[Code of Federal Regulations]
[Title 26, Volume 6]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.471-11]

[Page 503-513]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.471-11  Inventories of manufacturers.

    (a) Use of full absorption method of inventory costing. In order to 
conform as nearly as may be possible to the best

[[Page 504]]

accounting practices and to clearly reflect income (as required by 
section 471 of the Code), both direct and indirect production costs must 
be taken into account in the computation of inventoriable costs in 
accordance with the ``full absorption'' method of inventory costing. 
Under the full absorption method of inventory costing production costs 
must be allocated to goods produced during the taxable year, whether 
sold during the taxable year or in inventory at the close of the taxable 
year determined in accordance with the taxpayer's method of identifying 
goods in inventory. Thus, the taxpayer must include as inventoriable 
costs all direct production costs and, to the extent provided by 
paragraphs (c) and (d) of this section, all indirect production costs. 
For purposes of this section, the term ``financial reports'' means 
financial reports (including consolidated financial statements) to 
shareholders, partners, beneficiaries or other proprietors and for 
credit purposes. See also Sec. 1.263A-1T with respect to the treatment 
of production costs incurred in taxable years beginning after December 
31, 1986, and before January 1, 1994. See also Sec. Sec. 1.263A-1 and 
1.263A-2 with respect to the treatment of production costs incurred in 
taxable years beginning after December 31, 1993.
    (b) Production costs--(1) In general. Costs are considered to be 
production costs to the extent that they are incident to and necessary 
for production or manufacturing operations or processes. Production 
costs include direct production costs and fixed and variable indirect 
production costs.
    (2) Direct production costs. (i) Costs classified as ``direct 
production costs'' are generally those costs which are incident to and 
necessary for production or manufacturing operations or processes and 
are components of the cost of either direct material or direct labor. 
Direct material costs include the cost of those materials which become 
an integral part of the specific product and those materials which are 
consumed in the ordinary course of manufacturing and can be identified 
or associated with particular units or groups of units of that product. 
See Sec. 1.471-3 for the elements of direct material costs. Direct 
labor costs include the cost of labor which can be identified or 
associated with particular units or groups of units of a specific 
product. The elements of direct labor costs include such items as basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d)), shift differential, payroll taxes and payments to a 
supplemental unemployment benefit plan paid or incurred on behalf of 
employees engaged in direct labor. For the treatment of rework labor, 
scrap, spoilage costs, and any other costs not specifically described as 
direct production costs see Sec. 1.471-11(c)(2).
    (ii) Under the full absorption method, a taxpayer must take into 
account all items of direct production cost in his inventoriable costs. 
Nevertheless, a taxpayer will not be treated as using an incorrect 
method of inventory costing if he treats any direct production costs as 
indirect production costs, provided such costs are allocated to the 
taxpayer's ending inventory to the extent provided by paragraph (d) of 
this section. Thus, for example, a taxpayer may treat direct labor costs 
as part of indirect production costs (for example, by use of the 
conversion cost method), provided all such costs are allocated to ending 
inventory to the extent provided by paragraph (d) of this section.
    (3) Indirect production costs--(i) In general. The term ``indirect 
production costs'' includes all costs which are incident to and 
necessary for production or manufacturing operations or processes other 
than direct production costs (as defined in subparagraph (2) of this 
paragraph). Indirect production costs may be classified as to kind or 
type in accordance with acceptable accounting principles so as to enable 
convenient identification with various production or manufacturing 
activities or functions and to facilitate reasonable groupings of such 
costs for purposes of determining unit product costs.
    (ii) Fixed and variable classifications. For purposes of this 
section, fixed indirect production costs are generally those costs which 
do not vary significantly with changes in the amount of goods produced 
at any given level of production capacity. These fixed costs may 
include, among other costs, rent

[[Page 505]]

and property taxes on buildings and machinery incident to and necessary 
for manufacturing operations or processes. On the other hand, variable 
indirect production costs are generally those costs which do vary 
significantly with changes in the amount of goods produced at any given 
level of production capacity. These variable costs may include, among 
other costs, indirect materials, factory janitorial supplies, and 
utilities. Where a particular cost contains both fixed and variable 
elements, these elements should be segregated into fixed and variable 
classifications to the extent necessary under the taxpayer's method of 
allocation, such as for the application of the practical capacity 
concept (as described in paragraph (d) (4) of this section).
    (c) Certain indirect and production costs--(1) General rule. Except 
as provided in paragraph (c)(3) of this section and in paragraph 
(d)(6)(v) of Sec. 1.451-3, in order to determine whether indirect 
production costs referred to in paragraph (b) of this section must be 
included in a taxpayer's computation of the amount of inventoriable 
costs, three categories of costs have been provided in subparagraph (2) 
of this paragraph. Costs described in subparagraph (2)(i) of this 
paragraph must be included in the taxpayer's computation of the amount 
of inventoriable costs, regardless of their treatment by the taxpayer in 
his financial reports. Costs described in subparagraph (2)(ii) of this 
paragraph need not enter into the taxpayer's computation of the amount 
of inventoriable costs, regardless of their treatment by the taxpayer in 
his financial reports. Costs described in subparagraph (2)(iii) of this 
paragraph must be included in or excluded from the taxpayer's 
computation of the amount inventoriable costs in accordance with the 
treatment of such costs by the taxpayer in his financial reports and 
generally accepted accounting principles. For the treatment of indirect 
production costs described in subparagraph (2) of this paragraph in the 
case of a taxpayer who is not using comparable methods of accounting for 
such costs for tax and financial reporting see paragraph (c)(3) of this 
section. For contracts entered into after December 31, 1982, 
notwithstanding this section, taxpayers who use an inventory method of 
accounting for extended period long-term contracts (as defined in 
paragraph (b)(3) of Sec. 1.451-3) for tax purposes may be required to 
use the cost allocation rules provided in paragraph (d)(6) of Sec. 
1.451-3 rather than the cost allocation rules provided in this section. 
See paragraph (d)(6)(v) of Sec. 1.451-3. After a taxpayer has 
determined which costs must be treated as indirect production costs 
includible in the computation of the amount of inventoriable costs, such 
costs must be allocated to a taxpayer's ending inventory in a manner 
prescribed by paragraph (d) of this section.
    (2) Includibility of certain indirect production costs--(i) Indirect 
production costs included in inventoriable costs. Indirect production 
costs which must enter into the computation of the amount of 
inventoriable costs (regardless of their treatment by a taxpayer in his 
financial reports) include:
    (a) Repair expenses,
    (b) Maintenance,
    (c) Utilities, such as heat, power and light,
    (d) Rent,
    (e) Indirect labor and production supervisory wages, including basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d), shift differential, payroll taxes and contributions to a 
supplemental unemployment benefit plan,
    (f) Indirect materials and supplies,
    (g) Tools and equipment not capitalized, and
    (h) Costs of quality control and inspection,

to the extent, and only to the extent, such costs are incident to and 
necessary for production or manufacturing operations or processes.
    (ii) Costs not included in inventoriable costs. Costs which are not 
required to be included for tax purposes in the computation of the 
amount of inventoriable costs (regardless of their treatment by a 
taxpayer in his financial reports) include:
    (a) Marketing expenses,
    (b) Advertising expenses,
    (c) Selling expenses,

[[Page 506]]

    (d) Other distribution expenses,
    (e) Interest,
    (f) Research and experimental expenses including engineering and 
product development expenses,
    (g) Losses under section 165 and the regulations thereunder,
    (h) Percentage depletion in excess of cost depletion,
    (i) Depreciation and amortization reported for Federal income tax 
purposes in excess of depreciation reported by the taxpayer in his 
financial reports,
    (j) Income taxes attributable to income received on the sale of 
inventory,
    (k) Pension contributions to the extent that they represent past 
services cost,
    (l) General and administrative expenses incident to and necessary 
for the taxpayer's activities as a whole rather than to production or 
manufacturing operations or processes, and
    (m) Salaries paid to officers attributable to the performance of 
services which are incident to and necessary for the taxpayer's 
activities taken as a whole rather than to production or manufacturing 
operations or processes.

Notwithstanding the preceding sentence, if a taxpayer consistently 
includes in his computation of the amount of inventoriable costs any of 
the costs described in the preceding sentence, a change in such method 
of inclusion shall be considered a change in method of accounting within 
the meaning of sections 446, 481, and paragraph (e)(4) of this section.
    (iii) Indirect production costs includible in inventoriable costs 
depending upon treatment in taxpayer's financial reports. In the case of 
costs listed in this subdivision, the inclusion or exclusion of such 
costs from the amount of inventoriable costs for purposes of a 
taxpayer's financial reports shall determine whether such costs must be 
included in or excluded from the computation of inventoriable costs for 
tax purposes, but only if such treatment is not inconsistent with 
generally accepted accounting principles. In the case of costs which are 
not included in subdivision (i) or (ii) of this subparagraph, nor listed 
in this subdivision, whether such costs must be included in or excluded 
from the computation of inventoriable costs for tax purposes depends 
upon the extent to which such costs are similar to costs included in 
subdivision (i) or (ii), and if such costs are dissimilar to costs in 
subdivision (i) or (ii), such costs shall be treated as included in or 
excludable from the amount of inventoriable costs in accordance with 
this subdivision. The costs listed in this subdivision are:
    (a) Taxes. Taxes otherwise allowable as a deduction under section 
164 (other than State and local and foreign income taxes) attributable 
to assets incident to and necessary for production or manufacturing 
operations or processes. Thus, for example, the cost of State and local 
property taxes imposed on a factory or other production facility and any 
State and local taxes imposed on inventory must be included in or 
excluded from the computation of the amount of inventoriable costs for 
tax purposes depending upon their treatment by a taxpayer in his 
financial reports.
    (b) Depreciation and depletion. Depreciation reported in financial 
reports and cost depletion on assets incident to and necessary for 
production or manufacturing operations or processes. In computing cost 
depletion under this section, the adjusted basis of such assets shall be 
reduced by cost depletion and not by percentage depletion taken thereon.
    (c) Employee benefits. Pension and profit-sharing contributions 
representing current service costs otherwise allowable as a deduction 
under section 404, and other employee benefits incurred on behalf of 
labor incident to and necessary for production or manufacturing 
operations or processes. These other benefits include workmen's 
compensation expenses, payments under a wage continuation plan described 
in section 105(d), amounts of a type which would be includible in the 
gross income of employees under non-qualified pension, profit-sharing 
and stock bonus plans, premiums on life and health insurance and 
miscellaneous benefits provided for employees such as safety, medical 
treatment, cafeteria, recreational facilities, membership dues, etc., 
which are otherwise allowable as deductions under chapter 1 of the Code.

[[Page 507]]

    (d) Costs attributable to strikes, rework labor, scrap and spoilage. 
Costs attributable to rework labor, scrap and spoilage which are 
incident to and necessary for production or manufacturing operations or 
processes and costs attributable to strikes incident to production or 
manufacturing operation or processes.
    (e) Factory administrative expenses. Administrative costs of 
production (but not including any cost of selling or any return on 
capital) incident to and necessary for production or manufacturing 
operations or processes.
    (f) Officers' salaries. Salaries paid to officers attributable to 
services performed incident to and necessary for production or 
manufacturing operations or processes.
    (g) Insurance costs. Insurance costs incident to and necessary for 
production or manufacturing operations or processes such as insurance on 
production machinery and equipment. A change in the taxpayer's treatment 
in his financial reports of costs described in this subdivision which 
results in a change in treatment of such costs for tax purposes shall 
constitute a change in method of accounting within the meaning of 
sections 446 and 481 to which paragraph (e) applies.
    (3) Exception. Except as provided in paragraph (d)(6) of Sec. 
1.451-3, in the case of a taxpayer whose method of accounting for 
production costs in his financial reports is not comparable to his 
method of accounting for such costs for tax purposes (such as a taxpayer 
using the prime cost method for purposes of financial reports), the 
following rules apply:
    (i) Indirect production costs included in inventoriable costs. 
Indirect production costs which must enter into the computation of the 
amount of inventoriable costs (to the extent, and only to the extent, 
such costs are incident to and necessary for production or manufacturing 
operations or processes) include:
    (a) Repair expenses,
    (b) Maintenance,
    (c) Utilities, such as heat, power and light,
    (d) Rent,
    (e) Indirect labor and production supervisory wages, including basic 
compensation, overtime pay, vacation and holiday pay, sick leave pay 
(other than payments pursuant to a wage continuation plan under section 
105(d)), shift differential, payroll taxes and contributions to a 
supplemental unemployment benefit plan,
    (f) Indirect materials and supplies,
    (g) Tools and equipment not capitalized,
    (h) Costs of quality control and inspection,
    (i) Taxes otherwise allowable as a deduction under section 164 
(other than State and local and foreign income taxes),
    (j) Depreciation and amortization reported for financial purposes 
and cost depletion,
    (k) Administrative costs of production (but not including any cost 
of selling or any return on capital) incident to and necessary for 
production or manufacturing operations or processes,
    (l) Salaries paid to officers attributable to services performed 
incident to and necessary for production or manufacturing operations or 
processes, and
    (m) Insurance costs incident to and necessary for production or 
manufacturing operations or processes such as insurance on production 
machinery and equipment.
    (ii) Costs not included in inventoriable costs. Costs which are not 
required to be included in the computation of the amount of 
inventoriable costs include:
    (a) Marketing expenses,
    (b) Advertising expenses,
    (c) Selling expenses,
    (d) Other distribution expenses,
    (e) Interest,
    (f) Research and experimental expenses including engineering and 
product development expenses,
    (g) Losses under section 165 and the regulations thereunder,
    (h) Percentage depletion in excess of cost depletion,
    (i) Depreciation reported for Federal income tax purposes in excess 
of depreciation reported by the taxpayer in his financial reports,
    (j) Income taxes attributable to income received on the sale of 
inventory,
    (k) Pension and profit-sharing contributions representing either 
past service costs or representing current

[[Page 508]]

service costs otherwise allowable as a deduction under section 404, and 
other employee benefits incurred on behalf of labor. These other 
benefits include workmen's compensation expenses, payments under a wage 
continuation plan described in section 105(d), amounts of a type which 
would be includible in the gross income of employees under nonqualified 
pension, profit-sharing and stock bonus plans, premiums on life and 
health insurance and miscellaneous benefits provided for employees such 
as safety, medical treatment, cafeteria, recreational facilities, 
membership dues, etc., which are otherwise allowable as deductions under 
chapter 1 of the Code,
    (l) Cost attributable to strikes, rework labor, scrap and spoilage,
    (m) General and administrative expenses incident to and necessary 
for the taxpayer's activities as a whole rather than to production or 
manufacturing operations or processes, and
    (n) Salaries paid to officers attributable to the performance of 
services which are incident to and necessary for the taxpayer's 
activities as a whole rather than to production or manufacturing 
operations or processes.
    (d) Allocation methods--(1) In general. Indirect production costs 
required to be included in the computation of the amount of 
inventoriable costs pursuant to paragraphs (b) and (c) of this paragraph 
must be allocated to goods in a taxpayer's ending inventory (determined 
in accordance with the taxpayer's method of identification) by the use 
of a method of allocation which fairly apportions such costs among the 
various items produced. Acceptable methods for allocating indirect 
production costs to the cost of goods in the ending inventory include 
the manufacturing burden rate method and the standard cost method. In 
addition, the practical capacity concept can be used in conjunction with 
either the manufacturing burden rate or standard cost method.
    (2) Manufacturing burden rate method--(i) In general. Manufacturing 
burden rates may be developed in accordance with acceptable accounting 
principles and applied in a reasonable manner. In developing a 
manufacturing burden rate, the factors described in paragraph (d)(2)(ii) 
of this section may be taken into account. Furthermore, if the taxpayer 
chooses, he may allocate different indirect production costs on the 
basis of different manufacturing burden rates. Thus, for example, the 
taxpayer may use one burden rate for allocating rent and another burden 
rate for allocating utilities. The method used by the taxpayer in 
allocating such costs in his financial reports shall be given great 
weight in determining whether the taxpayer's method employed for tax 
purposes fairly allocates indirect production costs to the ending 
inventory. Any change in a manufacturing burden rate which is merely a 
periodic adjustment to reflect current operating conditions, such as 
increases in automation or changes in operation, does not constitute a 
change in method of accounting under section 446. However, a change in 
the concept upon which such rates are developed does constitute a change 
in method of accounting requiring the consent of the Commissioner. The 
taxpayer shall maintain adequate records and working papers to support 
all manufacturing burden rate calculations.
    (ii) Development of manufacturing burden rate. The following 
factors, among others, may be taken into account in developing 
manufacturing burden rates:
    (a) The selection of an appropriate level of activity and period of 
time upon which to base the calculation of rates which will reflect 
operating conditions for purposes of the unit costs being determined;
    (b) The selection of an appropriate statistical base such as direct 
labor hours, direct labor dollars, or machine hours, or a combination 
thereof, upon which to apply the overhead rate to determine production 
costs; and
    (c) The appropriate budgeting, classification and analysis of 
expenses (for example, the analysis of fixed and variable costs).
    (iii) Operation of the manufacturing burden rate method. (a) The 
purpose of the manufacturing burden rate method used in conjunction with 
the full absorption method of inventory costing is to allocate an 
appropriate amount of indirect production costs to a taxpayer's goods in 
ending inventory by

[[Page 509]]

the use of predetermined rates intended to approximate the actual amount 
of indirect production costs incurred. Accordingly, the proper use of 
the manufacturing burden rate method under this section requires that 
any net negative or net positive difference between the total 
predetermined amount of indirect production costs allocated to the goods 
in ending inventory and the total amount of indirect production costs 
actually incurred and required to be allocated to such goods (i.e., the 
under or over-applied burden) must be treated as an adjustment to the 
taxpayer's ending inventory in the taxable year in which such difference 
arises. However, if such adjustment is not significant in amount in 
relation to the taxpayer's total actual indirect production costs for 
the year then such adjustment need not be allocated to the taxpayer's 
goods in ending inventory unless such allocation is made in the 
taxpayer's financial reports. The taxpayer must treat both positive and 
negative adjustments consistently.
    (b) Notwithstanding subdivision (a), the practical capacity concept 
may be used to determine the total amount of fixed indirect production 
costs which must be allocated to goods in ending inventory. See 
subparagraph (4) of this paragraph.
    (3) Standard cost method--(i) In general. A taxpayer may use the so-
called ``standard cost'' method of allocating inventoriable costs to the 
goods in ending inventory, provided he treats variances in accordance 
with the procedures prescribed in paragraph (d)(3)(ii) of this section. 
The method used by the taxpayer in allocating such costs in his 
financial reports shall be given great weight in determining whether the 
taxpayer's method employed for tax purposes fairly allocates indirect 
production costs to the ending inventory. For purposes of this 
subparagraph, a ``net positive overhead variance'' shall mean the excess 
of total standard (or estimated) indirect production costs over total 
actual indirect production costs and a ``net negative overhead 
variance'' shall mean the excess of total actual indirect production 
costs over total standard (or estimated) indirect production costs.
    (ii) Treatment of variances. (a) The proper use of the standard cost 
method pursuant to this subparagraph requires that a taxpayer must 
reallocate to the goods in ending inventory a pro rata portion of any 
net negative or net positive overhead variances and any net negative or 
net positive direct production cost variances. The taxpayer must 
apportion such variances among his various items in ending inventory. 
However, if such variances are not significant in amount in relation to 
the taxpayer's total actual indirect production costs for the year then 
such variances need not be allocated to the taxpayer's goods in ending 
inventory unless such allocation is made in the taxpayer's financial 
reports. The taxpayer must treat both positive and negative variances 
consistently.
    (b) Notwithstanding subdivision (a), the practical capacity concept 
may be used to determine the total amount of fixed indirect production 
costs which must be allocated to goods in ending inventory. See 
subparagraph (4) of this paragraph.
    (4) Practical capacity concept--(i) In general. Under the practical 
capacity concept, the percentage of practical capacity represented by 
actual production (not greater than 100 percent), as calculated under 
subdivision (ii) of this subparagraph, is used to determine the total 
amount of fixed indirect production costs which must be included in the 
taxpayer's computation of the amount of inventoriable costs. The portion 
of such costs to be included in the taxpayer's computation of the amount 
of inventoriable costs is then combined with variable indirect 
production costs and both are allocated to the goods in ending inventory 
in accordance with this paragraph. See the example in subdivision 
(ii)(d) of this subparagraph. The difference (if any) between the amount 
of all fixed indirect production costs and the fixed indirect production 
costs which are included in the computation of the amount of 
inventoriable costs under the practical capacity concept is allowable as 
a deduction for the taxable year in which such difference occurs.
    (ii) Calculation of practical capacity--(a) In general. Practical 
capacity and theoretical capacity (as described in (c)

[[Page 510]]

of this subdivision) may be computed in terms of tons, pounds, yards, 
labor hours, machine hours, or any other unit of production appropriate 
to the cost accounting system used by a particular taxpayer. The 
determination of practical capacity and theoretical capacity should be 
modified from time to time to reflect a change in underlying facts and 
conditions such as increased output due to automation or other changes 
in plant operation. Such a change does not constitute a change in method 
of accounting under sections 446 and 481.
    (b) Based upon taxpayer's experience. In selecting an appropriate 
level of production activity upon which to base the calculation of 
practical capacity, the taxpayer shall establish the production 
operating conditions expected during the period for which the costs are 
being determined, assuming that the utilization of production facilities 
during operations will be approximately at capacity. This level of 
production activity is frequently described as practical capacity for 
the period and is ordinarily based upon the historical experience of the 
taxpayer. For example, a taxpayer operating on a 5-day, 8-hour basis may 
have a ``normal'' production of 100,000 units a year based upon three 
years of experience.
    (c) Based upon theoretical capacity. Practical capacity may also be 
established by the use of ``theoretical'' capacity, adjusted for 
allowances for estimated inability to achieve maximum production, such 
as machine breakdown, idle time, and other normal work stoppages. 
Theoretical capacity is the level of production the manufacturer could 
reach if all machines and departments were operated continously at peak 
efficiency.
    (d) Example. The provisions of (c) of this subdivision may be 
illustrated by the following example:

    Corporation X operates a stamping plant with a theoretical capacity 
of 50 units per hour. The plant actually operates 1960 hours per year 
based on an 8-hour day, 5 day week basis and 15 shutdown days for 
vacations and holidays. A reasonable allowance for down time (the time 
allowed for ordinary and necessary repairs and maintenance) is 5 percent 
of practical capacity before reduction for down time. Assuming no loss 
of production during starting up, closing down, or employee work breaks, 
under these facts and circumstances X may properly make a practical 
capacity computation as follows:

Practical capacity without allowance for down time based on       98,000
 theoretical capacity per hour is (1960x50)....................
Reduction for down time (98,000x5 percent).....................    4,900
Practical capacity.............................................   93,100



The 93,100 unit level of activity (i.e., practical capacity) would, 
therefore, constitute an appropriate base for calculating the amount of 
fixed indirect production costs to be included in the computation of the 
amount of inventoriable costs for the period under review. On this basis 
if only 76,000 units were produced for the period, the effect would be 
that approximately 81.6 percent (76,000, the actual number of units 
produced, divided by 93,100, the maximum number of units producible at 
practical capacity) of the fixed indirect production costs would be 
included in the computation of the amount of inventoriable costs during 
the year. The portion of the fixed indirect production costs not so 
included in the computation of the amount of inventoriable costs would 
be deductible in the year in which paid or incurred. Assume further that 
7,600 units were on hand at the end of the taxable year and the 7,600 
units were in the same proportion to the total units produced. Thus, 10 
percent (7,600 units in inventory at the end of the taxable year, 
divided by 76,000, the actual number of units produced) of the fixed 
indirect production costs included in the computation of the amount of 
inventoriable costs (the above-mentioned 81.6 percent) and 10 percent of 
the variable indirect production costs would be included in the cost of 
the goods in the ending inventory, in accordance with a method of 
allocation provided by this paragraph.

    (e) Transition to full absorption method of inventory costing--(1) 
In general--(i) Mandatory requirement. A taxpayer not using the full 
absorption method of inventory costing, as prescribed by paragraph (a) 
of this section, must change to that method. Any change to the full 
absorption method must be made by the taxpayer with respect to all 
trades or businesses of the taxpayer to which this section applies. A 
taxpayer not using the full absorption method of inventory costing, as 
prescribed by paragraph (a) of this section, who makes the special 
election provided in subdivision (ii) of this subparagraph during the 
transition period described in subdivision (ii) of this subparagraph 
need not change to the full absorption method of inventory costing for 
taxable years prior to the year for which

[[Page 511]]

such election is made. In determining whether the taxpayer is changing 
to a more or less inclusive method of inventory costing, all positive 
and negative adjustments for all items and all trades or businesses of 
the taxpayer shall be aggregated. If the net adjustment is positive, 
paragraph (e)(3) shall apply, and if the net adjustment is negative, 
paragraph (e)(4) shall apply to the change. The rules otherwise 
prescribed in sections 446 and 481 and the regulations thereunder shall 
apply to any taxpayer who fails to make the special election in 
subdivision (ii) of this subparagraph. The transition rules of this 
paragraph are available only to those taxpayers who change their method 
of inventory costing.
    (ii) Special election during two-year-transition period. If a 
taxpayer elects to change to the full absorption method of inventory 
costing during the transition period provided herein, he may elect on 
Form 3115 to change to such full absorption method of inventory costing 
and, in so doing, employ the transition procedures and adopt any of the 
transition methods prescribed in subparagraph (3) of this paragraph. 
Such election shall be made during the first 180 days of any taxable 
year beginning on or after September 19, 1973 and before September 19, 
1975 (i.e., the ``transition period'') and the change in inventory 
costing method shall be made for the taxable year in which the election 
is made. Notwithstanding the preceding sentence if the taxpayer's prior 
returns have been examined by the Service prior to Sept. 19, 1973, and 
there is a pending issue involving the taxpayer's method of inventory 
costing, the taxpayer may request the application of this regulation by 
agreeing and filing a letter to that effect with the district director, 
within 90 days after September 19, 1973 to change to the full absorption 
method for the first taxable year of the taxpayer beginning after Sept. 
19, 1973 and subsequently filing Form 3115 within the first 180 days of 
such taxable year of change.
    (iii) Change initiated by the Commissioner. A taxpayer who properly 
makes an election under subdivision (ii) of this subparagraph shall be 
considered to have made a change in method of accounting not initiated 
by the taxpayer, notwithstanding the provisions of Sec. 1.481-1(c)(5). 
Thus, any of the taxpayer's ``pre-1954 inventory balances'' with respect 
to such inventory shall not be taken into account as an adjustment under 
section 481. For purposes of this paragraph, a ``pre-1954 inventory 
balance'' is the net amount of the adjustments which would have been 
required if the taxpayer had made such change in his method of 
accounting with respect to his inventory in his first taxable year which 
began after December 31, 1953, and ended after August 16, 1954. See 
section 481(a)(2) and Sec. 1.481-3.
    (2) Procedural rules for change. If a taxpayer makes an election 
pursuant to subparagraph (1)(ii) of this paragraph, the Commissioner's 
consent will be evidenced by a letter of consent to the taxpayer, 
setting forth the values of inventory, as provided by the taxpayer, 
determined under the full absorption method of inventory costing, except 
to the extent that no determination of such values is necessary under 
subparagraph (3)(ii)(B) of this paragraph (the cut off method), the 
amount of the adjustments (if any) required to be taken into account by 
section 481, and the treatment to be accorded to any such adjustments. 
Such full absorption values shall be subject to verification on 
examination by the district director. The taxpayer shall preserve at his 
principal place of business all records, data, and other evidence 
relating to the full absorption values of inventory.
    (3) Transition methods. In the case of a taxpayer who properly makes 
an election under subparagraph (1)(ii) of this paragraph during the 
transition period--
    (i) 10-year adjustment period. Such taxpayer may elect to take any 
adjustment required by section 481 with respect to any inventory being 
revalued under the full absorption method into account ratably over a 
period designated by the taxpayer at the time of such election, not to 
exceed the lesser of 10 taxable years commencing with the year of 
transition or the number of years the taxpayer has been on the inventory 
method from which he is changing. If the taxpayer dies or ceases to 
exist in a transaction other than one

[[Page 512]]

to which section 381(a) of the Code applies or if the taxpayer's 
inventory (determined under the full absorption method) on the last day 
of any taxable year is reduced (by other than a strike or involuntary 
conversion) by more than an amount equal to 33\1/3\ percent of the 
taxpayer's inventory (determined under the full absorption method) as of 
the beginning of the year of change, the entire amount of the section 
481 adjustment not previously taken into account in computing income 
shall be taken into account in computing income for the taxable year in 
which such taxpayer so ceases to exist or such taxpayer's inventory is 
so reduced.
    (ii) Additional rules for LIFO taxpayers. A taxpayer who uses the 
LIFO method of inventory identification may either--
    (a) Employ the special transition rules described in subdivision (i) 
of this subparagraph. Accordingly, all LIFO layers must be revalued 
under the full absorption method and the section 481 adjustment must be 
computed for all items in all layers in inventory, but no pre-1954 
inventory balances shall be taken into account as adjustments under 
section 481; or
    (b)(1) Employ a cut-off method whereby the full absorption method is 
only applied in costing layers of inventory acquired during all taxable 
years beginning with the year for which an election is made under 
subparagraph (e)(1)(ii).
    (2) In the case of a taxpayer using dollar value LIFO, employ a cut-
off method whereby the taxpayer must use, for the year of change, the 
full absorption method in computing the base year cost and current cost 
of a dollar value inventory pool for the beginning of such year. The 
taxpayer shall not be required to recompute his LIFO inventories based 
on the full absorption method for a taxable year beginning prior to the 
year of change to the full absorption method. The base cost and layers 
of increment previously computed shall be retained and treated as if 
such base cost and layers of increment had been computed under the 
method authorized by this section. The taxpayer shall use the year of 
change as the base year in applying the double extension method or other 
method approved by the Commissioner, instead of the earliest year for 
which he adopted the LIFO method for any items in the pool.
    (4) Transition to full absorption method of inventory costing from a 
method more inclusive of indirect production costs--(i) Taxpayer has not 
previously changed to his present method pursuant to subparagraphs (1), 
(2), and (3) of this paragraph. If a taxpayer wishes to change to the 
full absorption method of inventory costing (as prescribed by paragraph 
(a) of this section) from a method of inventory costing which is more 
inclusive of indirect production costs and he has not previously changed 
to his present method by use of the special transition rules provided by 
subparagraphs (1), (2) and (3) of this paragraph, he may elect on Form 
3115 to change to the full absorption method of inventory costing and, 
in so doing, take into account any resulting section 481 adjustment 
generally over 10 taxable years commencing with the year of transition. 
The Commissioner's consent to such election will be evidenced by a 
letter of consent to the taxpayer setting forth the values of inventory, 
as provided by the taxpayer determined under the full absorption method 
of inventory costing, except to the extent that no determination of such 
values is necessary under subparagraph (3)(ii)(b) of this paragraph, the 
amount of the adjustments (if any) required to be taken into account by 
section 481, and the treatment to be accorded such adjustments, subject 
to terms and conditions specified by the Commissioner to prevent 
distortions of income. Such election must be made within the transition 
period described in subparagraph (1)(ii) of this paragraph. A change 
pursuant to this subparagraph shall be a change initiated by the 
taxpayer as provided by Sec. 1.481-1(c)(5). Thus, any of the taxpayers 
``pre-1954 inventory balances'' will be taken into account as an 
adjustment under section 481.
    (ii) Taxpayer has previously changed to his present method pursuant 
to subparagraph (1), (2), and (3) of this paragraph or would satisfy all 
the requirements of subdivision (i) of this subparagraph but fails to 
elect within the transition period. If a taxpayer wishes to change to 
the full

[[Page 513]]

absorption method of inventory costing (as prescribed by paragraph (a) 
of this section) from a method of inventory costing which is more 
inclusive of indirect production costs and he has previously changed to 
his present method pursuant to subparagraphs (1), (2), and (3) of this 
paragraph or he would satisfy the requirements of subdivision (i) of 
this subparagraph but he fails to elect within the transition period, he 
must secure the consent of the Commissioner prior to making such change.

[T.D. 7285, 38 FR 26185, Sept. 19, 1973, as amended by T.D. 8067, 51 FR 
393, Jan. 6, 1986; T.D. 8131, 52 FR 10084, Mar. 30, 1987; T.D. 8482, 58 
FR 42234, Aug. 9, 1993]