Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board

LIFO - Reconstruction of New Item Cost
Treas. Reg. section 1.472-8(e)(2) states in part; "Double-extension method.--(i) Under the
double-extension method the quantity of each item in the inventory pool at the close of the
taxable year is extended at both base-year unit cost and current-year unit cost (emphasis
added)."
Under the double-extension method a base-year unit cost must be ascertained for new items
entering a pool for the first time. The base-year unit cost of the new item shall be the
current-year cost of that item unless the taxpayer is able to reconstruct or otherwise establish
a different cost.
If the new item is a product or raw material not in existence on the base date, its cost may be
reconstructed, that is, the taxpayer using reasonable means may determine what the cost of
the item would have been had it been in existence in the base-year. If the item was in
existence on the base date but not stocked by the taxpayer, he or she may establish, by using
available data or records, what the cost of the item would have been to the taxpayer had he or
she stocked the item.
If the base-year unit cost of the entering item is either reconstructed or otherwise established
to the satisfaction of the Commissioner, such cost may be used as the base-year unit cost in
applying the double-extension method. If the taxpayer does not reconstruct or establish to the
satisfaction of the Commissioner a base-year unit cost, but does reconstruct or establish to the
satisfaction of the Commissioner the cost of the item at some year subsequent to the baseyear,
he or she may use the earliest cost which he or she does reconstruct or establish as the
base-year unit cost.
It is clear from the language used in the regulations that this issue is highly factual. The
regulations state the taxpayer "using reasonable means may determine what the cost of an
item would have been had it been in existence in the base year."
The regulations place the burden of reconstruction on the taxpayer by creating a presumption
that base-year cost equals current-year cost for new items unless the taxpayer can demonstrate
otherwise. This burden should not be taken lightly. The Supreme Court, in Burnet v.
Houston, 283 U.S. 223 (1931) stated, "The impossibility of proving a material fact upon
which the right to relief depends, simply leaves the claimant upon whom the burden rests with
an unenforceable claim, a misfortune to be borne by him, as it must be borne in other cases, as
the result of a failure of proof."
Taxpayers have developed a number of techniques to make it easier or even sidestep the
reconstruction burden. One technique is to elect the link-chain method. This method, which
has generally been permitted, substantially reduces the task of reconstruction. This is so,
because reconstructed costs only have to be established as of the beginning of the current year
and generally there will be fewer completely new items.
Another technique used is to broadly define the inventory item. If a car dealer treats all cars
8-4