SECTION 3. PROCEDURES FOR

DETERMINATION OF FAIR MARKET VALUE.

Three basic methods a taxpayer may use to determine the fair market value of inventory are the replacement cost method, the comparative sales method, and the income method.

.01 Replacement Cost Method . The replacement cost method generally provides a good indication of fair market value if inventory is readily replaceable in a wholesale or retail business, but generally should not be used in establishing the fair market value of the work in process or finished goods of a manufacturing concern. In valuing a bulk inventory of raw materials or goods purchased for resale under this method, the determination of the replacement cost of the individual items should be only a base or starting point. This base amount must be adjusted for factors that are generally relevant. For example, a willing purchaser might be expected to pay (and a willing seller might be expected to demand) a price for inventory that would compensate the seller not only for the current replacement cost, but also for a fair return on expenditures in accumulating and preparing the inventory for distribution. Thus, an amount equal to the fair value of the related costs that the taxpayer would have incurred in acquiring and accumulating the same quantity of goods had the goods been purchased separately ( e.g., purchasing, handling, transportation, and off-site storage costs) should be added to the base amount. Additionally, in valuing a particular inventory under this method, other factors may be relevant. For example, a well balanced inventory available to fill customers' orders in the ordinary course of business may have a fair market value in excess of its cost of replacement because it provides a continuity of

business, whereas an inventory containing obsolete merchandise unsuitable for customers may have a fair market value of less than the cost of replacement.

.02 Comparative Sales Method . The comparative sales method utilizes the actual or expected selling prices of finished goods to customers in the ordinary course of business as the base amount that must be adjusted for factors that are generally relevant in determining the fair market value of the inventory. The inventory to be valued may represent a larger quantity than the normal trading volume. The expected selling price is a valid starting point only if the inventory is expected to be used to fill customers' orders in the ordinary course of business. If the expected selling price is used as a basis for valuing finished goods inventory, the base amount must be adjusted for relevant factors, including:

(1) the time that would be required to dispose of this inventory;

(2) the expenses that would be expected to be incurred in the disposition, for example, all costs of disposition, applicable discounts (including those for quantity), sales commissions, and freight and shipping charges; and

(3) a profit commensurate with the amount of investment in the assets and the degree of risk. (This analysis should include (but is not limited to) an evaluation of risks of possible changes in style/design, changes in price levels, increased competition, possible adverse economic conditions, the fact that the inventory to be valued may represent a larger quantity than the normal trading volume, etc .).

.03 Income Method . The income method, when applied to fair market value determinations for finished goods, recognizes that finished goods must generally be valued in a profit motivated business. As the amount of inventory may be large in relation to normal trading volume, the highest and best use of the inventory will be to provide for a continuity of the marketing operation of the going business. Additionally, the finished goods inventory will usually provide the only source of revenue of an acquired business during the period it is being used to fill customers' orders. The historical financial data of an acquired company can be used to determine the amount that could be attributed to finished goods in order to pay all costs of disposition and provide a return on the

July 21, 2003 122 2003-29 I.R.B.

allocating the lump sum payment is computed as follows:

Gross expected selling price $6,000,000

Disposition costs (1,000,000)

Holding costs (50,000)

Corporation A's profit (450,000)

Fair Market Value of finished goods inventory 4,500,000

Current replacement cost of raw materials 310,000

Purchasing, storage, and handling costs 4,100

Obsolete and subnormal goods (100)

Fair Market Value of raw materials inventory 314,000

Fair Market Value of acquired inventories $4,814,000

this revenue procedure to § 338 are effective for:

(1) certain acquisitions occurring before September 1, 1982, if: (a) the acquisition date with regard to an acquired corporation was after August 31, 1980, and before September 1, 1982; (b) the acquired corporation was not liquidated before September 1, 1982; and (c) the acquiring corporation made an election pursuant to § 338; and (2) acquisitions occurring after August 31, 1982.

DRAFTING INFORMATION

The principal author of this revenue procedure is Willie E. Armstrong, Jr., of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this Revenue Procedure, contact Mr. Armstrong at (202) 622–4970 (not a toll-free call).