenue ruling is to clarify that payments made or
received with respect to floor stocks must be accounted for as adjustments
to the invoice price or production cost of the goods physically held on
the floor stocks date to which the payments relate, rather than as an
adjustment to the tax basis (carrying value) of those goods. This revenue
ruling also provides, for costing purposes, an optional simplifying
assumption for LIFO taxpayers regarding identification of the goods
physically held on the floor stocks date to which the floor stocks
payments relate.


LAW

Section 471(a) of the Internal Revenue Code provides that inventories
must be taken on such basis as the Secretary may prescribe as conforming
as nearly as may be to the best accounting practice in the trade or
business and as most clearly reflecting income.

Section 1.471-3 of the Income Tax Regulations provides rules for
determining the cost of merchandise on hand at the beginning of the
taxable year and the cost of merchandise purchased or produced since the
beginning of the taxable year.

Section 472(a) provides that taxpayers may use the LIFO method of
inventorying goods in accordance with such regulations as the Secretary
may prescribe as necessary in order that the use of such method may
clearly reflect income.

Section 472(b) and section 1.472-1 require taxpayers using the LIFO
inventory method to treat goods 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 and to the extent thereof,
and second, those acquired during the taxable year. Section 472(b) and
section 1.472-2 require taxpayers using the LIFO method to inventory their
goods at cost.

Section 263A(a) provides, in the case of property that is inventory in
the hands of the taxpayer, that the direct costs and an allocable share of
the indirect costs (including taxes) of the property must be included in
inventory costs.

Section 1.263A-1(e)(3)(i) provides that indirect costs are properly
allocable to property produced or property acquired for resale when the
costs directly benefit or are incurred by reason of the performance of
production or resale activities.

Section 1.263A-2(a)(3)(iii) provides that producers must capitalize all
indirect costs incurred subsequent to completion of production that are
properly allocable to the property produced.

Section 61(a) provides generally that gross income means all income
from whatever source derived.

Rev. Rul. 85-30 addresses the income tax treatment of payments received
by a retail dealer of highway vehicle tires as a reimbursement of federal
excise taxes previously paid with respect to floor stocks of certain tires
held on the floor stocks date. Rev. Rul. 85-30 holds that the excise tax
reimbursement should be treated as a reduction in ending inventory to the
extent that it relates to tires the cost of which remains in ending
inventory. Rev. Rul. 85-30 further holds that the excise tax reimbursement
should be treated as an item of gross income to the extent that it relates
to tires the cost of which does not remain in ending inventory and has
been included in cost of goods sold.

Rev. Rul. 88-95 addresses the income tax treatment of two types of
payments received by a textile manufacturer that were attributable to
domestically produced raw cotton that was either held as of a specific
date (i.e., floor stocks) or purchased subsequent to that date. Rev. Rul.
88-95 holds that both types of payments should be treated as a reduction
in the inventory cost of the cotton giving rise to the payments to the
extent that the cost is deemed to remain in inventory at the date the
payments are accrued under the taxpayer's method of accounting. Rev. Rul.
88-95 further holds that the payments should be treated as an item of
gross income to the extent that the cost of the cotton giving rise to the
payments is deemed to have been relieved from inventory and accounted for
through cost of goods sold as of the date the payments are accrued under
the taxpayer's method of accounting.

Mohawk Liqueur Corp. v. United States, 324 F.2d 241 (6th Cir. 1963),
cert. denied, 377 U.S. 905 (1964), addressed the specific question of
whether the taxpayer, a manufacturer of alcoholic beverages, could deduct
floor stocks taxes on distilled spirits instead of including them in
inventory in accordance with its previous practice. The court held that
consistency in inventory practice is required. As a result, the taxpayer
was not allowed to deviate from its prior practice of including floor
stocks taxes in inventory.

Turtle Wax, Inc. v. Commissioner, 43 T.C. 460 (1965), held that refunds
of federal excise taxes on watches were taxable income to the extent that
the taxpayer had derived a tax benefit related to the payment of such
taxes from deductions taken in prior years.


ANALYSIS

The inventory accounting rules generally require a taxpayer to first
determine the cost of goods purchased or produced during a taxable year
and then to allocate that cost between goods sold during that taxable year
and goods that remain in ending inventory based on the taxpayer's
inventory cost flow assumption. See sections 1.471-3 and 1.263A-1(c)(1).

Payments made with respect to floor stocks (e.g., taxes) represent an
inventoriable cost of the goods to which the payments relate under
sections 471 and 263A. See section 263A(a). Similarly, payments received
with respect to floor stocks (e.g., tax refunds or subsidy payments)
represent a reduction in the purchase price or production cost of the
goods giving rise to the payments. See Rev. Rul. 85-30; Rev. Rul. 88-95.

Thus, consistent with the requirements of sections 1.471-3 and
1.263A-1, payments made or received with respect to floor stocks must be
accounted for as adjustments to the cost of the goods physically held on
the floor stocks date to which the payments relate. "Cost" for this
purpose means invoice price or production cost. The resultant effect on
either gross income or inventory depends on the extent to which the cost
of the goods physically held on the floor stocks date remains in ending
inventory. Whether the cost of the goods physically held on the floor
stocks date remains in ending inventory is determined by applying the
taxpayer's inventory cost flow assumption (e.g., LIFO, first-in, first-out
(FIFO), or a specific-goods method) to identify the particular costs that
are deemed to be contained in ending inventory. See Rev. Rul. 85-30; Rev.
Rul. 88-95.

Therefore, to the extent that the cost of the goods associated with the
floor stocks payments has been included in cost of goods sold under the
taxpayer's inventory cost flow assumption, payments made (or received)
with respect to floor stocks increase (or decrease) cost of goods sold.
However, payments received that relate to goods the cost of which has been
included in cost of goods sold in a previous year under the taxpayer's
inventory cost flow assumption increase gross income, consistent with
operation of the tax benefit rule as illustrated in Turtle Wax, 43 T.C. at
466. For taxpayers using a LIFO inventory method, this treatment ensures
that payments made or received with respect to floor stocks do not affect
historical LIFO cost increments that contain the cost of unrelated goods.

Similarly, to the extent that the cost of the goods associated with the
floor stocks payments remains in ending inventory under the taxpayer's
inventory cost flow assumption, payments made (or received) with respect
to floor stocks increase (or decrease) ending inventory. For taxpayers
using a LIFO inventory method, payments made or received with respect to
floor stocks affect ending inventory only when one or more LIFO cost
increments that remain in ending inventory, as computed under section
472(b) and section 1.472-1, include the cost of the goods physically held
on the floor stocks date. For taxpayers using a FIFO inventory method,
payments made or received with respect to floor stocks generally are
included in cost of goods sold and not ending inventory because the goods
physically held on the floor stocks date to which the payments relate
usually do not remain in FIFO inventory at the end of the year.

Mohawk Liqueur was decided on grounds of consistency in inventory
practice and did not address the issue considered in this revenue ruling,
i.e., the proper method of accounting for floor stocks taxes under a
particular inventory cost flow assumption.


EXAMPLES

The following four examples illustrate the proper income tax accounting
treatment of payments made and received with respect to floor stocks:

Example 1. X files returns on a calendar year basis using an accrual
method of accounting and the double-extension, dollar-value LIFO method of
inventorying goods. X has only one item, Product 1, in its dollar-value
LIFO pool. The federal excise tax on Product 1 decreases on January 1,
2000, from 100 to 80 per unit. Simultaneously, a floor stocks provision is
implemented that entitles merchants holding Product 1 in inventory on
January 1, 2000, upon which an excise tax of 100 per unit had previously
been paid, to a refund of 20 per unit. X held 10,000 units of Product 1 on
January 1, 2000, and received an associated $200 excise tax refund in
2000. The 10,000 units of Product 1 that X physically held on January 1,
2000, were purchased in 1999. A"s December 31, 1999, LIFO inventory
consists of a 1995 LIFO cost increment that includes the cost of 3,000
units of Product 1 and a 1999 LIFO cost increment that contains the cost
associated with an additional 7,000 units. These 1995 and 1999 increments
remain in X's 2000 LIFO ending inventory.

X must account for the $200 excise tax refund in 2000 as follows: The
$200 refund represents a reduction in the invoice price of the 10,000
units of Product 1 purchased in 1999 and held on January 1, 2000. Of these
10,000 units, only the cost of 7,000 units remains in X's 2000 ending
inventory under X's LIFO inventory cost flow assumption as part of a 1999
increment; thus, $140 of the $200 refund (7,000/10,000 x $200 - $140) is
allocated to these units, resulting in a $140 decrease in 2000 ending
inventory. ($140 must be subtracted from the current-year cost of the 1999
LIFO cost increment and the index (i.e., the ratio of total current-year
cost to total base-year cost) for the 1999 increment would be
recalculated). The cost of the remaining 3,000 of these 10,000 units was
included in cost of goods sold in 1999 under X's LIFO inventory cost flow
assumption. Thus, $60 of the refund (3,000/10,000 x $200 $60) must be
included in gross income in 2000.

Example 2. Y files returns on a calendar year basis using an accrual
method of accounting and the double-extension, dollar-value LIFO method of
inventorying goods. A floor stocks provision is implemented on July 1,
2000, that entitles merchants holding Product 2 in inventory on that date
to receive inventory protection (subsidy) payments of $1 per unit. Y held
50,000 units of Product 2 on July 1, 2000, and received an associated
$50,000 inventory protection payment in 2000. The 50,000 units of Product
2 that Y physically held on July 1, 2000, were purchased in 2000. The cost
of these units does not remain in Y's 2000 LIFO ending inventory, which
consists of 1996, 1997, and 1998 LIFO cost increments.

Y must include the entire $50,000 inventory protection payment as a
decrease in 2000 cost of goods sold because the cost of the associated
goods was included in 2000 cost of goods sold and thus does not remain in
2000 ending inventory under Y's LIFO inventory cost flow assumption.

Example 3. Z files returns on a calendar year basis using an accrual
method of accounting and the double-extension, dollar-value LIFO method of
inventorying goods. Z has only one item, Product 3, in its dollar-value
LIFO pool. The federal excise tax on Product 3 increases on January 1,
2000, from 60 to 100 per unit. Simultaneously, a floor stocks tax
provision is implemented that requires producers holding Product 3 in
inventory on January 1, 2000, upon which an excise tax of 60 per unit had
previously been paid, to pay an additional excise tax of 40 per unit. Z
has 100,000 units of Product 3 on hand on January 1, 2000, and pays the
additional excise tax of $4,000 in 2000. The 100,000 units of Product 3
that Z physically held on January 1, 2000, were produced in 1999 and
subjected to a 60 per unit excise tax in 1999. Z's December 31, 1999, LIFO
inventory consists of LIFO cost increments from 1990, 1993, and 1996. The
cost of these 100,000 units does not remain in Z's 2000 LIFO ending
inventory because Z did not add a LIFO cost increment in 1999.

Z must include the entire $4,000 floor stocks tax in cost of goods sold
in 2000 because the production cost of the associated goods was included
in cost of goods sold in 1999 and thus does not remain in 2000 ending
inventory under Z's LIFO inventory cost flow assumption.

Example 4. The facts are the same as Example 3, except that the cost of
60,000 of the 100,000 units of Product 3 that Z produced in 1999 and
physically held on January 1, 2000, is included in a 1999 LIFO cost
increment. The cost of these 60,000 units remains in Z's 2000 LIFO ending
inventory because Z did not have an inventory decrement in 2000.

Z must account for the $4,000 floor stocks tax in 2000 as follows:
$2,400 must be assigned as an increase in the production cost of the
60,000 units held on January 1, 2000, that were produced in 1999 the cost
of which remains in 2000 ending inventory under Z's LIFO inventory cost
flow assumption as part of a 1999 LIFO cost increment (60,000/ 100,000 x
$4,000 $2,400). This adjustment results in an increase in 2000 ending
inventory ($2,400 must be added to the current-year cost of the 1999 LIFO
cost increment and the index (i.e., the ratio of total current-year cost
to total base-year cost) for the 1999 increment would be recalculated).
The remaining $1,600 of the floor stocks tax must be included in cost of
goods sold in 2000 because the production cost of the 40,000 units of
Product 3 produced in 1999 with which it is associated was included in
1999 cost of goods sold and thus does not remain in 2000 ending inventory
under Z's LIFO inventory cost flow assumption.


HOLDING

Payments made or received with respect to floor stocks must be
accounted for as adjustments to the invoice price or production cost of
the goods physically held on the floor stocks date to which the payments
relate. Payments made or received with respect to floor stocks affect
inventory valuation only to the extent that the invoice price or
production cost of the goods on hand that gave rise to the payments has
not been included in cost of goods sold but remains in ending inventory
under the taxpayer's inventory cost flow assumption. Payments made or
received with respect to floor stocks affect gross income to the extent
that the invoice price or production cost of the goods on hand that gave
rise to the payments has been included in cost of goods sold and thus is
not included in ending inventory under the taxpayer's inventory cost flow
assumption.


SIMPLIFYING ASSUMPTION REGARDING GOODS ON HAND

Identification of the goods that were physically held on the floor
stocks date may be unduly burdensome for some taxpayers, particularly LIFO
taxpayers with large inventories of fungible goods. As a matter of
administrative convenience, the Service will permit LIFO taxpayers to
assume that the goods physically held on the floor stocks date are those
most recently purchased or produced. This simplifying assumption for
payments made or received with respect to floor stocks is a method of
accounting that must be applied on a consistent basis and used only for
the purpose of identifying the goods physically held on the floor stocks
date for costing purposes.


PROSPECTIVE APPLICATION

Pursuant to the authority contained in section 7805(b) of the Code, the
conclusions in this revenue ruling will not be applied adversely to
challenge a consistent treatment by taxpayers of payments made or received
with respect to floor stocks on or before February 26, 2001.


CHANGE IN METHOD OF ACCOUNTING

A change to comply with this revenue ruling is a change in method of
accounting to which the provisions of section 446 and the regulations
thereunder apply. A taxpayer wanting to change its method of accounting to
conform with the holding in this revenue ruling or to elect the
simplifying assumption must follow the automatic change in accounting
method provisions of Rev. Proc. 99-49, 1999-2 C.B. 725 (or its successor),
provided the change is made for the first taxable year in which payments
are made or received with respect to floor stocks subsequent to February
26, 2001, with the following modifications: (1) the scope limitations in
section 4.02 of Rev. Proc. 99-49 do not apply (if the taxpayer is under
examination, before an appeals office, or before a federal court with
respect to any income tax issue, the taxpayer must provide a copy of the
Form 3115, Application for Change in Accounting Method, to the examining
agent, appeals officer, or counsel for the government, as appropriate, at
the same time that it files the copy of the Form 3115 with the national
office); (2) in lieu of the label required by section 6.02(3) of Rev.
Proc. 99-49, a taxpayer should write "Filed pursuant to Rev. Rul. 2001-8"
at the top of its Form 3115; (3) the change in method of accounting to
comply with the holding in this revenue ruling is to be made using a
cut-off method relative to payments made or received with respect to floor
stocks on or before February 26, 2001 (see section 2.06 of Rev. Proc.
99-49); (4) a taxpayer should clearly indicate on its Form 3115 or in an
attachment thereto if it is electing to use the simplifying assumption to
identify the goods physically held on the floor stocks date for costing
purposes.


EFFECT ON OTHER DOCUMENTS

Rev. Rul. 85-30 is clarified to reflect that the reimbursement of
excise taxes is treated as a reduction in the invoice price of the tires
physically held on the floor stocks date.

Rev. Rul. 88-95 is clarified to reflect that the inventory protection
payments are treated as a reduction in the invoice price of the cotton
physically held on the floor stocks date.

Rev. Proc. 99-49 is modified and amplified to include this automatic
change in section 9 of the APPENDIX.


RAFTING INFORMATION

The principal author of this revenue ruling is Alan J. Tomsic of the
Office of Associate Chief Counsel (Income Tax and Accounting). For further
information regarding this revenue ruling, contact Mr. Tomsic at (202)
622-4970 (not a toll-free call).

<<END RULING>>

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