Valuation Methodologies: Special Inventory Considerations

In previous articles, we have addressed the standard three methodologies for appraisal of property: the sales comparison approach, the cost approach, and the income approach. Under Section 23.0101 of the Texas Tax Code, these approaches are supposed to be considered to determine the value of all forms of taxable property (real and personal). However, there is a category of personal property that is subject to separate consideration under the Tax Code.

Under the Tax Code, the valuation of inventory receives special treatment in three ways: (1) it has its own appraisal methodology; (2) it potentially has an alternative valuation date; and, (3) in some cases, it has its value based on sales rather than existent property as of a particular date.

Section 23.12 provides that "the market value of an inventory is the price for which it would sell as a unit to a purchaser who would continue the business." This results in several considerations.

The inventory should be valued "as a unit." In other words, it is not to be valued piecemeal, assigning high values to some items of inventory and lower values to other items of inventory. It essentially is to be valued in bulk.

The inventory must be valued at the price for which it would sell to "a purchaser who would continue in the business." In other words, the inventory is not to be valued at the retail value that it would sell to a consumer or end user. Instead, it is to be valued at the wholesale value (or potentially less) that it would sell to someone who is then going to mark it up to sell to a consumer.

The Tax Code also recognizes that an inventory can consist of residential real property; i.e., a group of development lots held for sale. To qualify as residential property inventory, the lots must never have been occupied as a residence, be held for sale in the ordinary course of business, remain unoccupied, not be leased or rented, and not produce any income.

Section 23.12(f) allows a business owner to elect an alternative valuation date of September 1. Thus, taxpayers electing such a valuation date would have their inventory valued based on what they held in inventory on September 1, while all other property would be valued as of January 1. The benefit of this alternative date would normally only be apparent in businesses that have significantly less inventory on September 1 than January 1, as the appraisal method remains the same regardless of the valuation date. (See related story.)

The primary issue relating to the valuation of non-special inventory is adjusting the inventory cost to reflect market value. Appraisal districts often take the view that inventory is worth what a business owner paid for it, without any deductions.

However, if inventory is valued on a cost basis (as appraisal districts do), then Section 23.011(2) of the Tax Code requires that the chief appraiser "make any appropriate adjustments for physical, functional, or economic obsolescence." There may be many obsolescence factors associated with inventory.

Clothing and other goods go out of season or out of style. Books and records go from best-sellers to bargain bins. Food goes bad.

Many appraisal districts eventually recognize adjustments to inventory for these factors, but only after the need for adjustment is pointed out. When an appraisal district sends out a value notice based on a rendition showing inventory, the property owner can expect that the initial value will reflect inventory at cost.

In some industries, it is possible to have more than one type of inventory. For example, a business might have an inventory of new products and parts and also have an inventory of used parts utilized as part of the business operations.

For example, rotable spares, or rotable spare parts, consist of an inventory of interchangeable spare parts maintained to repair machinery or equipment. The issue of rotable spares as depreciable property was addressed in two mid-1990s lawsuits: Hewlett Packard, Inc. v. United States, 71 F.3d 398 (Fed. Cir. 1995) and Honeywell, Inc. and Subsidiaries v. Commissioner, 27 F.3d 571 (8th Cir. 1994).

In Hewlett Packard, the taxpayer attempted to declare its inventory of rotable spares as depreciable property. In that case, the rotable spares consisted of computer parts used by Hewlett Packard to maintain and repair computers under its customer service agreements. When a customer's computer experienced problems, it would be sent to a repair facility where technicians would use the supply of rotable spares to diagnose and, if necessary, fix the problem. Essentially, if a computer part was found to be malfunctioning, it would be replaced with an identical part from the rotable spare inventory. The broken part would then be repaired, if possible, and placed in the rotable spare inventory for use in another customer's computer at a later date.

Hewlett Packard claimed the pool of rotable spare inventory as a capitalized fixed asset and sought federal income tax depreciation. The IRS disallowed the depreciation, characterizing the rotable spares as property held primarily for sale in the ordinary course of business and thus consisting of inventory. Inventory normally is not entitled to depreciation under federal tax law.

In the initial court action, the Court of Federal Claims sided with the IRS, holding that a sale essentially occurred each time that Hewlett Packard exchanged a customer's computer part with a rotable spare. However, the Court of Appeals reversed and sided with the taxpayer, holding that the pool of rotable spares was a capital asset used to provide services to Hewlett Packard's customers under maintenance agreements. The depreciation was therefore allowed.

The Honeywell case had essentially the same fact situation and the same eventual outcome, with the courts allowing depreciation of the rotable spare inventory.

In Rev. Rul. 2003-37, the IRS decided that a taxpayer could treat rotable spare parts as depreciable assets "if the taxpayer's facts are substantially similar to those of" the Hewlett Packard and Honeywell cases.

Though in the two cases the rotable spares consisted of computer parts, rotable spares can also be found in other businesses. Rotable spares exist in other aspects of the electronics industry and also in the avionics industry. Rotable spares might exist in any industry where the manufacturer also provides after-sale maintenance or service.

What does this mean for property tax valuation in Texas?

Often, appraisal districts take the view that inventory is entitled to no depreciation, that its value is essentially the original cost of the inventory on hand as of the valuation date. The rotable spare cases, as well as the subsequent IRS ruling, show that at least in certain cases inventory can be entitled to be considered a depreciating asset.

In some situations, inventory is accorded separate treatment and is not really valued as of any valuation date. In the case of qualifying motor vehicle inventory, heavy equipment inventory, vessel and outboard motor inventory, and manufactured housing inventory, the value of the inventory is based on the sales occurring during the prior calendar year. In effect, all qualifying retail sales are totaled for the year and then the total is divided by 12 to obtain a market value. Sales to other dealers, fleet sales (five or more sales to the same person or entity), and subsequent sales of the same item of property during the same year are excluded from the calculation of market value.

Theoretically, the resulting value would reflect a monthly average of the retail inventory of the business. Though there are those who believe that separate treatment of these inventory items result in some special and unfair treatment, the "average sales in the prior year" method is actually the method suggested by the Texas Supreme Court for all forms of inventory. In Enron Corp. v. Spring Independent School District, the Court stated: "Perhaps the most equitable system of valuation would permit an owner to have its inventory valued on a monthly average basis over a year's time." The Court noted that such a methodology was in place for motor vehicles and similar inventory.

As a tradeoff for the special valuation provisions, the owners of these types of inventory are required to file monthly sales reports and prepay property taxes based on those sales. Also, the owners are not allowed to receive a refund of any excess taxes that might be prepaid. Therefore, it is possible for an owner to actually pay more in taxes on the special inventory than is actually owed based on the determined market value.

Additionally, even if the owner goes out of business during a year and thus has no actual inventory as of January 1 of the following year, the owner still is assessed taxes based on the special inventory calculation as long as there were some sales in the prior year to calculate a value.

If you have any questions about the contents of this article, please contact the GPD Property Tax Section at propertytax@gpd.com.