items, see sec. 1.472-2, Income Tax Regs., and the dollarvalue 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 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 Regs.7

7A 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:

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. 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. 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 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

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 dollarvalue 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.

method, 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:

At December 31, year 1, the closing inventory of Pool No. 1 contains 3,000 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:

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

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

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

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:

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

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. 1.4728(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:

the 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 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 14100.7 through 100.8 (2006) (fn. refs. omitted).9]

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.

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.

Product: Chain percentage, Dec. 31, yr. 2, relative

to Jan. 1, yr. 1, base date (121.25% × 127.62%)

154.74%

$21,649

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

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

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