Court Opinion

ID: 2976299
Source: CourtListenerOpinion
Date Created: 2015-09-22 17:49:39.786297+00
Date Added: 2024-06-11T11:37:42.866728
License: Public Domain

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                                     Pursuant to Sixth Circuit Rule 206
                                             File Name: 08a0100p.06

                        UNITED STATES COURT OF APPEALS
                                         FOR THE SIXTH CIRCUIT
                                           _________________

                                                X
                                                 -
 DOW A. HUFFMAN (06-2134/2135) and KIMBERLEE
                                                 -
 H. WOLFORD (06-2135/2136), Individually and as
                                                 -
 Personal Representatives of the Estate of Neil A.
                                                 -
                                                                          Nos. 06-2134/2135/2136;
 Huffman; SANDRA E. HUFFMAN (06-2134); ETHEL
                                                 ,
                                                                          07-1180
 M. HUFFMAN (06-2135); DOUGLAS M. WOLFORD         >
 (06-2136); JAMES A. PATTERSON (07-1180);        -
                                                 -
                                                 -
 DOROTHY A. PATTERSON (07-1180),

                                                 -
                               Petitioners-Appellants,

                                                 -
                                                 -
          v.
                                                 -
 COMMISSIONER OF INTERNAL REVENUE,               -
                           Respondent-Appellee. -
                                                 -
                                                N

                               On Appeal from the United States Tax Court.
                                Nos. 2845-04; 2848-04; 2847-04; 2846-04.
                                          Argued: January 29, 2008
                                    Decided and Filed: March 4, 2008
     Before: SUHRHEINRICH and ROGERS, Circuit Judges; BELL, Chief District Judge.*
                                             _________________
                                                   COUNSEL
ARGUED: Mark F. Sommer, GREENEBAUM, DOLL & McDONALD, Louisville, Kentucky, for
Appellant. Michelle B. Smalling, UNITED STATES DEPARTMENT OF JUSTICE, Washington,
D.C., for Appellee. ON BRIEF: Mark F. Sommer, GREENEBAUM, DOLL & McDONALD,
Louisville, Kentucky, for Appellant. Michelle B. Smalling, Jonathan S. Cohen, UNITED STATES
DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee.

         *
           The Honorable Robert Holmes Bell, Chief United States District Judge for the Western District of Michigan,
sitting by designation.

                                                         1
Nos. 06-2134/2135/2136; 07-1180                   Huffman, et al. v. Commissioner                              Page 2

                                              _________________
                                                  OPINION
                                              _________________
        ROGERS, Circuit Judge. The Tax Court upheld the determination by the Commissioner of
Internal Revenue that the correction of a consistently repeated inventory accounting error in this case
amounted to a “change in method of accounting” under I.R.C. § 481. Section 481 permits correction
of accounts for otherwise time-barred years. Because the Commissioner properly determined that
§ 481 applies, we affirm.
         Taxpayers are shareholders of various new and used car dealerships. For a period of ten to
twenty years, the dealerships employed the same accountant to calculate the value of year-end
inventory using the dollar-value, link-chain, “last in, first out” method. During that time, the
accountant consistently omitted a computational step required by the relevant tax statutes and
regulations. That error generally resulted in an understatement of gross income and decreased tax
liability for taxpayers, although if carried through consistently the error would create offsetting
increased liability in later years.
        In 1999, the Commissioner of Internal Revenue commenced an examination of the
dealerships’ tax returns and identified the accountant’s error. The Commissioner revalued the
dealerships’ inventories and made corresponding adjustments to reported gross income for certain
years. Included in the Commissioner’s adjustments were income amounts attributable to years
closed by the applicable statute of limitations. Under I.R.C. § 481, the Commissioner is authorized
to adjust a taxpayer’s taxable income in an open year to reflect amounts attributable to years for
which the applicable statute of limitations has expired, so long as a “change in method of
accounting” has occurred.
        Based in part on the income adjustments with respect to the time-barred years, the
Commissioner issued notices of federal income tax deficiency to taxpayers with respect to open
years. Taxpayers filed a petition with the United States Tax Court seeking a redetermination of the
deficiencies. Taxpayers challenged the propriety of the Commissioner’s adjustments under § 481
with respect to otherwise time-barred years, arguing that the Commissioner’s correction of the
accountant’s computational error is not a “change in method of accounting.” Taxpayers argued that
the Commissioner’s inventory revaluations constitute a correction of “mathematical error” or
“computational error,” and that such corrections are expressly excluded from the regulatory
definition of “change in method of accounting.” See Treas. Reg. § 1.446-1(e)(2)(ii)(b). The Tax
Court held that the Commissioner’s § 481 adjustments were permissible. See 126 T.C. 322 (2006).
Taxpayers challenge this determination.
                                                           I.
       Taxpayers Dow A. and Sandra E. Huffman, James A. and Dorothy A. Patterson,  1
                                                                                     Douglas M.
and Kimberlee H. Wolford, and Neil A. and Ethel M. Huffman are married     couples.  At least one
member of each couple owns stock in one or more of four S corporations2 in the “Huffman Group,”
informally referred to as Huffman Nissan, Huffman Volkswagen, Huffman Dodge, and Huffman
Chrysler.

         1
        Taxpayer Neil A. Huffman died during the pendency of this appeal. His estate is represented by taxpayers
Dow A. Huffman and Kimberlee H. Wolford.
         2
           An S corporation is a “pass-through” entity. The corporation’s income is not taxed to the corporation itself;
it is passed through to its shareholders on a pro rata basis. See I.R.C. §§ 1366, 1368.
Nos. 06-2134/2135/2136; 07-1180                     Huffman, et al. v. Commissioner                            Page 3

        Each Huffman Group corporation sells new and used automobiles in the Louisville area. For
tax purposes, the corporations compute yearly gross income by subtracting the cost of goods sold
from sales revenue. Treas. Reg. § 1.61-3(a). As merchants, the corporations must compute the
value of year-end inventory to determine the cost of goods sold. Treas. Reg. §§ 1.471-1, 1.446-
1(c)(2)(i). And to compute the value of year-end inventory, the cost of goods available during the
year must be allocated between goods sold during the year and goods remaining in inventory at the
end of the year. E.g., Boris I. Bittker, Martin J. McMahon, Jr. & Lawrence A. Zelenak, Federal
Income Taxation of Individuals ¶ 39.06[3], at 39-67 (3d ed. 2002); Stephen F. Gertzman, Federal
Tax Accounting ¶ 6.08, at 6-83 (2d ed. 1993). In certain3cases, a cost-flow assumption is used to
make this allocation. Gertzman, supra, ¶ 6.08[1], at 6-83. Here, the Huffman Group elected to use
the “last in, first out” (“LIFO”) cost-flow assumption. See I.R.C. § 472. The elections were
effective as follows: (1) Huffman Nissan: June 30, 1979; (2) Huffman Volkswagen: December 31,
1979; (3) Huffman Dodge and Huffman Chrysler: December 31, 1989.
         The LIFO assumption treats the last goods acquired as the first goods sold. Gertzman, supra,
¶ 6.08[2], at 6-84. “The objective of the LIFO method is to match relatively current costs against
current revenues to compute a meaningful gross profit.” Id. ¶ 7.02[1], at 7-4. As a general matter,
LIFO provides a tax advantage to firms during periods of rising prices and increasing inventories.
See Bittker, McMahon & Zelenak, supra, ¶ 39.06[3], at 39-69; David W. LaRue, LIFO Recapture
on C-to-S Conversions: Filling the Gaps and Ameliorating the Deficiencies of Section 1363(D), 59
Tax Law. 1, 20 (2005). Because, in rising markets, later-acquired inventory is more expensive than
earlier-acquired inventory, the LIFO assumption results in a lower cost of year-end inventory. In
turn, the lower inventory cost results in a higher cost of goods sold, lower reported profits, and
decreased tax liability. See Bittker, McMahon & Zelenak, supra, ¶ 39.06[3], at 39-69. Thus, the
tax advantage of LIFO is derived from the taxpayer’s deferral of gains attributable to the sale of the
lower-cost, earlier acquired inventory. See id.; Larue, supra, at 20. The deferred gains, however,
will ultimately be recognized upon liquidation of the inventory items to which the lower costs have
been allocated. See Gertzman, supra, ¶ 7.02[1], at 7-5.
        There is more than one method for determining the LIFO value of year-end inventory, but
common among all LIFO methods are the following three steps: (1) the inventory must be separated
into groups or “pools” of similar items; (2) it must be determined whether there has been a
quantitative change in the inventory of each pool during the relevant period; and (3) the value of any
increase (“increment”) in the quantity of each pool must be determined. Gertzman, supra, ¶ 7.04[1],
at 7-30. To carry out these steps, the Huffman Group utilized the dollar-value, link-chain method.4
The following two paragraphs briefly summarize this technical accounting method, only a general
understanding of which is necessary to resolve the dispositive issue in this case. For those less
familiar with the intricacies of inventory accounting for tax purposes, a methodical and helpful
description of the dollar-value, link-chain LIFO method is contained in the Tax Court’s opinion.
See 126 T.C. 322, 325–33 (2006).

         3
             As Gertzman explains:
         [W]hen an inventory consists of a large number of essentially similar or fungible goods, practical
         problems arise as to how the aggregate cost of these goods should be allocated between goods sold
         during the year and goods remaining on hand at the end of the year. For financial accounting
         purposes, these problems are resolved by using assumptions as to which costs should be assigned to
         goods sold and which costs should be assigned to ending inventory.
Gertzman, supra, ¶ 7.01, at 7-3.
         4
             The parties stipulate that each Huffman Group corporation elected the dollar-value, link-chain method.
Nos. 06-2134/2135/2136; 07-1180                     Huffman, et al. v. Commissioner                               Page 4

        The dollar-value approach to LIFO measures the change in the quantity of an inventory pool
in terms of dollars, rather than physical units. See Treas. Reg. § 1.472-8(a). Under the dollar-value
approach, any change in the quantity of dollars invested in an inventory pool over the taxable year
is determined by comparing the aggregate base-year cost of the items in the 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. Gertzman,
supra, ¶ 7.04[3][b], at 7-45. The base-year cost of an item in a pool is the cost of the item as of the
base date—the first day of the first year for which LIFO is adopted. Id.; Treas. Reg. § 1.472-8(a).
        The tax regulations authorize three methods for computing the base-year cost of an inventory
pool and the value of any increment in the pool. See Treas. Reg. § 1.472-8(e). Implicated in this
case is the “link-chain” method. Under that 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-year’s index. Each year’s current-year index
         is multiplied (or “linked”) to all preceding years’ current-year indexes to arrive at a
         cumulative price index that relates back to the taxpayer’s base year.
1 Leslie J. Schneider, Federal Income Taxation of Inventories § 14.02[3][b] (2007). Once the
cumulative price index is calculated, the current-year cost of the year-end inventory is divided by
the cumulative price index to arrive at the base-year cost of the year-end inventory. E.g., I.R.S. Priv.
Ltr. Rul. 8008012 (Nov. 23, 1979).5 For years in which an increment is found (that is, the base-year
cost of the ending inventory exceeds the base-year cost of the beginning inventory), the tax
regulations provide that the increment must be “adjusted for changing unit costs or values by
reference to a percentage, relative to base-year-cost, determined for the pool as a whole.” Treas.
Reg. § 1.472-8(a).6 Under the link-chain method, the increment is adjusted (or “indexed”) by
multiplying the increment by the cumulative price index. I.R.S. Priv. Ltr. Rul. 8008012 (Nov. 23,
1979). The value of the indexed increment is then added to the beginning year inventory value to
arrive at the LIFO value of the year-end inventory.
        In periods of rising prices and increasing inventories, a failure to index the increment
generally leads to an understatement of the value of year-end inventory, a corresponding
overstatement of cost of goods sold, and a resulting understatement of gross income. See Bittker,
McMahon & Zelenak, supra, ¶ 39.06[5], at 39-71; cf. Primo Pants Co. v. Comm’r, 78 T.C. 705, 723
(1982). Although the income deferred as a result of the failure to index will ultimately be
recognized upon liquidation of the inventory pool (assuming that the improper method continues
to be applied), a consistent failure to index serves to defer the reporting of income for a period of
time greater than would be the case under a proper application of the dollar-value, link-chain
method.7

         5
         Though the relevant tax regulations do not contain examples illustrating the link-chain computation
procedures, Private Letter Ruling 8008012 offers an unofficial description.
         6
            This adjustment serves to value the increment at current costs. See Gertzman, supra, ¶ 7.04, at 7-30; Larue,
supra, at 23–25 n.54 (“Indexes developed using the double-extension or link-chain methods are internal indexes that
reflect changes in inventory replacement costs actually experienced by the taxpayer.”). The Tax Court has noted that
“[t]he rationale behind increasing the increment to current-year cost is that even under the LIFO method, inventory
cannot be carried at a cost existing earlier than the year of its acquisition.” Fox Chevrolet, Inc. v. Comm’r, 76 T.C. 708,
732 n.15 (1981).
         7
           Income is deferred rather than permanently omitted because a “consistent undervaluation of ending inventory
acts to defer income. . . . Since each year’s closing inventory becomes the opening inventory for the succeeding year,
the system will automatically self-correct whenever the closing inventory is correctly valued.” Primo Pants Co. v.
Comm’r, 78 T.C. 705, 723 (1982); see also Bittker, McMahon & Zelenak, supra, ¶ 39.06[5], at 39-71.
Nos. 06-2134/2135/2136; 07-1180            Huffman, et al. v. Commissioner                    Page 5

        In the instant case, the same certified public accountant performed the dollar-value, link-
chain LIFO method for each Huffman Group corporation. However, in years where an increment
existed, the accountant consistently failed to index the increment as required by the tax regulations.
Generally, this error led to an under-reporting of income for the Huffman Group and its
stockholders, reducing taxpayers’ tax liability for certain years. The accountant consistently
repeated the error with respect to each corporation, beginning in the year that each corporation
elected the link-chain, dollar-value method. Apart from any statute of limitations effects, the error
only deferred the reporting of income, it did not permanently avoid the reporting of any income.
        At some point after the Huffman Group filed their 1999 federal income tax returns, the
Commissioner of Internal Revenue commenced an examination of the corporations’ tax returns for
that year and years prior. After identifying the accountant’s mistake, the Commissioner revalued
each corporation’s year-end inventory values. Because of the statute of limitations prescribed in
I.R.C. § 6501, the earliest year (or “first year in issue”) that the Commissioner could make
adjustments to the corporations’ tax returns was 1998 for Huffman Nissan, Huffman Dodge, and
Huffman Chrysler, and 1997 for Huffman Volkswagen. Accordingly, the Commissioner proceeded
to adjust the corporations’ gross incomes—on the basis of the inventory revaluations—in two steps.
        First, for the first year in issue and each subsequent year, the Commissioner adjusted the
corporations’ gross incomes to reflect the recalculation of beginning and ending inventories for the
year. Taxpayers do not challenge the propriety of this adjustment. The changes in gross income
related to the Commissioner’s first adjustment are as follows: (1) Huffman Nissan: $17,251 and
$41,273 for tax years 1998 and 1999, respectively; (2) Huffman Volkswagen: $49,056, $35,484, and
$575,137 for tax years 1997, 1998 and 1999, respectively; (3) Huffman Dodge: ($37,752) and
$256,315 for tax years 1998 and 1999, respectively; and (4) Huffman Chrysler: $76,402 and
($88,687) for tax years 1998 and 1999, respectively.
        Second, for the first year in issue only, the Commissioner made an additional adjustment
under I.R.C. § 481. That statute allows the Commissioner to adjust a taxpayer’s taxable income in
an open year to reflect amounts attributable to adjustments to closed years (years for which the
statute of limitations has already expired) so long as a “change in method of accounting” has
occurred. See Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 571–72 (5th Cir. 1965); Gertzman,
supra, ¶ 8.02, at 8-5. This second adjustment served to increase the taxable income for the first year
in issue for each corporation by the cumulative amount of income attributable to the inventory
recalculations for all years prior to the first year in issue. The changes in gross income related to
this second adjustment are as follows: (1) Huffman Nissan: $794,993 for tax year 1998; (2) Huffman
Volkswagen: $273,115 for tax year 1997; (3) Huffman Dodge: $348,762 for tax year 1998; and
(4) Huffman Chrysler: $337,423 for tax year 1998.
       Based on these corporate income adjustments, the Commissioner issued notices of federal
income tax deficiency to each couple on December 19, 2003. Deficiencies were assessed against
taxpayers in the following amounts: (1) Dow and Sandra Huffman: $36,757 and $9,413 for tax years
1998 and 1999, respectively; (2) the Pattersons: $35,542 for tax year 1998; (3) the Wolfords:
$33,422 and $1,966 for tax years 1998 and 1999, respectively; and (4) Neil and Ethel Huffman:
$131,408, $535,065, and $304,033 for tax years 1997, 1998, and 1999, respectively. On February
17, 2004, each couple filed a petition with the United States Tax Court seeking a redetermination
of the deficiencies. Taxpayers challenged the propriety of the second adjustment (the § 481
adjustment), arguing that the adjustment was improper because no “change in method of accounting”
had occurred.
        On May 16, 2006, the Tax Court ruled in favor of the Commissioner. See 126 T.C. 322
(2006). The Tax Court concluded that the Commissioner’s correction of the accountant’s error
constituted a “change in method of accounting” under § 481 and, accordingly, that the
Nos. 06-2134/2135/2136; 07-1180            Huffman, et al. v. Commissioner                    Page 6

Commissioner’s § 481 adjustments were permissible. The Tax Court rejected the contention that
the inventory revaluations were corrections of “mathematical error” to which § 481 does not apply,
reasoning that the accountant had not made an error in arithmetic, but rather had omitted a
computational step. In doing so, the Tax Court applied a definition of “mathematical error” found
in a separate section of the Internal Revenue Code.
        On appeal, taxpayers challenge the Tax Court’s determination that the Commissioner’s
correction of the accountant’s error is a “change in method of accounting.” Taxpayers do not contest
the existence of the accountant’s error or the accuracy of the Commissioner’s calculations.
                                                 II.
       Because the Commissioner’s correction of the accountant’s error is a “change in method of
accounting,” we affirm. This case involves the timing of income recognition. The accountant’s
computational error improperly deferred the reporting of certain taxable income; it did not
permanently avoid the reporting of any income. The Commissioner’s correction simply causes the
improperly deferred income to be recognized at a time earlier than would be the case under
continued use of the accountant’s erroneous method. The correction thus determines the timing of
income recognition and properly constitutes a “change in method of accounting” for purposes of §
481 and Treas. Reg. § 1.446-1.
        At the outset, it is clear that the language and purposes of the statutory terms of § 481,
without looking at the language of implementing regulations, permit and indeed strongly support
the application of § 481 to the facts of this case. Taxpayers do not argue otherwise, but rather rely
on the provisions of implementing treasury regulations, discussed subsequently below. Section 481
provides in relevant part:
       (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.
I.R.C. § 481(a) (emphasis added). It cannot seriously be argued that the consistent correction in this
case to the repeated identical error in calculating yearly carryover inventory values is not a “change
in method of accounting,” in the plain English sense of the words.
        It is also consistent with the core purposes of § 481 to apply that provision in this case.
Section 481 is designed to address certain difficulties that arise when a taxpayer changes accounting
methods, and those are the identical difficulties that arose in this case. “Because different tax
accounting methods provide for different dates on which income or deductions are recognized, a
switch in accounting methods can create a situation in which a taxpayer is able to deduct the same
expense—or is required to recognize the same income—in two separate tax years.” Nat’l Life Ins.
Co. & Subsidiaries v. Comm’r, 103 F.3d 5, 7 (2d Cir. 1996); see also Bittker, McMahon & Zelenak,
supra, ¶ 39.09[1], at 39-81. Section 481 addresses these difficulties by authorizing the
Nos. 06-2134/2135/2136; 07-1180                    Huffman, et al. v. Commissioner                                   Page 7

Commissioner to adjust a taxpayer’s income in an open year to reflect amounts attributable to years
for which the applicable statute of limitations has expired. See Gertzman, supra, ¶ 8.02, at 8-5;
Graff Chevrolet, 343 F.2d at 572 (“[S]ection 481 would be virtually useless if it did not affect closed
years.”).8 The statute thus “ensure[s] that items of income and expense are neither duplicated nor
omitted in computing taxable income following a change in method of accounting.” Gertzman,
supra, ¶ 8.01, at 8-3. In so doing, § 481 “prevent[s] either a distortion of taxable income or a
windfall to the taxpayer arising from a change in accounting method when the statute of limitations
bars reopening of the taxpayer’s earlier returns.” Suzy’s Zoo v. Comm’r, 273 F.3d 875, 883 (9th Cir.
2001). The application of § 481 prevents such a distortion in this case. If the correct—or the
incorrect—calculation were made consistently throughout the years, then all of the income would
be properly taxed, albeit at different times. Only by correcting the error in midstream would some
of the income escape taxation altogether by operation of the statute of limitations. This is exactly
what § 481 was intended to avoid.
        Taxpayers accordingly do not rely directly on the language of § 481 or its purposes, but
rather focus on the treasury regulation interpreting § 481 to argue that the section does not apply.
That regulation, however, ultimately supports the Commissioner. Treas. Reg. § 1.446-1 provides
both inclusive and exclusive rules for determining when a “change in method of accounting” has
occurred. The inclusive aspect of the regulation is broad enough to encompass the corrections at
issue in this case, and—contrary to the primary argument of the taxpayers—the exclusive aspect
does not require a different result.
        The treasury regulation in its inclusive aspect covers the corrections here because the
corrections are an overall change affecting the timing of tax payment with respect to inventories.
Treas. Reg. § 1.446-1 provides that “[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.” Treas. Reg. § 1.446-1(e)(2)(ii)(a). Regarding inventories,
the regulation specifically provides that “a change in the treatment of any material item used in the
overall plan for identifying or valuing items in inventory is a change in method of accounting.” §
1.446-1(e)(2)(ii)(c). For purposes of these rules, a “material item” is “any item that involves the
proper time for the inclusion of the item in income or the taking of a deduction.” § 1.446-
1(e)(2)(ii)(a).
         As the Eleventh Circuit has observed, “[t]he essential characteristic of a ‘material item’ is
that it determines the timing of income or deductions.” Knight-Ridder Newspapers, Inc. v. United
States, 743 F.2d 781, 798 (11th Cir. 1984). In this case, the change from the accountant’s erroneous
method to the proper dollar-value, link-chain method does just that. The accountant erred by
consistently failing to index the increment every year beginning with the year of election for each
corporation. This error generally led to a lower year-end inventory value and a corresponding
decrease in taxable income, but the error would have self-corrected upon liquidation of the inventory
pool (assuming continued application). As a result, the error only served to defer the reporting of
income, it did not lead to the permanent omission of income. The upshot of the Commissioner’s

         8
             As the Fifth Circuit has explained,
         [t]here is no necessary conflict between section 481 and the statute of limitations. Until the year of
         the accounting change, the Commissioner has no claim against the taxpayer for amounts which the
         taxpayer should have reported in prior years. The statute of limitations is directed toward stale claims.
         Section 481 deals with claims which do not even arise until the year of the accounting change.
Graff Chevrolet, 343 F.2d at 572; see also Note, Problems Arising from Changes in Tax-Accounting Methods, 73 Harv.
L. Rev. 1564, 1576–77 (1960) (“Section 481, therefore, does not hold the taxpayer to any income which he has any
reason to believe he has avoided, and does not frustrate the policy that men should be able, after a certain time, to be
confident that past wrongs are set at rest.”).
Nos. 06-2134/2135/2136; 07-1180            Huffman, et al. v. Commissioner                         Page 8

correction (and proper application of the dollar-value, link-chain method going forward) is that
income that was improperly deferred under the accountant’s erroneous method will be recognized
at a time earlier than would be the case under continued use of the accountant’s method. The
Commissioner’s correction thus constitutes a “change in the treatment of [a] material item used in”
the overall plan of valuing inventory because the change from the accountant’s erroneous method
to the proper dollar-value, link-chain method determines the timing of income recognition.
        An illustrative example provided in the regulation itself is instructive in this regard. See §
1.446-1(e)(2)(iii). In Example 6, the regulation describes a scenario where a taxpayer has for many
taxable years valued inventories at cost improperly. Specifically, the taxpayer improperly computed
cost (and thus the value of inventory) by failing to include overhead costs. This improper
computation was contrary to the requirements of the tax code and regulations. After laying out this
scenario, the regulation provides that a change requiring the appropriate allocation of overhead costs
in the value of inventory is a change in accounting method because “it involves a change in the
treatment of a material item used in the overall practice of identifying or valuing items in inventory.”
See § 1.446-1(e)(2)(iii) ex.6. The circumstances of this case are analogous and require the same
conclusion. For a number of years, the accountant consistently and improperly computed the value
of inventory, and this improper computation was contrary to statutory and regulatory requirements.
The Commissioner’s correction appropriately values the inventory increment, and thus involves a
change in the treatment of a material item used to value inventory.
        The Tax Court has consistently applied the regulation in this way. In Primo Pants Co. v.
Commissioner, 78 T.C. 705 (1982), the taxpayer erroneously discounted the value of its inventory
over a number of years. In response, the Commissioner revalued the inventory to correct the errors
and made income adjustments under § 481 to reflect those revaluations. Id. at 706–14. Taxpayer
argued that the § 481 adjustments were improper because the Commissioner’s correction of its
erroneous valuation method did not constitute a change in accounting method. Id. at 714. The Tax
Court disagreed. The court stated that the relevant inquiry is “whether the accounting practices
permanently avoided the reporting of income over the taxpayer’s lifetime income or merely
postponed the reporting of income.” Id. at 723. The court went on to explain:
       The consistent undervaluation of ending inventory acts to defer income. . . . The
       cumulative income over the period of years involved will be the same total, but
       income will be deferred each year until the closing inventory is finally corrected. . . .
       Thus, we conclude that petitioner’s erroneous writedowns of its inventory do involve
       timing questions: the proper time for taking a deduction (indirectly through cost of
       goods sold) and for reporting income (income from sales). . . . In conclusion, we hold
       that [the Commissioner’s] revaluations of petitioner’s inventory . . . constitute
       changes in petitioner’s method of accounting.
Id. at 723–25.
        In Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500 (1989), the Tax Court reaffirmed
the holding of Primo Pants. In Wayne Bolt & Nut, the taxpayer valued its inventory using a “lower
of cost or market” approach. Id. at 501. To determine the amount of its ending inventory for each
year prior to 1982, taxpayer used a sampling method. Id. at 503. In 1982, taxpayer took a complete
physical count of its inventory and discovered that it had previously written off approximately $2
million worth of inventory that still existed in its warehouse. Id. at 504–05. Taxpayer’s flawed
accounting method resulted in understated inventory values and a consistent under-reporting of
income, and the error would have self-corrected over time. Id. at 508–09. To remedy the
miscalculations, the taxpayer increased its opening and ending inventory for the current year, and
adjusted inventory values and filed amended returns for fiscal years ending in February 1979, 1980,
and 1981. Id. at 505. Though most of the inventory understatements discovered in 1982 were made
Nos. 06-2134/2135/2136; 07-1180            Huffman, et al. v. Commissioner                       Page 9

prior to 1979, taxpayer took the position that adjustments to income for years prior to 1979 were
barred by the statute of limitations. Id. The Commissioner argued that taxpayer’s inventory
revaluations were a “change in method of accounting” and, accordingly, that § 481 adjustments were
required. Id. at 506. The Tax Court concluded that the inventory recalculations made by taxpayer
constituted a “change in method of accounting.” Id. at 511–13.
         Primo Pants and Wayne Bolt & Nut are persuasive on the facts of this case. Like the instant
case, both cases involve an error in inventory accounting that led to a consistent undervaluation of
year-end inventory. As a result of those undervaluations, income was deferred for a period of time,
but not permanently omitted. Because the later change in accounting practice altered the timing of
income recognition, the § 481 adjustments were permissible. Further, the holdings of Primo Pants
and Wayne Bolt & Nut are consistent with the purpose of § 481. As discussed, § 481 was enacted
to “prevent either a distortion of taxable income or a windfall to the taxpayer arising from a change
in accounting method when the statute of limitations bars reopening of the taxpayer’s earlier
returns.” Suzy’s Zoo, 273 F.3d at 883. In both Primo Pants and Wayne Bolt & Nut, application of
§ 481 prevented the taxpayers from experiencing a windfall due to the permanent exclusion of
certain income. See Primo Pants, 78 T.C. 714 (“If the opening inventory for 1973 is revalued as
petitioner requests, but without the section 481 adjustments, petitioner will receive a windfall.”);
Wayne Bolt & Nut, 93 T.C. 506. Similarly, it is uncontested here that, absent the § 481
adjustments, taxpayers stand to avoid taxation on nearly $2 million of income, notwithstanding the
fact that that income eventually would have been reported under the accountant’s erroneous method
(and, indeed, already would have been reported had the dollar-value, link-chain method been applied
properly at the outset).
      Taxpayers rely primarily on the exclusive aspect of the treasury regulation, which defines
“change in method of accounting” not to 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 any item of income or deduction that does not involve
       the proper time for the inclusion of the item of income or the taking of a deduction.
§ 1.446-1(e)(2)(ii)(b) (emphasis added). Taxpayers argue that the corrections involved in this case
are corrections of “mathematical errors” or “errors in the computation of tax liability.” Like the Tax
Court in Wayne Bolt & Nut, we are not persuaded. In Wayne Bolt & Nut, the Tax Court explicitly
rejected the taxpayer’s argument that the corrections of the inventory accounting errors were
corrections of “mathematical error,” explaining:
       [The] systemic flaws in petitioner’s pre-1982 system simply cannot be described as
       mere mathematical or posting errors. Prior to 1982, petitioner consistently used a
       method of determining inventory which resulted in premature write-downs of ending
       inventory. This constituted a method of accounting.
Wayne Bolt & Nut, 93 T.C. 512. Taxpayers read the Tax Court below to have adopted a definition
of “mathematical error” that is limited to arithmetic calculation errors, a definition that they argue
is too narrow. We do not need to bless or criticize the Tax Court’s general definition of
“mathematical error,” however, because we are fully satisfied that the regulation precludes
application of either the “mathematical error” or the “computational error” exception on the facts
of this case.
        To define “correction of mathematical error” to include the correction in this case would
lead to a contradiction within the regulation. In effect, taxpayers argue that “mathematical error”
arises any time there is a discrepancy between a computed value and the correct value. This
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definition would, for example, include the circumstance described in Example 6. As discussed,
Example 6 of § 1.446-1(e)(2)(iii) describes a situation where a taxpayer, consistently and for a
number of years, improperly computed the value of inventory by omitting overhead costs. The
taxpayer’s error would thus be considered a “mathematical error” under taxpayers’ definition, yet
the regulation provides that a correction of that error constitutes a “change in method of accounting.”
The example thus implicitly rejects the idea that the “mathematical error” or “computational error”
exception applies in those circumstances. The facts of the instant case are sufficiently analogous
to Example 6 to warrant a conclusion that neither exception applies here.
        Bolstering this conclusion, moreover, is the fact that this case involves an issue of regulatory
interpretation. The central dispute between the parties is whether the correction of a specific
accounting error constitutes a “change in method of accounting,” as that phrase is defined in a
regulation promulgated by the Treasury Department. Accordingly, we are here dealing with the
interpretation of rules of inclusion and exclusion that are “creatures” of the Treasury Department’s
own making. See Auer v. Robbins, 519 U.S. 452, 461 (1997). In this case, the Commissioner has
interpreted those rules as including within the ambit of § 481 the correction of the accountant’s
erroneous method. Although taxpayers provide their own interpretation, that interpretation is
certainly not, for the reasons stated above, compelled by the plain language of the regulation. The
Supreme Court held in Auer that an agency’s interpretation of its own regulation, presented in that
case in a brief to the Court, was “controlling” where the interpretation reflected a “fair and
considered judgment” and was not “plainly erroneous or inconsistent with the regulation.” Id. at
461–62. We cannot conclude that the Commissioner’s interpretation of what constitutes a “change
in method of accounting” (and therefore not “mathematical” or “computational” error) is “plainly
erroneous or inconsistent with the regulation,” and the Commissioner’s interpretation is accordingly
entitled to controlling weight. See id.; United States v. Cinemark USA, Inc., 348 F.3d 569, 578–79
(6th Cir. 2003).
        Taxpayers’ reliance on two pre-1970 published opinions of this court is misplaced. See
Thompson-King-Tate, Inc. v. United States, 296 F.2d 290 (6th Cir. 1961); Wood-Mosaic Co. v.
United States, 160 F. Supp. 636 (W.D. Ky. 1958), aff’d, 272 F.2d 944 (6th Cir. 1959) (per curiam).
Neither case involved facts analogous to those presented here. Moreover, both cases were decided
before the treasury regulation provisions relied upon were promulgated in 1970. The regulatory
language involving correction of mathematical and computational errors, along with the illustrative
examples, was added to the regulation in 1970. See T.D. 7073, 1970-2 C.B. 98. The pre-1970
regulation did not define “material item,” nor did it contain an exclusion for “mathematical error.”
See 25 Fed. Reg. 11,708, 11,709 (Nov. 26, 1960).
        Finally, the asserted inadvertence of the accountant’s error is not relevant to the
determination of whether there was a “change in method of accounting.” Taxpayers rely on the
Court of Claims decision in Korn Industries, Inc. v. United States for the proposition that
inadvertence should be considered in determining whether § 481 applies. See 532 F.2d 1352, 1356
(Ct. Cl. 1976). Korn Industries, however, has been characterized by the Federal Circuit as a case
of “posting error”9 and thus is not directly relevant to taxpayers’ arguments regarding mathematical
and computational error. See Diebold, Inc. v. United States, 891 F.2d 1579, 1582 (Fed. Cir. 1989).
In any event, there is simply no basis in the text of § 481 or § 1.446-1 for a conclusion that
inadvertence or intent is relevant to the inquiry of whether a change in accounting method has
occurred. As the Tax Court noted in Superior Coach of Florida, Inc. v. Commissioner, 80 T.C. 895,
913 n.5 (1983), to the extent that Korn Industries provides for an exception to § 481 for the

         9
          In Korn Industries, the Court of Claims held that a “change in method of accounting” had not occurred when
a taxpayer, for four years, deviated from the method of accounting for inventories that it had previously used by omitting
three items from its finished goods inventory. The three items, however, were included in raw materials inventory, work-
in-process inventory, and supplies inventory. 532 F.2d at 1353.
Nos. 06-2134/2135/2136; 07-1180          Huffman, et al. v. Commissioner                 Page 11

correction of good-faith mistakes, commentators have questioned the authority for such an
exception. Indeed, such considerations are inconsistent with the very purpose of § 481—to allow
for all adjustments necessary to prevent amounts from being omitted or duplicated as a result of a
change in accounting method.
                                               III.
       For the foregoing reasons, the judgment of the Tax Court is affirmed.