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 post contains the text of the IRS’s inventory rules. I have truncated the text of the IRS rules near the end of some sections where the content does not relate to inventory.
Section 471: General Rule for Inventories
This section is an authorization for the IRS to develop its own inventory 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, inventories shall be taken by such taxpayer 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 the income.
Section 472—Last-In, First-Out [LIFO] Inventories
Section 472 (a) is a general statement that anyone using the LIFO method shall follow IRS rules in doing so.
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.
(b) Method applicable
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.
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.
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.
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 specified 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 (1) to shareholders, partners, or other proprietors, or to beneficiaries, or (2) for credit purposes.
(d) 3-year averaging for increases in inventory value
Section 472 (d) describes the costing method to be used for LIFO layering.
The beginning inventory for the first taxable year for which the method described in subsection (b) is used shall be valued at cost. Any change in the inventory 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.
(e) Subsequent inventories
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.
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 authorized; or, (2) the Secretary determines that the taxpayer has used for any such subsequent taxable year some procedure other than that specified in paragraph (1) of subsection (b) in inventorying the goods specified in the application to ascertain the income, profit, or loss of such subsequent taxable year for the purpose of a report or statement covering such taxable year to shareholders, partners, or other proprietors, or beneficiaries, or 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 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 (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 published governmental indexes in such manner and circumstances as determined by the Secretary for purposes of the method described in subsection (b).
(g) Conformity rules applied on controlled group basis
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 combines 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
(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 corporations” means (A) any affiliated group as defined in section 1504 determined by substituting “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
Section 473—Qualified Liquidations of LIFO Inventories
Section 473 (a) states that liquidated LIFO layers cannot be replaced 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 respect to such liquidation, then the gross income of the taxpayer for such taxable year shall be adjusted as provided in subsection (b).
(b) Adjustment for replacements
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.
If the liquidated goods are replaced (in whole or in part) during any replacement 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 the aggregate replacement cost of the liquidated goods so replaced during such year, over 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 the aggregate cost reflected in such opening inventory of the liquidated goods so replaced during such year, over such aggregate replacement cost.
(c) Qualified liquidation defined
Section 473 (c) states that a LIFO inventory layer can be liquidated 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 referenced again in section 473(e)(2).
For purposes of this section:
(1) In general
The term ‘’qualified liquidation’’ means – a decrease in the closing inventory of the liquidation year from the opening inventory of such year, but only if the taxpayer establishes to the satisfaction of the Secretary that such decrease is directly and primarily attributable to a qualified inventory interruption.
(2) Qualified inventory interruption defined
(A) In general the term ‘’qualified inventory interruption’’ means a regulation, request, or interruption described in subparagraph (B) but only to the extent provided in the notice published pursuant to subparagraph (B).
(B) Determination by Secretary
Whenever the Secretary, after consultation with the appropriate Federal officers, determines: (i) that any Department of Energy regulation or request with respect to energy supplies, or any embargo, international boycott, or other major foreign trade interruption, has made difficult or impossible the replacement 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.
(d) Other definitions and special rules
Section 473 (d) defines the terms “liquidation year,” “replacement year,” “replacement period,” “LIFO method,” and “election”.
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.
(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 the period of the 3 taxable years following the liquidation year, or 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 described in section 472.
An election under subsection (a) shall be made subject to such conditions, and in such manner and form and at such time, as the Secretary may prescribe by regulation.
An election under this section shall be irrevocable and shall be binding 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.
(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 recently liquidated (whether or not in a qualified liquidation) and not previously replaced.
(2) Amount at which replacement goods taken into account In the case of any qualified liquidation, any goods considered under paragraph (1) as having been acquired in replacement of the goods liquidated in such liquidation shall be taken into purchases and included in the closing inventory of the taxpayer for the replacement year at the inventory cost basis of the goods replaced.
(f) Special rules for application of adjustments
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.
(1) Period of limitations
If an adjustment is required under this section for any taxable year by reason of the replacement of liquidated goods during any replacement year, and the assessment of a deficiency, or the allowance of a credit or refund of an overpayment of tax attributable to such adjustment, for any taxable 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.
Solely for purposes of determining interest on any overpayment or underpayment attributable to an adjustment made under this section, such overpayment or underpayment shall be treated as an overpayment or underpayment (as the case may be) for the replacement year.
Section 474—Simplified Dollar-Value LIFO Method for Certain Small Businesses
(a) General rule
Section 474 (a) allows a simplified LIFO valuation for small businesses.
An eligible small business may elect to use the simplified dollar-value method of pricing inventories for purposes of the LIFO method.
(b) Simplified dollar-value method of pricing inventories
Section 474 (b) describes the simplified dollar-value method, including the use of inventory pools and cost adjustments based on the Producer Price Index or Consumer Price Index.
For purposes of this section –
(1) In general
The simplified dollar-value method of pricing inventories is a dollarvalue method of pricing inventories under which the taxpayer maintains a separate inventory pool for items in each major category in the applicable Government price index, and 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 except as provided in subparagraph (B), the Producer Price Index published by the Bureau of Labor Statistics, or 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 in the case of the Producer Price Index, any of the 2-digit standard industrial classifications in the Producer Prices Data Report, or in the case of the Consumer Price Index, any of the general expenditure categories in the Consumer Price Index Detailed Report.
(c) Eligible small business
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 regulation 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.
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 preceding taxable years do not exceed $5,000,000. For purposes of the preceding sentence, rules similar to the rules of section 448(c)(3) shall apply.
(d) Special rules
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.
For purposes of this section –
(1) Controlled groups
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. 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.
(A) 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 to the taxable year for which it is made, and to all subsequent taxable years for which the taxpayer is an eligible 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
(4) Transitional rules
(A) In general
In the case of a year of change under this section the inventory pools shall in the case of the 1st taxable year to which such an election applies, be established in accordance with the major categories in the applicable Government price index, or in the case of the 1st taxable year after such election ceases to apply, be established in the manner provided by regulations under section 472; 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 the year of change shall be treated as a new base year in accordance 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 the 1st taxable year to which an election under this section applies, or in the case of a cessation of such an election, the 1st taxable year after such election ceases to apply.
Section 1504 (a)—Affiliated Group Definition
This section contains the complete IRS text referring to an affiliated 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 Section 1504 (a)(2) with 50%.
(a) Affiliated group defined
For purposes of this subtitle –
(1) In general
The term ‘’affiliated group’’ means 1 or more chains of includible corporations connected through stock ownership with a common parent corporation which is an includible corporation, but only if the common parent owns directly stock meeting the requirements of paragraph (2) in at least one of the other includible corporations, and 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 possesses at least 80 percent of the total voting power of the stock of such corporation, and 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 a corporation is included (or required to be included) in a consolidated return filed by an affiliated group for a taxable year which includes any period after December 31, 1984, and such corporation ceases to be a member of such group in a taxable year beginning after December 31, 1984, with respect to periods after such cessation, such corporation (and any successor of such corporation) may not be included in any consolidated return 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.
(B) Secretary may waive application of subparagraph (A) The Secretary may waive the application of subparagraph (A) to any corporation for any period subject to such conditions as the Secretary may prescribe.
(4) Stock not to include certain preferred stock
For purposes of this subsection, the term ‘’stock’’ does not include any stock which is not entitled to vote, is limited and preferred as to dividends and does not participate in corporate growth to any significant extent, has redemption and liquidation rights which do not exceed the issue price of such stock (except for a reasonable redemption or liquidation premium), and
(D) is not convertible into another class of stock.
The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this subsection, including (but not limited to) regulations which treat warrants, obligations convertible into stock, and other similar interests as stock, and stock as not stock, which treat options to acquire or sell stock as having been exercised, which provide that the requirements of paragraph (2)(B) shall be treated as met if the affiliated group, in reliance on a good faith determination of value, treated such requirements as met, which disregard an inadvertent ceasing to meet the requirements of paragraph (2)(B) by reason of changes in relative values of different classes of stock, which provide that transfers of stock within the group shall not be taken into account in determining whether a corporation ceases to be a member of an affiliated group, and which disregard changes in voting power to the extent such changes are disproportionate to related changes in value.