Inventories: General Principles; LIFO Method (Portfolio 578)

Tax Management Portfolio, Inventories: General Principles; LIFO Method, No. 578-4th, discusses the tax aspects of inventories with particular emphasis on the last-in, first-out (LIFO) method. The use of inventories for tax purposes is generally required whenever the sale of merchandise is an income-producing factor.

To view this Portfolio, take a free trial to Bloomberg Tax

Bloomberg Tax

This Portfolio is available with a subscription to Bloomberg Tax, a comprehensive research solution including over 500 Tax Management Portfolios, practice tools, primary sources and timely news.


Tax Management Portfolio, Inventories: General Principles; LIFO Method, No. 578-4th, discusses the tax aspects of inventories with particular emphasis on the last-in, first-out (LIFO) method. The use of inventories for tax purposes is generally required whenever the sale of merchandise is an income-producing factor.

This Portfolio analyzes when inventories must be used, the methods of valuation (e.g., cost, lower of cost or market, etc.), and the methods of determining the flow of inventory costs (e.g., specific identification, FIFO, LIFO). A decision to place all or a part of inventory on LIFO may have substantial tax effects in the year of election and subsequent years. Thus, the Portfolio describes the practical operation of LIFO and how it may be applied to a manufacturing or merchandising business.

The Portfolio discusses the tax considerations surrounding LIFO and is intended as a guide to current practice. It has been designed not only for taxpayers considering the adoption of LIFO, but also as a reference source for those already on LIFO.

It should be noted that although this Portfolio discusses the valuation of inventories for manufacturers under full absorption costing, these rules were significantly expanded under the Tax Reform Act of 1986 and a full examination of these rules is beyond the scope of this Portfolio. A discussion of the rules can be found in 576 T.M., Uniform Capitalization Rules: Inventory; Self-Constructed Assets; Real Estate, and 577 T.M., Uniform Capitalization Rules: Special Topics; Method Change Rules.


Kristine M. Mora

Kristine M. Mora, B.S., Michigan State University; M.S., Grand Valley State University; member, American Institute of Certified Public Accountants — Tax Accounting Technical Resource Panel; member, Michigan Association of Certified Public Accountants.

Barry A. Tovig

Barry A. Tovig, B.S., magna cum laude, Montclair State University; member, AICPA — Former Chair, Tax Accounting Technical Resource Panel; member, D.C. Institute of CPAs; formerly with Internal Revenue Service as Tax Law Specialist, Office of Chief Counsel, Corporation Tax (1981–1986) and Internal Revenue Agent, Wilmington District (1978–1981).

Table of Contents

Detailed Analysis

I. General Introduction

Introductory Material

A. History of Statutory and Regulatory Provisions

B. Statutory Framework

C. The Portfolio's Scope

II. The Need for Inventories

Introductory Material

A. Conditions for Using Inventories

1. Production, Purchase, or Sale of Goods Is Income-Producing

a. For Sale at a Profit

b. Supplies

c. Planned Overruns

2. Ownership Requirement

a. Title Considerations

b. Containers

3. Intent at Acquisition

a. Dual-Use Property

b. Treatment of Spare Parts

4. Ongoing Concern

B. Exception To General Conditions

1. In General

2. Real Estate Dealers

3. Farmers

4. Real Estate Mortgage Investment Conduits

III. Basic Requirements

Introductory Material

A. Best Accounting Practice

B. Clear Reflection of Income

IV. Valuation of Inventories in General

Introductory Material

A. Methods of Valuation

1. Cost

a. Definition

b. Trade Discounts

c. Cash Discounts

d. Incurred in Acquiring Possession

e. Excessive Costs

f. Government Payments to Purchasers of Commodities

2. Lower of Cost or Market

a. Basic Accounting Principles

b. Basic Tax Principles

3. Definition of Market

a. Purchased Goods

b. Manufactured Goods

c. Firm Sales Contract

d. Exceptions to Market Value

(1) No Open Market

(2) Offering at a Lower Price

4. Subnormal Goods

a. Definition

b. Offering at a Lower Price

5. Inventories Above Cost

6. Commingled Inventory

7. Shrinkage

a. Current Law

b. Prior Law

B. Flow of Cost Assumptions

1. Specific Identification



4. Average Costing

V. Valuation of Inventories for Manufacturers

Introductory Material

A. Basic Definitions

1. Product Costs or Inventoriable Costs

2. Production Costs

3. Direct Production Costs

4. Direct Materials Costs

5. Direct Labor Costs

6. Indirect Production Costs or Overhead

7. Fixed Indirect Production Costs

8. Variable Indirect Production Costs

B. Methods for Determining Which Production Costs Are Product Costs

1. Prime Costing

2. Variable or Direct Costing

3. Absorption Costing

a. Accounting Purposes

b. Tax Purposes

(1) Basic Rules

(2) Conflict with Other Tax Principles

C. Use of Predetermined Rates to Allocate Costs in Inventory Valuation

1. Basic Methods of Allocation

a. Standard Cost Method

(1) Setting Standard Cost Rates for Direct Materials and Direct Labor

(2) Setting Standard Cost Rates for Overhead

(a) Basis Used to Apply Overhead Cost to Products

(b) Setting Standards for Each Component

(c) Use of a Flexible Budget

(d) Fixed, Variable, and Semi-Variable Costs

(e) Setting a Standard Cost Rate for Variable Overhead

(3) Comprehensive Example

(4) Treatment of Variances

b. Manufacturing Burden Rate Method

2. Development of Predetermined Rates for Fixed Overhead Costs

a. In General

b. Practical Capacity Concept

VI. Inventory Valuation Methods for Special Taxpayers

A. Retailers

1. Inventory Valuation Under the Retail Method

2. Who May Use the Retail Method

3. Advantages and Disadvantages of the Retail Method

B. Dealers in Securities

1. Mark-to-Market Accounting Method for Dealers in Securities

a. Mark-to-Market - General Rule

b. Who Is a Dealer

c. Definition of a Security

2. Pre-1994 Law

C. Producers of Joint Products

D. Dealers in Commodities: Mark-to-Market Rules

E. Farmers

F. Automobile and Heavy Equipment Dealers

G. Automotive Remanufacturers

VII. LIFO - An Overview

A. Introduction

B. The LIFO Principle

C. Advantages of LIFO

D. Disadvantages of LIFO

VIII. Historical Development of LIFO

A. Early Concept - Specific-Goods LIFO

B. Origin of Dollar-Value Technique

C. Early Problems of Retailers

D. Hutzler Brothers Case

E. Basse Case

F. Litigation on Timeliness of LIFO Election

G. Dollar-Value LIFO for Manufacturers

1. IRS Opposition to Single Pool

2. Advisory Groups and Proposed Revenue Ruling

3. Dollar-Value Regulation

4. Klein Chocolate Co.

5. Simplified Dollar-Value LIFO Method for Small Taxpayers

H. Use of Government Price Indexes in Pricing Inventory

I. LIFO Recapture Rule

J. Earnings & Profits and Alternative Minimum Tax

K. Summary

IX. Technical Requirements for Adoption and Use of LIFO

A. Summary of Requirements

B. Time and Manner of Making Election - Checklist for Form 970

1. In General

2. Extension of Time to Make the Election

C. Opening LIFO Inventory Must Be at Cost

1. Write-Downs to Market Value

2. Subnormal Goods and Excess Stock

a. Subnormal Goods

b. Excess Stock

3. Average Cost

D. Determination of Cost

1. Specific Goods Method

2. Dollar-Value Method

3. Subsequent Adjustments to Cost

E. What Goods Can Be Part of LIFO

1. Retailers, Wholesalers, Jobbers, and Distributors

2. Manufacturers and Processors

3. Securities Dealers

4. Contractors

5. Real Estate Dealers

6. Lessors of Tangible Personal Property

7. Farmers

8. Timber

9. Utilities

F. Election Irrevocable by Taxpayer

G. Election Subject to Commissioner's Approval

H. Miscellaneous Restrictions

I. Readoption of LIFO

X. The Specific Goods Method

A. General Discussion

B. LIFO Computations

1. Increments

2. Decrements

3. Groupings

XI. The Dollar-Value Method

A. General Discussion

B. Methods of Computing LIFO Values

1. Double-Extension Method

2. Index Method

3. Link-Chain Method

C. Inventory Increments

1. Computation and Comparison of Three Methods

2. Any Other Proper Method

3. Use of Percentage of Completion-Capitalized Cost Method of LIFO

D. Earliest Cost Method Most Consistent with LIFO Principle

1. Procedures Relating to Earliest Cost Method - Dual Indexes

2. Another Approach to Earliest Cost Method

E. Other Methods

F. Technical Problems Associated with Application of Pricing Method

1. Moving Average

2. Average Price Index

3. No Purchases During Year

4. Quarterly Index

5. Determination of Index

6. Computations at Other Than Year-End

7. Exclusion of Inventory Items

8. Replacement Cost

9. Use of One Category of Items

10. Exclusion of New Items and Reconstructing Base-Year Costs of New Items

G. Current-Year Unit Costs Not Always Necessary

XII. Principles for Establishing LIFO Pools

A. General Discussion

B. Specific-Goods Method

1. Criteria for Pooling

2. Raw Materials Content Method

3. Pooling by Components of Cost

4. Pooling by Balance Sheet Classifications

C. Dollar-Value Pools - Manufacturers and Processors

1. Natural Business Unit Pools

2. Definition of Natural Business Unit

3. Purchased vs. Produced Goods

4. Multiple Pools

D. Pools for Wholesalers, Retailers, etc.

E. Single Pool Election Available for Small Business

1. Pre-1987 Rules

2. Post-1986 Rules

F. Pooling Under the Inventory Price Index Computation

G. Tax Planning

XIII. What Is an Item?

A. Introduction

1. Items of Manufacturers

2. Items of Wholesalers and Retailers

B. New Item Entering Pool After Base Year

1. Reconstruction of Base-Year Costs

2. Methods of Reconstructing Base-Year Costs

3. Establishing a New Base Year

XIV. The Inventory Price Index Computation Method and Simplified LIFO

A. Introduction

B. Inventory Price Index Computation Method

1. In General

2. Pooling

3. Adopting IPIC

4. Computing LIFO Under IPIC On or After December 31, 2001

a. Step 1 - Select Appropriate Table and Month

b. Step 2 - Assign Inventory Items to Categories

c. Step 3 - Compute Category Inflation Index

d. Step 4 - Compute Inventory Price Index

5. Examples of Computing LIFO Under IPIC On or After December 31, 2001

a. Double-Extension Method

b. Link-Chain Method

C. Section 474 - Simplified LIFO

1. In General

2. Election Requirements

3. Pooling Requirements

4. Selection of Indexes

5. Transitional Rules

XV. Retail LIFO Method

A. Introduction

B. Measuring Changes in Inventory Quantities

C. Bureau of Labor Statistics Indexes

D. Major Phases of the Retail LIFO Method

XVI. Bargain Purchase

XVII. Qualified LIFO Inventory Liquidations

A. Section 473 in General

B. Inventory Liquidation - Historical Background

XVIII. Transfers of Inventory in Nontaxable Transactions

Introductory Material

A. Transactions to Which § 381 Applies

1. Carryover Rules Not Applicable in Some Instances

2. Carryover Rules Apply to Inventory “Methods”

3. How the Applicable Rule Is Determined

a. No Difference in Inventory Methods

b. Separate Trades or Businesses

c. Integrated Trades or Businesses

4. Carryover of LIFO Base-Year Inventories and Layers

a. Acquiring Corporation Will Use LIFO; Transferor Had Used LIFO

b. Acquiring Corporation Will Use LIFO; Transferor Had Used FIFO

c. Acquiring Corporation Will Use FIFO; Transferor Had Used LIFO

5. Adjustments Resulting from Method Changes

6. Section 381(c)(5) Proposed Regulations

B. Capital Contributions or § 351 Transfer of LIFO Inventory

1. Transfer to an Existing Subsidiary That Used LIFO

2. Transfer to a Newly Formed Subsidiary or to an Existing Non-LIFO Subsidiary

3. Treatment of Transferor

C. Corporate Distributions

1. Liquidating Distributions

a. Pre-1986 TRA Law

b. Post-1986 TRA Law

2. Nonliquidating Distributions

a. Pre-1986 TRA Law

b. Post-1986 TRA Law

D. Transfers Between Members of an Affiliated Group Filing Consolidated Returns

1. Sale

2. Dividend or Return of Capital

3. Cancellation or Redemption

4. Contributions to Capital

E. Section 721 Transfers of LIFO Inventory to Partnerships

F. Section 338 Transactions and Lump Sum Purchases

XIX. Financial Reporting Conformity Requirements

A. Introduction

B. Conformity Regulations

1. Supplemental and Explanatory Information

2. Certain Balance Sheet Disclosures

3. Internal Management Reports

4. Interim Reports

5. Lower of LIFO Cost or Market

C. Financial Reports for the Year of LIFO Adoption and Later Years

D. Problems Related to Consolidated Financial Statements

1. LIFO Conformity Requirement Applied to Related Groups - § 472(g)

a. Insilco Corp. v. Comr.

b. Group of Financially Related Corporations

2. Intercompany Profits

3. Foreign Subsidiaries

E. Financial Accounting for Business Combinations

F. Section 351 Transfers

G. Retailers Using BLS Indexes

H. Election Under § 631(a): Cutting of Timber

I. Method Changes

J. IRS Audit Adjustments

K. Consolidated Tax Returns

L. Short-Period Returns

M. Disclosures Required by Government Agencies

N. Financial Forecasts

O. Miscellaneous Exceptions

1. Disclosure of Sharp Inventory Increases

2. Use of Different LIFO Methods

3. Premature Write-Downs

4. Inventoriable Costs

XX. Changes in LIFO Procedures Where LIFO Is Continued

Introductory Material

A. Changes Requiring Permission

1. Changes That Do Not Require a § 481(a) Adjustment

2. Changes That Require a § 481(a) Adjustment

B. Extension of LIFO Election

C. Information Required for Change in LIFO Method

XXI. Technical Rules for Combining and Splitting Pools

Introductory Material

A. Combining Pools Having the Same Base Year

B. Combining Pools Having Different Base Years

C. Splitting One Pool into Several Pools

XXII. Termination of LIFO

A. Change to Another Method at Taxpayer's Request

1. Filing an Application to Terminate LIFO Under Automatic Accounting Method Change Procedures

a. Eligibility

b. Taxpayers Not Eligible for Automatic Accounting Method Change Procedures

c. General Requirements of Automatic Accounting Method Change Procedures

d. Effective Date

e. Specific Requirements of Automatic Accounting Method Change Procedures

2. Filing an Application for Change in Accounting Method Under Rev. Proc. 97-27

B. Change Required by the IRS

XXIII. LIFO Recapture on C to S Corporation Conversions

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Form 970 - Application to Use LIFO Inventory Method - Natural Business Unit Pool

Worksheet 2 Form 970 - Application to Use LIFO Inventory Method - Application of a Wholesaler and Manufacturer

Worksheet 3 Comparative Computations Under the Double-Extension and Link-Chain Methods

Worksheet 4 Comparative Computation Methods Re: New Item Entering Pool at High Unit Cost

Worksheet 5 Calculation of Manufacturing Overhead Index

Worksheet 6 Manufacturing Costs Subject to Capitalization Under UNICAP

Worksheet 7 Accounting Standards - Original Pronouncements: Inventory Pricing (Accounting Research Bulletin 43 Chapter 4)

Worksheet 8 IRS Industry Specialization Program Coordinated Issue Paper on Dollar-Value LIFO Segment of Inventory Excluded from Computation of LIFO Index

Worksheet 9 IRS Industry Specialization Program Coordinated Issue Paper on Dollar-Value Last-In, First-Out Bargain Purchase Inventory

Worksheet 10 IRS Industry Specialization Program Coordinated Issue Paper on Dollar-Value LIFO Earliest Acquisition Method




Committee Reports:

Treasury Regulations:

Treasury Procedures and Rulings:


Financial Accounting Pronouncements: