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"Thor Power" decision
In Thor Power Tool Co. v. Commissioner,1 decided January 16, 1979, the U.S. Supreme Court affirmed decisions of the Seventh Circuit and Tax Court upholding the disallowance of "excess inventory" writedowns which failed to satisfy the requirements under the section 471 regulations for writedowns of inventory below cost. The Court stated that the Congress has given the Internal Revenue Service broad discretion, under Code sections 446 and 471, to determine whether a particular method of inventory accounting clearly reflects the taxpayer's income. Citing the "well-known potential for tax avoidance that is inherent in inventory accounting," the Supreme Court stated that to permit writedowns without objective evidence of the inventory's value (e.g., actual sales prices during the year) would allow a taxpayer "to determine how much tax it wanted to pay for a given year.
The taxpayer in Thor Power manufactured hand-held power tools that contained from 50 to 200 parts. The company had a policy of manufacturing all estimated future replacement parts at the same time it manufactured a new product. In this way, the company sought to avoid the problem of having to retool at some future date in order to provide replacement parts to its customers. Therefore, the company had more replacement parts on hand than it would need in the immediate future.
In 1964, Thor Power's new management determined that a large portion of the parts inventory was in excess of any reasonably foreseeable future demand. Therefore, the company wrote the inventory down to scrap value for both financial statement purposes and tax purposes. The taxpayer did not attempt to sell these goods at reduced prices or to scrap them; instead, the parts were retained for possible future sales to customers at their original list price.
On audit, the Internal Revenue Service agreed that the company's method of accounting for its inventory was in conformity with the best accounting practice in its trade or business, because it was standard accounting policy to write down excess inventories to their net realizable value. However, the Revenue Service determined that the writedown did not clearly reflect the taxpayer's income. The Revenue Service contended that in order to clearly reflect income for tax purposes, the writedown had to conform to the requirements of the section 471 regulations regarding market writedowns, and that the taxpayer's writedown did not conform to those requirements.
The company's writedown of "excess inventory" reflected not a reduction in the market value of the individual replacement parts, but a judgment that less than all the parts would be sold. Also, the writedown did not reflect an offer to sell the replacement parts at less than market value or actual sales of subnormal goods. The "excess" inventories were physically indistinguishable from normal goods, and the company stated that it continued to sell the parts at their original list prices. The writedown, therefore, did not meet the requirements of the regulations, which provided only for writedowns to market value, writedowns to offering price below market value (less direct costs of disposition) and writedowns to bonafide selling price (less direct costs of disposition) for subnormal goods.
1439 U.S. 522 (1979).
Upholding the Revenue Service's determination that the writedown did not clearly reflect income, as required by the regulations, the Supreme Court also rejected the taxpayer's argument that conformity to generally accepted accounting principles gave rise to a presumption of clear reflection of income. Because income tax rules have different objectives than accounting rules, the Court stated, tax issues are not controlled by accounting practices; the Court also observed that divergence between accounting and tax treatment is particularly great where a taxpayer seeks a current deduction for estimated future expenses or losses.
Revenue Procedure 80-5 and Revenue Ruling 80-60
On February 8, 1980, the Internal Revenue Service issued a news release (IR-80-19, I.R.B. 1980-6) announcing the publication of Revenue Procedure 80-5 and Revenue Ruling 80-60. Both pronouncements dealt with the Supreme Court's 1979 decision in Thor Power and the writedown of excess inventories. The pronouncements required full implementation of the Thor Power decision for taxpayers with 1979 calendar year-ends.
Under Code section 446, a taxpayer may not change the method under which it accounts for income unless it secures the consent of the Revenue Service. This procedure can have the result of requiring a taxpayer to continue to use an erroneous accounting method unless it secures consent to change.
With respect to the Thor Power decision, the Internal Revenue Service believed that many taxpayers would not request permission to change to the proper method of accounting for excess inventories and, under the requirement that they maintain their method of accounting, would continue improperly to write down excess inventories. This not only would give taxpayers the advantage of continuing to write off excess inventories until eventually challenged on audit, but it held out the prospect that the erroneous method of inventory accounting might never be discovered by the Revenue Service.
As a response to the possibility that taxpayers would not request permission to change erroneous methods of inventory accounting in accordance with the Thor Power decision, the Revenue Service issued Revenue Procedure 80-5 and Revenue Ruling 80-60 on February 8, 1980. Rev. Proc. 80-52 granted blanket permission to all taxpayers to change their method of inventory accounting to conform with the Thor Power decision. Rev. Rul. 80-60,3 which presented a fact situation regarding excess inventories, stated in its conclusion that if a taxpayer did not account for inventory in accordance with the Thor Power decision and Revenue Procedure 80-5, the taxpayer would be filing its tax return "not in accordance with the law." The implication of this last statement was that the taxpayer would be liable for various penalties for failure to file a proper tax return.
It is the position of many taxpayers that the retroactive application of the two Revenue Service pronouncements (issued in 1980 but to take effect in 1979) precludes them from being able to comply in 1979 with certain Treasury regulations that would have mitigated the income recapture required under the Thor Power decision. Under the
1980-1 C.B. 582.
1980-1 C.B. 446.
regulations, normal goods may be written down to below market value if the goods are offered for sale at below market prices in the taxable year the writedown is to be taken. The taxpayers claim that if they had had proper notice of the pronouncements in 1979, they would have offered a large part of their excess inventory for sale at reduced prices in 1979. Thus, they would have been in compliance with both the Treasury regulations and the Thor Power decision on such inventory writedowns and would not have had to recapture income with respect to that inventory.
The principal issue is whether taxpayers should be able to write down the value of excess inventories that continue to be sold at prices in excess of cost. A secondary issue is whether the application of Rev. Rul. 80-60 and Rev. Proc. 80-5 should be delayed from 1979 to
Explanation of provisions
S. 578, Section 1
S. 578 would allow taxpayers to value excess inventory at net realizable value. The bill would define excess inventory as that portion of the taxpayer's ending inventory which the taxpayer reasonably expects will be disposed of at less than full realization of its cost.
The amount of the excess inventory would be based on the taxpayer's five-year experience with each group of articles contained in the inventory. Thus, the taxpayer would look to each group of articles contained in its inventory and determine the average percentage of its inventory that was disposed of at less than cost for the past five years. The taxpayer would then apply that average percentage to the current amount in the ending inventory for that group; the resulting amount would be the taxpayer's excess inventory for that group. That amount of excess inventory would then be written down to its net realizable value.
S. 1276 would provide an election for qualified small businesses to write down, over a four-year period, inventory items which have been held by the taxpayer for more than 12 months.
Under the election, inventory items that have been held for more than one year but not more than two years could be written down by not more than one-third of their inventory value as of the time of the writedown. Items held for more than two years but not more than three years could be written down by not more than half their inventory value as of the time of the writedown. Inventory items held more than three years could be written down by not more than the full inventory value of the item as of the time of the writedown.
A qualified small business would be defined as a domestic trade or business with equity capital of $25 million or less. Special rules would be provided to treat commonly controlled trades or businesses as a single trade or business for purposes of determining whether the members of the group are qualified small businesses.
The bill also would delay the effective date of Rev. Proc. 80-5 and Rev. Rul. 80-60 from taxable years endiing after December 24, 1979, to taxable years beginning after December 31, 1980. A taxpayer which changed its method of accounting for a taxable year ending after
December 24, 1979 and before January 1, 1981, in accordance with Rev. Rul. 80-60 and Rev. Proc. 80-5, would be able to change the method of accounting for any such taxable year back to the method of accounting that had been previously used. This change could be made without the consent of the Revenue Service by filing an amended tax return.
S. 578, Section 1
This provision of S. 578 would apply to taxable years ending on or after December 25, 1979 (the date on which Rev. Proc. 80-5 and Rev. Rul. 80-60 became effective to implement the Thor Power decision).
The amendments made by S. 1276 relating to inventory writedowns for qualified small businesses would apply to taxable years beginning after December 31, 1980. The provisions relating to Rev. Rul. 80-60 and Rev. Proc. 80-5 would apply to taxable years ending after December 24, 1979 and beginning before January 1, 1981.
b. Sections 2 and 3 of S. 578-LIFO Inventories Present law
Gross income from the sale of goods equals gross sales receipts less the cost of goods sold. The computation of cost of goods sold is made by taking the beginning inventory, adding the purchases made during the year, and subtractiing the ending inventory. The resulting amount is the amount of goods that were disposed of during the year and are presumed sold.
The dollar value of the ending inventory is determined by actually counting the goods on hand at the end of the year and then ascribing a value to those goods. The valuation method is important because a higher value will result in a lower cost of goods sold and thus greater taxable income, while a lower value will result in a higher cost of goods sold and thus lower taxable income.
There are several methods for valuing ending inventories. The firstin, first-out ("FIFO") method presumes that the earliest acquired goods are sold first and that the ending inventory consists of the most recent purchases. The last-in, first-out ("LIFO") method presumes that the goods most recently purchased are sold first and that the ending inventory consists of the earliest acquired goods. Other principal methods are the average cost method, under which the costs of all goods owned during the year are averaged, and the specific identification method, under which the individual price of each item in inventory is determined.
In 1938, the Congress allowed the use of LIFO by taxpayers in a few specified industries, and in 1939, by all taxpayers. However, it was unclear at that time whether the accounting profession accepted LIFO as clearly reflecting income for purposes of financial statements. Since clear reflection of income has always been the primary standard for approved methods of accounting, the use of LIFO for tax purposes was conditioned on the requirement (the "conformity requirement") that the taxpayer use LIFO in preparing its financial statements (sec. 472). At present, LIFO is an accepted method of accounting for inventories for financial statement purposes.
Since the use of LIFO in times of rising inflation results in lower taxable income than would be the case with FIFO, these comparatively lower earnings are also reflected in the taxpayer's published financial statements because of the conformity requirement. Inasmuch as the operating success of a business is measured in large part by its earnings, many taxpayers using LIFO feel at a competitive disadvantage with similarly situated taxpayers which do not use LIFO and thus report higher earnings on essentially the same income. Many of these businesses have not changed to LIFO because of this effect of the conformity requirement.