                           126 T.C. No. 17



                       UNITED STATES TAX COURT



         DOW A. AND SANDRA E. HUFFMAN, ET AL.,1 Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 2845-04, 2846-04,       Filed May 16, 2006.
                 2847-04, 2848-04.

          The sole issue for decision is whether a
     correction to the inventory method employed by S
     corporations owned by certain of the petitioners
     constitutes an accounting method change that requires
     an adjustment pursuant to sec. 481, I.R.C. For periods
     ranging from 10 to 20 years, the corporations’
     accountant, in applying the link-chain, dollar-value
     method of valuing LIFO inventory, omitted a step
     required by that method.

          Held: R’s revaluations of the corporations’
     inventories, to correct for the accountant’s omissions,
     constituted changes in a method of accounting employed by
     the corporations, requiring adjustments pursuant to sec.
     481, I.R.C., to prevent amounts of income from being omitted
     solely on account of the changes.

     1
        Cases of the following petitioners are consolidated
herewith: James A. and Dorothy A. Patterson, docket No. 2846-04;
Douglas M. and Kimberlee H. Wolford, docket No. 2847-04; and Neil
A. and Ethel M. Huffman, docket No. 2848-04.
                                 - 2 -


     Charles Fassler, Mark F. Sommer, Jennifer S. Smart, and

Brett S. Gumlaw, for petitioners.

     Mark D. Eblen, for respondent.



                              OPINION


    HALPERN, Judge:    These cases have been consolidated for

purposes of trial, briefing, and opinion.    By notices of

deficiency dated December 19, 2003 (the notices), respondent

determined deficiencies in Federal income taxes as follows:

                                           Taxable (Calendar) Year
                                                 Deficiency
Petitioners (Husband and Wife)           1997       1998      1999

Dow A. and Sandra E. Huffman             --      $36,757      $9,413
James A. and Dorothy A. Patterson        --       35,542         --
Douglas M. and Kimberlee H. Wolford      --       33,422       1,966
Neil A. and Ethel M. Huffman        $131,408     535,065     304,033

     Petitioners have conceded some of the adjustments made by

respondent that give rise to the deficiencies in question, and

other adjustments are merely computational and do not require our

attention.   The sole issue for decision is whether a correction

to the inventory method employed by corporations owned by certain

of the petitioners constitutes an accounting method change that

requires an adjustment pursuant to section 481 of the Internal

Revenue Code of 1986, as amended and in effect for the years in
                               - 3 -

issue.2

     Some facts have been stipulated and are so found.   The

stipulation of facts, with accompanying exhibits, is incorporated

herein by this reference.   We need find few facts in addition to

those stipulated and shall not, therefore, separately set forth

our findings of fact.   We shall make additional findings of fact

as we proceed.

                            Background

     All petitioners except for James A. and Dorothy A. Patterson

resided in Kentucky at the time they filed their respective

petitions.   The Pattersons resided in Florida at the time they

filed their petition.

The Huffman Group

     The Huffman group of corporations (Huffman group) consists

of four members (sometimes, the members):   Neil Huffman Nissan,

Inc. (Nissan); Neil Huffman Volkswagen, Inc. (Volkswagen); Neil

Huffman Enterprises, Inc., d.b.a. Neil Huffman Dodge (Dodge); and

Neil Huffman, Inc., d.b.a. Huffman Chrysler Plymouth (Chrysler).

The members sell new and used automobiles in Kentucky.   At least

one of each married pair of petitioners owns stock in one or more

of the members.   Each of the members has elected to be treated as

an S corporation under the provisions of section 1361.


     2
        Hereafter, all section references are to the Internal
Revenue Code of 1986, as amended and in effect for the years in
issue.
                                - 4 -

Use of Inventories

     The members of the Huffman group all sell merchandise (new

and used automobiles).   Each, therefore, computes its gross

income from sales during a year by subtracting from sales revenue

the cost of the goods sold.   See sec. 1.61-3(a), Income Tax Regs.

Because each is a merchant, each must also use inventories and an

accrual method of accounting to determine the cost of the goods

sold and to match that cost against sales revenue.   See secs.

1.471-1 (merchants must use inventories) and 1.446-1(c)(2)(i)

(generally, where inventories necessary, accrual method must be

used with regard to purchases and sales), Income Tax Regs.     As

explained by Stephen F. Gertzman (Gertzman) in his treatise,

Federal Tax Accounting, par. 6.02[2], at 6-5 & 6-6, (2d ed. 1993)

(cited hereafter as Gertzman par. __, at __), in the case of a

merchant that sells a large number of essentially similar or

fungible items, the cost of the goods sold during any period is

computed in steps, using inventories and an accrual method of

accounting, along with various assumptions as to the manner in

which the actual costs incurred in acquiring or producing items

of inventory are allocated among the items so acquired or

produced.   To compute the cost of goods sold during a year, the

steps are as follows:    First, the costs of the items acquired or

produced during the year are aggregated.    That total is then

combined with the aggregate cost of the items on hand at the
                                  - 5 -

beginning of the year to produce the total cost of the goods

available for sale during the year.       That last total is then

allocated among items on hand at the end of the year (cost of

ending inventory) and items sold during the year (cost of goods

sold).   The formula for determining cost of goods sold is

essentially as follows:

             Cost of beginning inventory
         +   Purchases and other acquisition or production costs
         =   Cost of the goods available for sale
         -   Cost of ending inventory
         =   Cost of goods sold

     Various cost-flow assumptions are used to allocate the cost

of goods available for sale between goods sold during the year

and goods remaining on hand at the end of year.      Two assumptions

generally used for financial accounting and tax purposes are

first-in, first-out (FIFO) and last-in, first-out (LIFO).3          Id.

par. 6.08[2], at 6-84.     Under FIFO, it is assumed that the first

goods acquired or produced are the first goods sold and that the

goods remaining in ending inventory are the last goods acquired

or produced.     Id.   Under LIFO, it is assumed that the last goods

acquired or produced are the first goods sold.4      Id.   We are


     3
        FIFO is authorized by sec. 1.471-2(d), Income Tax Regs.,
and LIFO is authorized by sec. 472.
     4
        The following example is based on an example in Gertzman,
Federal Tax Accounting, par. 7.02, at 7-4 (2d. ed. 1993) (cited
hereafter as Gertzman par. __, at __):

     Example:     Assume that, in its first year of operation, a
                                                      (continued...)
                                - 6 -

concerned here with certain aspects of LIFO.

The LIFO Method

     –- Introduction

     We have said “the overriding purpose of * * * LIFO * * * is

to match current costs against current income.”      UFE, Inc. v.

Commissioner, 92 T.C. 1314, 1322 (1989).      Gertzman describes the

objective of the LIFO method similarly:      “The objective of the

LIFO method is to match relatively current costs against current


     4
      (...continued)
retailer acquires identical products at the following times and
costs:

           Date        Number    Unit Cost       Total

          Jan.   1       10        $1.00        $10.00
          Apr.   1       15         1.02         15.30
          July   1       15         1.04         15.60
          Oct.   1       10         1.06         10.60
                         50                      51.50

Assuming that 12 units remain on hand at the end of the year, it
is necessary to determine what portion of the $51.50 aggregate
cost of goods available for sale should be allocated to those 12
units. The balance will be allocated to the 38 units sold and
will be deemed the cost of goods sold.

     Under FIFO, the ending inventory would be deemed to cost
$12.68 (consisting of a layer of 10 units at $1.06 a unit and a
layer of 2 units at $1.04 a unit). The balance of the cost of
goods available for sale, $38.82, would be allocated to the 38
units sold and would be deemed the cost of goods sold.

     Under LIFO, the ending inventory would be deemed to cost
$12.04 (consisting of a layer of 10 units at $1.00 a unit and a
layer of 2 units at $1.02 a unit). The balance of the cost of
goods available for sale, $39.46, would be allocated to the 38
units sold and would be deemed the cost of goods sold.
                                   - 7 -

revenues to compute a meaningful gross profit.”       Gertzman par.

7.02[1], at 7-4. Gertzman posits that businesses have a

continuing need for a certain level of inventory, and he

justifies LIFO on the ground that the changing costs associated

with maintaining that level of inventory should be expensed in

the year incurred.      Id.   Gertzman believes that the LIFO

objective of matching is achieved because the costs associated

with changing prices are generally reflected in the cost of goods

sold.     Id. at 7-5.   To the extent so reflected, those costs (when

increasing) are, in effect, treated as deductible expenses.5      See

id.   Because the LIFO method matches current revenues against

relatively current costs, Gertzman views the LIFO method of

accounting as producing a “meaningful” or “true” measure of the

gross profit from sales for a period.       Id. at 7-4 & 7-5.

      For a taxpayer whose ending inventory computed under LIFO

reflects the lower prices of antecedent purchases (rather than

the higher price of current purchases), the income tax advantage

of LIFO is obvious: a reduction in current income, leading,

generally, to a reduction in current income tax.      The potential

for increased gain on account of the allocation of the lower



      5
        In the example supra in note 4, the use of LIFO instead
of FIFO increased the cost of goods sold by $0.64 (from $38.82 to
$39.46). That $0.64 represents the inflation that had occurred
during the year in the cost of the 12 items that remained on hand
at the end of the year ((10 units x increase in price of $0.06 a
unit) + (2 units x increase in price of $0.02 a unit)).
                               - 8 -

costs of antecedent purchases to ending inventory is not

eliminated, however; it is simply deferred until, in time, there

is a liquidation of the items to which those lower costs have

been allocated.   See id. at 7-5.   The term “LIFO reserve” refers

to the amount by which the FIFO value (e.g., the current

replacement cost) of inventory exceeds the LIFO value shown in

the accounting records of the taxpayer.   See id. par. 7.03[2], at

7-15.6   It is a measure of the potential gain in a store of

inventoried items on account of the use of the LIFO method.

     There is more than one method for computing the value of a

LIFO inventory.   Id. par. 7.04[1], at 7-30.   Nevertheless, all

LIFO computational methods involve essentially three

determinations:   (1) The LIFO inventory must be segmented into

groups or “pools” of similar items; (2) a determination must be



     6
        In the example supra note 4, assuming LIFO, the LIFO
reserve at the end of the year would be $0.64, calculated as
follows:

     FIFO value (current replacement cost)
     of ending inventory:
           2 units at $1.04 = $2.08
          10 units at $1.06 = 10.60
                                               $12.68

     LIFO value of ending inventory:
          10 units at $1.00 = $10.00
           2 units at $1.02 =   2.04
                                                12.04
           Difference (LIFO reserve):            0.64
                                - 9 -

made as to whether there has been a quantitative change in the

inventory of each pool during the period in question, and (3)

there must be a determination of the manner in which increments

to (i.e., increases in the quantity of) each pool are to be

valued.   Id.   We are here concerned mainly with the third of

those determinations.

     Two basic LIFO computational methods are permitted by the

income tax regulations: the specific goods method, a measure of

inventory in terms of physical units of individual items, see

sec. 1.472-2, Income Tax Regs., and the dollar-value method, a

measure of inventory in terms of dollars, see sec. 1.472-8,

Income Tax Regs.   Each method is designed to make the three

determinations previously identified.   Gertzman par. 7.04[1], at

7-30.   We are here concerned with the dollar-value method.

     –- Dollar-Value Method of Valuing LIFO Inventories

     Gertzman explains the dollar-value method as follows:

          Under the dollar-value method, the common
     denominator for measuring items within a pool is not
     units, such as pounds or yards, but dollars as of a
     particular date. Thus, a reduction in the number of
     inventory items within a pool will not reduce the LIFO
     value of the inventory as long as the total inventory
     stated in base-year dollars (i.e., the base [year] cost
     of the inventory) is not reduced. The base [year] cost
     of an item is generally what the item cost or would
     have cost at the beginning of the year for which LIFO
     was first adopted.

Id. par. 7.04[3], at 7-36 (fn. ref. omitted).    The dollar-value

method is described similarly in section 1.472-8(a), Income Tax
                                - 10 -

Regs.7


     7
        Consider the following example of the dollar-value
method, based on Gertzman par. 7.04[3], at 7-37.

     Assume that T (a manufacturer) began operations a number of
years ago with 4 pounds of item A that cost $0.10 a pound. Its
total inventory was thus valued at $0.40. Normal operations
require the taxpayer to purchase and consume 4 pounds of A each
year. The LIFO value of its closing inventory would, thus, have
remained $0.40 notwithstanding that the cost of A increased to
$0.50 a pound in the interim. Assume further, that, because of
technical advantages, an equal quantity of item B may now be used
in lieu of item A. The current price of B is $0.40 a pound, and,
because of the price advantage of B over A ($0.10), T, this year,
purchases 4 pounds of B and consumes its remaining stock of A.
Like A, B has a base-year cost of $0.10. Under those facts, if T
follows the dollar-value method with a single inventory pool that
includes both items A and B, its cost of goods sold and ending
inventory will be as follows:

     Quantitative change in base-year cost of inventory:
          Beginning inventory at base-year cost
          (4 pounds of A at $0.10)                $0.40
          (0 pounds of B at $0.10)                 0.00
                                                   0.40

          Ending inventory at base-year cost
          (0 pounds of A at $0.10)                 0.00
          (4 pounds of B at $0.10)                 0.40
                                                   0.40

          Increase in inventory cost               0.00

     LIFO value of inventory:
          Beginning inventory                      0.40
          Ending inventory                         0.40

     Cost of goods sold:
          Beginning inventory                      0.40
          Purchases (4 pounds of B at $0.40/lb)    1.60
                                                   2.00
          Less: Ending inventory                   0.40
          Cost of goods sold                       1.60


                                                   (continued...)
                               - 11 -

     Under the dollar-value method, once items have been grouped

into pools, the next step is to determine whether there has been

any change in the quantity of dollars invested in the pools over

the year.   See Gertzman par. 7.04[3][b], at 7-44.    Those changes

are determined by comparing the aggregate base-year cost of the

items in a pool at the beginning of the year to the aggregate

base-year cost of the items in the pool at the end of the year.

See id. par. 7.04[3][b], at 7-44 to 7-45.      If the latter exceeds

the former, there has been an increment in the pool; if the

former exceeds the latter, there has been a liquidation of all or

part of the pool.   Id. par. 7.04[3][b], at 7-45.     The base-year

cost of an item in a pool is the cost of the item (or what would

have been the item’s cost if it had been added to the pool) as of

the base date.   See id.   “Base date” is the first day of the

first year for which LIFO is adopted.    Id.    A similar description



     7
      (...continued)
     LIFO reserve at end of year:
          Replacement cost of ending inventory
          (4 pounds of B at $0.40/lb)                  1.60
          Less: LIFO value of ending inventory         0.40
          LIFO reserve                                 1.20

     The dollar-value method allowed T to take full advantage of
the current cost of B in determining its cost of goods sold. By
focusing solely on the change in the dollar value of T’s total
inventory investment, rather than the specific mix of items
constituting that investment, the dollar-value method allowed T
to liquidate its investment in A without incurring a tax on past
inflation. The LIFO reserve measures the potential gain built
into the inventory pool.
                               - 12 -

of the procedure for measuring the change in the size of a pool

is found in section 1.472-8(a), Income Tax Regs.

      Under any application of the dollar-value method, it is

necessary to have a means for computing the base-year costs of

the items in a pool and for computing the value of any increment

in, or liquidation of, the pool.    Gertzman par. 7.04[3][b], at 7-

45.   As stated by the regulations, with respect to an increment:

“In determining the inventory value for a pool, the increment, if

any, is adjusted for changing unit costs or values by reference

to a percentage, relative to base-year cost, determined for the

pool as a whole.”    Sec. 1.472-8(a), Income Tax Regs.     Three

methods for making those computations are authorized by section

1.472-8(e)(1), Income Tax Regs.: the double-extension method, an

index method, and a link-chain method.      The following Example

(1), based on an example in the regulations illustrating the

double-extension method,8 shows how all three methods work.

Example (1) demonstrates the computation of T’s ending inventory

for year 1.

     Example (1): T elects, beginning with calendar year 1, to
compute its inventory by use of the dollar-value LIFO method. T
creates Pool No. 1 for items A, B, and C. The composition of the
inventory for Pool No. 1 at the base date, January 1 of year 1,
is as follows:

      Items           Units     Unit Cost       Total Cost

          A           1,000        $5.00          $5,000


      8
          Sec. 1.472-8(e)(2)(v), Example (1), Income Tax Regs.
                                 - 13 -

       B            2,000        4.00               8,000
       C              500        2.00               1,000
       Total base year cost, Jan. 1, yr. 1         14,000

     At December 31, year 1, the closing inventory of Pool No. 1
contains 3000 units of A, 1,000 units of B, and 500 units of C.
T computes the current-year cost of the items making up the pool
by reference to the actual cost of the goods most recently
purchased. The most recent purchases of items A, B, and C are as
follows:

                                      Quantity             Unit
     Items      Purchase Date         Purchased            Cost

       A        Dec. 15, yr. 1            3,500           $6.00
       B        Dec. 10, yr. 1            2,000            5.00
       C        Nov. 1, yr. 1               500            2.50

     The inventory of Pool No. 1 at December 31, year 1, shown at
base-year and current-year costs is as follows:

                          Dec. 31, yr. 1,
                          inventory at              Dec. 31, yr. 1,
                          Jan. 1, yr. 1,            inventory at
                          base-year cost            current-year cost
    Items    Quantity   Unit Cost   Amount         Unit Cost   Amount

       A      3,000     $5.00      $15,000        $6.00           $18,000
       B      1,000      4.00        4,000         5.00             5,000
       C        500      2.00        1,000         2.50             1,250
       Totals                       20,000                         24,250

     If the amount of the December 31, year 1, inventory at base-
year cost were equal to, or less than, the base-year cost of
$14,000 at January 1, year 1, that amount would be the ending
LIFO inventory at December 31, year 1. However, since the base-
year cost of the ending LIFO inventory at December 31, year 1,
amounts to $20,000, and is in excess of the $14,000 base-year
cost of the opening inventory for that year, there is a $6,000
increment in Pool No. 1 during that year. That increment must be
valued at current-year cost; i.e., multiplied by the ratio of
$24,250 to $20,000 (24,250/20,000), or 121.25 percent. The LIFO
value of the inventory in Pool No. 1 at December 31, year 1, is
$21,275, computed as follows:
                                   - 14 -

                                            Ratio(as a
                                            percentage)
                      Dec. 31, yr. 1        of total
                      inventory at          current-year   Dec. 31, yr. 1,
                      Jan. 1, yr. 1,        cost to total inventory at
                      base-year cost        base-year cost LIFO value
     Jan. 1, yr. 1,
     base cost           $14,000             100.00%         $14,000

     Dec. 31, yr. 1,
     increment             6,000             121.25%           7,275
       Totals             20,000                              21,275

     The LIFO reserve for Pool No. 1 as of December 31, yr. 1, is
$2,975, computed as follows:

     Dec. 31, yr. 1, inventory at current-year cost           $24,250
     Less: LIFO value of ending inventory                      21,275
     Equals: LIFO reserve                                       2,975

     –- Link-Chain Method

     Where use of either an index or double-extension method is

impractical or unsuitable due to the nature of the inventory in a

dollar-value pool, a taxpayer may use a link-chain method of

computing the LIFO value of the pool.         Sec. 1.472-8(e)(1), Income

Tax Regs.   The regulations do not contain any examples that

illustrate the computational procedures employed in using a link-

chain method.   Leslie J. Schneider, in his treatise, Federal

Income Taxation of Inventories (2006), explains the link-chain

method as follows:

     [T]he link-chain method is comparable to the double-
     extension method, except that the base year is rolled
     forward each year. Thus, instead of comparing the
     current-year cost and the base-year cost of each item in
     the ending inventory, under the link-chain method, the
     current-year cost and the preceding year’s cost
     (referred to as the item’s “prior-year cost”) of each
     item are compared. This comparison is used to compute a
                                   - 15 -

     one-year index, referred to as the current years’ index.
     Each year’s current-year index is multiplied (or
     “linked”) to all preceding year’s [sic] current-year
     indexes to arrive at a cumulative price index that
     relates back to the taxpayer’s base year.

1 Schneider, Federal Taxation of Inventories, sec. 14.02[3][b], at

14-100.7 – 100.8 (2006) (fn. refs. omitted).9

     The following example, Example (2), continues the facts of

Example (1).    It is based on the assumption that, as of the

beginning of year 1, in addition to electing to compute its

inventory by use of the dollar-value LIFO method, T elected to use

the link-chain method to compute the base-year and current-year

cost of its inventory pools.       Example (2) illustrates the

computation of T’s ending inventory for Pool No. 1 for year 2.         An

increment in year 2 closing inventory is determined to exist at

base-year costs, and a LIFO value is assigned to that increment,

using yearly increments in cost, as shown.

     Example (2): During year 2, T completely disposes of Item A
and purchases Item D, which is properly includible in Pool No. 1.
T constructs a prior year unit cost for Item D.

                           Dec. 31, yr. 2,         Dec. 31, yr. 2,
                            inventory at             inventory at
                           prior-year cost         current-year cost
     Items     Quantity   Unit Cost   Amount      Unit Cost    Amount

         B     2,000       $5.00     $10,000        $6.00        $12,000
         C       500        2.50       1,250         3.00          1,500
         D     2,500        6.00      15,000         8.00         20,000
         Totals                       26,250                      33,500


     9
        The computational procedures for the link-chain method
are described by the Commissioner in Rev. Proc. 97-36, sec.
2.04(1)(c) and (d), 1997-2 C.B. 450, 451.
                               - 16 -

                          (33,500/26,250 = 127.62%)

     Cumulative index:
     Base-year cost of Dec. 31, yr. 2, inventory:
     1st year percentage link                            121.25%
     2nd year percentage link                            127.62%
     Product: chain percentage, Dec. 31, yr. 2, relative
     to Jan. 1, yr. 1, base date (121.25% x 127.62%)     154.74%

     Base-year cost ($33,500/154.74%)                     $21,649

     The LIFO value of the inventory in Pool No. 1 at December 31,
year 2, is $23,379, computed as follows:

                                      Ratio (as a
                                     percentage) of
                   Dec. 31, yr. 2,    current-year    Dec. 31, yr. 2,
                    inventory at        cost to        Inventory at
                   base-year cost    base-year cost     LIFO value
     Jan. 1, yr. 1,
     base cost      $14,000             100.00%        $14,000

     Dec. 31, yr. 1,
     increment         6,000            121.25%          7,275

     Dec. 31, yr. 2,
     increment        1,649             154.74%          2,552
       Totals        21,649                             23,827

     The LIFO reserve for Pool No. 1 as of December 31, yr. 2, is
$9,673, computed as follows:

     Dec. 31, yr. 2, inventory at current-year cost      $33,500
     Less: LIFO value of ending inventory                 23,827
     Equals: LIFO reserve                                  9,673

     Example (3) continues the facts of Example (2).   At base-year

costs, year 3 closing inventory is less than year 2 closing

inventory, indicating that a liquidation of inventory has occurred

during year 3.   That liquidation is reflected by the elimination of

the year 2 layer of inventory and a reduction in the year 1 layer

of inventory.
                                  - 17 -

     Example (3):
                         Dec. 31, yr. 3,              Dec. 31, yr. 3,
                          inventory at                 inventory at
                         prior-year cost             current-year cost
     Items   Quantity   Unit Cost   Amount           Unit Cost   Amount

      B     1,500         $6.00     $9,000            $6.00       $9,000
      C       600          3.00      1,800             4.00        2,400
      D     2,500          8.00     20,000             7.00       17,500
      Totals                        30,800                        28,900

                           (28,900/30,800 = 93.83%)

     Cumulative index:
     Base-year cost of Dec. 31, yr. 3, inventory:
     1st year percentage link                                     121.25%
     2nd year percentage link                                     127.62%
     3rd year percentage link                                      93.83%
     Product: Chain percentage, Dec. 31, yr. 3,
     relative to Jan. 1, yr. 1, base date
     (121.25% x 127.62% x 93.83%)                                 145.19%

     Base-year cost ($28,900/145.19%)                             $19,905

     The LIFO value of the inventory in Pool No. 1 at December 31,
year 3, is $21,161, computed as follows:

                                         Ratio of
                    Dec. 31, yr. 3,    current-year        Dec. 31, yr. 3,
                     inventory at         cost to          inventory at
                    base-year cost     base-year cost       LIFO value
    Jan. 1, yr. 1,
    base cost      $14,000                 100.00%         $14,000

    Dec. 31, yr. 1,
    increment        5,905                 121.25%             7,160
      Totals        19,905                                    21,160

     The LIFO reserve for Pool No. 1 as of December 31, yr. 3, is
$9,739, computed as follows:

     Dec. 31, yr. 3, inventory at current-year cost             $28,900
     Less: LIFO value of ending inventory                        21,161
     Equals: LIFO reserve                                         7,740

     –- Preconditions to Use of LIFO Method

     Use of the LIFO method for income tax purposes is dependent on
                                 - 18 -

certain conditions being satisfied and a proper election to adopt

and use the method being made.    See sec. 472(a), (c); 1.472-3,

Income Tax Regs. (“Time and manner of making election.”).

Huffman Group Elections

     The parties have stipulated that, prior to the tax years at

issue, each member of the Huffman group filed an election to use

the link-chain, dollar-value LIFO inventory method (the link-chain

method).10   The parties have further stipulated that those elections

were effective for the members as of the close of their taxable

years ending as follows:   Nissan, June 30, 1979; Volkswagen, Dec.

31, 1979; Dodge and Chrysler, Dec. 31, 1989.

The Accountant’s Method

     The Huffman group employed an accountant (the accountant) to

compute the values of the respective inventories of each member

using the link-chain method.   The accountant was consistent in his

method (the accountant’s method) of making those computations each

year, for each member, beginning with the year of each member for


     10
        The parties have attached documentation to the
stipulation of facts evidencing those elections. The
documentation is inconsistent with the described elections with
respect to (1) Neil Huffman Enterprises, Inc., d.b.a. Neil
Huffman Dodge, and (2) Neil Huffman, Inc., d.b.a. Huffman
Chrysler Plymouth, in that it indicates that those corporations
elected to adopt “an index method as provided in [sec. 1.472-
8(e)(1), Income Tax Regs., * * * which] will be developed by
double extending * * * a representative portion of inventory at
beginning of year cost and current cost.” Such an index method
is distinct from the link-chain method purportedly adopted. We
address the significance of that fact infra in sec. III.C.3.b.iii
of this report.
                               - 19 -

which it elected the link-chain method (the election year) and

continuing thereafter, without exception, until the actions of

respondent that led to this litigation (together, and without

distinguishing among members, the election and following years).

The parties have stipulated that, for each of the election and

following years, the accountant omitted a computational step

required by section 1.472-8, Income Tax Regs., which addresses the

dollar-value method of pricing LIFO inventories.     Pursuant to his

method, the accountant first determined the items in each dollar-

value pool at the end of each year.     He then determined the

current-year cost of each pool and divided that current-year cost

by a cumulative index to determine the base-year cost of the pool.

He compared the base-year cost so determined to the base-year cost

of the pool as of the beginning of the year.     When the end-of-the-

year base-year cost exceeded the beginning-of-the-year base-year

cost, the accountant determined that there had been an increment to

the pool, but he did not multiply the increment by the cumulative

index (he failed to “index” the increment) to determine a LIFO

value for the increment (sometimes, the accountant’s error).     He

assumed the LIFO value of the increment to be the difference

between the end-of-the-year and beginning-of-the-year base-cost of

the pool.   That assumption led him to conclude that the yearend

LIFO value of each pool was its value determined at base-year

costs.
                                 - 20 -

     Under the accountant’s method, for years in which he

determined that there had been an increment to an inventory pool,

his failure to index the increment resulted in his understating the

yearend LIFO value of the pool (assuming that the cumulative index,

expressed as a percent, was greater than 100%), which, in turn,

resulted in (1) an unwarranted increase in his computation of the

cost of the goods sold from the pool, (2) an understatement of the

gross income attributable to those sales, and (3) an overstatement

of the LIFO reserve attributable to the pool.11   For years in which

he determined that an inventory pool had been liquidated in whole

or in part, his past failures to have indexed any increments

remaining in the pool at the beginning of the year resulted in his

computing too low a cost of goods sold from the pool, which, in

turn, resulted in an overstatement of the gross income attributable

to those sales.   The accountant’s error did not result in the

permanent omission of any amount of gross income by any member.

     The distortion resulting from the accountant’s error can be

seen in the following example:    T, a merchant, elects to compute

her LIFO inventory using a dollar-value method and begins her first

year under the dollar-value method (year 1) with 100 units of an

inventoriable item with a base-year cost of $1.00 a unit.   Later


     11
        The yearend LIFO value of the pool was understated
because, even under the LIFO method, inventory cannot be carried
at a cost lower than the actual cost of purchasing the inventory.
Cf. Fox Chevrolet, Inc. v. Commissioner, 76 T.C. 708, 732 n.15
(1981).
                                 - 21 -

that year, after the wholesale price of the item has increased to

$2.00 a unit, T purchases 100 units more.    Unfortunately, T makes

no sales during that year.    Applying the accountant’s method,

nevertheless, T computes a cost of goods sold of $100.    She reaches

that result by determining the value of her ending inventory (200

units, comprising an opening inventory of 100 units plus an

increment of 100 units), at base-year unit cost ($1.00) to be $200

(200 x $1.00).   Since the base-year cost of her opening inventory

of 100 units is $100, and she purchased 100 units during the year

for $200, her cost of goods available for sale is $300, which,

after subtracting the value determined for her yearend inventory

($200), results in a cost of goods sold (and a loss) of $100.

Assume further that, in the next year (year 2), T decides to

liquidate her inventory (200 units) and retire.    She sells her

inventory in bulk for $300.    Her cost of goods sold is her year 2

opening inventory of $200, which results in T realizing a year 2

gain of $100.    Of course, T realizes neither a loss in year 1 nor a

net gain in year 2.     T’s failure to index the 100 unit increment

included in her year 1 ending inventory distorts her income for

both years 1 and 2.12    The distortion is only matter of timing,

however, since the understatement of income in year 1 is rectified

by the overstatement of income in year 2.    The following table


     12
        For the 100 units purchased during year 1, the index
would be 200%, reflecting the doubling during the year in the
unit cost of the inventoriable item.
                                  - 22 -

illustrates the distortions:

                                  LIFO inventory    LIFO inventory
                                    undistorted       distorted

                                   Yr. 1   Yr. 2    Yr. 1   Yr. 2

1.   Opening inventory              $100    $300    $100    $200
2.   Plus: Purchases                 200       0     200       0
3.   Equals: Cost of goods
     available for sale              300     300     300     200
4.   Less: Closing inventory         300       0     200       0
5.   Equals: Cost of goods sold        0     300     100     200

6.   Sales                             0     300       0     300
7.   Less: Cost of goods sold
     (line 5.)                         0     300     100     200
8.   Equals: Gross Income
     from sales                        0       0    (100)    100

     It should be noted that, if T’s failure to index the year 1

increment were corrected as of the beginning of year 2 (increasing

her year 2 opening inventory to $300), without any concomitant

increase in her year 1 ending inventory, then $100 of gross income

would go unreported (T would have a phantom loss of that amount in

year 1 with no offsetting gain in year 2), unless an offsetting

section 481 adjustment were made in year 2 to correct that apparent

windfall.

Respondent’s Examination and Adjustments

     –- The Examination

     Sometime after the members of the Huffman group filed their

1999 Federal income tax returns, respondent commenced an

examination of those and prior returns.    Respondent identified

mistakes in the members’ beginning and ending inventory values
                                - 23 -

shown on those returns due to the accountant’s error.   Respondent

revalued the members’ inventories for the election and following

years (beginning for Nissan and Volkswagen with 1979 and for Dodge

and Chrysler with 1990 and ending for all four corporations with

1999).   Those revaluations caused respondent to make adjustments to

the members’ gross incomes for those years.   For each inventory

pool, for each year, respondent proceeded as follows:   He first

calculated the correct yearend LIFO inventory value.    Based on the

correct yearend LIFO inventory value, he next calculated the

correct yearend LIFO reserve.   He then subtracted the correct

yearend LIFO reserve from the yearend LIFO reserve calculated by

the accountant.   The difference, generally a positive number (the

adjustment to ending inventory), is the amount that he calculated

would have to be added to or subtracted from (generally added to)

the yearend LIFO inventory value computed by the accountant to

conform that value with the correct yearend LIFO value.   To

calculate any necessary adjustment to gross income for the year,

respondent subtracted from the adjustment to ending inventory the

similarly calculated adjustment that he had made for the prior year

(except, of course, for the first year he commenced making

adjustments).   The difference was usually positive and would, thus,

increase gross income (by, in effect, decreasing the cost of goods

sold from the pool).
                                - 24 -

      The following table illustrates respondent’s adjustments with

respect to Nissan for 1997 through 1999 (all dollar figures in

thousands):

                                      1997        1998      1999
LIFO inventory value as corrected    $1,829      $1,848    $1,910

LIFO reserve as corrected           (1,048)      (1,032)   (1,009)
Less: LIFO reserve as reported      (1,843)      (1,844)   (1,862)
Equals: Adjustment to ending
inventory                               795         812         853
                                      1
Less: Adj. to beginning inventory       441         795         812
Equals: Yearly adjustment to income     354          17          41

Cumulative Adjustment to income            795      812         854
1
    Adjustment to 1996 ending inventory.

      Respondent’s adjustment to ending inventory is a measure of

the improper net increase in cost of goods sold (and net reduction

in gross income) through the end of the year due to the

accountant’s error.   It is, by definition, equal to the

accountant’s overstatement of the LIFO reserve as of that yearend

(which overstatement is a measure of the gain in the inventory pool

that should already have been recognized under the LIFO method).

In appendices attached to his brief, respondent calculates the

required adjustment to inventory for each member of the Huffman

group for each year for which he recalculated the member’s

inventories and, additionally, describes the required adjustment as

the “cumulative adjustment to income” for the year.

      Petitioners agree that respondent’s calculations of the

beginning and ending inventories of each member of the Huffman
                                   - 25 -

group are correct.

     –- The Adjustments

     Apparently because the expiration of the period of limitations

on assessment and collection of tax (see sec. 6501), respondent is

limited in the number of years open to adjustment by him.        The

earliest year open to an adjustment by respondent is 1998 for

Nissan, Dodge, and Chrysler, and it is 1997 for Volkswagen.          For

the earliest and each succeeding year of a member open to

adjustment by him, respondent increased or, in two cases, decreased

the taxable income of the member to reflect respondent’s

recalculation of the member’s beginning and ending inventories for

the year.    The amounts of the adjustments in taxable income

resulting from those recalculations, and the taxable years to which

they correspond, are as follows:

              Member        1997            1998          1999

            Nissan         ---          $17,251          $41,273
            Volkswagen     $49,056       35,484          575,137
            Dodge          ---          (37,752)         256,315
            Chrysler       ---           76,402          (88,687)

Petitioners do not contest those portions of the deficiencies that

result from those adjustments.

     In addition, for the earliest year of each member open to

adjustment by respondent (the first year in issue), respondent made

an additional adjustment under section 481.        That adjustment

increased the taxable income of the member for that year to reflect

the cumulative adjustments to income revealed by respondent’s
                                 - 26 -

recalculations for all years of the member’s up until that year.

Those adjustments (the section 481 adjustments) are as follows:

                    Member         1997            1998

                Nissan             ---           $794,993
                Volkswagen       $273,115             ---
                Dodge              ---            348,762
                Chrysler           ---            337,423

      The parties vigorously dispute whether the section 481

adjustments (cumulatively, $1,709,293) are permissible, and it is

that question that is the primary issue before us.

Change in Method of Accounting

      No member of the Huffman group requested respondent’s

permission to change its method of accounting.

                              Discussion

I.   Introduction

      The parties are in agreement that, in computing the LIFO

values of the Huffman group’s yearend inventories, the accountant

employed by the group omitted a computational step required by

section 1.472-8, Income Tax Regs. (addressing the dollar-value

method of pricing LIFO inventories).      The consequence of the

accountant’s error was that, generally, he understated the LIFO

value of those inventories (which, generally, resulted in an under-

reporting of income from sales).    Respondent corrected the

accountant’s error, and petitioners accept respondent’s adjustments

to the inventories of the members of the Huffman group for all of

the years in issue.    Petitioners do not accept, however,
                               - 27 -

respondent’s determination that, in making those adjustments for

the first year in issue of each member, he was implementing a

change that he had made in the members’ methods of accounting,

which necessitated his making additional adjustments for those

years pursuant to section 481(a).     Petitioners argue that

respondent’s adjustments were merely the result of his correction

of a mathematical error made by the accountant.     They point out

that, pursuant to section 1.446-1(e)(2)(ii)(b), Income Tax Regs.,13

the correction of a mathematical error is explicitly excluded from

constituting a change in method of accounting.    Because, they

argue, there was no change in any member’s method of accounting, no

section 481 adjustments were warranted.    They concede, however,

that if section 481 adjustments were warranted, respondent has

correctly computed those adjustments.    Our sole task is to

determine whether the section 481 adjustments were warranted, which

requires us to determine whether, in revaluing the members’

inventories, respondent corrected a mathematical error or changed

the members’ methods of accounting for those inventories.

     Before addressing that question, we shall discuss the relevant

provisions of sections 446 and 481.



     13
        In citing sec. 1.446-1(e)(2)(ii)(a) and (b), Income Tax
Regs., we refer to that section as in effect before its revision
by T.D. 9105, 2001-4 C.B. 419, 423, which replaced much of the
content of that section with the substantially similar content of
sec. 1.446-1T(e)(2)(ii)(a) and (b), Temporary Income Tax Regs.,
69 Fed. Reg. 42 (Jan. 2, 2004).
                                - 28 -

II.   Sections 446 and 481

      A.   Section 446

      Section 446 prescribes certain rules with respect to methods

of accounting:    A taxpayer computes its taxable income in

accordance with its method of accounting, see sec. 446(a), and has

some discretion in choosing a permissible method of accounting, see

sec. 446(c).    Nevertheless, no method of accounting is acceptable

unless, in the opinion of the Commissioner, it clearly reflects

income.    Sec. 1.446-1(a)(2), Income Tax Regs.; see sec. 446(b).

The regulations interpret the term “method of accounting” to

include not only the taxpayer’s overall method of accounting but

also the taxpayer’s accounting treatment of “any item.”    Sec.

1.446-1(a)(1), Income Tax Regs.    In general, a taxpayer wishing to

change its method of accounting must obtain the prior approval of

the Commissioner.    See sec. 446(e); sec. 1.446-1(e)(2)(i), Income

Tax Regs.    The regulations give guidance, but no comprehensive

definition, as to what constitutes a change in method of

accounting.    The regulations provide a rule of inclusion:

      A change in the method of accounting includes a change in
      the overall plan of accounting for gross income or
      deductions or a change in the treatment of any material
      item used in such overall plan. Although a method of
      accounting may exist under this definition without the
      necessity of a pattern of consistent treatment of an
      item, in most instances a method of accounting is not
      established for an item without such consistent
      treatment. A material item is any item which involves
      the proper time for the inclusion of the item in income
      or the taking of a deduction. Changes in method
      of accounting include * * * a change involving the method
                               - 29 -

     or basis used in the valuation of inventories * * *

Sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs.    The regulations also

provide certain rules of exclusion; e.g.,

     A change in method of accounting does not include
     correction of mathematical or posting errors, or errors
     in the computation of tax liability (such as errors in
     computation of the foreign tax credit, net operating
     loss, percentage depletion or investment credit). Also,
     a change in method of accounting does not include
     adjustment of an item of income or deduction which does
     not involve the proper time for the inclusion of the item
     of income or the taking of a deduction. For example,
     corrections of items that are deducted as interest or
     salary, but which are in fact payments of dividends, and
     of items that are deducted as business expenses, but
     which are in fact personal expenses, are not changes in
     method of accounting. * * *

Sec. 1.446-1(e)(2)(ii)(b), Income Tax Regs.    The regulations give

no guidance as to the meaning of the term “mathematical error”.

     B.   Section 481

     The distinction between a change in method of accounting and

the correction of a mathematical error is especially significant

because of section 481.   “Section 481 prescribes the rules to be

followed in computing taxable income in cases where the taxable

income of the taxpayer is computed under a method of accounting

different from that under which the taxable income was previously

computed.”   Sec. 1.481-1(a)(1), Income Tax Regs.     For purposes of

section 481, a change in method of accounting includes a change in

the taxpayer’s overall method of accounting or a change in the

taxpayer’s treatment of a material item.    See id.    Section 481(a)

specifies that, in computing the taxpayer’s income for the taxable
                                    - 30 -

year of the change in method of accounting (year of change), there

shall be taken into account those adjustments that are determined

to be necessary solely by reason of the change in order to prevent

amounts from being duplicated or omitted.14

III.    Discussion

       A.   Introduction

       A notable feature of section 481 is that the adjustments

called for by the section may be made notwithstanding that the

period of limitations on assessment and collection of tax may have

closed on the years (closed years) in which the events giving rise

to the need for an adjustment occurred.      See Superior Coach of

Fla., Inc. v. Commissioner, 80 T.C. 895, 912 (1983).     While section


       14
            Sec. 481(a) provides:

       SEC. 481.   ADJUSTMENTS REQUIRED BY CHANGES IN METHOD OF
                   ACCOUNTING.

            (a) General Rule.--In computing the taxpayer's
       taxable income for any taxable year (referred to in
       this section as the "year of the change")--

                  (1) if such computation is under a method of
             accounting different from the method under which
             the taxpayer's taxable income for the preceding
             taxable year was computed, then

                  (2) there shall be taken into account those
             adjustments which are determined to be necessary
             solely by reason of the change in order to prevent
             amounts from being duplicated or omitted, except
             there shall not be taken into account any
             adjustment in respect of any taxable year to which
             this section does not apply unless the adjustment
             is attributable to a change in the method of
             accounting initiated by the taxpayer.
                                - 31 -

481 may not necessarily conflict with the statute of limitations

found in section 6501, see id., it does place a premium on

distinguishing between the correction of errors (which is limited

to open years) and a change in a method of accounting (which

implicates section 481).    Here, a determination that the

accountant’s error was a mathematical error would work in

petitioners’ favor.    That is because, whether the adjustments

accepted by petitioners result from the correction of mathematical

errors or from accounting method changes, the adjustments result in

a decrease in each member’s LIFO reserves as of the beginning of

the member’s first year in issue, without any concomitant

recognition of gain.    If the adjustments result from the correction

of mathematical errors, then the unrealized gains eliminated by the

decreases in reserves simply escape taxation.    On the other hand,

if those decreases in LIFO reserves result from changes in the

members’ methods of accounting, then respondent’s section 481

adjustments will capture the unrealized gain eliminated by the

decreases in reserves.

     To distinguish between error correction and an accounting

method change, we must examine both the pertinent Treasury

regulation and caselaw.

     B.   Section 1.446-1(e)(2), Income Tax Regs.

     Section 1.446-1(a), Income Tax Regs., gives content to the

term “method of accounting”; section 1.446-1(e)(2), Income Tax
                               - 32 -

Regs., gives guidance as to what constitutes a change in a method

of accounting, and section 1.446-1(e)(2)(ii)(a), Income Tax Regs.,

provides that a change involving the method or basis used in the

valuation of inventories is a change in method of accounting.    That

final provision is suggestive that respondent’s adjustments,

correcting the accountant’s consistent failure to value properly

the members’ closing inventories, constitute changes in the

members’ methods of accounting.   That suggestion is reinforced by

other provisions in section 1.446-1(e)(2)(ii), Income Tax Regs.,

which give consistency and timing considerations an important, if

not determinative, role to play in determining whether an

adjustment constitutes a change in method of accounting.

     As we described supra in giving the background of this case,

the accountant erred in applying the link-chain method, he did so

consistently for each member, beginning in the year the member

elected the link-chain method and ending only when respondent found

the error, the error resulted in income being under-reported for

some (most) years and over-reported for other years, and, if not

corrected, the error would not result in the permanent omission of

income by the taxpayers.   The accountant’s error was an error in

allocating the cost of goods available for sale during a year

between the items sold during the year and the items on hand at the

end of the year.   Generally, under a system of inventory

accounting, the value assigned to the items on hand at the end of
                               - 33 -

one year establishes the value of the items on hand at the

beginning of the next year.   Consequently, the accountant’s error

would, if applied consistently (as, in fact, it was), self correct,

at least in the sense that, if the error were continued over the

life of any inventory pool, the total gain reported on account of

the sale of items in the pool would be correct.   See, e.g., Wayne

Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 509 (1989) (similar

conclusion with respect to the income reported through the period

in which ending inventory is correctly valued).   The accountant’s

error was, thus, an error in timing.    Because it was an error in

the proper time for reporting an item of income (gain from sales),

the accountant’s method was a material item in each member’s

overall plan of accounting.   See sec. 1.446-1(e)(2)(ii)(a), Income

Tax Regs.   On that ground alone, respondent’s change to that method

would appear to be a change in a method of accounting, as that

expression is used in section 1.446-1(e)(2)(ii)(a), Income Tax

Regs.   By consistently repeating the same error, the accountant

established a pattern, which (although not determinative of) is

indicative of a method of accounting.    Id.

     Nevertheless, section 1.446-1(e)(2)(ii)(b), Income Tax Regs.,

provides that a change in method of accounting does not include

correction of mathematical or posting errors, and petitioners argue

that, in correcting the accountant’s error, respondent did no more

than correct a mathematical or posting error.   We have interpreted
                               - 34 -

the term “posting error” to be an error in “‘the act of

transferring an original entry to a ledger’”.   Wayne Bolt & Nut

Co., v. Commissioner, supra at 510-511 (quoting Black’s Law

Dictionary 1050 (5th ed. 1979)).   That does not describe the

accountant’s error, and we conclude that the accountant made no

posting error.   The term “mathematical error” is not, as stated,

defined in the regulation, nor have we or any other court defined

it for purposes of section 1.446-1(e)(2)(ii)(b), Income Tax Regs.

The term does, however, appear in the Internal Revenue Code,

principally in section 6213(b), which allows the unrestricted

assessment and collection of tax arising out of mathematical or

clerical errors.   For purposes of section 6213, the term

“mathematical or clerical error” is defined by section 6213(g)(2).

As pertinent to this case, the definition is “an error in addition,

subtraction, multiplication, or division”.   Sec. 6213(g)(2)(A).

Moreover, before Congress provided the specific definition of the

term “mathematical or clerical error” found in section 6213(g),

Courts generally had limited the scope of the term “mathematical

error” for purposes of section 6213(b) and its predecessors to

errors in arithmetic.   E.g., Farley v. Scanlon, 13 AFTR 2d 932,

933, 64-1 USTC par. 9371 (E.D. N.Y. 1964) (mathematical error

“means an error in computing the tax on what the return itself

concedes to be income”); Repetti v. Jamison, 131 F. Supp. 626, 628

(N.D. Cal. 1955) (“the term * * * was meant to refer to errors in
                                 - 35 -

arithmetic.    This opinion is based primarily on the common meaning

given to the phrase ‘mathematical error,’”).     We have no reason to

believe that the drafters of section 1.446-1(e)(2)(ii)(b), Income

Tax Regs., intended the term “mathematical error” to have any

meaning beyond its common meaning, and petitioners have failed to

show us that the term has a common meaning different from the

common meaning found by the District Court in Repetti; i.e., an

error in arithmetic.    That definition comports with the scope of

the term “posting error”, with which the term “mathematical error”

is associated in the regulations, and we conclude that the term

“mathematical error”, as used in section 1.446-1(e)(2)(ii)(b),

Income Tax Regs., describes an error in arithmetic; i.e., an error

in addition, subtraction, multiplication, or division.

     The accountant did not make a mathematical error because he

did not make an error in arithmetic.      He neither divided when he

should have multiplied nor multiplied 2 x 2 and found the product

to be 5.    The accountant erred in that, after deflating the

current-year cost of each inventory pool to determine whether, at

base-year costs, there had been an increment in the pool, and

finding an increment, he failed to multiply the increment by the

cumulative index in order to determine the yearend LIFO value of

the pool.     The accountant reached an erroneous result not because

he made a mistake in arithmetic (multiplication) but because he

omitted the critical step of multiplication altogether.     That kind
                               - 36 -

of error no more lends itself to being classified as an

arithmetical (mathematical) error than does the error of the baker

who, having intended to double the recipe for a cake he has baked,

finds that the cake has only risen half way because he failed to

double the measure of baking powder called for by the recipe.

Petitioners cannot avoid respondent’s section 481 adjustment on the

ground that respondent changed no method of accounting because he

corrected only mathematical or posting errors.

     Nor can petitioners avail themselves of the exceptions in

section 1.446-1(e)(2)(ii)(b), Income Tax Regs., specifying that an

accounting method change does not include the correction of errors

in the computation of tax liability or adjustments not involving

the proper time for inclusion of an item of income or the taking of

a deduction.

     Although section 1.446-1(e)(2)(ii), Income Tax Regs., appears

dispositive in respondent’s favor, our inquiry does not end there,

because courts addressing the issue of whether a change in method

of accounting has occurred have not uniformly given consistency and

timing considerations the weight given those considerations by the

regulations.

     C.   Caselaw

           1.   Introduction

     In considering the caselaw dealing with what constitutes a

change in method of accounting, we must distinguish between cases
                                 - 37 -

decided before and after 1970.    Before 1970, courts were mostly

left to their own devices to resolve whether an accounting

adjustment rose to the level of a change in method of accounting.

In 1970, paragraphs (e)(2) and (3) of section 1.446-1(e), Income

Tax Regs., were revised by Treasury Decision.      See T.D. 7073, 1970-

2 C.B. 98 (the 1970 revision).    Included in those revisions were

the following:   The addition of the language found in paragraph

(e)(2)(ii)(a) of section 1.446-1(e), Income Tax Regs., to the

effect that, although a pattern of consistent treatment is not

necessary to establish a method of accounting for an item, “in most

instances a method of accounting is not established for an item

without such consistent treatment.”       Id. at 99.   The term “material

item” (also found in paragraph (e)(2)(ii)(a)) which, before the

1970 revision, was unqualified, was redefined with the following

qualification:   “A material item is any item which involves the

proper time for the inclusion of the item in income or the taking

of a deduction.”   Id.   The rules of exclusion, found in section

1.446-1(e)(2)(ii)(b), Income Tax Regs., that a change in method of

accounting includes neither mathematical or posting errors nor the

adjustment of any item of income or deduction which does not

involve the proper time for the inclusion of the item of income or

the taking of a deduction, were added.      Petitioners do not

challenge the validity of section 1.446-1(e)(2), Income Tax Regs.

(1970).
                                 - 38 -

          2.   Petitioners’ Argument

     Petitioners’ argument is as follows:     “It has long been held

that where a taxpayer properly elects a particular accounting

method, the making by the taxpayer of an error in the use of that

accounting method is an error.    Thus, it logically follows that the

correction of that error is not a change of accounting method.”

Petitioners’ argument rests on the premise that a taxpayer does not

change its method of accounting by deviating from it.     If the

premise is sound, then the taxpayer does not change its method of

accounting by correcting that deviation, since before, during, and

after the deviation, the taxpayer used the same method of

accounting.

     Petitioners can find some support for their premise in cases

holding that a taxpayer does not change its method of accounting

when it does no more than conform to a prior accounting election or

some specific requirement of the law.     Many of the cases that

petitioners rely on, however, were decided before the 1970

revisions to section 1.446-1(e), Income Tax Regs., emphasizing

consistency and timing considerations.     Petitioners refer us to

Thompson-King-Tate, Inc. v. United States, 296 F.2d 290 (6th Cir.

1961), in which the Court of Appeals held that the taxpayer had the

right to change its original reporting position and report income

from a construction contract in the year the contract was finally

completed and accepted because the taxpayer had previously adopted
                                 - 39 -

that method for reporting income from construction contracts.     Id.

at 294.   The Court of Appeals emphasized that the taxpayer had “no

election” (i.e., choice) but to report the income in the correct

year pursuant to the method of accounting it had adopted.     Id. at

294, 295.    Petitioners also cite N.C. Granite Corp. v.

Commissioner, 43 T.C. 149 (1964), and Underhill v. Commissioner, 45

T.C. 489 (1966).    In the first case, we said that a taxpayer need

not obtain the Commissioner’s consent to change its method of

accounting “where the law specifically prescribes or proscribes a

method of accounting or computation”.     N.C. Granite Corp. v.

Commissioner, supra at 168.     In the second case, we held that no

timing question was presented (so, therefore, the consent of the

Commissioner to change a method of accounting was not required)

when, to conform to caselaw, the taxpayer changed its method of

recovering its basis in speculative installment notes from a pro-

rata recovery method to a method that allowed it to recover all of

its basis before it reported any gain.     Underhill v. Commissioner,

supra at 496.    Because those cases were decided before 1970 and do

not address the consistency and timing considerations emphasized in

section 1.446-1(e)(2)(ii), Income Tax Regs., their weight is

uncertain.

            3.   Post-1970 Decisions

            a.   Primo Pants Co. v. Commissioner

     This Court has generally agreed with section 1.446-
                                - 40 -

1(e)(2)(ii), Income Tax Regs., that consistency in matters of

timing defines a method of accounting.15     For example, in Primo

Pants Co. v. Commissioner, 78 T.C. 705 (1982), the petitioner

arbitrarily valued its finished goods inventory at 50 percent of

selling price and its materials and work in process inventories at

50 percent of cost.    The taxpayer contended that the Commissioner’s

adjustments to those values, eliminating the unwarranted discounts

(and making certain other changes), were not a “change in the

treatment of any material item”.      Id. at 722.   In making that

assertion, the taxpayer argued that its discounting practices had

nothing to do with proper time for reporting income.       Id.    We

reached the opposite conclusion, based on our inquiry whether the

taxpayer’s discounting practices caused its lifetime income to be

underreported or merely shifted the time at which some of that

income was reported.    Id. at 723.   We concluded:   “Because we are

here dealing with inventory, where one year’s closing inventory

becomes the next year’s opening inventory, we are satisfied that

the present case involves only postponement of income and therefore

involves a timing question.”    Id.    Primo Pants Co. has been

extensively cited, and we have applied a similar analysis in other

cases to conclude that a change from a flawed method of determining



     15
        We have held that consistent treatment of an item is
shown by two or more taxable years of application. Johnson v.
Commissioner, 108 T.C. 448, 494 (1997), affd. in part and revd.
in part 184 F.3d 786 (8th Cir. 1999).
                                - 41 -

inventory to a correct method involves only timing questions and,

thus, constitutes a change in method of accounting.    See, e.g.,

Superior Coach, Inc. v. Commissioner, 80 T.C. at 910; Wayne Bolt &

Nut Co. v. Commissioner, 93 T.C. at 511.

     Because the accountant’s error in the instant case had

precisely the same effect as did the taxpayer’s discounting

practices in Primo Pants Co.--viz, it served merely to alter the

distribution of a lifetime income among taxable periods--that case

would seem to govern us here, requiring us to conclude that

respondent’s adjustments to the members’ inventories constituted a

change in the members’ methods of accounting.    Petitioners attempt

to distinguish Primo Pants Co. and the cases of the Court that

follow it, but their reading of those cases is flawed.    For

example, on brief, petitioners discount the relevance of our

holding in Primo Pants Co. because, they suggest:     “No contention

was made that the undervalued inventory was the result of a

mathematical error.”   On the contrary, our report in Primo Pants

Co. states:    “Petitioner characterizes the various adjustments to

inventory as the mere correction of its application of its lower of

cost or market method of valuing inventory.”    Primo Pants Co. v.

Commissioner, 78 T.C. at 714.

          b.    Cases Cited by Petitioners

          i.    Korn Indus., Inc. v. United States

     Petitioners rely heavily on Korn Indus., Inc. v. United
                               - 42 -

States, 209 Ct. Cl. 559, 532 F.2d 1352 (1976), to support their

position that respondent merely corrected mathematical errors and

there were no accounting method changes.   In Korn Indus., Inc. for

4 consecutive years, the taxpayer, a furniture manufacturer,

deviated from its long-established method of valuing inventories.

For those 4 years, the taxpayer improperly omitted certain costs

from the value of its finished goods inventory, which caused a

correspondingly improper addition to the cost of goods sold and,

thus, an understatement of gross income.   On its tax return for the

fifth year, the taxpayer showed a correct beginning inventory,

which included costs that had been omitted from the previous year’s

ending inventory.   The taxpayer viewed its action as the correction

of an error and not a change in its method of accounting.

Therefore, it accepted the Commissioner’s adjustments to its

beginning and ending inventories for the 2 preceding years (for

which the period of limitations on assessment and collection had

not run), but it objected to the Commissioner’s section 481

adjustment, which the Commissioner made to account for the

disparity between the taxpayer’s opening inventory for the second

preceding year and its ending inventory for the third preceding

year (which could not be adjusted since the period of limitations

had run).   If the taxpayer were right, that its method of

accounting had not changed, it would enjoy, in effect, a double

deduction, to the extent of the costs improperly omitted from
                                - 43 -

inventory in the first 2 years.   The Court of Claims conceded that

the taxpayer had not properly accounted for the omitted costs.

Nevertheless, it agreed with the taxpayer that, in revaluing its

finished goods inventory for the first open year, the Commissioner

had not changed its method of accounting.    Id. at 1356.   The court

reasoned that the taxpayer’s omissions were “inadvertent”, and,

thus, analogous to mathematical or posting errors, the correction

of which would not have amounted to a change in method of

accounting.   Id.

     Taxpayers on other occasions have brought Korn Indus., Inc. to

our attention.   See, e.g., Superior Coach of Fla., Inc. v.

Commissioner, 80 T.C. at 912 (facts before us distinguishable from

those in Korn Indus., Inc.); Wayne Bolt & Nut Co. v. Commissioner,

supra at 511 (similar).    In Superior Coach, we noted that some

commentators had pointed out that the good-faith exception

seemingly created by Korn Indus., Inc. appears to be without

statutory authorization.    Superior Coach, Inc. v. Commissioner,

supra at 914 n.5.   Indeed, assuming that consistently made

accounting errors are generally inadvertent (i.e., made in good

faith), an inadvertence-based exception to the general rule (that

the consistent treatment of an item amounts to a method of

accounting) would seem to swallow that general rule.   We need not

resolve that conundrum today, because, as in the past, the facts

before us are distinguishable from those in Korn Indus., Inc. v.
                                 - 44 -

United States, supra.16    Unlike in Korn Indus., Inc., the

accountant’s error in failing properly to apply the link chain

method neither was an interruption in a history of proper

application of that method nor was it restricted to only a portion

of the costs to be taken into account in valuing inventories.     The

facts of Korn Indus., Inc. are distinguishable.

            ii.   Evans v. Commissioner

     Petitioners also refer us to Evans v. Commissioner, T.C. Memo.

1988-228.    In Evans, the question was whether individual taxpayers

on the cash method of accounting had established a different method

of accounting for employment-related bonuses by, for 3 years,

reporting such bonuses in the year in which the bonuses were

authorized rather than in the year in which they were received.

The taxpayers argued that, for those 3 years, they had merely

misapplied the cash method and, therefore, no change in accounting

method was involved when, in the fourth and fifth years, they

changed their practice of reporting bonuses, from the year

authorized to the year received, and reported the fourth year’s

bonuses in year five.     We agreed, concluding that the taxpayers

never intended to adopt an accrual method of accounting for bonuses


     16
        Though adhering to the holding of its predecessor in
Korn Indus., Inc. v. United States, 209 Ct. Cl. 559 (1976), see
Diebold, Inc. v. United States, 16 Cl. Ct. 193, 204 n.9 (1989),
affd. 891 F.2d 1579 (Fed. Cir. 1989), the U.S. Claims Court (now
the U.S. Ct. of Fed. Claims) has emphasized the primacy of
consistency and timing in establishing a method of accounting.
See Diebold, Inc. v. United States, supra.
                                - 45 -

and their change in practice merely corrected inadvertent errors

analogous to posting errors.   We cited Korn Indus., Inc. v. United

States, supra.

     Evans v. Commissioner, supra, is a Memorandum Opinion of this

Court, and memorandum opinions are not binding.   See, e.g., Dunaway

v. Commissioner, 124 T.C. 80, 87 (2005).   Moreover, the conclusion

we expressed in Evans, that the taxpayer merely misapplied the cash

method, appears to contradict an example in the regulations

interpreting section 481.    Example (2), in section 1.446-

1(e)(3)(iii), Income Tax Regs., involves a taxpayer who

consistently reports its income and expenses on an accrual method

of accounting except for real estate taxes, which it reports on the

cash method of accounting.   The example concludes that a change in

the treatment of real estate taxes from the cash method of

accounting to an accrual method of accounting is a change in method

of accounting because the change is a change in the treatment of a

material item in the taxpayer’s overall accounting practice.

Finally, it is doubtful that intent plays a significant role in

determining whether a taxpayer has adopted a method of accounting.

See Buyers Home Warranty Co. v. Commissioner, T.C. Memo. 1998-98;

see also Johnson v. Commissioner, 108 T.C. 448, 494 (1997) (“If the

change affects the amount of taxable income for 2 or more taxable

years without altering the taxpayer's lifetime taxable income, then

it is strictly a matter of timing and constitutes a change in
                               - 46 -

method of accounting.”), affd. in part and revd. in part 184 F.3d

786 (8th Cir. 1999).

          iii.   Gimbel Brothers; Standard Oil

     Petitioners cite two additional cases for the proposition that

a taxpayer does not change its method of accounting when it

corrects a deviation from a previously elected method of

accounting:   Gimbel Bros., Inc. v. United States, 210 Ct. Cl. 17,

535 F.2d 14 (1976) (use of accrual method in accounting for one of

five types of credit plans following election that required

taxpayer to apply installment method to all plans was impermissible

given that election, and retroactive application of installment

method was mere correction of error);17 Standard Oil Co. v.

Commissioner, 77 T.C. 349 (1981) (election under section 1.612-4,

Income Tax Regs., to deduct intangible drilling and development

costs meant that taxpayer “[had] no choice” but to do so, and

reversal of capitalization of some such costs was not change in

method of accounting).   Petitioners equate the elections by the

members of the Huffman Group to use the link-chain method with the

elections in those two cases, so that deviation and subsequent



     17
        Gimbel Bros., Inc. v. United States, 210 Ct. Cl. 17,
535 F.2d 14 (1976), like Korn Indus., Inc. v. United States,
supra, was decided by the Court of Claims and is therefore not
binding upon us. Further, the former case analyzes and applies
regulations in effect before 1970. We nevertheless include the
case in this discussion because it was decided following the
issuance in 1970 of the regulations in effect for the instant
case.
                                  - 47 -

adherence do not amount to changes in any accounting method.

Respondent distinguishes those cases by arguing that, though the

members duly elected the link-chain method, because the method was

never properly applied, the Huffman Group never adopted the link-

chain method.

     We agree with respondent that the facts of Gimbel Bros., Inc.

and Standard Oil Co. are distinguishable from those now before us.

The parties have stipulated that, for each member, for the election

and following years (i.e., for 10 or 20 years), the accountant

omitted a computational step required by the regulations governing

the dollar-value method of pricing LIFO inventories.    We agree with

respondent that the members may, individually, have elected the

link-chain method, but no member adopted it until respondent made

his corrections.    That alone distinguishes the facts before us from

those in Gimbel Bros., Inc. and Standard Oil, Co., where the errors

were committed in the context of a broader compliance with the

taxpayer’s proper method of accounting.    Moreover, although

stipulated by the parties, it is questionable whether all four of

the members actually elected to use the link-chain method to value

their respective inventories.18    Gimbel Bros., Inc. and Standard Oil

Co. are distinguished.

            4.   Discussion

     There is an evident incongruity between section 1.446-


     18
          See supra note 10.
                               - 48 -

1(e)(2)(ii), Income Tax Regs., which gives consistency and timing

considerations an important, if not determinative, role to play in

determining whether the treatment of an item constitutes a method

of accounting, and the proposition, advanced by petitioners and

evidenced by a body of caselaw (including cases of this Court),

that a taxpayer does not change its method of accounting when it

does no more than conform to a prior accounting election or some

specific requirement of the law.

     The notion that a taxpayer does not change its method of

accounting when it merely conforms to a prescribed (but ignored)

method of accounting is contradicted by at least one example in

section 1.446-1(e)(2)(ii)(c), Income Tax Regs.   Sec. 1.446-

1(e)(2)(ii)(c), Example (1), Income Tax Regs., addresses a merchant

(a jeweler) erroneously reporting income from sales on the cash

method of accounting.   As discussed supra under the heading “Use of

Inventories”, inventories and an accrual method of accounting are

required when the sale of merchandise is an income-producing

factor.   The example holds that a change from the cash method to

the accrual method is a change in the merchant’s overall plan of

accounting and thus is a change in method of accounting.   Moreover,

the notion is also inconsistent with the more recent view of the

courts that a taxpayer needs the Commissioner’s consent to change

from an erroneous to a correct method of accounting.   See, e.g.,

Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. at 511 (“A change in
                                - 49 -

method of accounting occurs even when there is a change from an

incorrect to a correct method of accounting.”), and other cases

noted in Convergent Techs., Inc. v. Commissioner, T.C. Memo. 1995-

320.    There are also three examples in section 1.446-

1(e)(2)(iii)(c), Income Tax Regs., holding that an impermissible

method of accounting is a method of accounting a change from which

requires the consent of the Commissioner: Examples (6), (7), and

(8).    We question whether there is vitality to the notion that a

taxpayer conforming to a required but theretofore ignored method of

accounting does not change its method of accounting by so

conforming.

       Consider a taxpayer that elects a method of accounting and,

for some time, adheres to the method (thereby adopting it).    The

taxpayer then, for some time, deviates from the method before,

again, adhering to it.    The notion that the taxpayer did not change

its method of accounting when it either, first, deviated from the

method or, thereafter, adhered to the method is a notion that is

narrower than the previously described notion, and it is one we

have supported.    See, e.g., Evans v. Commissioner, T.C. Memo. 1988-

228.    We have not, however, been consistent in holding that a

taxpayer does not change its method of accounting when it does no

more than adhere to a method adopted pursuant to a prior accounting

election.    See, e.g., Sunoco, Inc. & Subs. v. Commissioner, T.C.

Memo. 2004-29 (retroactive attempt to change treatment of certain
                                - 50 -

mining expenses would be change in method of accounting, and not

mere correction of error, where taxpayer had knowingly and

consistently, albeit improperly, capitalized and amortized expenses

that should have been included in taxpayer’s cost of goods sold);

Handy Andy T.V. & Appliances, Inc. v. Commissioner, T.C. Memo.

1983-713 (specifically finding that an impermissible change in

accrual methodology was a change in method of accounting and that

reversion to original methodology was a second change in method of

accounting, warranting a section 481 adjustment).    Indeed, in First

Natl. Bank of Gainesville v. Commissioner, 88 T.C. 1069 (1987), a

transferee liability case, the transferee argued that the

transferor’s alteration of a LIFO inventory valuation procedure

constituted the correction of an accounting error and not a change

in method of accounting.   We held that, although the alteration in

question may have constituted the correction of an error, it also

constituted a change in method of accounting pursuant to section

472(e).   Id. at 1085.   We added:   “Where the correction of an error

results in a change in accounting method, the requirements of

section 446(e) are applicable.”      Id.

     Our inconsistency in holding that a taxpayer does not change

its method of accounting when it does no more than conform to a

prior accounting election is not necessarily inconsistent with

section 1.446-1(e)(2)(ii)(a), Income Tax Regs.    That is because,

generally, pursuant to section 1.446-1(e)(2)(ii)(a), Income Tax
                                 - 51 -

Regs., it is the consistent treatment of an item involving a

question of timing that establishes such treatment as a method of

accounting.   Therefore, a short-lived deviation from an already

established method of accounting need not be viewed as establishing

a new method of accounting.19    If not so viewed, neither the

deviation from, nor the subsequent adherence to, the method of

accounting would be a change in method of accounting.     The

question, of course, is what is short-lived.     The Commissioner’s

position is that consistency is established for purposes of section

1.446-1(e)(2)(ii)(a), Income Tax Regs., by the same treatment of a

material item in two or more consecutively filed returns.       Rev.

Proc. 2002-18, 2002-1 C.B. 678.     We have said something similar.

Johnson v. Commissioner, supra at 494.     We need not today determine

how long is short.     Here, even if we were to assume that the

members elected the link-chain method and adopted it, see supra pp.

46-48, no member deviated from the link-chain method for less than

10 years.   That is not a short-lived deviation.

     D.   Conclusion

     We affirm the conclusions that, tentatively, we reached supra

in section III.B. of this report.     The accountant erred in applying

the link-chain method.     He did so consistently, and his error was

an error in timing.     It was not, within the meaning of section


     19
        Nor in reaching that conclusion would a court have to
find that the taxpayer committed a posting or mathematical error.
See sec. 1.446-1(e)(2)(ii)(b), Income Tax Regs.
                                 - 52 -

1.446-1(e)(2)(ii)(b), Income Tax Regs., either a mathematical or

posting error.20   While, in some circumstances, a taxpayer deviating

from its previously established method of accounting may again

adhere to its established method before the deviation has time to

harden into a method of its own, the accountant’s consistent error

for no less than 10 years rules out that possibility.      The

accountant’s method was, therefore, a material item in each

member’s overall plan of accounting.      Respondent’s change to the

accountant’s method (a material item) was, thus, a change in method

of accounting.

IV.   Conclusion

      For the first year in issue of each member, respondent’s

revaluation of the member’s inventory constituted a change in the

member’s method of accounting.    Therefore, respondent’s section

481(a) adjustments are permissible.       Each petitioner owning shares

of stock in any member of the Huffman group must take into account

his or her share of the section 481 adjustments.      We need decide no

other issue.


      20
        It is worth mentioning that the use of price indexes in
applying the dollar-value method is a matter to which Congress in
sec. 472(f) and the Secretary of the Treasury in his regulations,
see, e.g., sec. 1.472-8(e)(3), and revenue procedures have
devoted attention. Among the latter are Rev. Proc. 97-36, 1997-2
C.B. 450, and Rev. Proc. 97-37, 1997-2 C.B. 455 The first of
those revenue procedures describes the adoption of the
“Alternative LIFO Method” (a dollar-value link-chain method for
retailers of autos and light-duty trucks) as a change in method
of accounting. The second likewise describes the inventory
price index computation (IPIC) method.
                                 - 53 -

     To reflect the foregoing,


                                          Decisions will be entered

                                     for respondent.




[Reporter’s Note: This opinion was amended by order on Sept. 25, 2006.]
