Inventory is always an interesting subject in the context of an IRS audit. We have dealt with it on numerous occasions to the point where I think it’s worth the blogging effort.
For an accrual basis taxpayer that maintains an inventory of items to sell in the ordinary course of business, this post is applicable to those who must maintain inventory on their books for tax purposes. In other words, for purposes of this post we are disregarding the IRC exceptions to maintaining inventory.
In the context of an IRS examination, revenue agents search fairly diligently to either establish an inventory at year end (if inventory hasn’t been kept), or boost it higher. Either way, the adjustment is (debits to the window, I think) to increase inventory and conversely to decrease purchases expense, thus resulting in higher income. I am writing this post primarily because on a number of occasions, we were surprised to get the case and be the first to raise a challenge to this type of inventory adjustment. Thus we hope this information is useful to a preparer representing a client out there, somewhere.
I experienced this for the first time years ago when I was representing a used car dealer under examination. The IRS performed this analysis, which was very straightforward in that it’s pretty easy to review a used car sales book (which must be kept by law), and track the date of purchase and date of sale. As such, it’s even easier to then figure out what cars were purchased and remained unsold at year end. And in this case an understatement of inventory was found and the report of examination changes, Form 4549, was issued reporting the discrepancy. Ok.
But it occurred to me. “Wait a minute! What about the beginning inventory? Shouldn’t the methods used be consistent?” I mentioned this to the examiner, who replied, “Well if you want to go through that trouble…” Huh? Are you kidding? A $150,000 adjustment, resulting in $50,000 of additional tax, penalties and interest, and the question is whether or not I want to go through the “trouble?” Well, we went through the trouble, which as stated above was pretty easy, and that went a long way to making the examination more palatable…and fair.
Over the years I have seen more and more of this, with the IRS giving no attention to the beginning inventory, and fighting vehemently against allowing a re-evaluation of it, the idea being, “Hey, your client got away with deducting those purchases in earlier years (barred by the statute of limitations), and we’ll be damned if they are going to get those deductions, and then double dip by calling it back into inventory at the beginning of year, diminishing our audit adjustment.”
Now we having something we can work with.
First, it’s a pleasure to tell the IRS to “call their congressman” for a change, if they don’t like the tax law. The statute of limitations is generally three years, and that is the law. If it was five years, we’d oblige. But it’s not, and that statute is pretty much out of our control. It’s the law. If an older year cannot be audited, so be it (but admittedly, I do understand their reasoning!).
Second, IRC §471 says in part, “inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting income.” The case law appears to interpret that to mean that beginning and ending inventory should be done using the same method, if you want an honest bottom line in any given year. Isn’t that what it’s all about, an honest bottom line? I like John Wanamaker Philadelphia Inc. v. U.S., Primo Pants Co. v. Commissioner, Superior Coach of Florida v. Commissioner, and Wayne Bolt & Nut Co. v. Commissioner. There are other cases as well where the court believed that beginning and ending inventory should be consistent in their application.
Bottom line, if there has been an adjustment by the IRS to the ending inventory, look at mitigating the effects by re-evaluating beginning inventory using the same method, then fight tooth and nail to show that the change to beginning inventory must be utilized to arrive at a “clear reflection of income.” I have found that, fairly regularly, inventory levels for stable companies stay pretty constant (make sure first!). But I think the IRS is pretty fair on the issue when confronted with the case law. If not, disagree and take it to appeals.