A mistake made in a taxpayer’s last-in, first-out (LIFO) computation may repeat in later-year returns if staff preparing the computation take a “same as last year” approach. When the mistake ultimately is detected, there is a question of whether the mistake represents a method of accounting or an error.
Huffman Decision
The Sixth Circuit recently affirmed a Tax Court decision holding that a taxpayer that consistently had omitted a step in its LIFO computation (for 10–20 years) had adopted a method of accounting (Huffman, 518 F.3d 357 (6th Cir. 2008), aff’g 126 TC 322 (2006)). Thus, the IRS could impose an IRC § 481(a) adjustment representing the entire amount of income that had been omitted as a result of using the improper LIFO method, including the portion that had arisen in closed years.
This result hinged on the court’s determination that the mistake was a method of accounting as opposed to an error. Under Treas. Reg. § 1.446-1(e)(2)(ii)(b), the correction of a mathematical or posting error is not a change in method of accounting and thus does not involve a section 481(a) adjustment, whereas a change in accounting method generally requires a section 481(a) adjustment.
Method of Accounting or Error
Whether a mistake involves an accounting method or an error may not be clear. In Huffman, the mistake might be viewed as an “error” in the ordinary sense of that word. Within the LIFO computation, the court stated, the accountant consistently had failed to extend the base-year cost of LIFO increments by the current-year cumulative index, which effectively valued inventory at base-year prices (some 10–20 years prior), instead of properly valuing each increment at the applicable price for the year in which it was created. As a result, the accountant did not compute the proper LIFO value of the inventory under the dollar-value method.
The taxpayer argued that the IRS adjustment was the “correction of an error,” which would avoid section 481(a) treatment and limit the adjustment to open years only. The taxpayer cited Treas. Reg. § 1.446-1(e)(2)(ii)(b), which provides that “[a] change in method of accounting does not include correction of mathematical or posting errors.” The Tax Court, however, found that “[t]he regulations give no guidance as to the meaning of the term ‘mathematical error.’ ” The Tax Court concluded that the accountant “reached an erroneous result not because he made a mistake in arithmetic (multiplication) but because he omitted the critical step of multiplication altogether.”
The Sixth Circuit agreed and cited, as “sufficiently analogous,” Treas. Reg. § 1.446-1(e)(2)(iii), Example 6, in which a taxpayer for many years had excluded overhead costs in valuing inventories at cost. The example concludes that allocating overhead is a change in method of accounting “because it involves a change in the treatment of a material item used in the overall practice of identifying or valuing items in inventory.”
It is at this point where error and method become fused into the concept of erroneous methodology. In essence, a consistently repeated error becomes a method of accounting.
Consistency
Consistency may play a significant role in answering the “error or method” question. Treas. Reg. § 1.446-1(e)(2)(ii)(a) states that “in most instances a method of accounting is not established for an item without such consistent treatment.” Since the facts in Huffman reflected that the taxpayer used the improper method from the beginning and continued for 10–20 years, the court ruled that consistency had been established.
Consistency is not always clear-cut. Some taxpayers may properly elect and use a LIFO methodology in the first year and subsequent years but inadvertently (often by way of spreadsheet error) migrate to an improper method. The Tax Court in Huffman only briefly discussed this issue, noting that “a short-lived deviation from an already established method of accounting need not be viewed as establishing a new method of accounting.” The IRS sought to define consistency in Rev. Rul. 90-38 and Rev. Proc. 2002-18. However, that guidance stops short of addressing a situation in which a taxpayer properly has elected and used a method of accounting for a number of years, but then subsequently used a different method in two or more consecutively filed returns.
Observations
If a taxpayer discovers an error with respect to its LIFO computation that results in the understatement of income, the item is an exposure until the statute of limitations expires. The taxpayer should eliminate the exposure through an amended return.
If a taxpayer discovers an error with respect to its LIFO computation that results in the overstatement of income, the taxpayer should request a refund through amended returns. However, if the IRS believes the error is a method of accounting, the request for refund may be disallowed.
If a taxpayer presently is using an erroneous LIFO methodology (such as skipping or misapplying a step in the LIFO computation) that results in an understatement of income, the taxpayer is at risk for the IRS to impose a section 481(a) adjustment and recover the entire understatement as in Huffman. However, if that taxpayer requests a change to a proper method by filing a Form 3115, Application for Change in Accounting Method, it should receive audit protection for all years before the year of change. In addition, since most LIFO method changes are made on a cutoff basis, no section 481(a) adjustment may be required.
If a taxpayer is presently using an erroneous LIFO methodology that results in an overstatement of income, the taxpayer should file Form 3115 to request a change to a proper method. Unfortunately, the requirement that most LIFO changes be made on a cutoff basis likely will prevent the taxpayer from obtaining a favorable section 481(a) adjustment. Even so, a taxpayer may benefit by changing to a proper LIFO method that does not overstate income going forward. If there is uncertainty as to whether the mistake is an error or an improper method, the taxpayer also should file an amended return to prevent the statute of limitations from expiring. This will allow the taxpayer to obtain a refund on the overstatement of income from open years if the IRS National Office concludes that the mistake is an error.
While the implications of Huffman reach further than LIFO, taxpayers using LIFO should take a closer look at their present calculations to determine whether any mistakes might have been made and, if so, whether the mistakes would be considered errors or improper methods.
Tom Sehman , CPA, PricewaterhouseCoopers LLP, Minneapolis.
This article originally appeared in The Tax Adviser, the AICPA’s monthly journal of tax planning, trends and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price. Call 800-513-3037 or e-mail taxsection@aicpa.org for a subscription to the magazine or to become a member of the Tax Section.
