Opinion
Docket No. 93-722T.
Filed April 25, 1997.
Timothy A. Frautschi, Milwaukee, Wisconsin, for plaintiffs.
Stuart J. Bassin, Washington, D.C., with whom was Loretta C. Argrett, Assistant Attorney General, for defendant.
Opinion and Order
The question presented by this income tax case is whether the Internal Revenue Service (IRS) abused its discretion in determining that a new corporation's valuation of bargain goods under the dollar-value, double-extension last-in-first-out (LIFO) method of inventory accounting failed clearly to reflect income, as required by numerous provisions of the IRS's inventory accounting statutes and the regulations thereunder. See, e.g. I.R. Code sections 446, 472. A trial was held in Madison, Wisconsin. Post-trial briefing and supplementary briefing were submitted, and the court heard oral argument. The court concludes that the IRS's disallowance of plaintiff's accounting method was proper, because plaintiff's use of the bargain price for its base-year inventory cost does not clearly reflect income.
Citations to I.R.C. and Treas. Reg. are to the provisions in effect during the years at issue, unless otherwise noted.
Plaintiff, LaCrosse Footwear, Inc. (LaCrosse), contends that it is entitled to use the dollar-value, double-extension LIFO inventory accounting method and that, under the rules applicable to such method, "items" of inventory it acquired in a bulk purchase, and at a bargain price, from LaCrosse Rubber Mills Company (Rubber Mills), may (or must) be valued at the bargain purchase cost, rather than at the considerably higher book value used for financial reporting purposes.
LaCrosse was incorporated on April 27, 1982. Stip. 2. Although LaCrosse's immediate predecessor, LaCrosse Acquisition Corp., initially purchased the Rubber Mills assets, see Exh. 1 at 1, and LaCrosse Footwear was known as LaCrosse Rubber Mills, Inc., Stip. 3, until December 26, 1985, the court, for convenience, refers throughout to the new company (buyer) as "LaCrosse" and the seller as "Rubber Mills."
International Footwear Corporation, the other named plaintiff, is a holding company that acquired LaCrosse after the transaction at issue here, on August 15, 1983. Stip. 4. As the subsidiary's dispute with the Internal Revenue Service does not directly involve the parent corporation, the court treats LaCrosse as the sole plaintiff and refers to plaintiff in the singular.
Defendant has two principal arguments. One is that the goods LaCrosse subsequently (after the purchase of Rubber Mills) purchased, whether for resale or for use in the manufacturing process, must be treated as different classes of goods ("items") from the identical goods acquired earlier from Rubber Mills, because of the significant price differential between the bargain cost of the acquired goods and the (market) cost of the goods it bought or manufactured subsequently (the "item" argument). The second defense argument is that all of the inventory purchased at a bargain from Rubber Mills, including what would have been Rubber Mills' manufactured inventory, belongs in LaCrosse's purchased goods pool (the "pooling" argument).
Generally, defendant maintains that LIFO accounting treatment is intended to compensate only for the effects of inflation on the out-of-pocket costs a merchant or manufacturer must incur each year in order merely to maintain his current inventory levels, not to permit a one-time bargain purchase price to shelter indefinitely a taxpayer's subsequent in-hand income unrelated to inflation. Plaintiff's item and pooling treatments, defendant argues, allow LaCrosse to defer, through each succeeding year that the goods comprising that "item" or pool of inventory are not liquidated (i.e., so long as plaintiff keeps its year-end inventories up to prior levels), any recognition and taxation of plaintiff's actual income or "profit" from this bargain purchase.
The court rejects defendant's "item" and "pooling" arguments. In addition, the court rejects both parties' implicit positions regarding the proper measure of the base-year cost of the taxpayer's inventory. As did the Service in 1983, in disallowing the taxpayer's 1982 cost of goods deduction, the court concludes that a new taxpayer first electing LIFO must calculate the base-year cost of the bargain-purchase inventory at the fair or market value of those items at the beginning of its first taxable year, not at the taxpayer's actual bargain cost. Exh. 51 at 3-4.
Defendant identified a different cause for disallowing the refund request in 1991. See Ex. 51 at 3-4; see also Gen. Couns. Mem. 39,470, 1986 IRS GCM LEXIS 9 (January 6, 1986) (holding that, under Rev. Rul. 85-172, 1985-2 C.B. 151, LaCrosse was required to treat the bargain bulk purchase as a first purchase, not as opening inventory, and that LaCrosse had to place only the finished goods manufactured by Rubber Mills in its purchased pool). The Service's report gave no rationale other than Rev. Rul. 82-192, 1982-2 C.B. 102, for placing finished manufactured goods in the purchased pool. Exh. 12 at 3-5. This ruling held that a taxpayer that manufactures an item, and purchases an identical item, is not the manufacturer of the purchased item and may not include the manufactured and purchased items in one manufactured goods pool.
The 1991 IRS examiner testified that the disallowance was based on plaintiff's failure to place Rubber Mills' finished manufactured goods into LaCrosse's purchased pool, and on the treatment of the bargain purchase as opening inventory rather than a first purchase. Tr. 222. Of course the first purchase/opening inventory distinction is of no effect if the taxpayer is permitted to value the base-year cost of opening inventory as a current-year cost and, as has LaCrosse, elects the earliest acquisition method of setting current-year cost. Rev. Rul. 85-172, 1985-2 C.B. at 151.
The Service has not pursued any of these arguments in this litigation.
Accordingly, the court concludes that the Commissioner did not abuse her discretion in determining that taxpayer's application of the dollar-value, double-extension LIFO inventory accounting method to its first year's inventory, as carried through to succeeding years, did not clearly reflect income.
The Service's action must be sustained even if it was right for the wrong reason. Helvering v. Gowran, 302 U.S. 238, 245-46 (1937).
Background
This dispute centers on the tax years following LaCrosse's purchase on May 26, 1982 of substantially all of the assets, including all of the inventory, of Rubber Mills, a closely-held shoe-selling and manufacturing corporation. Stip. 7, 10. The transaction was consummated on June 21, 1982, effective as of May 1, 1982. Stip. 7. Rubber Mills apparently remained in existence for at least a year thereafter. See Exh. 1 at 59.LaCrosse was formed by certain members of the management and ownership group of Rubber Mills, Tr. 20-21, who agreed to purchase Rubber Mills' assets for $7,491,606 ($4,500,000 in cash, plus acquisition expenses of $404,271, and $2,587,335 in assumed liabilities). See Exh. 31 at 1-2 (letter of intent). Most of the shareholders of Rubber Mills redeemed their shares. See Exh. 27 at 4.
LaCrosse established May 1, 1982 as the commencement of its first (1983) taxable year. Exh. 9. LaCrosse and its holding company, International, use the accrual method of accounting. Stip. 6. LaCrosse filed a separate federal income tax return for the year ending April 30, 1983. Stip. 5.
According to Rubber Mills' financial statements, the book value for the assets sold was $10,670,498, consisting of approximately $50,000 in cash, approximately $4,500,000 in accounts receivable, approximately $4,105,000 in inventory, and approximately $2,100,000 in fixed ( i.e., plant, property, and equipment) and other assets. Stip. 12.
LaCrosse and Rubber Mills signed an "allocation agreement" providing that, for tax purposes, LaCrosse would assign to the cash and accounts receivable a tax basis equivalent to their full book value to Rubber Mills, less a slight allowance for doubtful accounts, for a net total of $4,525,095 ($46,965 in cash; $4,478,130 in accounts receivable). Id.; Exh. 2. Rather than the $5,817,321 total book value carried by Rubber Mills, LaCrosse for tax purposes allocated only $494,145 to plant, property, and equipment and $1,905,755 to inventory, id., based, purportedly, on unspecified tax "basis" rules that require a purchaser to allocate no more than the actual total purchase price among purchased assets. Tr. at 183-84. The parties did not bargain over the allocation agreement. Tr. 49; see 121-24.
The court finds that plaintiff sustained its burden of proving that the accounts receivable were a "cash equivalent." See Whitlow v. Commissioner, 82 F.2d 569, 571 (8th Cir. 1936); Victor Meat Co. v. Commissioner, 52 T.C. 929, 933 (1969). (The taxpayer bears the burden of proof. Welch v. Helvering, 290 U.S. 111, 115 (1933).) This finding is based on experience that the buying group was familiar with Rubber Mills' historical evidence and knew that the amounts ultimately collected would exceed their assigned value, as they indeed did. Tr. 26, 66. While accounts receivable are not, per se, cash "equivalents," see Treas. Reg. section 1.334-1(c)(4), but only when the price assigned reasonably reflects economic reality, the court finds as a matter of fact that they were in this case. See UFE, Inc. v. Commissioner, 92 T.C. 1314, 1329-30 (1989). Under financial accounting principles, accounts receivable are a "current asset" if they are expected to be realized within a year. Tr. 57.
Basis rules are utilized to determine the starting point from which to compute numerous calculations under the Code, e.g., a taxpayer's deductions for depreciation, amortization, and depletion; a taxpayer's gain or loss on the sale of the property; the value of an estate; etc. See generally 3 Mertens Law of Federal Income Taxation section 21.01 (1996). The basis rules use various valuation principles, depending on the purpose of establishing basis in the particular context; thus, valuation is not always based on cost. Treas. Reg. sections 1.167(a)-5 (basis for depreciation cannot exceed amount proportional to total as VALUE of depreciable property bears to value of entire (depreciable and nondepreciable) property), 1.334-1, 1.1012-1 (general basis rule for computing gain or loss), 1.1014-6(a) (basis for property acquired from decedent will be its fair market value at time of decedent's death).
The "tax" allocation for the non-cash assets purchased from Rubber Mills was substantially lower than either the fair (market) value or the acquisition/manufacture (book) cost to Rubber Mills: the inventory had a book value to Rubber Mills of $4,015,269, an agreed-upon market value of $5,817,321, but an allocated bargain purchase cost for tax purposes of only $1,905,755. Stip. 12; Exh. 21. For non-tax purposes, LaCrosse valued the inventory at $5,817,321 (book value). Stip. 12. The actual cost to LaCrosse of Rubber Mills' inventory, thus, was only thirty-three percent of, or sixty-seven percent less than, its market value (and only forty-seven percent of, or fifty-three percent less than, its book value to Rubber Mills).
For both tax and accounting purposes, LaCrosse selected the dollar-value, double-extension LIFO inventory accounting method, as authorized by I.R.C. section 472(a), see Treas. Reg. section 1.472-8, for its first taxable year, ending April 30, 1983. Stip. 16. It did so by filing Form 970 with the IRS on July 15, 1983. Id.; see Exh. 9. Plaintiff also selected the "[e]arliest acquisitions during the year" method for establishing current year inventory cost when valuing closing inventory, Stip. 16, see Exh. 9, and created two pools, a natural business unit (NBU) pool for manufactured goods, and a purchased pool.
After the acquisition, LaCrosse operated essentially as Rubber Mills had, using the same employees, plant, and equipment to manufacture, purchase, and sell the same types of footwear. Stip. 10. Although both companies used LIFO, LaCrosse used two inventory accounting pools, a natural business unit (NBU) pool for manufacturing and another one for wholesaling, whereas Rubber Mills had used only one NBU pool. Tr. 85-87. LaCrosse placed the goods used or produced in Rubber Mills' manufacturing process (raw materials, work-in-process, and a very large volume — representing $3,828,933 of the $5,375,988 FIFO book value of Rubber Mills' manufacturing pool — of finished manufactured goods), as well as the (identical) goods LaCrosse subsequently manufactured, or used in manufacture, into its manufactured pool. LaCrosse placed the finished goods purchased for resale by Rubber Mills (a small dollar quantity, $441,333) and those purchased subsequently by LaCrosse for resale (also a relatively small amount), into its purchased goods pool. Stip. 18; Exh. 4.
Plaintiff's continued reiteration of these facts apparently is intended to establish that the items or goods it subsequently purchased or used in manufacturing are the same items, or belong in the same pools, as in the hands of its predecessor. However, Rubber Mills had only one NBU pool. See Treas. Reg. section 1.472-8(b). Further, the benefit of an automatic presumption of continuity of inventory classification or valuations is available only to corporations that are the legal successors of the acquired corporation, e.g., those eligible by virtue of acquisitions specified in section 381(a). See Treas. Reg. section 1.471-9 ("Inventories of acquiring corporations) (cross-referencing I.R.C. sections 381(a), 381(c)(5), and the regulations under section 381(c)(5)). Plaintiff has not claimed that its acquisition of Rubber Mills fell within the category of reorganizations listed in I.R.C. section 381(a). Nor, even if it did, could it claim the base-year cost valuation it seeks here. Rather, it would be required as a legal successor to use Rubber Mills' base-year cost (Rubber Mills' book value), rather than plaintiff's bargain acquisition cost, as its own base-year cost and would have to treat Rubber Mills' closing inventory as its own opening inventory. See S. Rep. No. 76-648, at 6-7 (1949), 1939-2 C.B. 524, 528; see also Rev. Rul. 70-564, 1970-2 C.B. 109, 109.
Nor would the LIFO rules have permitted Rubber Mills itself to discount its base-year or book inventory costs for LIFO purposes in 1982 since it was required to continue using its own base-year costs, established in its base year, i.e., when it acquired its inventory. Treas. Reg. section 1.472-8(e).
In 1986, the IRS audited the 1983 return, challenging plaintiff's valuation of the base-year cost of its inventories at the bargain purchase price on the grounds that goods obtained in a bulk purchase immediately after a taxpayer's incorporation may not be treated as opening inventory, but merely as the first acquisition. It also required LaCrosse to place the finished goods portion of the bargain bulk purchase inventory into LaCrosse's purchased pool. Exh. 12. LaCrosse agreed to increase its base-year cost valuation by $1,491,625, from $1,905,668 to $3,397,293, and, correspondingly, reduce its "cost of goods sold" from $17,940,983 to $16,449,358. Exh. 10. The agreed-upon adjustment for 1983 was $686,148, plus interest and penalties. Exh. 10, 32, 56. The amount of the adjustment to its tax liability for taxable years 1984 to 1986 also was negotiated, see Tr. 219-24; Exh. 51, and set at approximately $165,233, plus interest and penalties, Exh. 11, 14, 15.
Plaintiff paid the tax and interest in 1987, and filed amended returns seeking a refund in 1989, Stip. 22, based on the decision inUFE, Inc. v. Commissioner, 92 T.C. 1314 (1989), which upheld the taxpayer's position in similar circumstances. Exh. 51. (The Service has never acquiesced to the Tax Court's position in UEE.) Plaintiff waived disallowance of the claims on November 27, 1991. Stip. 23. The Service has taken no action on them. Id. Plaintiff timely filed the complaint on November 29, 1993. Stip. 24.
Standard of Review
In Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979), the Supreme Court held that I.R.C. sections 446 and 471 "vest the Commissioner with wide discretion in determining whether a particular method of inventory accounting should be disallowed as not clearly reflective of income. " See also Commissioner v. Hansen, 360 U.S. 446, 467 (1959). The Commissioner's decision may not "be set aside unless shown to be 'plainly arbitrary.'" Thor Power Tool Co., 439 U.S. at 532-33 (quoting Lucas v. Structural Steel Co., 281 U.S. 264, 271 (1930)); accord Hewlett-Packard Co. v. United States, 71 F.3d 398, 399-400 (Fed. Cir. 1995).
Neither Hewlett-Packard nor the other supplemental authority offered by plaintiff, Travelers Insurance Co. v. United States, 35 Fed. Cl. 138, 140-41 (1996), and Wal-Mart Stores, Inc. v. Commissioner, 73 T.C.M. (CCH) 1625, 1634 (1997), apply, or purport to apply, a stricter standard of review to the Commissioner's determinations regarding a taxpayer's application of LIFO rules. That the plaintiffs in those cases prevailed, on completely different facts and issues, in no way supports plaintiff herein.
The Commissioner not only may disallow the use of a method of inventory accounting, such as the LIFO cost flow assumption or the dollar-value method, but also may adjust the manner of applying a method of accounting, as by adjusting the basis used in valuation. See Treas. Reg. section 1.446-1(e)(2)(ii)(a) ("Changes in method of accounting include . . . a change involving the method or basis used in the valuation of inventories . . . [and] a change involving the adoption, use or discontinuance of any other specialized method of computing taxable income. . . ."), (c); Clement v. United States, 580 F.2d 422, 430 (Ct.Cl. 1978).
When "no method of accounting has been regularly used," as here, with a new corporation first electing a method of accounting, the computation or method "shall be made under such method as, in the opinion of the Secretary, does clearly reflect income." I.R.C. section 446(b); see Treas. Reg. section 1.446-1(b)(1). Thus, the Secretary's discretion is even broader in the case of a new taxpayer, and the issue raised by some courts, that the Secretary before imposing a new method must first consider whether the taxpayer's current selected method clearly reflects income, does not arise. See e.g., Photo-Sonic, Inc. v. Commissioner, 357 F.2d 656, 658 n. 1 (9th Cir. 1966).
The question of whether the application of a particular method of accounting clearly reflects income is a question of fact, to be decided on a case-by-case basis by the Commissioner. See Treas. Reg. section 1.446-1(a)(2). The court does not review de novo the IRS's finding disallowing a taxpayer's inventory accounting method as not clearly reflecting income. See, e.g., Asphalt Prods. Co. v. Commissioner, 796 F.2d 843, 847 (6th Cir. 1986), rev'd on other grounds, 482 U.S. 117 (1987); Homes by Ayres v. Commissioner, 795 F.2d 832, 834 (9th Cir. 1986); RCA Corp. v. United States, 664 F.2d 881, 886 (2nd Cir. 1981).
I.R.C. section 446(a) sets forth the general rule that a taxpayer shall compute taxable income "under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." This furthers the goal of tax accounting to clearly reflect income by preventing a taxpayer from using one method to report (high) income to shareholders, but another method to report (low) income to the IRS. Mazzocchi Bus Co. v. Commissioner, 14 F.3d 923, 931 (3rd Cir. 1994); Wood v. Commissioner, 197 F.2d 859, 861 (5th Cir. 1952); see Gimbel Bros., Inc. v. United States, 404 F.2d 939, 949 (Ct.Cl. 1968) ("Obviously, a taxpayer should not be permitted to report higher profits to its shareholders than it reports to the Government for tax purposes). The issue particularly applies when a taxpayer changes its accounting method. Commissioner v. Welch, 345 F.2d 939, 942 (5th Cir. 1965).
The accompanying regulation states that "no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income." Treas. Reg. section 1.446-1(a)(2). In order to clearly reflect income, a taxpayer's inventory practice should be consistent from year to year. Treas. Reg. section 1.471-2(b). The basis adopted for a year is controlling, and can be changed only with the Commissioner's consent. Treas. Reg. section 1.471-2(c).
"In all cases in which the production, purchase, or sale of merchandise is an income-producing factor, merchandise on hand . . . at the beginning and end of the year shall be taken into account in computing the taxable income of the year." Treas. Reg. section 1.446-1(a)(4)(I). Inventories at the beginning and end of each taxable year are necessary in every case. Treas. Reg. section 1.471-1. Each inventory "must conform as nearly as may be to the best accounting practice in the trade or business, and . . . must clearly reflect the income." Treas. Reg. section 1.471-2(a).
Provided that it clearly reflects income, "'the best accounting practice' . . . is synonymous with 'generally accepted accounting principles [GAAP]. " Thor Power Tool Co., 439 U.S. at 532. That is, the taxpayer should use GAAP unless, in the Commissioner's judgment, the purposes of tax accounting require a different method in order to clearly reflect income.
General Inventory Accounting Principles
Generally, taxable income for a merchant is based on total sales (gross receipts), from which is deducted the "cost of goods sold" (CGS), and any other applicable deductions. See Treas. Reg. section 1.61-3(a); Grant Oil Tool Co. v. United States, 381 F.2d 389, 397 (Ct. Cl. 1967). CGS in turn consists of the beginning inventory, plus production and acquisition costs during the year, less the closing inventory. Peninsula Steel Prods, Equip. Co. v. Commissioner, 78 T.C. 1029, 1953 n. 32 (1982) ( citing W.B. Meigs et al., Accounting: The Basis for Business Decisions 845-50 (4th ed. 1977)).
Under any inventory taxation system, an accounting method that INCREASES the value of the closing inventory will (assuming that all other factors remain constant) DECREASE the CGS, Hamilton Indus. v. Commissioner, 97 T.C. 120, 129 (1991), which in turn will INCREASE a taxpayer's taxable income (and taxes).
LIFO Inventory Accounting
The often stated purpose of the LIFO inventory flow method is to match current revenues against current costs, and thus to remove "inflationary increases in inventory costs" from the cost of closing inventory. Hamilton Indus., 97 T.C. at 130 (citing Amity Leather Prods. Co. v. Commissioner, 82 T.C. 726, 732 (1984)). The taxpayer achieves this by being permitted (1) not to have to trace particular goods, and (2) to treat the goods last purchased as those first sold. This reverses the presumption in the other major inventory flow rule that does not trace particular goods, the first-in-first-out (FIFO) inventory accounting method. Under LIFO, the taxpayer is permitted to match his revenue with his current costs since, to continue in business, he must replace sold inventory with new inventory at current costs, which may be inflated over the original acquisition costs, due either to general economy-wide inflation or to increased costs for those particular goods.
Dollar-Value LIFO
Unlike taxpayers choosing another cost-flow inventory accounting system that identifies the specific goods to determine which are present at year end or sold (this is known as the unit method, see Rev. Rul. 79-290, 1979-2 C.B. 221, 221) the taxpayer here selected the dollar-value LIFO method, a method of accounting in which particular units are not identified and counted. Instead, the method counts dollars (base dollars). In this method, the goods contained in the inventory are grouped into one or more pools, each containing one or more classes of goods ("items"). Treas. Reg. section 1.472-8(a). Changes in inventory levels are accounted for in terms of pools of dollars of cost, not by numbers of specific physical units. Exh. 53 (Gaffney report) at 9.
The rules for establishing pools are set out at Treas. Reg. section 1.472-8(b) to (d). The regulation does not specially define the term "item."
There are two types of pooling, the natural business unit (NBU) method and multiple pooling. Treas. Reg. section 1.472-8(b). Rubber Mills, which was mostly engaged in manufacturing, used a single NBU for its entire business. LaCrosse was required to create a second pool for its purchased goods. See Treas. Reg. section 1.472-8(b)(2).
Plaintiff's witnesses conceded that Rubber Mills also should have had two pools, a purchased pool in addition to the NBU pool.
The taxpayer selected the double-extension measure of valuing the increment, which extends the current-year per-unit cost for each item in ending inventory (in base-year and current-year dollars). See Treas. Reg. section 1.472-8(e)(2). Within pools, inventory is divided into "items." The total dollar-value unit "base-year" cost of the "items" in a pool at the beginning of the year is totalled. The total dollar-value of the units in the pool at year-end at base-year cost is also calculated for each item, and totalled. These sums are added to yield the total dollar-value unit base-year cost at year-end for the pool. If there is an increment in the pool from the beginning of the year total to the end of the year total, it must be valued. The ratio of ending inventory at current-year cost to ending inventory at base-year cost is then multiplied by the increment to create a "layer." The layer is added to base-year opening inventory to yield closing inventory (and next year's opening inventory). Treas. Reg. section 1.472-8(e)(2)(iv).
Current-year cost may be: (1) the actual price the taxpayer most recently paid (that taxable year) for goods of the same type or category ("item"), (2) the actual price it paid after the beginning of the taxable year for such goods, or (3) the average of the actual prices paid for such goods during the taxable year. Treas. Reg. section 1.472-8(e)(2)(ii). LaCrosse chose (2), the so-called "earliest acquisitions" method.
In sum, for each item in an inventory pool, the quantity of units of goods comprising each item at the end of the taxable year is "extended" (aggregated and multiplied by both base-year unit cost and current-year unit cost). Treas. Reg. section 1.472-8(e)(2)(I). The extensions of the items at base-year cost are totalled, to give the value of the inventory pool at base-year cost; the total of the extensions of all items at current-year cost constitutes the current-year cost of the pool. Id.
When the ending inventory for a pool at base-year cost exceeds the beginning inventory for that pool at base-year cost, an increment has occurred. Treas. Reg. section 1.472-8(e)(2)(iv). That increment, once it is multiplied by the "LIFO index" (the ratio of the current-year cost to the base-year cost), becomes the 'LIFO layer," which is added to the opening inventory to yield the taxpayer's closing inventory for that taxable year. Because the closing inventory becomes the next year's opening inventory, the LIFO layer is carried forward from year to year. S. Rep. No. 648, 76th Cong., 1st Sess. 6-7 (1949), 1939-2 C.B. 524, 528 (cited in Rev. Rul. 85-172, 1985-2 C.B. 151, 152).
When the ending inventory at base-year cost is less than the beginning inventory at base-year cost, however, a liquidation occurs. Any liquidation is subtracted from opening inventory, reducing in reverse chronological order the most recently added increments, to yield the closing inventory. Treas. Reg. section 1.472-8(e)(2)(iv). Thus, cost increases that were sheltered in prior years become taxable (up to the extent of the liquidation). Id. For this reason, taxpayers are advised to limit the number of pools and to use the earliest acquisition method, see Tr. 157-158, so as to avoid the risk of an unwanted liquidation. See, e.g., Donald E. Kieso Jerry J. Weygandt, Intermediate Accounting 399 (Exh. 53, App. D); cf. 2 Mertens Law of Fed. Income Tax, section 16.89, at 390 n. 35 (1996); Ex. 54 paragraph 4-2 ( AICPA, Issues Paper: Identification and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories (1984)).
Discussion Defendant's Arguments Item treatment
Defendant's "item" argument is that the goods acquired from Rubber Mills must be treated as different "items" from identical goods LaCrosse manufactured or acquired after the discount purchase, based on the substantially lower bargain price of the Rubber Mills goods. Two courts (neither constituting binding precedent for this court) have held that bargain bulk purchase inventory must be treated as a different item from identical goods acquired or manufactured afterward at greater (full) cost. Kohler Co. v. United States, 34 Fed. Cl. 379, 384-85 (1995); Hamilton Indus., 97 T.C. at 136-39. Defendant would require the creation of a new item based on increased cost only after "substantial" or "material," price changes, Hamilton Indus., 97 T.C. 120, 137 (1991), i.e., those that cause the prices to be "greatly disparate," id. at 139.
The consequence of creating new "item" classifications when there is a pre-year-end turnover (i.e., when all the old (bargain) items are sold prior to year's end) is that there are NO bargain items entering into the end-of-year calculations. Therefore, there is virtually no difference between end-of-year inventory at base-year cost and end-of-year inventory at current-year costs. This means there is no increment or layer and no impact on (increase in) CGS. (The "new items" generate virtually no increment or layer because they come in at a (market) cost, which is usually virtually identical to the closing-year (market) cost.)
Plaintiff disputes defendant's "item" argument based on (1) inconsistency with the LIFO matching principle, (2) an accounting profession Issues Paper, and (3) industry practice. The court finds plaintiff's arguments unpersuasive. Plaintiff contends that the overriding purpose of LIFO is to match actual current costs with actual current income; the court concludes, however, that the purpose of LIFO inventory accounting is to exclude only the effects of inflation (general, or in the cost for the particular item) upon the value of a taxpayer's inventory, not the effect of a price increase attributable to an original bargain purchase.
As defendant's expert pointed out, the Issues Paper does not represent GAAP, or any authoritative source of accounting principles. Exh. 53 at 4; Tr. 246-47. In light of the inconsistency of this method both with LIFO and with the most authoritative GAAP rules on this point, A Practices Board Opinion (APB Op.) No. 16, the court finds the evidence of industry practice on this point neither persuasive nor relevant.
APB opinions are the most authoritative pronouncements of the accounting profession, and thus provide a standard as to the most accurate method for clear reflection of income provided by accounting practice. Exh. 53 at 4; see, e.g., United States v. Winstar Corp., 116 S.Ct. 2432, 2443 (1996).
The court nevertheless accepts plaintiffs "bottom-line" position, based instead on the unworkability of defendant's standard, its inconsistency with LIFO principles, and the absence of any support for that standard in the statute or regulations. Determining what is so "substantial" that a new item must be created may appear easy when there is a ninety-six percent discount in base-year cost, as in Hamilton, but is difficult if not impossible to specify in other cases. For example, a one hundred dollar increase in the price of a two hundred dollar item (fifty percent) is more "substantial" than a one hundred dollar increase in the price of a ten thousand dollar item (one percent). However, if these figures include sales volume, the appearance of "substantiality" can be inverted, since a fifty unit sales volume increase for the formerly two hundred dollar item yields a total five thousand dollar increase, whereas a ten thousand unit increase for the formerly ten thousand dollar item yields a far more "substantial" total one million dollar increase. Delineating the extent of value change that constitutes a change in item classification is a project for the agency, by regulations, not for a court.
Such a standard should have been communicated to the taxpayer in advances so that it might plan its business, maintain proper records of sales and purchases, and calculate its taxes accurately. Absent such a standard, the Service may be branded as arbitrary. Compare William R. Sutherland, Inventories section 804, at 175 (1995) ("'A NEW ITEM is a raw material, product, or cost component not previously present in significant quantities in the inventory. . . . Changes in the market value of an item or merely purchasing a virtually identical item from a different supplier does not make the item a NEW ITEM.'" (quoting LIFO Issues Paper (Exh. 54) paragraphs 4-21), which does not look at price as a factor creating a new item, with the decided cases that use an ad hoc approach, e.g., Hamilton Industries, 97 T.C. at 135-38; Amity Leather, 82 T.C. at 739-40. To the extent the issue is addressed by the AICPA, it does not consider a price difference to create a new item. See Exh. 54 paragraph 4-21 ("A NEW ITEM is a raw material, product, or cost component not previously present in significant quantities in the inventory. . . . Changes in the market value of an item or merely purchasing a virtually identical item from a different supplier does not make the item a new item.").
Creating and carrying on one's books a potentially limitless number of "items" of the identical goods based upon price variations alone also would be administratively burdensome and thus inconsistent with the purposes of the dollar-value, double-extension LIFO inventory accounting rules, which are designed precisely to ELIMINATE the need to track or trace specific or particular goods, see Exh. 53 at 7-8, as would be necessary under this approach if there were frequent price fluctuations.
Also, it is clear from Treas. Reg. section 1.482-8(e)(2)(iii) that goods join previously-created item classifications for the same goods, whenever they are acquired, and that whether the purchased goods are the same type of goods in an existing item classification determines the price (if so, the price must be the same as the base-year cost for the same goods), and not vice versa (i.e., price does not determine the item classification).
Finally, using increased unit cost alone as a basis for differentiating goods in inventory flies in the face of another purpose of dollar-value inventory accounting, which is to measure increases in inventory costs ONLY in the AGGREGATE, from year to year, i.e., for the item or pool as a whole, and using only two measures — base-year cost (beginning cost) and current-year cost (ending cost) each made in total dollars — not based on changes in unit prices during the course of the taxable year, in which a taxpayer may turn over its inventory several or many times. See Tech. Adv. Mem. 9243010 (July 15, 1992) (taxpayer is required to determine only one current-year price for each item, for that is all that is needed to calculate an increment or decrement). The court therefore holds that the goods acquired from Rubber Mills may be placed in the same item category as the identical goods subsequently acquired for manufacture, manufactured or purchased for resale, as the case may be, by LaCrosse.
Pooling
Defendant alternatively argues that all the inventory LaCrosse acquired from Rubber Mills should have been placed in LaCrosse's purchased goods pool, and that none belongs in its manufactured pool. Defendant relies on Treas. Reg. section 1.472-8(b)(2)(I), which states, "Where a manufacturer or processor is also ENGAGED in the wholesaling or retailing of goods purchased from others, the wholesaling or retailing operations WITH RESPECT TO SUCH PURCHASED GOODS shall not be considered a part of any manufacturing or processing unit." (Emphasis added.) Defendant construes this regulation as forbidding a dual-function taxpayer from including bulk-purchased raw materials, work-in-process, or finished manufactured goods from another manufacturer in its own manufactured pool, and as requiring instead that ALL of the acquired goods be placed in the purchased goods pool, even if there is a one-time-only acquisition.
As discussed supra note 8, the court rejects plaintiff's argument that, merely because certain goods were used or produced by Rubber Mills in its manufacturing process, they automatically become manufactured goods and not purchased goods to LaCrosse, because this argument hinges on the incorrect presumption that LaCrosse was a successor to Rubber Mills for purposes of I.R.C. section 381. (Furthermore, as previously noted, were LaCrosse legally deemed Rubber Mills' successor it would not be entitled to use the bargain cost as the base-year cost for any category of goods, but rather would be required to value the items at the base-year cost (book cost) to Rubber Mills, i.e., at Rubber Mills' closing inventory value. See S. Rep. No. 76-648, at 6-7, 1939-2 C.B. at 528 (cited in Rev. Rul. 85-172, 1985-2 C.B. at 152).
The court first rejects defendant's reading as to the raw materials or work-in-process that it purchased from Rubber Mills, finding, as a matter of fact, that plaintiff never intended to be and never was "engaged in the wholesaling or retailing" of "SUCH purchased goods" either before or after the bargain purchase transaction, and, instead, intended to use them only in its manufacturing process. That LaCrosse wholesales some goods does not convert other goods it purchases solely for use in the manufacturing process into goods purchased for wholesaling or retailing. Therefore, plaintiff's pooling treatment as to those goods was correct. See Hamilton Indus., 97 T.C. at 134-35; UFE, Inc., 92 T.C. at 1322 (holding that a taxpayer acquiring the assets of a manufacturing business that the taxpayer then carries on is a manufacturer, not a wholesaler, of the inventory).
There is no dispute that LaCrosse was "engaged in wholesaling or retailing" the goods that Rubber Mills had purchased for wholesaling or retailing, as well as those goods that LaCrosse subsequently purchased for wholesaling or retailing. Thus, plaintiff properly placed those goods in its purchased pool.
However the situation with respect to the finished manufactured goods purchased from Rubber Mills is not so clear. It is hard to determine whether these goods are identical to those LaCrosse was (later) "engaged" in wholesaling or retailing, either as a matter of intent at the time of their purchase or as a matter of subsequent practice. See Tr. 39-40; Exh. 48. No evidence was presented as to whether LaCrosse intended to (or did) engage in "wholesaling" any or all of such goods. It seems unlikely that all of such goods were wholesaled. (The witnesses described the goods both Rubber Mills and LaCrosse were engaged in purchasing for resale as athletic footwear, fashion boots and "moon boots," Tr. 39-30, 109, whereas the goods both companies manufactured included only some of these categories (athletic shoes, but not moon boots). See Exh. 47, 48.) Only if there is an overlap between these two categories can the overlapping finished manufactured goods from Rubber Mills arguably be deemed the same as goods LaCrosse was engaged in purchasing for resale and, thus, allocable to LaCrosse's purchased pool.
It is unclear whether any subsequently-purchased wholesale goods were identical to the goods purchased for wholesaling by Rubber Mills, Exh. 29, since LaCrosse substantially increased (from 7.6% in May 1982 to 11.5% in December 1982) its inventory of purchased goods. Tr. 40, 88-90. However, plaintiff does not argue that all of these goods do not belong in the purchased pool.
In sum, only those finished goods manufactured by Rubber Mills that are identical to goods that LaCrosse intended to (or did) regularly engage in wholesaling belong in LaCrosse's purchased pool.Amity Leather, 82 T.C. at 738 (when there is a regular purchase of goods identical to its manufactured goods from a subsidiary for resale, the purchased goods belong in purchased pool). NeitherHamilton Industries nor UFE requires a contrary rule. In UFE, as here, there was a one-time purchase of the goods that were identical to those manufactured by the purchaser. The purchased goods were not required to be placed in a purchased goods pool. UFE, 92 T.C. at 1322. In Hamilton Industries, too, the purchases were "isolated," and "part of larger business acquisitions." In addition, the goods were not identical to the manufactured goods, as in Amity Leather. Hamilton Indus., 97 T.C. at 134.
The Court's Interpretation, Improper Base-Year Cost Calculation
As explained above, in order to calculate the cost of the closing inventory under dollar-value, double-extension LIFO inventory accounting (for a pool having an increment), one adds to the value of the beginning inventory at base-year cost a LIFO layer (units in closing inventory at base-year cost minus units in opening inventory at base-year cost, times a LIFO index (total current-year cost divided by total base-year cost)). Treas. Reg. section 1.472-8(e). Thus, current-year cost is taken into account only in determining the ratio used to increase the amount of the increment to opening inventory that will yield the value of closing LIFO inventory. Decreases to the base-year cost will decrease both opening inventory and the closing LIFO inventory.
All other factors remaining equal, a decrease in the closing LIFO inventory will increase CGS and decrease a taxpayer's taxable income. Since the value of each of these factors depends on base-year cost, the determination of how to calculate base-year cost is critical. The regulations explain how dollar-value LIFO inventories are priced:
The term "base-year cost" is the aggregate of the (determined as of the beginning of the taxable year for which the LIFO method is first adopted, i.e., the base date) of all items in a pool. The taxable year for which the LIFO method is first adopted with respect to any item in the pool is the "base year" for that pool.
Treas. Reg. section 1.472-8(a) (emphasis added).
The question of how to set the base-year "cost" of items first entering new taxpayer LaCrosse's opening inventory during its first taxable year, 1983, is not answered by the tax rules. The general regulation, Treas. Reg. section 1.471-2(c), states that the basis of valuing inventories is "(1) cost and (2) cost or market, whichever is lower." However, Treas. Reg. section 1.471-2(c) is largely descriptive and specifically excepts LIFO inventories, at (e). It also refers to Treas. Reg. section 1.472 for the rules governing LIFO inventory accounting.
The general LIFO regulation, Treas. Reg. section 1.472-2, which states that "inventory shall be taken at cost regardless of market value," Treas. Reg. section 1.472-2(b), specifically excepts computations under section 1.472-8 "with respect to the 'dollar-value' method." Treas. Reg. section 1.472-2. This leaves Treas. Reg. section 1.472-8(e)(2) as the specific rule for dollar-value, double-extension LIFO. See Busic v. United States, 446 U.S. 398, 403 (1990) (specific rules are given precedence over general rules).
But, the specific dollar-value, double-extension regulation measures only the cost of new items entering AFTER the base date, and provides no express guidance as to how to set the base-year "cost" of items or other inventory entering AT the beginning of the first taxable year for a new taxpayer. See Treas. Reg. section 1.472-8(e)(2)(iii). For such inventory, the regulation states that current-year cost is the measure of cost of a new item unless the taxpayer reconstructs its cost on the base date (the first day of the taxable year that the pool was created).
Purportedly relying on this rule, plaintiff looked to the three measures for current-year cost and selected "first acquisition cost," i.e., the bargain purchase cost. However, this rule, by its terms, is not applicable to a new taxpayer's opening inventory on its base date, but only to new items entering an existing taxpayer's inventory after the base date.
Nevertheless, the specific dollar-value LIFO regulation does appear to incorporate useful certain presumptions. One is that base-year cost will be based either on an approximation of current MARKET value, determined by actual current-year purchase cost (whether first acquisition, average cost or latest purchase, see Treas. Reg. section 1.472-8(e)(2)), or on an historical (reconstructed) MARKET value. Also, it presumes that the HIGHER cost (in a time of rising costs, such as would prompt a LIFO election in the first place) is the taxpayer's current-year cost, and that this will presumptively be imposed in lieu of a lower cost, UNLESS the taxpayer is able to reconstruct the lower cost. Treas. Reg. section 1.472-8(e)(2)(iii).
The regulation establishes two ways of accomplishing the reconstruction, both of which appear to look to historical (actual) market value: If the product or raw material WAS NOT IN EXISTENCE on the base date, the taxpayer using reasonable means may determine WHAT THE COST OF THE ITEM WOULD HAVE BEEN had it been in existence in the base year. Treas. Reg. section 1.472-8(e)(2)(iii). If the item (as here) WAS IN EXISTENCE on the base date, BUT NOT STOCKED by the taxpayer, he may establish, by using available data or records, WHAT THE COST OF THE ITEM WOULD HAVE BEEN to him had he stocked the item. Id.
All the current-year cost measures reflect actual cost to the taxpayer as determined by actual purchases. Thus, these measures are presumptively are intended to be arm's-length purchases. If so, they must reflect current-year fair market value. If the taxpayer wishes to use an even lower figure than its best actual arm's-length current-year cost measure to establish base-year cost, it bears the burden of reconstructing the (market) cost on the base date. Thus, the regulation does not appear to contemplate the circumstance urged by the taxpayer here, that the current-year cost — and thus the base-year cost — for a new item would be LOWER than a market historical (reconstructed) cost. (For this very reason, perhaps, no write-DOWN, even to market, is allowed by the LIFO rules. I.R.C. section 472(b)(2); Treas. Reg. section 1.472-2(b).)
The assumption of the dollar-value LIFO regulation that both the (reconstructed) base-year cost and the current-year cost will reflect actual out-of-pocket costs, i.e., what it actually cost the taxpayer to obtain the goods in an arm's-length transaction, does not appear to envision that a taxpayer selecting dollar-value LIFO in its first year of operation may either begin operations with an inventory priced at a non-market (bargain) cost or may select a current-year cost measure based on an inflated non-market (non-arm's-length) purchase.
Allowing base-year cost for dollar-value LIFO inventories by a new corporation first electing LIFO to be calculated as plaintiff urges, i.e., based on an actual (but bargain) cost of a corporation's opening inventory that tax year, rather than on the market value of that inventory, would permit manipulation, e.g., pricing a new item with a market value of $10,000 at $1 because of a fortuitous non-arm's-length purchase could set the taxpayer's base-year cost for that item at $1 in perpetuity. This would shelter $9,999 of the sales income as CGS for that item in every succeeding year. Such a reading of the LIFO regulations leads to a ludicrous, and thus presumably unintended, result. United States v. Turkette, 452 U.S. 576, 580 (1981); see Hamilton Indus., 97 T.C. at 138 n. 5 ("base stock" method under which artificially low base price is used and costs above that are carried into cost of goods sold is not a permissible method of tax accounting because it "'obscures the true gain or loss of the year and, thus, misrepresents the facts'") (quoting Lucas v. Kansas City Structural Steel Co., 281 U.S. 264, 269 (1930)).
Plaintiff used the bargain price of the inventory acquired from Rubber Mills to determine its tax liability, but used the Rubber Mills FIFO value of the inventory on its financial statement balance sheets. Stip. 12; Exh. 3 at 2; Exh. 52 at 5. It also appears that LaCrosse used the latter figure as its base-year cost to determine the cost of goods sold that appears in its income statements. See Exh. 3 at 3; Exh. 52 at 3: see also Exh. 51 at 3. Only in a note to the financial statements is it disclosed that the inventory had a much lower tax value. Exh. 3 at 7; Exh. 52 at 6.
This would seem to violate the requirement of I.R.C. section 472(c)(1) and (e)(2) that a LIFO taxpayer use the same inventory accounting method to report its income (as opposed to its balance sheet assets, Treas. Reg. section 1.472-2(e)(1)(ii), (e)(4)) to its shareholders as it does to calculate its income for tax purposes. See Gimbel Bros., Inc. v. United States, 404 F.2d 939, 950 (Ct.Cl. 1968) (using different method to calculate CGS violates conformity requirement). The regulation permits a taxpayer to state its income to its shareholders under another method than its tax method, provided that the TAX METHOD calculation appears on the face of the income statement, and the OTHER calculation is presented only in a footnote. Treas. Reg. section 1.472-2(e)(1)(i), (3)(ii). This is the opposite of what LaCrosse apparently did.
It is unclear to the court why defendant did not invoke its discretion to rule that plaintiff's LIFO election was invalid for failure to meet the conformity-of-reports requirements in Treas. Reg. section 1.472-2(e).
Plaintiff bears the burden of proving that its financial reports conform to its tax calculation. H.C. Goodman Co. v. Busey, 56-2 U.S.T.C. (CCH) paragraph 9856, at 56,251 (S.D. Ohio 1956). The Commissioner may require a taxpayer that violates the rule to change its tax accounting method to clearly reflect income. I.R.C. section 472(e); Treas. Reg. section 1.472-2(g)(2).
Plaintiffs current-year cost-based tax accounting approach also is inconsistent with GAAP. As defendant's expert repeatedly noted, APB Op. No. 16, the most authoritative pronouncement of GAAP principles, requires that the base-year cost for this inventory be stated at fair or market value. Exh. 53 at 4, 6-7; Exh. 55 paragraph 87; Tr. 246-48, 254-59; see Thor Power Tool Co., 439 U.S. at 532 (GAAP followed when the statute and regulations provide no clear guidance).
Plaintiff violated another APB requirement in 1984 in failing to carry land and equipment at cost. Their financial statements were qualified accordingly. See Exh. 3 at 9.
While plaintiff claims that "basis" rules required it to value the bargain purchase at the allocated actual purchase cost, it does not identify any such purportedly applicable tax "basis" rule. The court concludes that, even if certain basis rules look to cost rather than to market value, plaintiff does not establish why any of these rules would apply in this case, or why, if they did, they would override the more specific tax and financial accounting rules regarding valuation of bargain purchases that are applicable to inventory accounting. Cf. Treas. Reg. section 1.1060-1T(e)(2) (1996) ("The amount of consideration allocated to an asset is subject to any applicable limitations under the Code or general principles of tax law."), (4) (IRS "may challenge the taxpayer's determination of the [FMV] of any asset by any appropriate method and take into account all factors, including any lack of adverse tax interests between the parties.').
Whatever basis rules plaintiff relies upon squarely conflict with the American Institute of Certified Public Accountants accounting rules, which require that the "fair value" at the acquisition date of such bargain-purchased goods be reflected on a company's financial statements; and that, if the fair value exceeds the cost, negative goodwill (a deferred credit) be recorded and amortized. See APB Op. No. 16 paragraphs 11, 67 (Exh. 55). (The negative goodwill is simply the difference between FMV and cost.) Moreover, as previously noted, LaCrosse DID record the fair or market value ( i.e., the purchased price in arm's-length transactions) of the bargain inventory for book, but not for tax, purposes. Therefore, the book value of the inventory recorded by LaCrosse for financial accounting purposes was higher than its tax value to LaCrosse. This conflicts with the rule in I.R. Code section 446(a), that a taxpayer must compute taxable income under the method of accounting on the basis of which the taxpayer regularly computes his income.
A LIFO index that reflects price increases caused by factors other than cost inflation (such as bargain purchases) foils the purpose of LIFO inventory accounting. Amity Leather, 82 T.C. at 733; see T.D. 7814, 1982-1 C.B. 94, 85 ("the use of overstated inflation rates to value LIFO inventory pools should be reduced to the extent possible"). An artificially low base-year cost is preserved in the LIFO index, and thus inflates CGS and closing inventory (and reduces taxes) by the deflated amount, year after year. See Kohler Co., 34 Fed. Cl. at 385; Hamilton Indus., 97 T.C. at 136 n. 6; Robert N. Anthony James S. Reece, Accounting Principles 148-49 (5th ed. 1983).
The assumption of the dollar-value LIFO regulations, which underlies the use of base-year cost as a component of calculating the LIFO layer value and, thus, the cost of goods sold in inflationary circumstances, is that current-year cost exceeds base-year cost and that both are based on arm's-length purchases. See Gen. Couns. Mem. 39,470 (Jan. 6, 1986) ("We believe that the potential distortion of income resulting from locking in a bargain purchase as opening inventory . . . is particularly great where the selling and acquiring corporations are related and/or the purchase includes a purchase of substantially all the assets . . . such that a portion of the purchase price must be allocated to inventory.").
The evidence does not support plaintiff's contention, which defendant contested, that this was a fully arm's-length transaction. There was extensive overlap and numerous familial relationships between the directors, officers, and owners of the two groups. For example, two officers and directors of LaCrosse were directors of Rubber Mills, and one of these (Frank Uhler, Jr.) was president and chief operating officer of both LaCrosse and Rubber Mills. Exh. 27 at 6; Tr. 13. Thirty-eight and a-half (38.5) percent of LaCrosse was owned by a trust for the benefit of the wife of a Rubber Mills officer and director, who was also the sister of three other Rubber Mills officers and directors. Exh. 27 at 6. Also, those officers and directors of Rubber Mills were employees of that trust and, with two cousins, constituted the majority of the board of directors of Rubber Mills. Id.
In addition, the company was on the market for only a relatively brief period of time, less than a year, from June 31, 1981, when Northstar issued its valuation, to April 1982, when the Schneider group (per Uhler) made the offer. Ex. 27 at 7-8. Furthermore, Northstar's valuation was based solely on Rubber Mills' liquidation value, not its replacement cost, sales comparison, or income analysis. Exh. 29 at 10. Absent all three methods, the appraisal may be viewed as highly questionable. Cf. I.R.M. Manual Supp. 76G-33 (Q 23).
Rubber Mills at one time was willing to sell its plant, equipment, and inventory assets for less than market value because it expected to recover at least some part of the difference through tax benefits, "as a loss carryback for federal income tax purposes . . . after reduction for the capture of investment tax credits." Exh. 27 at 5. At that time, the price apparently was to be set so that the bargain discount would equal these losses. Exh. 31 paragraph 12. Rubber Mills had no other (adverse) tax interest in keeping the cost high. See Treas. Reg. section 1.1060-1T(e)(4) (1996) (IRS 'may challenge the taxpayer's determination of the fair market value of any asset by any appropriate method and take into account all factors, including any lack of adverse tax interests between the parties"). Mr. Uhler conceded that there was no bargaining over the allocation provision.
Finally, the only business justification given for the sale — "philosophical conflicts" between Mr. Uhler and the board, on the one hand, and Albert Funk, on the other, Tr. 14-15 — appears weak. This purpose could have been accomplished by a simple buy-out of Mr. Funk's interest, since Mr. Uhler and the board were in accord on this issue and the retirement of Mr. Funk was contemplated in any event. Tr. 15.
Thus, insufficient evidence was presented to dispel the conclusion that the true purposes driving the sales were: (1) to increase business in the more profitable purchased imported goods (from .9% of inventory in 1980 to 3.4% in 1981 to 7.6% at the time of the sale to LaCrosse, Tr. 88), see Exh. 50 at 2, (because this could/would have been accomplished anyway upon Mr. Funk's retirement), (2) to obtain a tax benefit for Rubber Mills from the sale at a loss, and most importantly, (3) to write down the older inventory. See Tr. 57, 118-21. While Mr. Uhler testified that LaCrosse was "simply going forward" and not changing its earlier inventory procedure, Tr. 36, in fact, a new pool was created (he conceded that a purchased pool should have been set up by Rubber Mills) and the inventories were written down considerably. LaCrosse's use of the bargain value of Rubber Mills' closing inventory as book in calculating LaCrosse's cost of goods sold represented a sizeable tax benefit (over three million dollars). See Treas. Reg. section 1.471-2.
The Secretary may reallocate payments between two corporations "owned or controlled directly or indirectly by the same interests" to clearly reflect income. I.R.C. section 482; see Treas. Reg. sections 1.482-1(a)(3) ("The term 'controlled' includes any kind of control, direct or indirect, whether legally enforceable, and however exercisable or exercised."), 1.482-3(e)(1) (reallocation of sale price of tangible property between controlled entities); see also, e.g., E.I. du Pont de Nemours Co. v. United States, 608 F.2d 445, 450-54 (Ct.Cl. 1979) (readjusting price for sale of assets between related corporations when price was calculated to maximize subsidiary's earnings, and did not reflect market value). Given this authority in the Commissioner, the court need not reach the question of whether the sale was a sham transaction. See Boyer v. Commissioner, 58 T.C. 316, 327 (1972).
Thus, because it accords with the language and intent of the regulations, particularly Treas. Reg. section 1.472-8(e)(2)(iii), is consistent with GAAP principles and I.R. Code section 446, as well as with the Commissioner's authority to prescribe the method of taking inventories and the value of inventories that most clearly reflects income, I.R.C. section 471(a); see generally I.R.C. section 446(b); Treas. Reg. section 1.446-1(a)(2), the court concludes that the IRS may prohibit LaCrosse from using the bargain cost of the bulk purchase items as the base-year cost for those items in the year in which they were acquired. See generally Mark Dalton, Note, An Examination of Some Considerations Relating to the Adoption and Use of the Last-in, First-out (LIFO) Inventory Accounting Method, 28 Vand. L. Rev. 521, 528 (1975) (LIFO inventory must be taken at cost in first LIFO year to prevent "windfall tax liability reduction"). Rather, the items must be valued as of the first day of LaCrosse's first taxable year. That valuation must be an arm's-length, market-based valuation. Plaintiff's contention that the base-year cost valuation may be their current-year costs and, specifically, the costs of their earliest acquisition, misreads the purpose of the calculation of base-year and current-year costs, which is to approximate the INCREASED cost to the taxpayer due to inflation (general or in the cost of the relevant item) during the taxable year, not to REDUCE the item's base-year cost. Thus, the IRS may require LaCrosse to use a market-based cost to measure the base-year cost of the goods acquired from Rubber Mills.
The issue deemed so thorny in the case law, whether the subsequently — acquired or — manufactured goods are treated as different items from the bargain opening inventory (the "items" issue discussed above) becomes irrelevant if the value of the items acquired from Rubber Mills is set at market value. The result will be substantially the same as that advocated by the government because LaCrosse must carry over the value of both new AND old items at the market value, and there was not much variation in market value during the course of that first year. See attached comparison among defendant's, plaintiff's, and the court's methods of calculating plaintiff's base-year cost and CGS, treating the goods and prices listed in Exh. 56 Illus. VI as items in a pool.
CONCLUSION
The Commissioner's disallowance of plaintiff's accounting methods was proper. On or before May 30, 1997, the parties shall file a joint status report stipulating to whether, after plaintiffs income tax liability for the years at issue is recalculated in accordance with this opinion (i.e., allocating the items between the pools in accordance with the court's conclusion that manufactured goods that are identical to goods regularly purchased belong in the purchased pool, then recalculating the cost of goods sold in accordance with the court's conclusion that the base-year cost must be fair market value), plaintiff is entitled to a refund, and if so, how much; or setting forth the reasons for their failure to so stipulate.Attachment [Attachment omitted]