Rev. Rul. 80-60

ISSUE

Whether a taxpayer using a method of inventory valuation for "excess" inventory that is not in accordance with the Income Tax Regulations must change its method of accounting to a method permitted by the regulations, 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.

FACTS

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 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.

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.")

In Rev. Proc. 80-5, page 582, this Bulletin, the Commissioner has granted consent for 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." The Commissioner's consent is applicable for the taxpayer's first taxable year ending on or after December 25, 1979. In order to implement the decision of the Supreme Court and under the authority contained in section 1.446-1(e)(3)(ii) of the regulations, the Commissioner has prescribed certain procedures with respect to the change in method of accounting including a provision that will allow taxpayers to treat the change in method either as a change initiated by the taxpayer or as a change not initiated by the taxpayer.

LAW

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.

Section 6011 of the Code provides that any person made liable for any tax imposed by this title, or for the collection thereof, shall make a return or statement according to the forms or regulations prescribed by the Secretary.

ANALYSIS

The requirement to secure the Commissioner's consent before changing a method of accounting was first required in 1919 by Section 212, Article 23, Regulation 45 (T.D. 2873, 1 C.B. 58). Similar regulations were contained under the 1939 Code in regulation 118, section 39.41. These regulations were then codified in section 446(e) of the 1954 Code. The Senate Finance Committee expressly stated that section 446(e) was added to "codify existing regulations" (S. Rep. No. 1622, 83rd Cong., 2d Sess. 300 (1954)). The purpose of the regulations and the subsequent enactment of section 446(e) was to provide the Commissioner with the authority to monitor changes in method of accounting; to insure that no duplication or omission of items of income or expense resulted; and to allow the Commissioner to obtain agreement from the taxpayer as to the terms and conditions under which the change would be effected. At the same time section 446(e) was enacted, section 481 was also enacted to take into account those adjustments which are determined to be necessary solely by reason of the change in method of accounting.

In the Thor Power case, the Supreme Court determined that the method of inventory valuation did not clearly reflect income and, accordingly, was impermissible. Taxpayers and the Commissioner are bound by the decisions of the Supreme Court. Therefore, any taxpayer that is using a method of accounting of inventory valuation for writing down "excess" inventory that is not in accordance with the "prescribed method" must change such method of accounting to the "prescribed method." Consent under section 446(e) is required prior to a change in method of accounting. In Rev. Proc. 80-5 the Commissioner has granted advance consent for taxpayers who are using a method of inventory valuation of "excess" inventory that is not in accordance with the "prescribed method," to change to the "prescribed method" for the taxpayer's first taxable year ending on or after December 25, 1979. Therefore, section 446(e) does not prevent a taxpayer who is not using the "prescribed method" to change on the taxpayer's federal income tax return for the first taxable year ending on or after December 25, 1979, to the "prescribed method."

Taxpayers have an obligation to file returns prepared in accordance with appropriate laws and regulations; income tax return preparers are subject to a similar obligation in preparing returns. Therefore, if a taxpayer files a Federal income tax return not using the "prescribed method" of inventory valuation the taxpayer will have filed a return not in accordance with the law.

HOLDING

A taxpayer using a method of inventory valuation for "excess" inventory that is not in accordance with the "prescribed method" must change its method of accounting to such method for its first taxable year ending on or after December 25, 1979.

¹ Also released in News Release IR-80-19, dated February 8, 1980.