Rev. Proc. 80-5

Section 1. Purpose and Scope

The purpose of this revenue procedure is to provide a procedure for taxpayers to change their method of accounting for "excess" inventory pursuant to the decision of the Supreme Court of the United States in Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979), 1979-1 C.B. 167.

This procedure is mandatory for the first taxable year (calendar or fiscal) ending on or after December 25, 1979. See Rev. Rul. 80-60, page 97, this Bulletin.

Sec. 2. Background

.01 In the Thor Power case, the taxpayer used the "lower of cost or market" method of valuing inventories for both financial accounting and for income tax purposes. See section 1.471-4 of the Income Tax Regulations. The taxpayer wrote down what it regarded as "excess" inventory to its net realizable value which, in most cases, was determined to be scrap value. The taxpayer determined that these articles were excess inventory because they were held in excess of any reasonably foreseeable future demand although such inventory was not scrapped or sold at reduced prices. The taxpayer retained the excess items in inventory and continued to sell them at original prices. The taxpayer contended that by writing down excess inventory to scrap value, it thereby reduced its inventory to "market" (net realizable value) in accord with its "lower of cost or market" method of accounting. The Commissioner of Internal Revenue disallowed this write-down. (The taxpayer also wrote down the cost of inventory that was either promptly scrapped or actually sold at reduced prices below cost. The Commissioner allowed these write-downs.)

The Supreme Court in Thor Power stated that sections 446 and 471 of the Internal Revenue Code vests the Commissioner with wide discretion in determining whether a particular method of inventory accounting should be disallowed as not clearly reflecting income. The Court affirmed the lower court's decision, sustaining the Commissioner, that although the taxpayer's write-down of excess inventory did conform to the best accounting practice in the trade or business and thus satisfied the first test of section 1.471-2(a) of the regulations, it failed to satisfy the second test of section 1.471-2(a), that it clearly reflect the taxpayer's income. The Court stated that where a taxpayer, under the "lower of cost or market" method of accounting, values its inventory for tax purposes at "market" (replacement cost), the taxpayer is permitted to depart from replacement cost only in specified situations described in sections 1.471-2(c) and 1.471-4(b) of the regulations. When such a departure to a lower inventory valuation is made, the regulations require that it be substantiated by objective evidence of actual offerings, sales, or contract cancellations and further require that records of actual dispositions be kept. The Court concluded that because the taxpayer provided no objective evidence of the reduced market value of its excess inventory, its write-down was plainly inconsistent with the regulations and was properly disallowed by the Commissioner. The taxpayer could not have properly taken advantage of any permitted write-downs since it did not scrap its "excess" inventory nor sell or offer it for sale at prices below replacement cost.

.02 The Thor Power case affirmed the method of accounting for inventory valuation established under the income tax regulations where the lower of cost or market method is applicable. In using the lower of cost or market method the regulations require a taxpayer having "excess" inventory to value such "excess" inventory at replacement cost (if lower than actual cost as defined in section 1.471-4 of the regulations) unless the goods have been scrapped, or they have been sold or offered for sale (at a lower price) within the meaning of the regulations under section 471 of the Code. (The "prescribed method.")

.03 Although the Thor Power case involved a method of inventory write-down that the taxpayer had initiated in the year in question, the Supreme Court's decision clearly applies to a taxpayer that has been consistently taking prohibited inventory write-downs described in the Thor Power decision. See Will-Burt Co. v. Commissioner, 38 T.C.M. 861 (1979).

.04 Section 446(e) of the Code and section 1.446-1(e)(2)(i) of the regulations state that, except as otherwise provided, a taxpayer must secure the consent of the Commissioner before changing a method of accounting for federal income tax purposes. Section 1.446-1(e)(3)(i) provides, in relevant part, that except as otherwise provided in subdivision (ii), in order to secure the Commissioner's consent, the taxpayer must file an application on Form 3115 with the National Office within 180 days after the beginning of the taxable year in which the taxpayer desires to make the change. Subdivision (ii) provides that notwithstanding subdivision (i), the Commissioner may prescribe administrative procedures, subject to such limitations, terms, and conditions as he deems necessary to obtain his consent, to permit taxpayers to change their accounting methods to an acceptable method consistent with applicable regulations.

Section 481(a) of the Code provides, in part, that if a taxpayer's taxable income for any taxable year is computed under a method of accounting different from the method used for the preceding taxable year, then there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted. Section 481(c) provides that in the case of any change described in subsection (a), the taxpayer may, in such manner and subject to such conditions as the Secretary may by regulations prescribe, take the adjustments required by subsection (a)(2) into account in computing the tax for the taxable year or years permitted under such regulations.

Sec. 3. Application

.01 In accordance with section 1.446-1(e)(3)(ii) of the regulations the 180 day rule is waived and consent is hereby granted taxpayers to change from a method of accounting for inventory valuation of "excess" inventory, that is not in accordance with the "prescribed method," to such "prescribed method." See section 2.02 above. Such consent is granted for the first taxable year ending on or after December 25, 1979, and shall be made in accordance with the provisions of this revenue procedure, including the adjustment under section 481(a) described in section 3.03 below.

.02 Pursuant to the consent granted in section 3.01, a taxpayer that is using a method of accounting for inventory valuation by writing down "excess" inventory in a manner that is not in accordance with the "prescribed method" must change such method of accounting to the "prescribed method" on its federal income tax return for the first taxable year ending on or after December 25, 1979. See Rev. Rul. 80-60.

.03 An adjustment is required to prevent amounts of income from being duplicated or omitted within the meaning of section 481 of the Code and the regulations thereunder when the change in method of accounting is made pursuant to the provisions set forth in this revenue procedure. Such adjustment, whether positive or negative, referred to as the "net section 481(a) adjustment," shall be taken into account as provided in either section 3.04 or section 3.05 below.

.04 (1) The taxpayer may treat the change in method of accounting as a change initiated by the taxpayer. In such case, unless otherwise provided in this revenue procedure, the net section 481(a) adjustment shall be taken into account ratably over a period of taxable years equal to the number of taxable years the taxpayer used a method of accounting where inventory was written down using an impermissible method. This period may not exceed 10 taxable years. In addition, the rules described in sections 3.07, 3.08, and 3.09 apply.

(2) When the entire net amount of an adjustment is attributable to the taxable year immediately preceding the year of change (first preceding year), the total net adjustment will be taken into account in computing taxable income for the year of change. The amount attributable to the taxable year immediately preceding the year of change is the difference in the amount required under section 481(a) of the Code for the year of change and the amount that would have been required under section 481(a) if the same change in accounting method had been made in such preceding year.

(3) When 67 percent or more of the net amount of an adjustment is attributable to the 1 taxable year period, 2 taxable year period, or 3 taxable year period immediately preceding the year of change, the highest percent attributable to such 1, 2, or 3 taxable year period will be taken into account ratably over a 3 taxable year period beginning with the year of change. An amount attributable to such 1, 2, or 3 taxable year period is the difference in the amount required under section 481(a) of the Code for the year of change and the amount that would have been required under section 481(a) if the same change in accounting method had been made at the beginning of such preceding 1, 2, or 3 taxable year period. Any remaining balance will be taken into account ratably over an additional period equal to the remainder of the number of taxable years the taxpayer has used the accounting method that is being changed. However, the total adjustment period will not exceed 10 taxable years. This paragraph 3.04(3) only applies if the taxpayer has used the method being changed for at least 3 taxable years and the entire amount of the adjustment is not attributable to the taxable year immediately preceding the year of change.

(4) In all other situations the total net adjustment will be taken into account ratably over the number of taxable years (not to exceed 10) the taxpayer has used the accounting method that is being changed.

(5) See section 4 of this revenue procedure for an example of the computation of a net section 481(a) adjustment pursuant to this revenue procedure where the taxpayer elected to treat the change in accounting method as a change initiated by the taxpayer.

.05 The taxpayer may treat the change in method of accounting as a change not initiated by the taxpayer within the meaning of section 481(a)(2) of the Code. In such case, the net section 481(a) adjustment, as modified by the "pre-1954 Code years" adjustment described in section 1.481-3 of the regulations, shall be taken into account in the year of change in full; in addition, see section 481(b) for the limitation on tax. See section 4 of this revenue procedure for an example of the computation of a net section 481(a) adjustment where the taxpayer elected to treat the change in accounting method as a change not initiated by the taxpayer.

.06 This revenue procedure does not apply to a taxpayer that has used a method of accounting for inventory valuation of "excess goods" that is not in accordance with the "prescribed method" and the use of such impermissible method has been raised and is pending as an issue as of February 8, 1980, in connection with the examination of the taxpayer's federal income tax return. In such case, Rev. Proc. 70-27, 1970-2 C.B. 509, clarified by Rev. Proc. 75-18, 1975-1 C.B. 687, and as subsequently modified or superseded, is available.

.07 This revenue procedure does not apply to a method of accounting for inventory, where the taxpayer elects to use (or is using) the last-in first-out (LIFO) method of accounting for such inventory for the first taxable year ending on or after December 25, 1979. In the case of a taxpayer electing LIFO for the first taxable year ending on or after December 25, 1979, pursuant to section 472(d) of the Code and the regulations thereunder, the difference between the carrying value of such inventory under the taxpayer's method of accounting (if less than cost) and cost shall be included in income for the preceding taxable year by filing an amended return for such preceding year. For a taxpayer using the LIFO method, see Rev. Proc. 76-6, 1976-1 C.B. 545, Rev. Proc. 76-28, 1976-2 C.B. 645, and Rev. Rul. 76-282, 1976-2 C.B. 137. If a taxpayer elects the LIFO method of inventory valuation during the "spread period" referred to in section 3.04, other than in the first taxable year ending on or after December 25, 1979, the unamortized balance of the section 481(a) adjustment, referred to in section 3.03, must be taken into account in full as an item of ordinary income in the year for which such election is made.

.08 If, at the end of any taxable year during the "spread period" referred to in section 3.04, the value of the taxpayer's inventory to which the section 481(a) adjustment under section 3.03 relates, as of the last day of any taxable year, is reduced by more than 331/3 percent of the inventory valued at the beginning of the first taxable year ending on or after December 25, 1979 (see section 3.03), the balance of the unamortized net section 481(a) adjustment, at such time, must be taken into account in full as an item of ordinary income in the year of such inventory reduction. This section shall not apply in the event such reduction is attributable to a strike or involuntary conversion.

.09 (a) With respect to a corporation.

If the taxpayer ceases to engage in the trade or business, to which this adjustment (section 3.03) relates, at any time prior to the expiration of the "spread period" referred to in section 3.04, the taxpayer will take into account in such year the balance of the adjustment not previously taken into account in computing taxable income. For purposes of this condition, the taxpayer is not considered to have ceased the trade or business if such cessation is the result of a transaction to which section 381 of the Code applies, but in such case the acquiring corporation shall continue to be subject to this revenue procedure as though it were the acquired corporation.

(b) With respect to a partnership:

In the event the partnership terminates or ceases to engage in the trade or business, to which this adjustment (section 3.03) relates, at any time prior to the expiration of the "spread period" referred to in section 3.04, the balance of the adjustment not previously taken into account in computing ordinary income shall be taken into account in such year. A partnership ceasing to engage in the trade or business includes the incorporation of such trade or business in a transaction to which section 351 of the Code applies; see Rev. Rul. 77-264, 1977-2 C.B. 187.

(c) With respect to a sole proprietor:

If the taxpayer ceases to engage in the trade or business, to which this adjustment (section 3.03) relates, at any time prior to the expiration of the "spread period" referred to in section 3.04, the balance of the adjustment not previously taken into account in computing taxable income shall be taken into account in such year. A sole proprietor ceasing to engage in the trade or business includes the incorporation of such trade or business in a transaction to which section 351 of the Code applies; see Rev. Rul. 77-264, 1977-2 C.B. 187.

.10 For purposes of the addition to tax for underpayment of estimated tax under section 6654(a) of the Code (applicable to individuals) or section 6655(a) (applicable to corporations), in applying the exceptions under sections 6654(d)(2), 6654(d)(3), and 6655(d)(3), the increase in taxable income in the year of change attributable to a change in method of accounting for inventory under this revenue procedure shall be considered to be taxable income for the last month of such taxable year. The increase in taxable income attributable to the change includes the difference in taxable income resulting from using the new method (the "prescribed method") to value beginning and ending inventory as well as the adjustment required by section 481(a) of the Code.

Furthermore, in determining the amount of income for the installment periods under sections 1.6554-2(d) and 1.6655-2(d) of the regulations (which provide for apportioning the cost of goods sold for the year on the basis of gross receipts for the year unless a more exact determination is available) any adjustment to the cost of goods sold for the first taxable year ending on or after December 25, 1979, resulting from the application of this revenue procedure shall be considered to be an adjustment in the last month of the taxable year.

.11 Section 1375(f) of the Code provides that certain distributions by corporations that qualify as electing small business corporations must be made within 21/2 months after the close of the corporation's taxable year in order to be considered as distributions of the corporation's undistributed taxable income for such year. The Service will consider requests from electing small business corporations with taxable years ending on or after December 25, 1979, but before March 10, 1980, for a 1-year modification of the taxable year for which consent is granted in section 3.01. Such requests for modification must be made by July 28, 1980, and must be accompanied by a statement of justification, filed under penalty and perjury, and must include (1) a statement establishing (a) that there was insufficient time for reaching a fully informed decision with respect to making a distribution under section 1375(f) as a result of section 3.01, and (b) that the corporation has a history of making timely section 1375(f) distributions, and (2) a description of the change in method of accounting resulting from the application of this revenue procedure. The requests should be addressed to the Commissioner of Internal Revenue, Attention: T:C:C:1, 1111 Constitution Avenue, N.W., Washington, D.C. 20224. In order to assist in the processing of these requests, reference to this paragraph should be made a part of the request by either typing or legibly printing at the top of the request the following statement:

"SUBMITTED UNDER SECTION 3.11 OF REV. PROC. 80-5."

.12 In applying sections 3.04(2) or (3), if a taxpayer's books and records do not contain sufficient information to compute the section 481(a) adjustment attributable to the 1, 2, or 3 taxable year period immediately preceding the year of change, the taxpayer may reasonably estimate such amounts and also attach the following statement to the Form 3115:

Under penalty of perjury, I hereby certify that:

(1) the books and records of (name of the taxpayer) do not contain sufficient information to permit a computation of the section 481(a) adjustment attributable to the 1 taxable year period, 2 taxable year period, or 3 taxable year period immediately preceding the year of change as required by section 3.04 of Rev. Proc. 80-5, and

(2) based on the information that is contained in such records, to the best of my information and belief, the entire amount of the section 481(a) adjustment for the year of change (indicate either "is" or "is not", as the case may be) attributable to the taxable year immediately preceding the year of change, and 67 percent or more of the section 481(a) adjustment for the year of change (indicate either "is" or "is not", as the case may be) attributable to the 1 taxable year period, 2 taxable year period, or 3 taxable year period immediately preceding the year of change.

Sec. 4 EXAMPLE (1)

X is a domestic corporation incorporated in 1950 and engaged in the business of manufacturing that reports its income on a calendar year basis. In the normal course of its business, X maintains an inventory of replacement parts for its products for sale to the public. X has consistently written down the value of excess inventory of replacement parts as a result of anticipated losses with respect to such inventory. As of December 31, 1978, X had on hand inventory items which it had written down to its estimate of scrap value by taking an inventory write-down for excess goods in the amount of $100,000. The write-down by X did not conform with the regulations under section 471 of the Code.

X filed a Form 3115 (Application for Change in Method of Accounting) with its tax return for taxable year 1979 in accordance with the provisions set forth in section 5 of this revenue procedure. Accordingly, X restored the write-down of $100,000 to its opening inventory for the taxable year 1979. As a result of such restoration, X will, in effect, receive a double deduction through the cost of goods sold in the amount of $100,000. Thus, under section 481(a) of the Code, an adjustment is necessary solely by reason of the change in method of accounting in order to prevent the $100,000 from being duplicated. Less than 67 percent of the adjustment is attributable to taxable years 1976, 1977, and 1978. If X had changed its method of accounting in 1954, the adjustment would have been $10,000.

If X elects to treat its change in method of accounting as a change initiated by the taxpayer pursuant to section 3.04 above, an adjustment in the amount of $100,000 shall be taken into account as an item of gross income ratably over 10 taxable years (1/10 each year).

If X elects to treat its change in method of accounting as a change not initiated by the taxpayer pursuant to section 3.05 above, an adjustment in the amount of $90,000 ($100,000 - $10,000) shall be taken into account as an item of gross income in taxable year 1979, the year of change. The tax for 1979 on the adjustment shall be limited as provided in section 481(b) of the Code.

EXAMPLE (2)

The facts are the same as presented in Example (1) with the exception that X has used the improper write-down method for 6 taxable years and the net section 481(a) adjustment if the year of change had been one of the 3 preceding taxable years, would have been $60,000 in 1976, $28,000 in 1977, and $50,000 in 1978. In this example, the difference between the net section 481(a) adjustment if the year of change had been 1977, and such adjustment in 1979, the year of change, is more than 67% ($100,000 - $28,000 = $72,000/$100,000 = 72%) and represents the highest percent of the adjustment attributable to any one of the 1, 2, or 3 taxable year period preceding the year of change. Under the provisions of section 3.04 of this revenue procedure the adjustment for 1979 of $100,000, therefore, shall be taken into account in the amount of $24,000 in 1979, 1980, and 1981 ($72,000 spread ratably over 3 years) and $9,333 in 1982, 1983, and 1984 (the remainder of $28,000 from the $100,000 adjustment spread over 3 years, the remaining number of years that X used the accounting method that is being changed).

EXAMPLE (3)

The facts are the same as presented in example (1) with the additional fact that the value of X's inventory as of December 31, 1978 (the end of the year preceding the year of change) was $800,000, which takes into account the write-downs for excess inventory (the old method). The value of the inventory as of January 1, 1979 (the beginning of the year of change), computed in accordance with a method of accounting permitted by the regulations (the new method), was $900,000. If X treats the change in method of accounting as a change initiated by the taxpayer, the net section 481(a) adjustment is $100,000 ($900,000 - $800,000). The taxable income for the year ended December 31, 1979, based on the foregoing and the amounts indicated below, should be computed as follows:

Sales ________________________________ $1,600,000

Sec. 5. Manner of Effecting the Change

.01 Taxpayers to which this revenue procedure applies must effect the change in their methods of accounting for their first taxable year ending on or after December 25, 1979, pursuant to the provisions set forth in this revenue procedure by filing a Form 3115 in duplicate. The original shall be attached to the taxpayer's timely filed federal income tax return for such year or to an amended return for such year filed no later than the extended time period prescribed in section 6081 of the Code and the regulations thereunder whether or not the taxpayer has, in fact, been granted an extension of time for filing its income tax return for the first taxable year ending on or after December 25, 1979. For example, a domestic corporation whose taxable year ends December 31, 1979, must effect the change described in this revenue procedure on an original timely filed return, or on an amended return filed no later than September 15, 1980. At the same time a copy of the Form 3115 shall be filed with the National Office addressed to the Commissioner of Internal Revenue, Attention: T:C:C:1, 1111 Constitution Avenue, N.W., Washington, D.C. 20224. In addition to the information required on Form 3115, the taxpayer must state whether section 3.04 or section 3.05 has been applied and must provide (1) a computation of the net section 481(a) adjustment, (2) the pre-1954 Code year adjustment, if applicable, and (3) the period over which the net section 481(a) adjustment will be taken into account and the basis for such conclusion. The National Office will sample the Form 3115's to determine whether the requirements of this revenue procedure have been followed. The National Office or the District Director may advise the taxpayer of required adjustments to the change in method of inventory valuation. Any adjustment made by the National Office will be limited to those necessary to properly comply with this revenue procedure.

.02 In order to assist in the processing of these changes in methods of accounting and to insure proper handling, reference to this revenue procedure shall be made a part of the Form 3115 by either typing or legibly printing the following statement: "FILED UNDER REV. PROC. 80-5."

.03 If a taxpayer applies the provisions of this revenue procedure to change a method of accounting with respect to a method of accounting for inventory write-downs not in accordance with the regulations under section 471 of the Code, and if it is subsequently determined that such change in method is not within the scope of this revenue procedure, the taxpayer will be deemed to have properly filed a timely application for a change in such method of accounting at the time that and for the taxable year in which the Form 3115 is filed pursuant to sections 5.01 and 5.02.

Sec. 6. Inquiries

Inquiries regarding this revenue procedure may be addressed to the Commissioner of Internal Revenue, Attention: T:C:C:1, 1111 Constitution Avenue, N.W., Washington, D.C. 20224.