[Code of Federal Regulations]
[Title 26, Volume 11]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1321-1]

[Page 645-648]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.1321-1  Involuntary liquidation of lifo inventories.

    (a) Section 22(d)(6)(B) of the Internal Revenue Code of 1939 
provides as follows:

    Sec. 22. Gross income. * * *
    (d) * * *
    (6) Involuntary liquidation and replacement of inventory. * * *
    (B) Definition of involuntary liquidation. The term involuntary 
liquidation, as used in this paragraph, means the sale or other 
disposition of goods inventoried under the method described in this 
subsection, either voluntary or involuntary, coupled with a failure on 
the part of the taxpayer to purchase, manufacture, or otherwise produce 
and have on hand at the close of the taxable year in which such sale or 
other disposition occurred such goods as would, if on hand at the close 
of such taxable year, be subject to the application of the provisions of 
this subsection, if such failure on the part of the taxpayer is due, 
directly and exclusively, (i) to enemy capture or control of sources of 
limited foreign supply; (ii) to shipping or other transportation 
shortages; (iii) to material shortages resulting from priorities or 
allocations; (iv) to labor shortages; or (v) to other prevailing war 
conditions beyond the control of the taxpayer.

    (b)(1) If, during any taxable year ending after June 30, 1950, and 
before January 1, 1955, the disruption of normal trade relations between 
countries, or one or more of the conditions attributable to a state of 
national preparedness and beyond the control of the taxpayer, as 
prescribed by section 22(d)(6)(B) of the Internal Revenue Code of 1939, 
as modified by section 1321(b) of the Internal Revenue Code of 1954, 
should render it impossible during such period for a taxpayer using the 
last-in first-out inventory method to have on hand at the close of the 
taxable year a stock of merchandise in kind and description like that 
included in the opening inventory for the year, or in a quantity equal 
to that of the opening inventory, the resulting inventory decrease for 
the year will be regarded, at the election of the taxpayer, as 
reflecting an involuntary liquidation subject to replacement. If the 
taxpayer notifies the Commissioner within the period prescribed below 
that he intends to effect a replacement of the liquidated stock, in 
whole or in part, and that he desires to have applied in his case the 
involuntary liquidation and replacement provisions of section 1321, and 
if he establishes to the satisfaction of the Commissioner the 
involuntary character of the liquidation to which his stock has been 
subjected, effect shall be given, when replacement has been made, in 
whole or in part, but only to the extent made in taxable years ending 
before January 1, 1956, to an adjustment of taxable income for the year 
of liquidation in the amount of the difference between the replacement 
costs incurred and the original inventory cost of the liquidated base 
stock inventory that is replaced. The notification is to be given within 
6 months after the filing by the taxpayer of his income tax return for 
the year of the liquidation. However, if the liquidation occurs in a 
taxable year ending after December 31, 1953, the notification may be 
given at any time within 3 months after the promulgation of regulations 
under section 1321, or prior to the expiration of the 6-month period 
following the filing of the return, whichever expiration date later 
occurs.
    (2) If the replacement costs exceed such inventory costs, the 
taxable income of the taxpayer otherwise computed for the year of 
liquidation shall be reduced by an amount equal to such excess. If the 
replacement costs are less than the inventory costs, taxable income 
otherwise computed for the year of liquidation shall be increased to the 
extent of such difference. Any deficiency in the income or excess 
profits tax of the taxpayer, or any overpayment of such taxes, 
attributable to such adjustment shall be assessed and

[[Page 646]]

collected or credited or refunded to the taxpayer without interest.
    (c)(1) A failure on the part of the taxpayer to have on hand in his 
closing inventory for the taxable year merchandise of the kind, 
description, and quantity of that reflected in his opening inventory 
will be considered as an involuntary liquidation only if it is 
established to the satisfaction of the Commissioner that such failure is 
due wholly to his inability to purchase, manufacture, or otherwise 
produce and procure delivery of such merchandise during the taxable year 
of liquidation by reason of the disruption of normal trade relations 
between countries or by reason of certain war conditions, described in 
section 22(d)(6)(B) of the Internal Revenue Code of 1939, as modified by 
section 1321(b). Such war conditions are (i) shortages in the source of 
foreign supply by reason of capture or control by an enemy; (ii) 
shipping or other transportation shortages; (iii) material shortages 
resulting from priorities or allocations; (iv) labor shortages; and (v) 
similar war conditions beyond the control of the taxpayer. For the 
purpose of the preceding sentence, the words enemy and war shall be 
interpreted to apply to circumstances, occurrences, and conditions 
lacking a state of war, which are similar, by reason of a state of 
national preparedness, to those which would exist under a state of war.
    (2) The various directives, orders, regulations, and allotments 
issued by the Federal Government in connection with national 
preparedness are among such circumstances and conditions which might be 
recognized as effecting an involuntary liquidation under this section. 
Likewise, a voluntary compliance with a request of an authorized 
representative of the Federal Government made upon an industry or an 
important segment thereof, or a voluntary allocation of materials by an 
industry or important segment thereof sanctioned by the Federal 
Government, if made in connection with the national preparedness 
program, might be considered as such a circumstance or condition. 
Similarly, so much of an inventory decrease as is directly and 
exclusively attributable to the Federal Government's stockpiling program 
for periods during which an item is not subject to allotment shall also 
be considered as subject to the provisions of section 1321. Thus, so 
much of an inventory decrease as is due wholly to the effect of 
directives, orders, regulations, or allotments issued pursuant to the 
Defense Production Act of 1950, as amended (50 U.S.C. App. 2061 et 
seq.), or to any other circumstance or condition which is solely 
dependent upon other action taken by the Federal Government in 
furtherance of the national preparedness program, ordinarily shall be 
considered as an involuntary liquidation under section 1321 and this 
section; however, to the extent that such a decrease is due to the 
disposition of goods acquired in violation of such directives, orders, 
regulations, or allotments, such decrease shall not be considered as 
such an involuntary liquidation. An inventory decrease due directly and 
exclusively to a disruption of normal trade relations between countries 
shall be considered as an involuntary liquidation subject to the rules 
and requirements prescribed in this section, including the requirement 
that the taxpayer establish to the satisfaction of the Commissioner the 
cause of the involuntary liquidation. A disruption of normal trade 
relations between countries may be reflected by unusual export 
limitations imposed by a foreign government, by unusual exchange 
restrictions, or by other unusual circumstances or conditions beyond the 
control of the taxpayer.
    (3) A voluntary shift by the taxpayer, in the exercise of business 
judgment, to merchandise of a different character, description, or use, 
or to merchandise processed out of a substantially different kind of raw 
materials while raw materials of the type originally used are still 
available will not be considered as an involuntary liquidation 
notwithstanding the fact that such a shift in merchandise stocked was 
prompted by a shifting market demand attributable to the above 
conditions. The term involuntary liquidation presupposes a physical 
inability to maintain a normal inventory as distinguished from a 
financial or business disinclination on the part of the taxpayer to do 
so.

[[Page 647]]

    (d) If the taxpayer would have the involuntary liquidation and 
replacement provisions applicable with respect to any inventory 
decrease, he must so elect within the time prescribed by this section. 
In making such election, the taxpayer shall attach to his return and 
make a part thereof, or he shall furnish separately to the Commissioner, 
a statement setting forth the following matters:
    (1) The desire of the taxpayer to invoke the involuntary liquidation 
and replacement provisions;
    (2) A detailed list or other identifying description of the items of 
merchandise claimed to have been subjected to involuntary liquidation 
and the extent to which replacement is intended;
    (3) The circumstances relied upon as rendering the taxpayer unable 
to maintain throughout the taxable year a normal inventory of the items 
involved, including evidence of the applicable inventory control figures 
for the beginning and the close of the taxable year submitted to the 
appropriate Federal agency in control of defense production (or if none, 
a statement to that effect), allotments applied for, allotments 
received, and reason for failure to place allotments received;
    (4) Detailed proof of such circumstances to the extent that they may 
not be the subject-matter of common knowledge;
    (5) A full description of what efforts were made on the part of the 
taxpayer to effect replacement during the taxable year and the result of 
such efforts; and
    (6) In the case of an election made pursuant to an extension of time 
granted by the Commissioner, the circumstances relied upon as justifying 
the election at such time, together with a disclosure of the extent, if 
any, to which replacements have already been made.
    (e) The election of the taxpayer to treat an involuntary decrease of 
inventory as subject to the replacement adjustments is to be exercised 
separately for each taxable year reflecting such a decrease and the 
election, once exercised with respect to a given year, shall be 
irrevocable with respect to the particular decrease involved and its 
replacement, and shall be binding for the year of liquidation, the year 
of replacement, and all prior, intervening, and subsequent years to the 
extent that such prior, intervening, and subsequent years are affected 
by the adjustments authorized. The ultimate replacement and the 
resulting adjustment for the year of liquidation may have consequences, 
among others, in the earnings and profits of intervening years and the 
inventory accounts of subsequent years. They may have consequences in 
the prior years by reason of adjustments in net operating loss or unused 
excess profits credit carrybacks, and in intervening and subsequent 
taxable years by reason of adjustments in carryovers. Adjustments are to 
be made for the several years affected consistent with the adjustments 
made for the year of liquidation. Detailed records shall be maintained 
such as will enable the Commissioner, in his examination of the 
taxpayer's return for the year of replacement, readily to verify the 
extent of the inventory decrease claimed to be involuntary in character 
and the facts upon which such claim is based, all subsequent inventory 
increases and decreases, and all other facts material to the replacement 
adjustment authorized. For taxable years subject to the Internal Revenue 
Code of 1939, an election under 26 CFR (1939) 39.22(d)-7(e) (Regulations 
118) or 26 CFR (1939) 29.22(d)-7 (Regulations 111) to have the 
involuntary liquidation and replacement provisions of section 22(d)(6) 
of the Internal Revenue Code of 1939 apply with respect to any inventory 
decrease for taxable years to which such section applies, shall be given 
the same effect as if such election had been made under this section. 
(See section 7807(b)(2).)
    (f) Notwithstanding the ultimate purchase price or the cost of 
production ultimately incurred by the taxpayer in effecting replacement 
of a stock involuntarily liquidated, the merchandise reflecting the 
replacement shall be taken into purchases and included in the closing 
inventory for the year of replacement, and shall be included in the 
inventories of subsequent taxable years, at the inventory cost figure of 
the merchandise replaced.
    (g) The goods reflected in any inventory increase in a year 
subsequent to a

[[Page 648]]

year of involuntary liquidation, to the extent that they constitute 
items of the kind and description liquidated in prior years, whether or 
not in a year of involuntary liquidation, shall be deemed, in the order 
of their acquisition, as having been acquired by the taxpayer in 
replacement of like goods most recently liquidated and not previously 
replaced. In a case involving involuntary liquidations of goods of the 
same class subject to the provisions of both section 22(d)(6)(A) of the 
Internal Revenue Code of 1939 and section 1321 of the Internal Revenue 
Code of 1954, the involuntary liquidations of such goods subject to the 
provisions of section 1321 shall, for the purpose of replacements made 
in taxable years ending before January 1, 1953, be considered as having 
occurred prior to the involuntary liquidations of such goods subject to 
the provisions of section 22(d)(6)(A) of the Internal Revenue Code of 
1939. To the extent that the items of increase are allocated to items 
liquidated voluntarily, no adjustment will be required or permitted. 
Such replacement merchandise will be carried in the inventory at its 
actual cost of acquisition. To the extent that replacements are 
allocated to items involuntarily liquidated, however, the provisions of 
this section shall apply, both with respect to adjustments for the year 
of liquidation and other taxable years affected and with respect to 
inventory computations for the year of replacement and all subsequent 
taxable years.
    (h) In some cases it may appear that, at the time of the filing of 
the income tax return for the year of replacement, or within three years 
thereafter, an adjustment with respect to the income or excess profits 
taxes for the year of the involuntary liquidation, or for some prior, 
intervening, or subsequent taxable year, is prevented by the running of 
the statute of limitations, by the execution of a closing agreement, by 
virtue of a court decision which has become final, or by reason of some 
other provision or rule of law other than section 7122 (relating to 
compromises) and other than the inventory replacement provisions. The 
adjustments provided for in connection with the involuntary liquidation 
and replacement of inventory shall nevertheless be made, but only if, 
within a period of three years after the date of the filing of the 
income tax return for the year of replacement, a notice of deficiency is 
mailed or a claim for refund is filed. No credit or refund will be 
allowed under such circumstances, whether within or without such three-
year period, in the absence of a claim for refund duly filed; nor will a 
resulting deficiency be assessed or collected under section 6213(d) 
relating to waivers of restrictions. The issuance of the statutory 
notice of deficiency or the filing of a claim for refund are statutory 
conditions upon which depend the provisions of section 22(d)(6)(E) of 
the Internal Revenue Code of 1939, referred to in section 1321(c) of the 
Internal Revenue Code of 1954. The adjustment authorized by section 
22(d)(6)(E) of the Internal Revenue Code of 1939 is limited further to 
the tax attributable solely to the replacement adjustments. The amount 
of the adjustment shall be computed by reference to the amount of the 
tax previously determined, and without regard to factors affecting the 
taxable year involved to which no effect was given in such prior 
determination. The tax previously determined shall be ascertained in 
accordance with the principles stated in section 452(d) of the Internal 
Revenue Code of 1939. Any deficiency paid or any overpayment credited or 
refunded under these circumstances shall not be subject to recovery on a 
claim for refund or a suit for the recovery of an erroneous refund in 
any case in which such claim or suit is based upon factors other than 
those giving rise to the adjustments made.


[T.D. 6500, 25 FR 12040, Nov. 26, 1960]