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Lower-of-cost-or-market: it didn't mean what they thought it meant

October 28, 2008

Some taxpayers who value inventories on the first-in, first-out, lower-of-cost-or-market (FIFO-LCM) method think that it gives them unfettered ability to write down inventory as needed to control taxable income. That's not necessarily so, as the Tax Court demonstrated yesterday.

A California Dodge dealer took over $300,000 in LCM markdown deductions on used cars in 1999 and 2000. The tax law specifically allows this method, but not only with restrictions. The Tax Court summarized the rules this way (citations omitted; my emphasis):

A taxpayer using the lower of cost or market method of valuing inventory may write-down a decline in the value of merchandise from its cost to a lower market value in the year in which the decline occurs, even though the goods have not been sold. This is referred to as an inventory write-down. If the market value of the inventory at the end of the year is lower than its cost, the taxpayer writes down the basis of the inventory to the lower market value, thereby reducing gross income. Deducting a reserve for price changes from the inventory or writing down inventory based on mere estimates, however, is not allowable. Further, we will not disturb the Commissioner's determination disallowing a taxpayers's write-downs without objective evidence substantiating an item-by-item comparison of cost-to-market value.

In short - you have to be able to demonstrate that each item has declined in value, and you can't just deduct a general valuation or obsolescence reserve.

The Dodge dealer went about the computation this way:

Petitioner's accountant determined market value for writedown purposes as the wholesale Kelly Blue Book value with the assumption that the automobiles were in average condition.8 Petitioner's accountant testified that it is necessary to know the make, model, and year of the automobile, as well as the automobile's condition, mileage, and equipment options to determine the Kelly Blue Book value. Yet petitioner's write-down records do not include complete information. Petitioner's records lack the make, model, and year of several automobiles and do not include the mileage, condition, or options of any automobiles. Petitioner argues that this method is the industry standard and any differences between the method used and a more detailed analysis would have been immaterial. We are not persuaded given the incomplete write-down records and absence of any corroborating evidence to support the estimated Kelly Blue Book values.

Lesson #1: At least with cars, the Tax Court says you need to do your computation car-by-car based on mileage, condition, options and the like. But then the dealer made a worse blunder:

In addition, petitioner did not then use its write-down calculations of $309,172.04 in 1999 and $344,207.67 in 2000 to determine its cost of goods sold. Rather, petitioner violated the regulations when it substituted a reserve amount of $340,181.09 as the write-down for both years.

Lesson #2: you can't deduct an inventory reserve. You can only deduct actual LCM markdowns, determined item-by-item.

There's no explanation of why the dealer went through the trouble of valuing inventory and then just trying to deduct a reserve. This made it easy for the judge - inventory reserves are clearly not deductible.

Cite: West Covina Motors, Inc., T.C. Memo. 2008-237

Tags: inventories.