Rev. Rul. 77-408

Advice has been requested whether a taxpayer who requests a modification to a consent letter that gave the taxpayer permission to change to the full absorption method of inventory costing prior to the publication of Rev. Proc. 75-40, 1975-2 C.B. 571, will violate the conformity requirements of section 472(c) and (e) of the Internal Revenue Code of 1954, under the circumstances described below.

X, the taxpayer, received a consent letter dated November 10, 1974, permitting X to change to the full absorption method of inventory costing commencing with the taxable year 1974. The consent letter also permitted X to exclude taxes and insurance costs listed in section 1.471-11(c)(2)(iii) of the Income Tax Regulations from inventoriable costs for Federal income tax purposes for the year 1974. X issued its financial reports for 1974 to its shareholders on January 31, 1975 excluding taxes and insurance from inventoriable costs in its reports.

The Internal Revenue Service released Rev. Proc. 75-40 in TIR-1402, dated September 9, 1975, which augmented section 1.471-11 of the regulations. Sections 5.02 and 5.03 of Rev. Proc. 75-40 set forth certain representations that had to be made by taxpayers who had filed applications with the Service seeking permission to change to the full absorption method set forth in section 1.471-11. Section 5.04 recognized that the Service had issued letters of consent to certain taxpayers granting permission to change to the full absorption method during the transition period provided by section 1.471-11(e)(1)(ii) without requiring the representations specified in sections 5.02 and 5.03. Therefore, section 5.05 provides that a taxpayer such as X who was issued a consent letter prior to the publication of Rev. Proc. 75-40 may elect to have its original consent letter (dated November 10, 1974 in X's case) modified to incorporate any additional adjustments required by section 5.04.

Subsequent to the publication of Rev. Proc. 75-40, it was determined that X was unable to justify the continued exclusion of taxes and insurance costs listed in section 1.471-11(c)(2)(iii) of the regulations from inventoriable costs as was permitted in the consent letter of November 10, 1974. Pursuant to section 5.05 of Rev. Proc. 75-40, X elected, commencing with 1974, to have its consent letter amended to include in inventoriable costs the costs for taxes and insurance previously excluded by the consent letter of November 10, 1974.

The question presented is whether the election to amend the consent letter to require inclusion in inventoriable costs the previously eliminated taxes and insurance costs for Federal tax purposes will result in a violation of the conformity requirements of section 472(c) or (e) of the Code for 1974 when the financial statements for 1974 (issued in January 1975) remain unchanged.

Section 472(c) of the Code provides that a taxpayer must not have used any procedure other than that specified in section 472(b)(1) and (3) in inventorying goods included within the LIFO election to ascertain the income, profit, or loss for the first taxable year for the purpose of a report or statement to shareholders, proprietors, beneficiaries, or creditors. Section 472(e)(2), which refers only to section 472(b)(1), imposes a similar requirement for inventorying goods included within the election for subsequent taxable years and provides that the Secretary may require a change to a different method if such requirement is not met.

Section 1.471-11(e)(1)(i) of the regulations provides, in part, that a taxpayer not using the full absorption method of inventory costing as prescribed in section 1.471-11(a) must change to that method.

Section 1.471-11(c)(2)(iii) of the regulations provides that the inclusion or exclusion of such costs (listed in the subdivision) from the amount of inventoriable costs for purposes of a taxpayer's financial reports shall determine whether such costs must be included in, or excluded from, the computation of inventoriable costs for Federal income tax purposes, but only if such treatment is not inconsistent with generally accepted accounting principles.

Rev. Rul. 76-379, 1976-2 C.B. 138, states that the full absorption method is a method of determining the cost of the inventory, while the LIFO method is a method of carrying the inventory at cost. Thus, the exclusion or inclusion of certain costs in or from inventoriable costs does not affect the sequential layering provisions of section 472(b)(1) and (3), and therefore does not result in the use of a method other than the LIFO method.

Accordingly, the election by X to have its consent letter of November 10, 1974 amended, pursuant to section 5.05 of Rev. Proc. 75-40, to include additional costs as inventoriable costs for Federal income tax purposes while its financial statements for 1974 remain unchanged will not result in a violation of the conformity requirements of section 472(c) and (e) of the Code for 1974.