Rev. Rul. 80-190

ISSUES

(1) Is the taxpayer's change in the cost computation of its last-in, first-out (LIFO) inventory to include the cost of freight-in a change in method of accounting under section 446 of the Internal Revenue Code that requires the advance consent of the Secretary?

(2) Does the taxpayer's exclusion of the cost of freight-in from the cost of its merchandise warrant disallowance or termination of the taxpayer's LIFO election?

FACTS

The taxpayer uses the accrual method of accounting. In 1974, the taxpayer adopted the LIFO inventory method provided in section 472 of the Code. In valuing its inventory at cost, the taxpayer consistently used the purchase price of the merchandise carried on its books, but the taxpayer excluded the cost of freight-in. The taxpayer instead, deducted the amount of freight-in for the taxable year in which it was incurred. In 1979, the taxpayer determined that the cost of freight-in should be included in the cost of its merchandise for purposes of valuing its inventory pursuant to section 1.471-3(b) of the Income Tax Regulations. In 1979, the taxpayer unilaterally changed the manner for determining the value of its inventory to include the cost of freight-in without securing the consent of the Commissioner.

LAW AND ANALYSIS

Section 472(b)(2) of the Code provides that goods inventoried under the last-in, first-out (LIFO) method are inventoried at cost.

Section 1.471-3(b) of the regulations provides that in the case of merchandise purchased since the beginning of the taxable year, cost means the invoice price less trade or other discounts. To this net invoice price should be added transportation charges incurred in acquiring possession of the goods.

Section 446(e) of the Code provides that a taxpayer who changes its method of accounting on the basis of which it regularly computes its income in keeping its books shall secure the consent of the Secretary of the Treasury before computing its taxable income under the new method.

Section 1.446-1(e)(2)(ii)(a) of the regulations provides that a change of accounting method includes a change in the overall plan of accounting for gross income or deductions, as well as a change in any material item within the plan, and a method of accounting is not established for an item unless there is a pattern of consistent treatment. A material item is defined as any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.

Section 1.446-1(e)(2)(ii)(c) of the regulations provides that a change in the treatment of any material item used in an overall plan for identifying or valuing inventory is a change of accounting method.

Rev. Proc. 79-23, 1979-1 C.B. 564, sets forth the types of situations that warrant disallowance or termination of a taxpayer's LIFO election. In addition, in that revenue procedure certain situations have been identified that do not warrant a disallowance or termination of a LIFO election. Section 3.01(c) of Rev. Proc. 79-23 provides that the failure by the taxpayer to value its LIFO inventory at cost for federal income tax purposes, for the year preceding the year of the LIFO election, and all subsequent taxable years may warrant the disallowance or termination of a LIFO election. However, in determining cost for the year of the LIFO election and any subsequent year, the failure to include (or exclude) an item of cost, such as in accordance with the full absorption inventory rules of section 1.471-11 of the regulations, will not warrant disallowance or termination.

Rev. Rul. 77-134, 1977-1 C.B. 132 states that the Internal Revenue Service will not follow the decision in Korn Industries, Inc. v. United States, 532 F.2d 1352 (Ct. Cl 1976). The United States Court of Claims held in that case that the taxpayer's change in its standard cost computation for finished goods to include 14 cost elements, where previously only 11 had been included, was not a change of accounting method but rather the correction of a mathematical or posting error. Rev. Rul. 77-134 holds that in Korn Industries, Inc. the taxpayer has changed its method of accounting under section 446 of the Code and such a change requires the consent of the Secretary.

Rev. Rul. 77-134 also states that if a taxpayer has consistently treated an item of income or expense in a particular manner, any change from that consistent treatment is a change of accounting method regardless of whether the consistent treatment was a proper method of accounting.

In the present situation, the taxpayer's exclusion of an item of cost (freight-in) for purposes of valuing the merchandise in its inventory established a consistent pattern of treating the cost of freight-in and the cost of the merchandise. The freight-in cost that was excluded by the taxpayer prior to 1979 in valuing its inventory is a material item because it involves the proper timing of an item of expense that is used in the overall plan for valuing the taxpayer's inventory.

Freight-in as provided in section 1.471-3 of the regulations is an item of cost. Its inclusion or exclusion in valuing the taxpayer's inventory is another example along with the full absorption rules mentioned in section 3.01(c) of Rev. Proc. 79-23 that will not warrant disallowance or termination of the taxpayer's LIFO election.

HOLDINGS

(1) The taxpayer's change in the cost computation of its LIFO inventory to include the cost of freight-in is a change in method of accounting under section 446 of the Code and the regulations thereunder, and such a change requires the consent of the Secretary. See section 1.446-1(e) of the regulations. When the Commissioner approves a change in method of accounting, both the opening and closing inventory in the year of change are placed on the new method. To the extent the opening inventory in the year of change exceeds the closing inventory at the end of the year preceding the year of change, there is an adjustment under section 481 solely by reason of the change to prevent an amount from being duplicated. The section 481 adjustment is taken into account in determining taxable income in the manner determined by the Commissioner in accordance with Rev. Proc. 70-27, 1970-2 C.B. 509, as clarified by Rev. Proc. 75-18, 1975-1 C.B. 687.

(2) The taxpayer's exclusion of the cost of freight-in from the cost of its merchandise alone does not warrant the disallowance or termination of the taxpayer's LIFO election.