AICPA Recommends Changes to Proposed IRS LIFO Regulations

The AICPA submitted a letter to the IRS on May 21st detailing change recommendations to the proposed IRS IPIC LIFO pooling regulations contained in the Treasury’s notice of proposed rulemaking (REG-125946-10). The AICPA’s recommended change letter read as follows:

The AICPA recommends that the Department of the Treasury (“Treasury”) and the IRS make the following changes to the proposed regulations to reduce the compliance burden on taxpayers and IRS exam controversy:
• Allow the inclusion of resale goods in the same LIFO IPIC pool with manufactured or processed goods under the IPIC pooling rules;
• Provide test year, qualifying period, retest year, and extended qualifying period rules similar to the rules provided in Treas. Reg. §§ 1.263A-2(b)(4) and -3(d)(4) for using the historic absorption ratio; and
• Provide an exception from the requirement to change pools as a result of the application of the 5-percent rules.

Each of the bullet points referenced in the AICPA letter are explained in detail below:

Allow the inclusion of resale goods in the same LIFO IPIC pool with manufactured or processed goods under the IPIC pooling rules

The original goal of the IPIC LIFO method was to provide taxpayers an alternative method of measuring inflation that would simplify the use of the dollar-value LIFO method, and a significant percentage of companies currently use IPIC LIFO in favor of internally-computed inflation indexes because of this (learn more at our IPIC LIFO Advantages page). Although the intent of the proposed IRS regulation was to clarify the existing IPIC pooling rules, the AICPA letter suggests that both the proposed and existing regulations cause more complexity and effort than clarity and simplification.

The proposed IRS regulation does not modify any of the existing rules in place; it merely spells out in plain language that it is not permissible for IPIC method taxpayers that use the IPIC pooling method to comingle manufactured and resold goods within the same IPIC pool. Essentially, the IRS has always held the stance that IPIC LIFO method taxpayers are required to set up separate manufacturing and resale pools for each of their IPIC LIFO pools (if both manufactured and resold goods exist within a LIFO pool). Under IRS IPIC pooling method regulations, taxpayers are required to establish separate LIFO pools for each BLS Major Commodity Group that contains 5% or more of a company’s combined total year end inventory balance. Both the existing and proposed IRS regulation further complicates the process of establishing LIFO pools because it potentially doubles the number of pools to be used, and LIFO calculationa become more complicated and volatile as the number of LIFO pools increase (the probability LIFO calculation errors and/or LIFO layer erosions/liquidations occurring is directly correlated to the number of LIFO pools, and the probability increases as the number of LIFO pools increase). To further illustrate this concept, we’ll use an example of a company called ABC Packaging Co. whom sells manufactured and resold goods and uses the IPIC pooling method. Within ABC Pkg.’s inventories are items that fall under the following three IPIC BLS PPI Table 9 Major Commodity Groups: 06 Chemicals and allied products, 07 Rubber and plastic products and 09 Pulp, paper and allied products. For simplicity sake, we’ll assume that ABC Pkg. has 1/3 of their inventory balances that fall under each of the three IPIC pools listed above, and the goods contained within two of the three pools (06/07) have a mix of both manufactured and resold goods. Because of the existing and proposed IRS Reg’s, ABC Pkg. would be required to maintain the following five pools:

Under the AICPA recommendations, ABC Pkg. would only be required to have the following three LIFO pools:

The IRS contends that the regulation, “is intended to limit cost transference, an inherent problem with pooling. Cost transference may occur, among other circumstances, when inventory items from separate economic activities (for example, manufacturing and resale activities) are placed in the same pool and may cause misallocation of cost or distortion of income.” Although cost transference may exist for companies that use internally-computed inflation indexes to make their LIFO calculation, the same can not be said about an IPIC LIFO method taxpayer. The BLS does not survey nor maintains separate manufactured and resale  Consumer Price Index (CPI) and Producer Price Index (PPI) categories. What this means is that in the example above, the same inflation indexes and BLS categories will be assigned to ABC Pkg.’s manufactured and resale items to measure inflation; therefore, there is no chance of cost transference occurring. For example, lets assume that ABC Pkg. has both manufactured and resold food containers inventories that are made from polystyrene foam. ABC Pkg. would use the same 072A01015 Polystyrene foam food containers BLS PPI Table 9 category inflation index for each of the manufactured and resold items since they’re required to be segregated into separate pools. The intent of the IPIC Pooling method is to establish LIFO pools in a manner where items assigned to the same BLS major commodity group are placed in a single LIFO pool; the existing/proposed IRS regulation prevents this from occurring by requiring taxpayers to have the same categories segregated into separate manufactured & resale pools.

Provide test year, qualifying period, retest year, and extended qualifying period rules similar to the rules provided in Treas. Reg. §§ 1.263A-2(b)(4) and -3(d)(4) for using the historic absorption ratio

Under both the existing/proposed IRS IPIC LIFO pooling regulations, any LIFO pool with a year end inventory balance that is less than 5% of the current-year cost (grand total year end inventory balance) may be rolled up in one of the following manners:

1. If the sum of each of the LIFO pools with inventory balances totaling less than 5% of the current-year cost is 5% or more of the current-year cost, create a standalone “Miscellaneous pool” containing the balances of all LIFO pools with year end inventory balances that are less than 5% of the current-year cost.
2. If the sum of each of the LIFO pools with inventory balances totaling less than 5% of the current-year cost is less than 5% of the current-year cost:
   1. Create a standalone Miscellaneous pool containing the balances of all LIFO pools with year end inventory balances that are less than 5% of the current-year cost OR
   2. Combine the sum of the LIFO pools with inventory balances totaling less than 5% of the current-year cost with the largest LIFO pool in terms of dollars

Furthermore, the IRS requires users of the 5-percent rule to perform a “5-percent test” every two years to determine if their current inventory mix satisfies the requirements for establishing IPIC LIFO pools. Although the form of both the existing/proposed IRS regulation makes it appear that the 5-percent test must be performed every three years (“redetermined every third taxable year”), many have considered the requirement to imply that taxpayers must actually perform this test every two years.

What the AICPA has recommended is that the IRS change the 5-percent retest rules in a similar manner as the historic absorption ratio test rules are worded, and essentially change the 5-percent testing requirement from two years to three years. This would again to appear to be more reasonable than the existing/proposed IRS regulations because the ultimate intent behind allowing taxpayers to use the IPIC method was to simplify LIFO calculations. In their current format, the requirement for IPIC LIFO method taxpayers to perform the 5-percent test every two years creates an additional unduly burdensome rule.

Provide an exception from the requirement to change pools as a result of the application of the 5-percent rules

Under the existing/proposed IRS regulation, the 5-percent test requires taxpayers to either eliminate/establish a pool if it falls above/below the 5-percent threshold described above. To further illustrate this concept, we’ll again use the example of a company called ABC Packaging Co. The combined total of their LIFO pools with inventory balances that totaled less than 5% of the current-year cost was 4.4%, and they subsequently elected to combine the sum of the LIFO pools with inventory balances totaling less than 5% of current-year cost with its largest LIFO pool in 2015. Pursuant to IRS Regs. ABC Pkg. performed the 5-percent test for their 2017 y/e to redetermine if the same LIFO pools currently existed that were created in 2015. Based on comparing the year end inventory balances for each of their pools based on the BLS major commodity groups, it was discovered that the sum of each of their LIFO pools with inventory balances totaling less than 5% of their current-year cost now equaled 5.1%. Based on the existing/proposed IRS Regs., ABC Pkg. would be required to perform a “repooling” and perform the following steps:

1. Remove the inventory balances of the LIFO pools with year end inventory balances that totaled less than 5% of the current-year cost from its largest LIFO pool
2. Create a new standalone Miscellaneous < 5% pool containing the balances of all LIFO pools with year end inventory balances that are less than 5% of the current-year cost

What the AICPA has recommended for the IRS to change is to allow for the “rounding down” and “rounding up” principles to be allowed during retesting the 5-percent rule in order to reduce the frequency of repoolings from occurring by allowing the five percent rule to be considered to apply within a range of 4.5 – 5.5% rather than exactly 5%. The AICPA proposed change would prevent repoolings from occurring due to a change within half of a percent below or above 5% of the current-year cost, and would largely alleviate the administrative burden associated with retesting the IPIC Pooling 5-percent rules.