Clevenger, Schall, and Bryson, Circuit Judges.
The opinion of the court was delivered by: Schall, Circuit Judge.
Appealed from: United States Court of Federal Claims
The United States appeals from the judgment of the United States Court of Federal Claims in favor of La Crosse Footwear, Inc. ("La Crosse") in La Crosse's tax refund suit. See LaCrosse Footwear, Inc. v. United States, *fn1 No. 93-722T (Fed. Cl. May 15, 1998). Following a trial, the court entered judgment in favor of La Crosse in the amount of $1.32 million in tax and assessed interest, plus statutory interest. The court held that La Crosse was entitled to a refund of income taxes paid for tax years 1982-1986 because it determined that the base-year cost of certain inventory acquired by La Crosse, for substantially less than either its fair market value or its book value, should be its fair market value instead of its bargain purchase cost, as asserted by the Internal Revenue Service ("IRS"). This determination had the effect of reducing La Crosse's tax liability for the years in question. We conclude, however, that the base-year cost established by the Court of Federal Claims would not clearly reflect La Crosse's income. Accordingly, we reverse and remand.
La Crosse Rubber Mills, Inc. ("Rubber Mills") was a closely-held corporation in the business of manufacturing and selling rubber, canvas, and plastic footwear. In 1982, members of the management and ownership group of Rubber Mills formed La Crosse for the purpose of acquiring the assets of Rubber Mills. *fn2 The purchase agreement was consummated on June 21, 1982, with a retroactive effective date of May 1, 1982. Pursuant to the terms of the purchase agreement, La Crosse acquired all the assets of Rubber Mills, including its inventory, accounts receivable, plant, equipment, and cash. The purchase price was approximately $7.5 million ($4.5 million in cash, $400,000 in acquisitions expenses, and $2.6 million in assumed liabilities). The book value of the assets acquired by La Crosse, however, was approximately $10.6 million ($50,000 in cash, $4.5 million in accounts receivable, $4.0 million in inventory, $500,000 in prepaid expenses, and $1.6 million in fixed and other assets (e.g., plant, property, and equipment)).
La Crosse and Rubber Mills signed an "allocation agreement" under which La Crosse agreed to use full book value as its tax basis in the cash and accounts receivable. In addition, La Crosse agreed to allocate $494,000 for fixed assets and $1.9 million for inventory. The following table shows the book value and tax allocation of the assets purchased from Rubber Mills.
Book Value Tax Allocation
Accounts Receivable 4,478,130 4,478,130
Inventory 4,015,269 1,905,755
Prepaid Expenses 481,035 513,735
Fixed Assets 1,509,223 494,145
Other Assets 91,876 52,876
Thus, for tax purposes, La Crosse acquired inventory with a book value of approximately $4.0 million for about $1.9 million. The fair market value of the inventory was even higher, at $5.8 million.
For tax accounting and book accounting purposes, La Crosse elected to use the dollar-value, double-extension, last-in-first-out ("LIFO") inventory accounting method. The LIFO accounting method is one of two common methods--the other being the first-in-first-out ("FIFO") method. The difference between these methods is whether a fungible item pulled from inventory is deemed to have been the last product placed in inventory (LIFO) or the product that has been in inventory for the longest period of time (FIFO). See Kohler Co. v. United States, 124 F.3d 1451, 1457 (Fed. Cir. 1997). "Using the LIFO system, the taxpayer's closing inventory is deemed to consist of the earliest acquired goods. Under FIFO, the closing inventory is deemed to consist of the most recently [acquired] goods." Id. The advantage of the LIFO method is that it matches current revenues against current costs, and thus removes inflationary increases in inventory costs from taxable income. See Hamilton Indus., Inc. v. Commissioner, 97 T.C. 120, 130 (1991).
There are two basic methods for valuing LIFO inventories: the dollar value method and the item-by-item method. Under the dollar value method, inventory is grouped into one or more "pools" composed of "items." Id. at 130-31. The inventory in a pool is accounted for on the basis of the dollar value of all the items in the pool, as opposed to the item-by-item method, in which the inventory is accounted for on the basis of the quantity and cost of individual items. Under the dollar value method, changes in inventory levels of a pool are measured in terms of increases or decreases in the aggregate value of all the items in the pool. This allows similar items to be interchanged without creating a liquidation of inventory. For example, under the dollar value method, if metal widgets are replaced by plastic widgets, the change is accounted for based on the difference in value between the widgets. In contrast, under the item-by-item method, the replacement of metal widgets with plastic widgets is treated as a liquidation of metal widgets, which causes the taxpayer to realize the inflationary gains of liquidation (i.e., ...