The Tax Court held that a business taxpayer's automatic consent request to change from the last-in, first-out (LIFO) inventory method failed due to defects in its Form 3115, Application for Change in Accounting Method, and the taxpayer's noncompliance with some of its terms. However, the court held the IRS had retroactively allowed the change when it examined tax returns for years subsequent to the taxpayer's submission of Form 3115 and had not challenged the taxpayer's use of a new method. The court further held the taxpayer's attempted reversion to LIFO was a second change in inventory method and that the IRS properly exercised its discretion when it did not approve of that change.
Facts: JHH Motor Cars Inc., an S corporation, was a California car dealership solely owned by James Hawse. Before 2001, the dealership used the LIFO method valued at cost for its new and used vehicle inventories but used the specific-identification method valued at lower of cost or market for its parts inventories. Hawse was concerned about having to pay the entire tax on JHH's LIFO reserve in one tax year if he sold the dealership's assets. He decided that JHH should switch from LIFO to specific identification to spread the tax on the LIFO reserve over four years. When JHH filed its 2001 S corporation income tax return, it also filed Form 3115 to obtain automatic consent to change inventory methods; however, the form as filed did not fully comply with the Form 3115 requirements. JHH's 2001 and 2002 income tax returns used the specific-identification method valued at cost to compute taxable income for its new vehicles and each year included income of $271,109, one-fourth of the LIFO reserve at the beginning of 2001.
Subsequently, its accountant believed JHH's LIFO termination was defective because JHH valued its new car inventory at actual cost, inconsistent with the lower of cost or market it used for its used car inventory. In 2009, JHH filed amended returns for tax years 2002 through 2007 assuming that no change from LIFO had occurred. JHH claimed refunds on the amended 2002 and 2003 returns, using the LIFO method for both years, deducting the 2001 and 2002 LIFO reserve adjustments on the 2002 return, and deducting the 2003 LIFO adjustment on the 2003 return. The IRS refused to accept the amended returns and issued a deficiency notice for 2002 and 2003. JHH petitioned the Tax Court for relief.
Issues: If a taxpayer wishes to change an accounting method, he or she must obtain the IRS's consent by either (1) receiving affirmative consent from the Service after submitting Form 3115 or (2) strictly complying with the requirements for automatic consent under an administrative ruling such as Rev. Proc. 99-49 (later superseded by Rev. Proc. 2002-9).
To obtain automatic consent to change from the LIFO inventory method, a taxpayer must change to a permitted method, which may be FIFO or specific identification, in either case valued at lower of cost or market, or if a retail merchant, the retail method. If the taxpayer has non-LIFO inventory using a permitted method, he or she must change to the identification and valuation method used for the non-LIFO inventory. The taxpayer must also comply with specific procedural requirements related to the completion and filing of Form 3115 and must include a LIFO reserve adjustment as income over a four-year period beginning with the year of the change.
JHH argued that it never received automatic consent to change inventory methods because it failed to value its new vehicle inventory at lower of cost or market as represented on its Form 3115 and therefore was still bound to the LIFO method. The IRS argued that automatic consent was granted because JHH complied with the relevant filing requirements of Form 3115 and was not required to actually implement the change in inventory methods.
Holding: The court agreed with JHH that it had not received automatic consent to change methods. According to the court, Rev. Proc. 99-49 (or 2002-9) tells taxpayers specifically what they must do to presume that they have received consent to change methods, and any deviation from those requirements would undermine the purpose of the automatic consent process. The court, however, disagreed that JHH was still using LIFO because the IRS has the authority to retroactively grant permission to change methods, and the IRS implicitly granted permission when it did not challenge the use of specific identification when examining JHH's 2002 and 2003 returns.
JHH argued that the use of specific identification on those returns was an error that it attempted to correct by filing amended returns, not a change in inventory method. The court held that JHH's use of specific identification was a change in methods because JHH used specific identification on tax returns for seven consecutive years and it was a change in the treatment of a material item. Therefore, the filing of the amended returns for 2002 and 2003 using LIFO was an attempt to change its inventory method a second time, and the IRS was entitled to reject the amended returns after not consenting to this change, according to the court.
- Hawse, T.C. Memo. 2015-99
—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.