The assets which make up a new store or remodeling project must be categorized for depreciation by type of property and then written off over a designated period. The basis for allocation is usually the building drawings and bid packages. The quality of this allocation varies depending on the expertise of the person(s) doing the work. The most aggressive tax posture frequently arises from an allocation study done by an outside firm. More conservative allocations tend to be done by in-house fixed asset accountants and engineers working independently from the taxpayer’s tax department.

Some taxpayers perform the allocation before any money is spent on a project. The assets are set up on a cost accumulation system and are periodically (monthly, quarterly) closed and capitalized by the computer system. The computer does this based on a predetermined allocation and estimated placed in service date. An advantage to this type of system is that there tends to be fewer off-system adjustments, making it easier to tie the fixed asset depreciation into the tax return.

Both hard copy and computer records should be available for each asset placed in service. Examination of the hard copy may be excessively time consuming. If that situation is encountered, detailed asset records should be obtained in a computer format which can be converted into a database or spreadsheet form. The examiner will gain efficiency and the flexibility to sort and perform a segmental analysis by asset description, asset class, location and other categories. Computerized records also facilitate statistical sampling techniques.

Many taxpayers use a separate account for each type of asset (buildings, leasehold improvements, retail trade assets, etc.). This information usually is summarized within the account by location. The summaries may be available on hard copy or could be generated from computer records received from the taxpayer. They are useful for performing comparative analyses, both within and among accounts, to establish consistency by the taxpayer in classifying assets. These analyses are most effective when they are segregated by similar types of construction including mall stores, free standing stores, distribution centers, and multi-level stores.

Detail of disposals should be available for each store location. It is important to check whether the taxpayer has taken a pro rata writeoff of any intangible assets (customer lists, goodwill, etc.) as locations are closed or moved. Many intangible assets relate to the business enterprise as a whole and tend not to attach to individual locations. This is especially true of goodwill for a large retail chain. For example, assume that Retailer A purchases Retailer B. Retailer B has 100 stores and the allocation of purchase price results in $100 million worth of goodwill. Retailer A is not allowed to take a $1 million (100/$100 million) deduction for disposed/abandoned goodwill when it closes one of Retailer B’s stores. As long as Retailer A still operates any Retailer B stores or holds goodwill related assets from Retailer B it continues to use the Retailer B goodwill. Even if all Retailer B locations were closed, Retailer B goodwill could still be used by Retailer A in the form of Retailer B brand names, trademarks, or trade names used on products sold in Retailer A stores.

Many retailers lease most or all of their retail space. The lease abstract summarizes the lease information including landlord, location, amount of space, amount of rent, term of lease, date of lease expiration and renewal options. The lease abstract is a good source from which to choose leases for detailed analysis. Comparative analyses can be made among leases to look for unique or unusual items that indicate a need for further analysis.

The taxpayer’s year-end trial balance shows each general ledger account and its year-end balance. The content of this record will usually include the prior year’s balance and sometimes the budgeted balance.

A comparative trial balance including the current and several prior years will assist the examiner in identifying accounts which are unusual in nature or amount.

In conjunction with the trial balance, the examiner should request adjusting and reclassifying entries including explanations, and the number of the income tax return line onto which each account was entered.

The activity within any general ledger account can be analyzed by reviewing the monthly detailed trial balance or equivalent, which should show the detail of all entries made to each general ledger account.

The detail should identify the source journal and document number for each general journal entry. A limited description of the entry may also be included.

If the detail is voluminous and computerized information is available, consideration should be given to using a Computer Audit Specialist (CAS) to obtain information such as:

Some retailers include details of all entries in the general ledger, in effect combining ledger and journal into one document. Others show only net debits and credits for each month, with the specifics recorded elsewhere. Review of the ledger can provide a quick overview of the activity of the account during the year.

Entries can include routine monthly accruals, standard journal entries, (computations made the same way each month on standardized journal entry forms), reversals, correcting entries, etc. Not all of these entries will necessarily flow through to the tax return.

In many cases the transaction numbering system used will indicate the source and type of each entry. There will generally be a brief explanation of the entry shown in the journal.

Taxpayers on computerized systems may use a combination general ledger/general journal, as mentioned in IRM 4.43.1.3.6.3.

This document has historically been very useful to agents during the examination of retail taxpayers. Most of the ledger entries reflect either the establishment of a payable for a future payment or the elimination of the payable when the subsequent payment is made.

Most retailers utilize an automated system to record and monitor the payables since there are numerous products, vendors, discounts and payment terms involved in merchandise acquisition, plus many expenditures associated with operating and expanding the business.

The payable entry will reflect substantial information, including vendor name and number, purchase invoice number, and amount. These records could be reviewed using a number of different techniques.

Refer to IRM 4.43.1.3.2 for related information regarding the records involving the acquisition of merchandise.

For retailers who do not have an in-house charge system, their accounts receivable should not be unusual. The amounts reflected in the receivable could be monies due from third party credit cards; from banks on installment contract paper which was sold; from customers whose checks were not accepted by the bank; or from vendors as a result of overpayments, rebates, or renegotiated items.

The retailers which utilize some form of in-house customer charge account will have much more extensive records and systems in place to record purchases and payments on account, to periodically send out bills, and to enforce collection.

In conjunction with the review of these records the examiner should consider reviewing the taxpayer’s criteria for writing off receivables it considers totally or partially worthless. Depending on the number, nature, and amount, a barometer of the reasonableness of the taxpayer’s current write-offs may be the collection history of previously written off accounts. Refer to IRM 4.43.1.4.19.5 for additional information on audit techniques pertaining to bad debts.

The detail of the adjustments from book to tax recording and the treatment of each item are very important for the examiner of a retailer. The agent should review the Schedule M on the return, including attached schedules which reflect detail of the differences between book and tax reporting.

The examiner should then request complete workpapers and computational detail for all items selected for examination. The failure to reconcile the books to the tax return early in the examination could result in unnecessary expenditures of time reviewing areas that ultimately were properly treated for tax purposes. The failure by the examiner to identify those items which were not reported for tax, or which were deducted only for tax purposes, could also result in the examiner overlooking potential adjustments to taxable income.

Retailers often use a unique accounting calendar for book cutoffs used in reporting income or claiming expenses. Grocery stores, for example, may use thirteen four week periods. Other retailers may report on the basis of four or five week periods, and still others may use a 52/53 week year. It is useful to secure the taxpayer’s calendar for each period under examination to assist the examiner in determining the proper treatment of timing or allocation issues.

When valuing leasehold interests the examiner must consider the application of appraisal principles and techniques. The principles are economic in basis and include:

In addition to the principles listed in (1) above, there are three approaches to value which should be utilized. They are based on economic theory and application.

The analysis of the retail industry is an important consideration in formulating a basis for market considerations and comparisons as well as the establishment of income plateaus. The retail industry, like any other specialized user of space, has needs and requirements which may not be universal to all commercial space users. These requirements change with the passage of time and do not remain static for long periods. They center on the marketing requirements of the industry and the ability of the retailer to attract their share of the retail market trade and thus remain competitive. Some considerations include:

All of the above elements play an important role in the retailer’s concept of outlet development, lease extension, or expansion into a market area. If a location is not producing a standard goal of gross sales per square foot of leased area, the retailer may consider relocation. The basic concern is not the cost of space rental, but the ability to generate sales and develop a positive image for the retailer. Thus, many considerations override the rental costs being paid by the retailer since the net rent is usually a very small percentage of gross sales and cost of operations for a particular site.

There may be a need to undertake a sampling procedure if the acquired target has a large number of outlets. They may be spaced over a large geographical area and located in multiple states. The importance of the sampling is to establish definite parameters to categorize the sites for rental and comparability identifications. The primary basis of the sampling designations should include, but need not be limited to:

Stratification of the data or sites into homogeneous groupings will allow analysis of the rental rates by categories and not by individual sites. With a large number of units, individual site analysis would be unmanageable.

Beneficial lease considerations can be a major factor when dealing with a key or anchor tenant. These tenants are given "perks" when a developer is putting together a center and needs financing as well as major tenants to draw in the smaller users. Most lenders require a 40 percent lease commitment prior to any funding approval. The anchors in convenience centers usually occupy about 30 to 40 percent of the gross leasable space. The leases for key tenants have a number of characteristics. Some are listed below:

Some valuation factors to consider in key tenant leases are:

An analysis of the capital accounts of the target should be undertaken to compare the lease requirements of repair costs to the target’s actual capital expenditures. Due to the low rent basis of the site, the lessor may refuse to complete renovations or capital repairs. The lessee may be required to spend the funds to remain in the location and remain competitive with other retailers. The target may categorize the costs as leasehold improvements, or may merely expense the items. The same units identified in the sampling could be used for the capital account analysis. Repair accounts to be examined should include, but not be limited to:

The estimation of fair rental value of the target’s retail outlets requires an understanding of appraisal theories as well as comprehension of the problem undertaken. What is being valued is an important consideration. Thus, being familiar with the site(s) and gathering comparables are requirements. Some of the considerations are:

It is not practical nor feasible to undertake a valuation of each outlet under these parameters. Generalizations have to be made by the examiner. The use of statistical sampling allows the examiner to set out groups of units by geographical importance, size, and value. If there are different types of retail chains within the target, such as auto, stand alone retail units, drug and variety units, home repair outlets, etc., a separate sampling per type of retail establishment may be required. Different comparables will be required for each type of retail unit. A survey of the rental data, as well as a summary of the targets is recommended. The format for the summary is subjective. A simplified sample follows:

Upon the establishment of the rent base for each type of retail outlet in each stratum, adjustments can be made to the base for:

A summary of the final determination of leasehold values should be set forth, with each outlet having an established leasehold basis. Consideration must be given to the exercising of the renewal provisions, but should be applied on a lease by lease basis. Renewals will vary due to economic considerations as well as location of sites in market areas.

Once the rent savings are determined, a "Present Worth " analysis of the future savings can be calculated. The summary should include headings for:

The sources of data will be dependent on what phase of the examination process is being undertaken. There are numerous articles available concerning the retail industry. These include marketing, developing, leasing, etc. Trends, competition, and demands of consumers are a focal point for these industry publications. Examples of industry publications which may be beneficial to the examiner are:

There are many more industry publications which should be researched and many which have regional importance. The sources of data for the value basis as well as market conditions are usually communal or regional in location, such as:

Additional reference sources are listed in Exhibit 4.43.1 - 6.

When examining an intangible, the examiner will need to consider the following:

The key to reviewing the valuation of an intangible asset is to thoroughly analyze the methods used by the appraiser in valuing the asset and in determining a useful life. By doing this the examiner may be able to show that an intangible asset is inseparable from goodwill/going concern or that the value and life of the asset, when separated from the goodwill/going concern, differs from the appraisal.

Most intangible assets are valued using an income approach. This is usually done because the income approach lends itself to manipulation due to the comparatively large number of assumptions and calculations which are required. Many appraisals exclude the cost and market approaches on the basis that they are not applicable. This is often incorrect. By relying on only one valuation approach, there is no reconciliation between approaches and no check and balance for the determined value.

The life of an intangible asset is usually determined either by using a survivor curve approach or through "management discussion. " The survivor curve approaches (Iowa survivor curves, Weibull curves) require substantial data and appraiser knowledge of the method in order to be accurate. Too often the appraisers circumvent this need for data by making unrealistic or unsubstantiated assumptions. "Management discussions " are suspect in establishing the life of an asset because they tend to be self-serving.

Some of the intangibles that may be encountered in a retail examination are:

The methods of valuing tangible assets are straightforward and are governed by both the FIRREA and the USPAP. All three approaches to value including cost, market, and income must be considered. Listed below are various types of tangible assets common in retail acquisitions. Each is briefly described and common valuation techniques are discussed.

LAND: This is the primary component of real property. It is valued using a market approach by selecting comparable land sales and comparing and contrasting values. It is also important to consider the environmental liabilities of the site including leaking underground storage tanks, conservation easements, and pollution cleanup requirements. This is especially true with former gasoline station sites and former warehouse/industrial facilities which have been converted to retailing.

LAND IMPROVEMENTS (except buildings): These include utilities, site lighting, parking lots, roadways, walkways, walls, fences, and landscaping and are usually valued in conjunction with either land or buildings. If land improvements are valued separately a cost approach usually is used.

BUILDINGS: All three approaches (cost, market, and income) should be used to value retail type buildings. These three approaches are then reconciled to arrive at a final value. Building values are probably the easiest to review and verify because the structures usually are still in use at the time the appraisal is reviewed and comparable information is readily available from realtors, local assessors, and others. Because the cost, market, and income approaches are all considered, it is difficult to skew the value as can be done when only one approach is used.

LEASEHOLD IMPROVEMENTS: These are improvements made to leased property. Typically they are in the nature of structural components such as walls, wallpaper, floors, suspended ceilings, and lighting and usually revert to the landlord at the end of the lease. In an acquisition, they have value only to the extent that the leasehold improvements actually have utility to the tenant (acquired company). The value is based on not having to make leasehold improvements for a period of time. This period of time is the shorter of the time the tenant is expected to remain at that location or the time until the tenant is expected to remodel or renovate the space. Further discussion of leasehold improvements can be found in IRM 4.43.1.4.3 above.

INVENTORY: See IRM 4.43.1.4.6. below.

EQUIPMENT: This constitutes most of the tangible personal property and includes store furnishings and fixtures such as display racks and shelves. Because of the large number of equipment items in a retail establishment, it may be necessary to use a judgement or statistical sample when reviewing their values. This may be accomplished by examining select locations or particular categories of asset types. Typical asset types for general retailing include shelving, show cases, gondolas, counters, display cases, racks, tables, mirrors, checkouts, computers, and POS equipment. At distribution centers, asset types include dock equipment/levelers, racks, conveyors, forklifts/lift trucks, battery chargers, conveyors, and computers.

Department stores have the largest physical plant, in terms of square footage, of any group of retailers. The large-scale operation is necessary because of the wide variety of merchandise which is held for sale. The range of department stores goes from those which offer only the best quality product in a very pleasant, service oriented environment, to a no frills, virtually self-service store offering a lesser quality product to its customers.

Similar merchandise is grouped by department to ease product marketing and control. In multi-store operations, a buyer is assigned to purchase the merchandise for one or more departments. A single store may have more than 100 departments. For some buyers, the product line is limited to high fashion clothing for the entire family, supplemented by perfumes and jewelry. For others, the merchandise is more basic and may include hard goods such as toys, tools, and paint.

The inventory turnover rate for these large department stores generally is three or four times per year, which is the lowest of all retailers. The high inventory, low turnover, and emphasis on customer service requires a higher than average markup on the merchandise held for sale. Those departments which offer seasonal or fashion merchandise may operate with predetermined markdown dates and percentages to ensure that the inventory will be disposed of on a timely basis, thereby maximizing profits.

Most department stores compute inventory using the retail method, as described in IRM 4.43.1.3.1.2 In conjunction with the retail method many will use the last-in, first-out (LIFO) valuation method, which reduces inventory by removing the impact of price changes. Departments with similar merchandise will be combined into pools. Statistical price changes, published by the Bureau of Labor Statistics (BLS), will be applied to factor out industry average price fluctuations for each pool. Due to the complexities involved, only a very limited number of department stores will develop their own statistics of price changes, rather than using the BLS published data.

The examining agent must become familiar with the retailer’s method of operation and the inventory valuation method.

A recommended approach to gaining a better understanding of the inventory is to request a complete tour of all aspects of the taxpayer’s operation which deals with inventory, both the physical product as well as an explanation of related paperwork. Become familiar with the employee classifications, responsibilities and cost centers involved. Who inputs data pertaining to merchandise acquisition, flow, and disposition? What records and systems contain this information?

The inventory methods, systems, and operations pertaining to discount stores will be very similar to those previously described for department stores. There will generally be fewer soft goods departments and more hard goods departments. The merchandise must be marketable to a customer who is more value and price conscious than the typical department store customer.

The turnover rate for inventory generally will be 4 or 5 times per year. Temporary or promotional markdowns are used to increase customer traffic flow, thereby giving the discounter an edge over competition.

Purchasing merchandise will involve many of the same steps undertaken by buyers employed by department stores. For many products, the discounter will be able to negotiate a better price and/or larger product rebates from the vendor than a retailer selling a smaller volume.

Grocery stores present several challenges for examiners. They have higher turnover rates than a department store or general merchandiser. They receive inventory shipments from a distribution warehouse 2 or 3 times a week, reducing the need for back room inventories. The highest volume merchandise usually is received by direct store delivery (DSD). Items shipped by DSD include dairy, soft drinks, bread, and snack foods. Many grocery stores are on a 52–53 week year, with 13 four-week periods a year.

Many grocery stores use LIFO for valuing inventories. Their physical inventory is often taken by an outside service, so that there is little to dispute over the actual physical count. Treas. Reg. 1.472–8(e)(3)(iv) allows retailers the option of having 11 pools. Private letter rulings have generally required 11 pools when a taxpayer is using too few pools. The National Office recommends as separate pools:

The bulk of a grocery store’s inventory is in the grocery pool, sometimes as much as 70 percent. In examining a grocery’s LIFO pooling, no manufactured items should be grouped with purchased items, per Treas. Reg. 1.472–8(c) and Revenue Ruling 82–192. This means that deli items which the store "manufactures" cannot be grouped with purchased goods. There should be a separate computation for each pool for its cost complement based on items in that pool to convert retail LIFO to cost, per Treas. Reg. 1.472–8(c). Examine the computations made by the taxpayer in computing his cost complement for each pool. This may require a CAS to do a system analysis of the taxpayer’s computer program that computes the cost complements.

Some grocery chains purchase their inventory from a separate grocery wholesaler, paying a distribution center fee. This fee should be part of cost of goods sold and ending inventory since it is a cost of acquiring the merchandise.

A grocery store’s LIFO index computations should be available for a complete and detailed audit per Treas. Reg. 1.472–1(k) and Treas. Reg. 1.472–8(e)(1).

Unlike department stores that attract customers with a vast variety of merchandise and discount stores that attract customers with low prices, specialty stores attract customers primarily with expertise in a particular field. Specialty stores tend to concentrate on one theme, and offer a greater breadth and depth of products within its selected area than any department store or discounter could profitably carry. New fads or fashion trends tend to originate from specialty stores and are quickly adopted by the other specialty stores in that field.

Specialty retailers attempt to market their inventory product lines as being unique from other retailers. The search for uniqueness and high margin profits has resulted in specialty operations developing private label brands. A specialty retailer may manufacture or contract to manufacture some of the goods it carries in order to distinguish itself from the competition. Private labels or store brands allow higher profit margins because the retailer can monitor and demand higher quality control standards in the manufacture of such inventory. Much of this manufacturing takes place overseas where the labor is cheaper.

The retailer may acquire a financial interest in the manufacturer or sourcing agent in order to assure itself of a continuous supply of goods. Some specialty stores become vertically integrated with manufacturing sources to ensure high product standards. Thus the examiner of a specialty retailer should be aware of potential international issues such as transfer pricing and excessive commissions and request the aid of an International Examiner when warranted.

Due to their position as trend setters, specialty stores will tend to have a higher inventory turnover than other types of stores. New merchandise or new fads are always being introduced (many stores use this as a technique to bring in customers) while the display space remains constant. Trendy merchandise, however, has a much greater risk of becoming obsolete or of going out of style. Anything that does not sell well must somehow be disposed of. The examiner auditing a specialty retailer should expect to see aggressive discounting policies on slow moving merchandise.

The same risk factors that make specialty retailers take an aggressive stance on slow moving merchandise also make them take an aggressive stance with their vendors on rebates and allowances (see IRM 4.43.1.4.18.1). They are likely to drive hard bargains (especially on untested merchandise) and take advantage of every rebate or allowance available to them. The examiner should verify that such vendor rebates and allowances are properly reported.

A specialty retailer on the retail LIFO inventory method cannot use the Bureau of Labor Statistics indexes that are available for department stores. Special attention should be paid to how the speciality retailer computes its index. Because the product lines carried by a given speciality retailer are closely related, it is not unusual to see few LIFO pools in each store. However, there must be separate pools for manufactured vs. purchased goods.

A significant portion of a retailer’s inventory at any point during the year has not been fully recorded on the final records, known as the merchandise or stock ledger. This delay is due to the fact that not all owned inventory has been received and not all received inventory has had the associated paperwork totally processed. At year-end the taxpayer must take additional steps to ensure that all owned merchandise is properly included in inventory for tax purposes. Methods used by retailers to determine the additional inventory which should be reported include the following:

Treas. Reg. 1.471–1 requires in-transit merchandise to be included in inventory. It states, "in order to reflect income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor. A purchaser should include in inventory merchandise purchased, although such merchandise is in-transit or for other reasons has not been reduced to physical possession, but should not include goods ordered for future delivery, transfer of title to which has not yet been effected. "

The failure to include the full amount of unprocessed or in-transit merchandise in inventory can affect different aspects of the year-end inventory computation. This includes:

The examiner should be aware of the following potential issues:

Consider the nature of the taxpayer’s business. Determine if the method used to accumulate the in-transit inventory figures, and the computations utilizing those totals, generate an amount which is in compliance with the rules outlined above. Refer to IRM 4.43.1.3.2 for additional discussion regarding the records which should be reviewed.

The retail method of computing inventory has as its starting point the retail price of merchandise owned. The retail price which is required to be used is the actual end-of-year price at which the product is marked. Temporary or promotional markdowns, which may be in effect as of year-end, should not be reflected in the retail price used in the computation. Permanent price changes in effect as of year-end should, however, be taken into account.

The retail price is multiplied by the cost complement, as explained in IRM 4.43.1.3.3.2 and shown at Exhibit 4.43.1-3. In the case of a taxpayer using the LIFO valuation method, the year-end retail price is converted to a base year amount, using an index, and compared with the beginning inventory in terms of the same base year values, as explained in IRM 4.43.1.3.3.3 through IRM 4.43.1.3.3.5. As stated above, use of the correct retail price is a critical factor in these computations. To the extent year-end retail is understated, ending inventory will be similarly understated to the extent of the cost complement.

A retailer may attempt to reduce inventory to a retail price which is not the permanently marked price as of year-end. There are a number of ways this may be accomplished. For example:

An automated valuation system may be used in the following ways:.

Another method which could possibly be used by a retailer is to reduce the retail price of merchandise prior to year-end and increase the price back up to the original price after year-end. For example, a diamond ring which retails at $4,000 is reduced to $3,000 before year-end with the $1,000 shown as a permanent markdown. Shortly after year-end the price of the ring is increased back up to $4,000. Such a reduction does not appear to be a permanent markdown, especially if a pattern exists. The taxpayer should be asked for an explanation of this transaction.

The examining agent should become thoroughly familiar with the retailer’s method of initially establishing the retail price as well as the subsequent price changes. Verify that the retail price shown in the stock ledger and on the final computation workpapers is in fact the full retail price marked on the merchandise as of year-end. Examiners have discovered the above systems by interviewing employees who are involved with the day-to-day processing of inventory records. In some situations, separate management reports were used by the retailer to track the actual marked (shelf) price of goods.

Retailers using a perpetual inventory system, which will reflect the amount of recorded merchandise on hand at any point in time, generally will estimate inventory shortage between inventory dates. Taxpayers who take an accurate physical inventory at year-end should have no shortage reserve at year-end because the books will be adjusted to reflect the actual inventory on hand. Some retailers do not take a complete physical inventory at year-end. Some may choose to take an inventory using one of the methods outlined in IRM 4.43.1.3.3.6. The taxpayers that do not take a physical inventory at year-end will usually claim an estimate of the shortage for the period between physical and year-end.

Records and information which will assist the examiner in making the determination as to whether an issue exists can be found in the following paragraphs of this text:

Inventory shortage, also known as shrinkage, is the difference between the amount of inventory which should be on hand, based upon purchases, sales etc., and the amount which is actually on hand. The exact amount of shrinkage can only be determined when an accurate physical inventory is completed. The results of the physical count will reflect only the amount of unaccounted for merchandise, without any detail regarding the exact causes.

The basic causes of stock shrinkage are listed below. Articles written on this subject state that retailers have been unable to identify which portion of the total shrinkage at each location results from each cause.

With regard to when the shortage actually took place, accurate physical inventories are unable to state more than the fact that it took place between the time since the last physical and the current physical. The question of when shrinkage takes place is an unknown. Possible factors include:

IRC section 471 provides that whenever the use of inventories is necessary in order to clearly determine the income of any taxpayer, inventories shall be taken on such basis as the Secretary may prescribe as conforms as nearly as may be to the best accounting practice in the trade or business and as most clearly reflects the income.

Treas. Reg. 1.471–2(d) provides that if the taxpayer maintains book inventories in accordance with a sound accounting system in which the respective inventory accounts are charged with the actual cost of the goods purchased or produced and are credited with the value of the goods used, transferred or sold, calculated on the basis of the actual cost of the goods acquired during the year (including the inventory at the beginning of the year), the net value as shown by such inventory accounts will be deemed to be the cost of the goods on hand. It further provides that the balances of the book inventories should be verified by physical inventories at reasonable intervals and adjusted to conform therewith.

Treas. Reg. 1.471–2(f) identifies certain methods that are not acceptable for purposes of the IRC section 471 inventory valuation. Two such practices are as follows:

Under Treas. Reg. 1.471–2(d), the amounts shown in inventory accounts that are maintained on a perpetual basis are deemed to be the cost of the inventory. While the regulations permit the balances in the perpetual accounts to be adjusted as a result of discrepancies that are verified by actual counts, the regulations do not permit additional adjustments that a taxpayer anticipates would occur if it were to take a physical inventory at year-end. Such an adjustment is nothing more than an unverified guess by the taxpayer that its book inventories must be incorrect because they have been verified to be incorrect in the past. Inventory shrinkage is an exception to this general rule.

Revenue Procedure 98-29 provides guidance for a taxpayer wanting to change to a method of accounting for estimating inventory shrinkage in computing ending inventory.

Revenue Procedure 97-37 provides a procedure for a taxpayer to automatically change to a method of accounting for estimating inventory shrinkage.

Section 961 of the Taxpayer Relief Act of 1997 amended IRC section 471(b) to permit adjustments to ending inventory for estimates of inventory shrinkage.

For retailers, LIFO price indexes may be internally computed or indexes published by the Bureau of Labor Statistics (BLS) may be used. Internal price indexes may be based on the complete population within the applicable pool or calculated with the use of statistical sampling. BLS indexes that are available include the Retail Price Indexes (RPI), Consumer Price Indexes (CPI), and Producer Price Indexes (PPI).

The product line of a retailer impacts on the type of index which may be used. RPI are intended for use with non-food items in department stores. In this context, the definition of what constitutes a department store has been broadly interpreted by the IRS. Retailers not eligible to use RPI may elect the use of CPI or PPI. Internally generated indexes are an option with any retailer. Taxpayers may not selectively pick and choose between BLS and internally generated indexes to achieve beneficial tax results. Generally, it does not matter which acceptable method a retailer adopts to determine its index as long as the index is used consistently and represents an accurate measure of price fluctuations during the measurement period. Whatever methodology is adopted constitutes a method of accounting, and the retailer may not change such method without the approval of the Commissioner.

Incorrect or inaccurate price indexes may distort a taxpayer’s entire LIFO computation. Although the size of the distortion in any one year may be small, the cumulative effect of such distortions over a period of years could be significant. The following items should be considered when examining this issue:

An examiner must have a fundamental understanding of LIFO in general and usually retail LIFO in particular to effectively examine this issue. Information found in this text; IRS rulings, procedures and announcements; IRS training materials and outside publications will provide sufficient knowledge with which to proceed. Relative to this issue, an IDR should be issued asking for the following information:

Governmental entities may impose taxes on items such as cigarettes and liquor to raise revenue. Retailers pay the taxes and receive stamps as proof of payment. The stamps are affixed to the applicable products and the cost of the tax is passed on to the consumer.

Some retailers consider stamp costs to be prepaid expenses. Others deduct them as a current period expense or include them in the retail LIFO inventory.

Tax stamps are supply type items similar in nature to size and price labels and should be considered as a prepaid expense. These costs should be deducted as they are consumed (when they are affixed to the product) to achieve optimum matching of income and expense.

Tax stamp costs should not be deducted as paid. The stamps represent taxes paid to a governmental entity and records exist of their purchases and use. Treas. Reg. 1.162–3 specifically precludes currently expensing the cost of items for which a record of consumption is kept. Since the cost is passed on to the consumer, immediate deduction also creates a mismatch of expense with corresponding income.

Including tax stamp costs in a retailer’s LIFO inventory is precluded because of potential distortion in the LIFO index. The LIFO index is intended to measure inflation for the purpose of preventing taxpayers from paying tax on inflationary profits. Increases in tax stamp costs result from political and economic motivations that are not proportionate to inflationary rates and could artificially inflate the LIFO index, resulting in a lower LIFO inventory figure, higher cost of sales and lower profit.

Including the cost of tax stamps in a retailer’s LIFO inventory also affects the cost complement percentage. Because the cost complement is the ratio of purchases at cost relative to purchases at retail, increasing purchases at cost by the tax stamp fees results in a higher cost complement percentage than would otherwise occur. This increased percentage of cost does not offset the amount of decrease in ending retail inventory resulting from inclusion of the tax stamps in the LIFO index computation. See Exhibit 4.43.1-7 for an example illustrating the effect of tax stamp cost on the retail LIFO computation.

If the examiner revises the method used by the retailer to report the cost of tax stamps, the examiner should consider whether a change in method of accounting has occurred.

Relative to this issue, an IDR should be issued asking for the following information:

Direct contact with applicable governmental entities may also provide useful information.

Furniture accessories are decorator items used by retailers to better display their products. For instance, a furniture retailer may put vases on tables, curtains or paintings on the walls, and other decorative items will be placed on or near the furniture that the retailer primarily intends to sell. Often, the accessories will have price tags, and will be available for sale to customers, although accessory sales are not the retailer’s primary objective and are not encouraged. Accessories are commonly used by retailers such as department and furniture stores, upscale clothing stores, and others whose merchandise can be better displayed by their use. They are seldom used by retailers such as discounters, pharmacies, etc. Accessories are apt to be trendy, and quickly out of fashion, although this is not always the case. Unsold accessories are often scrapped rather than marked down.

Because the accessories are not primarily held for sale in the ordinary course of business, and tend to be short lived, controls are apt to be much looser than for items of regular merchandise acquired for resale. They will, however, usually be inventoried along with the other merchandise. Because the retailer prefers to retain the accessories to showcase the furniture or other merchandise which is for sale, the accessories are often priced for sale at a higher than normal retail price to discourage customers from purchasing them.

The accessories may be "inventory" for tax purposes because they are held for sale, even though this is not the primary purpose of the retailer in acquiring them. In some cases, treatment as a deferred expense such as a "supply" inventory, may be more appropriate than treatment as merchandise inventory. Merchandise bought for resale is not inventoriable unless a profit motive is present, so accessories may represent either inventory or deferred expense, depending on the specific facts at issue. Generally, treatment as a current expense will be improper.

In cases where accessories are treated by the retailer as part of merchandise inventory, the agent should be prepared to ascertain that the accessory cost is properly accounted for. The retailer may make a decrease to retail price for inventory purposes which does not properly reflect the inventoriable cost of the items. Due to the unusually high pricing of the accessories, when LIFO is used, treatment as merchandise inventory may cause pricing to be distorted since the normal markups on overall inventory will not apply. The LIFO cost complement can be affected adversely by the artificially high retail pricing of the accessories by the retailer. Pricing accessories at twice the approximate cost would not be unusual.

The examiner should tour the merchandising location(s) and inspect departments which would benefit from the use of accessories, such as furniture, clothing, lingerie, or jewelry. A visual check will establish the presence of accessories and should indicate whether such accessories are priced at a normal retail level or are priced above market. The examiner can then interview appropriate taxpayer personnel to determine the circumstances under which such accessories are acquired and maintained, and the method of disposition. The examiner can also review accounts with titles such as: Furniture Accessories;Furniture Workroom; Accessories; Showroom Costs; Display Items, etc., to determine whether accessories are included and how the taxpayer treats such items. Some retailers maintain a subsidiary ledger for accessory items.

If accounts containing charges for furniture accessories are present, the examiner should review such accounts for unusual entries such as arbitrary write-downs to "market," or arbitrary write-ups.

Some large retail chains request that vendors invoice them for more than the purchase amount (I.e., the vendor overbills the retailer). Vendors do not have a "fixed right" to keep the overbilled amounts; these amounts represent liabilities to their customers.

Retailers may utilize their overbilled amounts in two ways. They request a check as repayment of the overbilling or utilize their overbilled amounts by taking a deduction off a subsequent invoice (i.e., the retailer initiates a credit memo that accompanies a payment to the vendor).

Vendors record the overbilled amount by debiting accounts receivable and crediting both sales (for the correct purchase price) and the overbilled liability account.

When retailers debit the full invoice amount as a purchase and do not account for the overbilled amount until they initiate a memo to the vendor, purchases are overstated in the interim. A lag period of several months is common. At year-end, this will result in a year-end overstatement of purchases.

Retailers have a system to track the overbilling. The initial overbilling policy/procedures letter, generally prepared by the retailers finance department, is provided to the vendor by the purchasing department.

IDR's can be used to request a description of the overbilling tracking procedures and the policy/procedures letter provided to the vendor. An interview of purchasing and finance department personnel will also assist in obtaining information relating to overbilling procedures.

UNICAP inventory purchasing costs required to be capitalized are described in Treas. Reg. 1.263A-3(c)(3). Purchasing activities under that section include functions associated with a purchasing department or office, and personnel such as buyers, assistant buyers, and clerical workers, whose function relates to the activities of the:

Generally, storage costs are capitalized under IRC section 263A to the extent they are attributable to the operation of an off-site storage or warehouse facility (Treas. Reg. 1.263A-3(c)(5)(ii)(F)).

A retail customer is defined as the final customer of the merchandise in question. However, be aware of the exceptions described in Treas. Reg. 1.263A-3(c)(5)(ii)(E)(2). Examples of off-site storage facilities are:

A dual function facility should be accounted for under Treas. Reg. 1.263A-3(c)(5)(iii)(B). The percentage of such a facility that is deemed to be off-site equals 100 percent less the percent which relates to on-site sales as determined from the following formula:

Total gross sales include the value of items shipped to other facilities of the taxpayer, per Treas. Reg. 1.263A-3(c)(5)(iii(B)(ii). The regulations contain a de minimis rule which states that if 90 percent or more is on-site, the entire facility is deemed to be an on-site facility. Similarly, if 10 percent or less of the sales are on-site, then the entire facility is deemed to be an off-site facility.

Costs incurred at an off-site storage facility which do not directly benefit or are not incurred by reason of the storage function should not be accounted for as an off-site cost.

Costs attributable to off-site facilities are enumerated in Treas. Reg. 1.263A–1(e)(3)(ii) as follows:

The more prevalent issues are the failure to include all off-site storage facilities or all costs associated with a facility.

Examples of miscellaneous issues follow:

Generally, handling costs incurred at an off-site storage facility or dual-function facility are required to be capitalized under IRC section 263A. Treas. Reg. 1.263A-3(c)(4) states that handling costs include costs attributable to processing, assembly, repackaging and other similar activities with respect to property acquired for resale. Examples of handling costs are:

Handling costs do not include:

Costs attributable to handling activities generally consist of:

The examiner should secure and review the taxpayers UNICAP computations pertaining to handling costs.

Several possible issues which the examiner should consider are:

General and administrative costs are known as "mixed service costs." These are costs incurred by administrative, service or support functions, or departments ( "service departments" ), that directly benefit or are incurred by reason of both:

Mixed service costs do not include administrative, service or support costs which:

Mixed service costs shall be allocated to particular activities or functions on the basis of a factor or relationship that reasonably relates the incurring of the service cost to the benefits received by the activity, per Treas. Reg. 1.263A–1(g)(4)(i).

Illustrations of types of activities with respect to which costs ordinarily are required to be allocated, are shown in Treas. Reg. 1.263A–1(e)(4)(iii), and are listed below.

Illustrations of types of activities with respect to which costs ordinarily are not required to be allocated are shown in Treas. Reg. 1.263A–1(e)(4)(iv), and are listed below.

The cost of any administrative, service or support function or department of the taxpayer not described in IRM 4.43.1.4.12.4(4) or 4.43.1.4.12.4(5) above are required to be allocated to particular resale activities to the extent that it directly benefits a resale activity or if it is incurred by reason of the activity.

The de minimis rule under Treas. Reg. 1.263A-1(g)(4)(ii), if elected by the taxpayer, fully includes or fully excludes certain service costs based upon the predominant nature of the functions performed. The costs meeting the following de minimis criteria are then not considered a mixed service cost:

The direct costs of a service department include costs that can be identified specifically with the services provided by the department. The indirect costs of a service department include costs not identified specifically with the services provided by the function or department, but that were incurred by reason of the direct costs of the function or department. Such direct and indirect costs include, but are not limited to:

Examiners should become familiar with the bottom line impact of making an adjustment to mixed service costs by modifying the taxpayer's records or using a spreadsheet, such as that shown as Exhibit 4.43.1-8 adjusted for your taxpayer's method and data.

Some areas the examiner may wish to review are:

Treas. Reg. 1.263A-3(d) provides for a simplified method for determining the additional UNICAP costs properly allocable to property acquired for resale or other eligible property. The taxpayer must be in a trade or business exclusively engaged in resale activities. Exceptions are allowed for de minimis production activities or property produced under contract by an unrelated third party.

The simplified resale method must be elected by the taxpayer and it can be made with or without the historic absorption ratio election, subject to certain restrictions.

The following steps are taken to compute the simplified resale method elected without the historic absorption ratio election:

If the Simplified Service Cost Method is not elected by the taxpayer to allocate mixed service costs, then the taxpayer must allocate these costs using a method described in Treas. Reg. 1.263A-1(g)(4).

Permissible Variations of the Simplified Resale Method are:

Treas. Reg. 1.263A-3(d)(4) permits resellers using the simplified resale method to elect a historic absorption ratio in determining additional UNICAP costs allocable to eligible property remaining on hand at the close of their taxable UNICAP cost ratios every year. The regulations have the following requirements:

Examination Techniques. Most retailers elect the simplified resale method and the simplified service cost method to compute their UNICAP costs. The taxpayer's UNICAP computation workpapers should include all the amounts used in the ratios discussed above. The examiner should also determine these amounts on his/her own to check the taxpayer's computation. Once a computer spreadsheet is created using all these ratios, the examiner can easily determine how an adjustment in a certain cost center or account or allocation percentage will affect the amount of UNICAP costs in ending inventory. This will aid the examiner in making a risk analysis of how much time and resources will be devoted to examining inventoriable UNICAP costs.

Notable changes from the temporary regulations, which still are effective for taxable years prior to January 1, 1994, in regards to sellers are: