Hawse v. Comm'r

• Decision Date: 27 May 2015
• Docket Number: T.C. Memo. 2015-99,Docket No. 8267-12.
• Parties: JAMES H. HAWSE AND CYNTHIA L. HAWSE, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

JAMES H. HAWSE AND CYNTHIA L. HAWSE, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

T.C. Memo. 2015-99
Docket No. 8267-12.

UNITED STATES TAX COURT

May 27, 2015

During 2002 and 2003 P-H was the sole shareholder of J, an S corporation. J, an automotive dealership, accounted for its new and used vehicles inventories on the LIFO method of accounting. For 2001 J sought automatic consent under a revenue procedure to change its method of accounting for its new and used vehicles from LIFO to specific identification, with vehicles valued at the lower of cost or market rather than actual cost. J never fully implemented the change as requested but thereafter filed Federal income tax returns as if it had, reporting I.R.C. sec. 481(a) LIFO recapture income and paying the tax thereon.

In 2009 J filed amended tax returns for 2002 and 2003 purporting to "correct" its prior returns to reflect continued use of LIFO. Ps contend that because J did not change its valuation method for all of its vehicles inventory to lower of cost or market, J never received automatic consent and therefore remained on the LIFO method. If so, Ps reason, they are entitled to refunds of the tax paid on LIFO recapture income for 2002 and 2003.

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Held: J failed to satisfy the requirements for automatic consent under Rev. Proc. 99-49, 1999-2 C.B. 725, because it did not comply with all terms and conditions of the revenue procedure.

Held, further, because J consistently accounted for its new and used vehicles inventory using the specific identification method on its 2001 through 2007 income tax returns, a seven-year period, J changed its method of accounting notwithstanding its failure to secure R's consent.

Held, further, J's attempt to revert to the LIFO method of accounting by filing amended returns is a change in method of accounting that requires R's consent under I.R.C. sec. 446(e).

Steven Ray Mather, for petitioners.

Halvor R. Melom, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WHERRY, Judge: Respondent determined deficiencies and section 6662(a)¹ accuracy-related penalties with respect to petitioners' 2002 and 2003 taxable years as follows:

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Year	Deficiency	Penalty; sec. 6662(a)
2002	$2,892,317	$578,463.40
2003	1,604,752	320,950.40

After the parties' filing of a stipulation of facts, a stipulation of settled issues, and a supplemental stipulation of settled issues, which are by this reference incorporated herein, the only remaining issues for decision are:

(1) whether for 2001 and the tax years at issue JHH Motor Cars, Inc. (JHH), petitioner James H. Hawse's wholly owned S corporation, received automatic consent to change its method of accounting for its new and used vehicles inventories (vehicles inventory) from LIFO to specific identification;

(2) if not, whether JHH changed that method of accounting for the years 2001 through 2007 notwithstanding its failure to secure respondent's automatic consent; and

(3) if so, whether JHH's attempt in 2009 to revert to the LIFO method of accounting for its vehicles inventory by filing amended income tax returns for 2002 and 2003 constitutes a proposed second change in accounting method which would be permissible only with respondent's consent.

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FINDINGS OF FACT

Petitioners James H. Hawse and Cynthia L. Hawse resided in California on the date the petition was filed.² At all relevant times, Mr. Hawse was the president and sole shareholder of JHH, a subchapter S corporation.³

JHH was incorporated under the laws of the State of California in 1984. Its original name was Taylaurel Motors, Inc., which it changed to Sierra Toyota, Inc., in 1985 and then to JHH Motor Cars, Inc., in 2001. During the tax years at issue JHH sold new Toyota and Mitsubishi vehicles and used vehicles and operated a full service automobile repair and parts department.

JHH's Method of Accounting

On September 10, 1985, JHH (under its former name Sierra Toyota, Inc.) elected to use the last-in, first-out (LIFO) method of accounting for its vehicles inventory.⁴ JHH made that election by filing Form 970, Application To Use LIFO

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Inventory Method, with the Internal Revenue Service (IRS). JHH did not make a similar LIFO election for its parts inventory (non-LIFO inventory), which it identified using the specific identification method and valued on the basis of lower of cost or market.⁵

In early 2001, Mr. Hawse, anticipating that he might sell his dealership at some point given the interest expressed by potential buyers, sought to terminate

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JHH's LIFO election because he viewed the LIFO method as an impediment to the eventual sale of his business. Mr. Hawse's specific concern, as he framed it at trial, germinated from the accumulated LIFO reserve that either he or the purchaser might have to recapture if he sold the dealership.⁶ Mr. Hawse felt that generally buyers prefer an asset sale to a stock purchase because they do not want to take on the potential corporate or personal income tax liability associated with an unrecaptured LIFO reserve. In the event of an asset sale, JHH would have to recapture the entire LIFO reserve and Mr. Hawse as its sole shareholder would have to pay tax on it in a single tax year. Because a taxpayer generally must obtain IRS consent to any change in its method of accounting, see sec. 446(e), JHH attempted to follow the automatic consent procedure in Rev. Proc. 97-37, 1997-2 C.B. 455.

JHH filed with the IRS an application for automatic consent to revoke its LIFO election for the vehicles inventory in favor of the specific identification method. It did so principally by attaching Form 3115 to its timely filed 2001 Form 1120S, U.S. Income Tax Return for an S Corporation. On that Form 3115 JHH

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stated that it was requesting permission to change its method of accounting for its vehicles inventory pursuant to the automatic consent provisions of Rev. Proc. 97-37, supra, and that the change would take effect for tax year 2001.

JHH further stated that it currently identified its vehicles inventory using the LIFO method and valued it at cost and that going forward it would identify that inventory using the specific identification method and would value it at the lower of cost or market. Form 3115 made clear that JHH's use of the specific identification method for its non-LIFO inventory and its valuation of that inventory at the lower of cost or market would remain unchanged. The table below summarizes the information JHH presented on Form 3115:

Inventory	Identification; method used before; LIFO termination	Identification; method used after LIFO; termination
Vehicles inventory	LIFO	Specific identification
Non-LIFO inventory	Specific identification	Specific identification

Inventory	Valuation; method used before; LIFO termination	Valuation; method used after LIFO; Termination
Vehicles inventory	Actual cost	Lower of cost or market
Non-LIFO inventory	Lower of cost or market	Lower of cost or market

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JHH also stated on Form 3115 that it would make the necessary section 481(a) adjustment by including in income, or recapturing, its stored LIFO reserve of $1,084,437⁷ over a period of four years--$271,109 per year for each of 2001, 2002, 2003, and 2004.⁸ JHH did not attach a statement explaining how its proposed new methods of identifying and valuing its vehicles inventory were consistent with the requirements of section 1.472-6, Income Tax Regs., or how these methods conformed to the requirements of Rev. Proc. 97-37, app. sec. 10.01, 1997-2 C.B. at 476. Mr. Hawse, JHH's president and sole shareholder, signed Form 3115, and JHH filed a copy with the IRS National Office.

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Consistent with its affirmations on Form 3115, on its 2001 through 2007 income tax returns JHH used the specific identification method of accounting for all of its inventory (vehicles and non-LIFO inventory). JHH also made the section 481(a) adjustment, reporting income of $271,109 under "RECAPTURE LIFO RESERVE", on each of its 2001, 2002, 2003, and 2004 income tax returns.

However, contrary to its representation on Form 3115 that it would value all of its inventory at the lower of cost or market, JHH in fact used different valuation approaches for its various inventories. It used actual cost for new vehicles, lower of cost or wholesale market for used vehicles, and lower of cost or market for parts. Neither JHH's 2001 income tax return nor its Form 3115 disclosed these various approaches. That JHH used these various inventory valuation approaches could be gleaned only from its yearend financial statements.

At no point after JHH filed Form 3115 did respondent advise JHH, in writing or otherwise, that the IRS had rejected JHH's application for automatic consent or that its application was in any way defective.

JHH's Amended Returns

During the years 2001, 2002, and 2003 Kruse Mennillo LLP (Kruse Mennillo) provided accounting services to JHH. JHH had worked with Kruse Mennillo since 1998. Kruse Mennillo reviewed JHH's financial statements,

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provided tax preparation services and inventory valuations, and worked on various other special projects that might come up during the year. With respect to inventory valuations, all inventory valuations on the operational level were done in-house by JHH personnel except that at the end of the year Kruse Mennillo would calculate the LIFO yearend inventory and determine the LIFO reserve amount on the basis of that calculation.

During the years 2001, 2002, and 2003 Victor Kawana was the managing partner of the Cerritos, California, office of Kruse Mennillo and was in charge of JHH's account. At some point before March 10, 2009, Mr. Kawana attended an online seminar, or webinar. Petitioners and Mr. Kawana contend that: (1) IRS Motor Vehicle Technical Specialist Terri Harris participated in that webinar and (2) Ms. Harris represented during the webinar that the IRS was rejecting Forms 3115 filed by taxpayers...