You messed up, but you’re stuck with it. A California auto dealer decided to get off LIFO inventory. “Last-in, First-out” inventory accounting generally reduces current income by capitalizing smaller amounts in inventory over time. If you sell your business, however, it catches up with you — those savings all come into income at once.
The auto dealership operated as an S corporation. The owner decided that because he might be selling soon, he would go off LIFO using the automatic method change procedure then offered by the IRS. That procedure, Rev. Proc. 97-37, allowed him to spread the additional income over four years.
Something went wrong. The taxpayer represented on the Form 3115 filed under the IRS procedure that it would value all inventory under the lower of (FIFO) cost or market, but instead it valued its new cars, used cars and parts three different ways. This went unnoticed and unchallenged for a number of years, starting in 2001. Needless to say, the contemplated sale of the dealership did not occur in the meantime.
At some point, the dealership’s tax preparer concluded the different methods might be a problem after attending a seminar. In 2009, they filed amended returns for 2002 through 2007 that said the LIFO termination was ineffective and that as a result the taxable income for those years was overstated – by about $875,000 for 2002 and 2003 alone.
This led to a strange argument, where the taxpayer argued that their failure to properly follow Rev. Proc. 97-37 meant their LIFO termination was never effective. The IRS said the taxpayer’s inadequate compliance was good enough, and the taxpayer is stuck with the no-longer-desired LIFO termination.
Tax Court Judge Wherry decided that the automatic change failed — siding with the taxpayer — but that didn’t settle the issue:
First, we must decide whether, notwithstanding its failure to secure respondent’s automatic consent in 2001, JHH’s filing of its 2001 through 2007 tax returns in accordance with a new method of accounting was a change in method of accounting. If so, second, we must ascertain whether the amended returns reflect a further change in method of accounting for which respondent’s consent is again required. If it is, then because respondent has not consented to the change, JHH may not revert to the LIFO method simply by filing amended returns.
The court decided that the filing of on-LIFO returns for 2001 through 2007 by the taxpayer — referred to as “JHH” — effected an accounting method change, even though the automatic change was ineffective (citations omitted):
…”a short-lived deviation from an already established method of accounting need not be viewed as a establishing a new method of accounting.” And in that case, “neither the deviation from, nor the subsequent adherence to, the method of accounting would be a change in method of accounting.”
As we observed in Huffman: “The question, of course, is what is short-lived.”
Seven years wasn’t short enough, to the court:
Regardless of the upper temporal boundary of a “short-lived deviation”, we think that seven years lies beyond it. JHH’s “consistent treatment of an item involving a question of timing * * * establishes such treatment as a method of accounting.” Notwithstanding its failure to secure respondent’s automatic consent, JHH changed its method of accounting from LIFO by accounting for its vehicles inventory on the specific identification method on its 2001 through 2007 tax returns.
The court said the IRS has two choices when confronted with such an unauthorized method change: force the taxpayer to change to the old method, or accept the unauthorized change, imposing any adjustments necessary to avoid double-counting. The IRS chose to accept the change.
That meant the attempt to go back on LIFO was another method change, again requiring IRS consent. The IRS wasn’t going along, and the taxpayer was stuck with FIFO.
The moral? Many taxpayers filed automatic accounting method changes for 2014 under the “repair reg” rules. This case shows that the IRS can enforce the automatic method change conditions and deny benefits to taxpayers who don’t dot all of their “i”s.
It also shows reminds us that if you are doing something wrong for a number of years, it becomes “right,” in that it becomes an accounting method. It might be an improper method, but you still need IRS consent to change it. Many improper methods can be changed automatically, but sometimes advanced IRS permission is required. If you don’t do it “right,” the IRS holds all the cards.
Cite: Hawse, T.C. Memo. 2015-99; No. 8267-12
Tom VanAntwerp, How Hackers Breached the IRS and Stole $50 Million (Tax Policy Blog):
Nicholas Weaver, a researcher at the University of California, Berkeley, previously tried to access his own transcripts without resorting to personal knowledge. Using the real estate website Zillow and personal information site Spokeo, he was able to successfully find answers to the personal questions that only he should have known.
Cybercriminals who specialize in stealing and processing this personal data en masse were able to answer these identifying questions at scale. Much of the information used by the IRS to verify identity is either publicly available or for sale to underground cybercriminals. Hackers can buy access to stolen consumer or financial data, and then write a program to plug answers into the questions asked by the IRS. Once hackers successfully claim an identity, they can use the information from previous years’ tax returns to file new, fraudulent returns and steal tax refunds.
That’s… not comforting.
Our friends the Russians. AP sources: IRS believes identity thieves from Russia (KWWL.com)
TaxProf, GAO, TIGTA Warned Of IRS’s Lax Computer Security For Years Before Hack Of 100,000 Taxpayer Accounts On IRS Website.
William Perez, What Can We Do Differently in Light of the IRS Data Breach. Some suggestions for protecting your personal data.
Robert D. Flach, WHAT A DISRUPTIVE DEVELOPMENT THIS IS!. Robert refers to the late arrival of corrected 1099s. “Clients who would normally send me their “stuff” in early or mid-February – allowing for a much smoother work flow during the season – now must wait until mid-March because of the need to “wait and see” if corrected brokerage reports arrive.”
Russ Fox, Surprise! You Heard About that May 29th Filing Deadline, Right?.
TaxGrrrl, Taxpayers Have More Time To File In 2016. “Three more days!”
Robert Wood, Man Gets Prison For Inventing His Own Church, And It’s Not Scientology. Technically, his prison time isn’t for starting a new church — that’s legal — but for using it to evade taxes.
Peter Reilly, Limits Of Hobby Lobby – Priests For Life Denied Rehearing On Contraception Mandate.
Kay Bell, Italy charges Bulgari luxury jewelry heirs with tax evasion
Len Burman, The Trouble with the FairTax (TaxVox). Mr. Burman concentrates on its distribution among income classes, rather than its overall implausibility.
TaxProf, The IRS Scandal, Day 749
Career Corner. Reminder: Robots Are Coming For Your Accounting Jobs (Caleb Newquist, Going Concern).