IRS Addresses Phantom Incomes And Ghost Core Values
By Mike Conlon
Sometimes patience and perseverance pays off. Over eight years ago my client, the Automotive Parts Rebuilders Association (APRA), learned that the Internal Revenue Service had issued new internal guidelines directing how rebuilders must value their core inventories for tax purposes. Of particular concern to the industry was the way IRS wanted a rebuilder to value the cores returned by his customer.
With no real input from the industry, the IRS determined that the only proper inventory value for these cores was the credit given to the customer when the core was returned. This valuation conflicted with the historic practice in the industry which generally valued customer cores at core supplier price or less. APRA recognized that if the new IRS policy was implemented and core inventories had to be written up, many rebuilders would have sizeable phantom income on which they would be taxed.
To avoid this potentially devastating result, APRA undertook extensive efforts to convince IRS that its position was erroneous and should be changed. It was supported in these efforts by the Engine Rebuilders Association (AERA) and the Production Engine Remanufacturers Association (PERA). APRA’s efforts included holding numerous meetings with IRS policymakers in Washington, DC; submission of several proposals to change the IRS position to conform it to industry practice; promotion of the industry position with the tax oversight committee on Capitol Hill and numerous Congressmen influential on tax matters; and providing substantial legal and financial support in the Consolidated Manufacturing case.
For many years these efforts seemed to have little or no success. But following the defeat of the IRS position in the appeal of the Consolidated Manufacturing case, APRA’s efforts were renewed and now success seems imminent.
Following publication of the Consolidated Manufacturing decision in the spring of 2001, APRA and its representatives engaged in numerous telephone conversations and consultative meetings with the IRS. These resulted in the submission by APRA of a proposed formal revenue procedure, which, if adopted by the IRS, would allow use of core supplier price as an acceptable value. After some initial delay, the IRS signified its intent to seriously deal with this issue by creating a formal working group to consider the industry proposal.
The specific charge to this group was to develop a formal IRS policy on core valuation which was consistent with the decision of the appellate court in Consolidated Manufacturing. Because the appellate court had found that those rebuilders who value their core inventories on the "lower of cost or market value" basis could use core supplier prices as their core values, the working group had a mandate to adopt what was largely the industry position.
In early July, representatives of APRA met with the IRS working group to review the proposal submitted by APRA, and to discuss the details of how the proposal would be implemented. Since that time, the IRS working group has met several times and a second meeting with APRA is scheduled soon. At that meeting, the IRS will present any changes it thinks are necessary to the industry proposal. The intent of both sides is to have a final decision on the new core policy by the end of October.
While the final position of the IRS is still unknown, one thing is virtually certain. The new policy will allow rebuilders to value their cores at core supplier prices as long as they do not use the last-in, first-out (LIFO) method of inventory valuation. LIFO taxpayers can only value their inventories at cost.
Non-LIFO taxpayers can elect to value their inventories at the lower of cost or market value. Both the IRS and the Consolidated Manufacturing court decision have held that the core credit is the "cost" for any core that a rebuilder takes back from his customer. Therefore, a LIFO taxpayer is stuck with that value.
However, consistent with the court, the IRS is willing to concede that the "market value" of the core is not the core credit but the price at which the core can be purchased from a core supplier. Thus, those taxpayers who have a choice between using cost and market value can value their cores at the core supplier price, if it is lower than the core credit.
Proving the core supplier price for a core in any given year will be the obligation of the rebuilder. The best evidence, of course, would be the actual price that a rebuilder purchased the same or a similar core from a core supplier. Under APRA’s proposal, a rebuilder could use such purchases as his value as long as they occurred at some time during the taxable year that the inventory valuation is being made, or within 30 days after the end of that taxable year.
However, most rebuilders do not purchase all of the different cores in their inventories from a core supplier during a particular year. Therefore, APRA suggested, and we believe the IRS will accept, the use of "core broker list prices" – prices paid to core brokers by other remanufacturers in the same region, prices listed in core broker advertising or Web sites for cores in the same region, or other similar pricing information. No matter what proof the IRS agrees to accept all rebuilders will have to retain written proof of the core broker prices they used and the source for those figures.
Other methods for valuing inventory that may yield a value lower than the core broker price won’t be allowed by IRS. Therefore, writing off usable cores entirely or valuing them at scrap value will result in a tax deficiency being assessed if the rebuilder is audited.
Valuing an unusable core at scrap value is permitted if the rebuilder can show he made legitimate efforts to sell the core at that value. Other valuation methods, such as using the price a core broker pays for a core or taking the core broker price and reducing it by some percentage, will also not be allowed.
We are negotiating with the IRS to accept a percentage reduction in the core broker price for those cores in inventory that will eventually be found unusable, i.e., a "fall-out" percentage. As part of the proposal, a specific percentage was suggested for the entire industry as a "safe harbor" fall-out figure. This safe harbor percentage was derived from past history in the industry. If a rebuilder used this safe harbor percentage to reduce his inventory value, he would not have to calculate his actual fall-out and IRS would accept the figure without any proof.
However, IRS officials have indicated that they may not be able to accept a safe harbor figure for legal reasons. Therefore, while it seems likely that they will accept the concept of a "fall-out" reduction, if a rebuilder wishes to reduce his inventory reduction for fall-out, he will probably have to demonstrate his own fall-out percentage based on his history of unusable cores.
Also important is the procedure by which a rebuilder may change his valuation method to this new method. New rebuilders do not have a problem. They can adopt the new core broker valuation method in their first tax year. But current rebuilders will have to change their inventory valuation to take advantage of the new procedure. Whether the rebuilder is changing from scrap value or from a value based on the customer credit, he cannot simply change the valuation method without notifying IRS.
There will be a formal procedure for rebuilders to notify IRS that they’re electing to use the new valuation method and change inventory values. As proposed by APRA, this election would best be made for the rebuilder’s first taxable year, which begins at least 180 days after the new valuation method is published by IRS. If a rebuilder elects the new method for that taxable year, IRS will accept the new method and also agree not to audit the rebuilder on his inventory valuation figures for any previous year.
Rebuilders who fail to make the election during that first taxable year may still do so in later years, but will not have any protection from IRS challenging their core inventory valuations on their previous years’ returns. So it is important for any rebuilder who wishes to adopt the new method to do so in that first taxable year.
Also not resolved is the number of years over which the rebuilder will be allowed to "spread" the inventory valuation change. For those valuing core inventories at scrap or less, an inventory write-up in one tax year would create a significant tax liability. The industry asked IRS to allow the change to be spread over six years so that one-sixth of the tax generated by the change would be due each year.
The IRS is willing to allow such a tax spread but is likely to limit it to three or four years.
The new willingness of IRS to accommodate the concerns of rebuilders on inventory valuation issues is very good news for rebuilders.