Retail Industry ATG - Chapter 2: General Issues in Retail
Publication Date - February 2009
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
- Initial Interview
- Information Document Request
- Books and Records
- Income Issues
- Cash Records
- Indirect Methods
- Specific Items Methods of Determining Income: IRM 184.108.40.206.1
- Bank Deposit Analysis: IRM 220.127.116.11.3.6
- Source and Application or Cash T: IRM 18.104.22.168.4
- Markup Method: IRM 22.214.171.124.5
- Percentage Markup Method of Determining Income: IRM 126.96.36.199.6
- Computations in the Percentage of Markup Method
- Net Worth Method: IRM 188.8.131.52.7
- Analysis of Gross Receipts
- Sources of Receipts
- Other Retail Income Sources
- Cost of Goods Sold
- Retail Inventory: IRM 4.43.1
- Personal Consumption of Inventory
- Retail Inventory Method (RIM): IRM 184.108.40.206.1
- Last In, First Out (LIFO): IRM 220.127.116.11.1.3
- Stock Ledger (INVENTORY): IRM 18.104.22.168.2.5.4
- Point of Sale Perpetual Inventory Control System
- Valuation of an Acquired Retailers Inventory (Coordinated Issue)
- Excise Tax Issues
- Employment Tax Issues
The initial interview is an important element of any examination, setting the stage for the rest of the examination. The primary purpose of the interview is to secure, by conversation with the taxpayer, sufficient facts which will present the overall financial picture, an understanding of the operations, and an overview of the recordkeeping practices. This is the examiner’s chance to learn exactly how the business works and how cash is handled. Information provided during the initial interview can save significant time and effort in unnecessary examination steps. Remember, the examiner is testing the accuracy of the taxpayer’s tax return and the sources of gross income. The interview is the best opportunity to allow the taxpayer to provide information not shown on the return.
In addition to the general interview items usually covered, specific questions relating to the retail business should also be included. Some of the items to be developed in the initial interview:
Most “mom and pop” stores are cash intensive. Understanding how the taxpayer handles and accounts for the money is very important.
Also secure a statement of how the inventories are valued and the method used. This is needed for calculations of markup and/or gross profit. Find out who actually takes the physical inventories and when they are performed. Ask for the work paper that calculates the inventory value.
Control procedures in many small businesses are often weak or nonexistent. This may be due to cost factors, the lack of well-trained accounting staff or a lack of concern with this aspect of the business. Smaller businesses generally have a higher level of "control risk," which is the risk that a material misstatement could occur and it will not be prevented or detected on a timely basis by the business's internal control structure, policies, or procedures.
It is imperative that cash-on-hand is covered during the interview. The examiner should probe for all funds the taxpayer had access to including funds available. Make sure the taxpayer understands that cash includes pocket money plus cash in a safe, safe deposit box or stored at home.
Many retail business owners use some of their inventory for personal purposes. This is especially noted in a restaurant or grocery business. The key here is to verify that the personal-use amount is properly accounted for and deducted from cost of goods sold or purchases.
This list is not all-inclusive and some of the questions may not be pertinent in all examinations. The initial interview should always be tailored to the taxpayer under examination.
Information Document Request
Shown below are some documents examiners may want to consider when preparing an IDR for a retail case. Not all of these items should be requested in every case, but examiners should use this information as a guide and request the items that are appropriate and relevant for their specific case:
All paid invoices for the year under examination, separated by vendor
A listing of all purchases paid in cash
Sales, Cash receipts, purchase, and general journal
Adjustment entries to such items as Sales, excise Taxes paid
All daily cash register tapes (including the summary tapes called ‘Z’ tapes)
All bank statements for the year under examination, including deposit slips and checks written
Work papers supporting the inventory computations
List of vendors who offer vendor allowances such as rebates
Documentation of any non taxable income
Books and Records
Due to the diversity of the industry and the types of business organizations, a variety of books and records may be found during the examination. Some taxpayers will have technologically sophisticated accounting systems that allow for very detailed records of sales and purchases. They may describe the quantities purchased and the price paid each time. Other taxpayers will not have a structured purchase journal, but may only have invoices and cancelled checks.
Z Tapes - Most simple cash registers contain a “Z” key which can only be operated by the manager, owner or a key employee. The Z key totals the entire history of activity on the cash register for a period of time, providing a summary total for (sales) taxable sales, non (sales) taxable sales, credit card sales, credit card tips, cash sales, lottery sales, coupons and discounts, etc. Each day’s Z tape is used to record the daily sales in the sale journal. These tapes must be retained by the owner and made available for the examination. Without the Z tapes the examiner cannot know if all transactions are actually being recorded.
The examiner will conduct an audit test on the Z tapes, matching them to the entries in the sales journal and determining what sales are captured on the tapes.
Point Of Sale (POS) - This is a computerized accounting system that records sales along with related items, such as employee’s time and tips received, or reductions to inventory and calculations of profit on each sale. These machines can produce financial statements, periodic statements of profit and loss, profits per item, payroll checks, etc.
When the examiner suspects that the computer program used by the taxpayer is not recording all sales properly, a referral should be made for an IRS computer examination specialist who will run an audit test of the computer program.
Inventory Reports - if maintained. The retailer will usually take a physical inventory annually to determine if there is old merchandise that should be discounted for a quick sale.
Cash Pay Outs - As discussed above, the accounting for cash is a primary focus for the examiner. Many taxpayers keep daily envelopes with the cash paid out and the cash taken in recorded on the envelope. Others maintain a separate file for receipts paid in cash.
The examination of Income is a mandatory audit issue and minimum income probes will be conducted during every examination. Please see IRM 22.214.171.124.3 (for individual business returns) and IRM 126.96.36.199.4 (for corporate and other business returns) for the Minimum Income Probes. If the minimum income probes and examination of gross receipts show all taxable income from known sources is reported, the examination may be limited at that point.
If the results indicate the potential of unreported income due to inaccurate reporting of taxable income from known sources, or if the books cannot be reconciled to the return, or if a material imbalance in the Financial Status Analysis cannot be reconciled, then a more in-depth examination of income is warranted. The examiner will need to decide which techniques are best suited for each individual taxpayer. The following indirect methods have been used successfully in analyzing the sources of income:
Retailers use different types of methods to collect and account for cash. In some stores only the owner collects cash from customers and it is kept in a drawer or box. In larger stores key employees collect and account for cash. In more sophisticated systems a point of sale (POS) cash register may record sales and decrease inventory at the same time.
It is important to find out who collects the cash, where it is kept and who reconciles it to sales at the end of the day or shift. When cash is used to pay vendors or make purchases, the examiner must know who is authorized to do this and what is the procedure? It is also important to find out who takes the cash to the bank and what accounts it may be deposited into.
A thorough understanding of how cash is handled is particularly important in the retail industry. Even with weak internal controls, a taxpayer may be properly reporting income, but the only way for the examiner to know this is to gather detailed information about how the business is conducted, documenting cash inflows and outflows and thoroughly interviewing the owner regarding cash receipts and expenditures.
The records created (hard copy or magnetic media) by the accounting system will also provide a valuable source of information in the examination of the retail businesses. A complete explanation of the accounting system, both in theory and business, should be obtained from the taxpayer prior to beginning the examination of the books and records.
If the taxpayer has a computerized cash register system and cannot provide the requested financial records, the examiner can contact the cash register manufacturer for instructions on how to obtain the reports needed. Most programs made within the last decade run the essential reports necessary to properly determine the correct tax liability and to comply with tip reporting.
During the initial interview, the examiner should ask the taxpayer what percentage of sales is attributed to cash compared to credit or check payments. When the examiner analyzes the bank deposits, this percentage can be verified and any discrepancies can be questioned. During the tour of the business the examiner should be alert to the type of payments that are made and how they are handled.
In spite of the modern record keeping systems available, many choose to report gross receipts according to amounts deposited to the business bank account. When cash is not deposited in the bank, or when checks are cashed or deposited into an account other than the business account, this method of reporting income is not accurate.
Interviews with return preparers who have been found to rely on the bank deposits to reconcile gross receipts (which in most cases understate income) indicated that they were unaware of the computerized record keeping systems. These preparers provide only year-end compilation rather than complete income analysis of services rendered by the retailer business. They have indicated that when they question their clients as to their deposit characteristics and are told that all gross receipts are deposited into the business bank account; the preparer confidently uses the bank statements to report income. Rarely are any adjustments made to the gross deposits shown on the bank statements.
For these reasons the examiner must check for unreported receipts. A retail business is likely to receive many personal checks as payment for services. If the owner is known at the business, whether it is a corporation or sole proprietorship, many of the checks will be made to the retailer personally. It would not be difficult to cash these checks or divert them into personal bank accounts.
Based on this discussion, the business income can easily be diverted from being deposited into the business bank account(s) and reported on the tax return. Therefore, it is imperative that each examination includes alternative methods to verify gross receipts.
When the taxpayers’ records are not available or are inadequate the examiner should consider the use of the following indirect methods:
Bank deposit analysis
Fully developed cash T method
Source and application of funds
Net worth method
Percentage of markup method
Unit and volume method
The following is a synopsis of the indirect methods and the supporting court cases. The examiner needs to review the appropriate IRM sections for the proper application of these methods. If any of these methods rely on estimates, they should be corroborated by other methods to establish a stronger position. When tracing cash through a bank deposit analysis or using the source and application of funds method, several unique facets of the operations should be recognized.
Cash payouts are not deposited, but the money used to make the cash purchases originated from sales. This is cash that would not be deposited into a bank account and must be added back to the bank deposit analysis.
In a restaurant business cash payment of employee credit card tips is money that is not deposited, but originated from sales. Again, this cash must be added back to the bank deposit analysis.
Sales tax collected from customers for cash sales is money deposited that is not a source of income. In many states the sales tax for restaurants and bars is higher than the sales tax for other retail businesses.
Cash collected from vending machines is cash that needs to be deposited and included in gross receipts. If significant coin and currency deposits are not found on the deposit slips the examiner may need to determine the amount of income from this source and add it to the bank deposit analysis.
Credit card payments from credit card companies for sales will include deposits of employee tips plus the sales taxes plus the sale. Only the portion representing the sale is taxable.
Loans from shareholders are a non-taxable source of cash. Proof of payment is necessary to establish facts.
Transfers between bank accounts are non-taxable.
The bank deposit analysis method assumes that the business owner deposits all income in a bank account. In a cash-intensive business such as a bar or restaurant, this may not be the case. For that reason, the bank deposits analysis should generally be supplemented with another indirect method when auditing a bar or restaurant.
To further support an indirect method another examination technique may be used such as having the examiner inspect the supply invoices to find the name of the company that prints the guest checks. This printing company can provide the number of guest checks purchased by the restaurant in a year. A projected income can then be determined from the average amount of the guest check times the number of checks. If these methods are used in combination, they strengthen the case.
In examining a bar, it is possible that the bar owner may remove cash from his or her drawer, purchase liquor off the shelf of a store, sell the drinks in his or her establishment and pocket the profits. (In most states this practice is illegal and bar owners cannot purchase liquor off the shelf or in discount stores.) In such case, there may be no indication in the books that anything is wrong as neither the invoice nor the income touches the books. An indirect method may uncover this.
Specific Items Method of Determining Income: IRM 188.8.131.52.1
Before we begin analysis of the retail indirect methods we should discuss the specific items methods. This method is preferable to an indirect method as it is based upon direct evidence of income. For example, a restaurant owner may receive rebates from a supplier. A copy of the supplier's invoices and cancelled checks establishes the amount of income from these rebates. The specific items method relies on evidence gathered from source documents, rather than estimates. If records cannot be obtained from the taxpayer, you may have to contact third parties. If you do, be certain you correctly follow third party contact procedures.
The specific items method of establishing income, supplemented by the bank deposit method, is illustrated in Ketler v. Commissioner, T.C. Memo. 1999-68. During 1990 and 1991, Warren Ketler operated two sole proprietorships, including a catering operation doing business as California Barbecue. Mr. Ketler failed to file Federal income tax returns for 1990 and 1991. The Service determined Mr. Ketlers unreported income for these years by reference to Forms 1099 provided by payers. Prior to trial, the Service obtained 1990 and 1991 bank records for all of Mr. Ketlers accounts and identified various nontaxable transfers and deductible business expenses. Based on this analysis, the Service asked that the Tax Court find increased income tax deficiencies. After trial, the Tax Court found that Mr. Ketler received the income reflected on the Forms 1099. It also found that the Service had properly performed the bank deposits analysis, and, therefore, Mr. Ketler was also liable for increased income tax deficiencies.
Kikolos v. Commissioner, T.C. Memo 2004-82, involved liquor store owners, Nick and Helen Kikalos. At the end of each day Mr. Kikalos would receive a bag from his store containing receipts which, among other things, included the cash register tapes (known as "Z tapes") from the store. The Z tapes from these store registers would have allowed for an accurate calculation of the Kikalos' gross income. However, after entering the information in his log books, Mr. Kikalos threw away all of the Z tapes.
When IRS used a mark-up percentage to figure accurate gross receipts, the Kikaloses wanted to use a different indirect method and filed their petition in court.
The court said that arithmetic precision was originally and exclusively in the hands of the Kikaloses, who had simply to keep their papers and data. Having defaulted in this duty, they cannot, in essence, "frustrate the Commissioner's reasonable attempts by compelling investigation and re-computation under every means of income determination.” The Court said that other indirect methods of estimating the Kikalos’ income are not relevant.
Quoting the Fifth Circuit, the court stated, “While the absence of adequate records "does not give the Commissioner carte blanche for imposing Draconian absolutes," such absence does weaken any critique of the Commissioner's methodology. Webb v. Commissioner, 394 F.2d 366, 373 (5th Cir. 1968).”
The court said, “Indirect methods are by their very nature estimates and courts reject the notion that the IRS should have checked their calculations by other methods."
Bank Deposit Analysis: IRM 184.108.40.206.3.6.
A bank deposit analysis (BDA) is used to identify deposits that may be taxable, to determine if business expenses were paid from other sources and to determine if business and personal accounts were co-mingled. The deposited items will show whether cash is deposited.
The examiner will analyze the deposits and reconcile non taxable deposit sources, comparing the total deposit with the reported gross income.
If the retail business is cash intensive, where a significant amount of receipts are not deposited and there are many expenses paid with un-deposited cash, a bank deposit analysis would not be a good indirect method for proving income. However the total known deposits should be added to cash expenditures to show the total amount of funds used.
This method is best for retailers whose books are unreliable, but who makes periodic bank deposits and pays expenses by check.
The bank deposits method of establishing income is illustrated in Ng v. Commissioner, T.C. Memo. 1997-248. From 1986 through 1990, Big Hong Ng owned interests in several business entities, including various restaurants. Ms. Ng controlled several bank accounts in the United States and Hong Kong. She commingled her personal funds with those of the business entities in which she had an interest. The Service conducted a bank deposit analysis and determined that Ms. Ng failed to report significant amounts of taxable income during the years in issue.
In analyzing the bank deposits, the Service separated cash, checks, cashiers checks and wire transfers. It examined the source of each deposit and separated items subject to self-employment tax from those not subject to such tax. Further, to the extent possible, the Service eliminated those items that had been reported on Ms. Ng's income tax returns or that came from nontaxable sources (for example, transfers and refinancing proceeds). The Service also analyzed Ms. Ng's cash expenditures. The expenditures that could not be traced to a nontaxable source or reported income were considered unreported income.
Source and Application or Cash T: IRM 220.127.116.11.4.
This method analyzes cash flows in comparison to all known expenditures, and shows that if there are excess expense items (applications) over income items (sources) an understatement of taxable income exists.
These methods may be useful for a retail business that has unreported sources of income and when business and personal expenses can be verified.
Markup Method: IRM 18.104.22.168.5.
This method reconstructs income based on the use of percentages or ratios for the type of retail business. For example, the examiner would determine the industry markup for a particular type of retailer and apply that markup percentage to the verified cost of goods sold of the taxpayer under examination.
Alternately, the examiner can use the taxpayer’s own markup percentages, if possible. A ‘shelf test’ can be performed where the current sales prices can be compared to the cost of those items to determine the markup percentage. This will be effective if there are only a few types of purchases or only a few suppliers of goods, such as for a gasoline retailer.
This method works well for a business that is cash intensive or one that does not use bank accounts to deposit receipts, or for a taxpayer where total expenditures (such as personal expenses) cannot be determined. This method is also recommended when inventories are present, but records are unreliable.
Percentage Markup Method of Determining Income: IRM 22.214.171.124.6
IRM 126.96.36.199.6.2 states that the percentage markup method is recommended in the following situations:
- When inventories are a factor and the taxpayer has nonexistent or inadequate records
- Where a taxpayer's cost of goods sold or merchandise purchased is from one or two sources and these sources can be ascertained with reasonable certainty and there is a reasonable degree of consistency as to sales prices.
Consider the following when applying the percentage of markup method:
- Judgment should be exercised by examiners to make sure the comparisons are made to situations that are similar to those under examination
- The availability of valid sources of information containing the necessary percentages and ratios
- Complexity of the taxpayer's product mix and the availability of valid percentages and ratios for each product
- Length of the period covered during the examination and the need to adjust the percentages and ratios to reflect those existing during the examination
Computations in the Percentage of Markup Method
Possible daily volume X Average check per seat = Daily sales
The possible daily volume would be the number of seats in the establishment X how many times in a day they are occupied. The possible daily volume can be broken down into time periods in a day (breakfast, lunch, or dinner) to get a more accurate tally. The average check per seat can be obtained from the taxpayer during the initial interview or from examining the sales tickets.
The daily sales can be extended to weekly and yearly sales based on the days open per week and the weeks open per year.
Daily sales X Days open in a week = Weekly sales
Weekly sales X Weeks open in a year = Yearly sales
These estimates should take into account the number of vacant seats and people who walk out before paying their bill. The examiner should also look at the taxpayer’s advertising account to test the accuracy of reported income. Are specials advertised? How often? Specials may refer to certain menu items or discounted prices or both. Are the times during which specials are offered (for example, happy hour or weekly breakfast hours) reflected in the daily receipts ledger? During the initial interview ask enough pertinent questions to determine if these or any other situations should be considered.
In addition to the above calculations, normal audit procedures should be followed, including tracing gross receipts to bank deposits, analyzing bank deposits of all business and personal accounts of the owner/manager, etc. The examiner will review the interview responses regarding internal controls. Does the same person who counts the daily receipts also make the bank deposit? Are the meal orders taken on numbered tickets or would it be easy to simply not ring up a sale on the cash register for some orders? The examiner must look closely at the supervision habits in the restaurant to evaluate how sales might be understated or how easily theft may occur and by whom.
Net Worth Method: IRM 188.8.131.52.7
This method measures the difference between a taxpayer’s net worth (total assets less total liabilities) at the beginning and at the end of the year. An overall increase in net worth represents taxable income. This method works when there is an entire business element missing, such as a retailer that does not report sales from an internet business, or a taxpayer who has additional income from an illegal source.
The net worth method can also be used to corroborate other methods of proof or to test the accuracy of reported taxable income.
The net worth method of establishing income is illustrated in Michas v. Commissioner, T.C. Memo. 1992-161. During 1984, the taxpayers owned several sole-proprietorships, including a liquor store. The Service determined that the books and records of these sole-proprietorships were inadequate and analyzed the taxpayer’s net worth to determine whether all taxable income had been reported. The Service performed this analysis by determining the cost of the taxpayers business and personal assets at the beginning and end of 1984. The Service then reduced these amounts by the taxpayer’s liabilities at the beginning and end of the year. Then, the difference was adjusted by adding nondeductible expenditures (for example, living expenses) and by subtracting nontaxable sources of income (for example, gifts and loans).
The Court largely agreed with the Service, but found that certain adjustments to net worth were not proper. Accordingly, the Court reduced the amount of unreported income determined by the Service.
Analysis of Gross Receipts
Before an auditor reviews records for specific sources of receipts, he should do the following:
Analyze the duplicate deposit slips. If the business is cash intensive there should be frequent and significant cash deposits. The examiner will calculate the percentage of cash to checks or credit card payments.
Analyze the cash register tapes. Cash registers print a daily total called ‘Z’ tapes. A months worth of Z-tapes will usually be entered into a spreadsheet or handwritten on a monthly sales sheet. Total the monthly sheets to compare with gross receipts on the tax return. Use the monthly sheet for a sample month and verify the daily tape amounts were entered correctly.
Analyze business cash pay outs. Verify that the income was reported before it was paid out for business expenses.
Sales taxes returns: The gross sales reported to a state sales tax agency will generally match the gross receipts reported on the income tax return. If not, the examiner should reconcile any differences.
It is also important to determine whether sales taxes were included in the total sales dollars. The retailer should not include sales taxes in gross receipts and should not deduct state and local sales taxes collected and paid over to the state or local government.
The examiner should be alert for double deductions in sales taxes paid for purchased items, such as taxes that are included in the cost of goods sold as well as a separate expense item.Sources of Receipts
Sources of Receipts
Vendor Rebates and Allowances
Many vendors offer a rebate or allowance to the retailer when they purchase certain items or quantities. For example, a soft drink vendor may allow a discount on all diet soda purchased, if the retailer also purchases 5 cases of a new product, soda light. Many times the vendor allowance will be a reduction of total purchases and will appear on the purchase invoice. This way payment is made only for the net purchase amount and no income should be recognized.
Some vendors, such as cigarette sellers, allow the retailer to purchase the product at discount or warehouse stores. The vendor then issues a rebate check to allow the purchase for less than the retail amount. There is no purchase invoice from the vendor in this transaction, since the purchase was made at another retail store. This type of rebate should appear as an income item.
Income from rebates or credits is includible when received by a cash basis taxpayer, and when the right to receive it becomes fixed and certain by an accrual basis taxpayer.
When a retailer receives allowances or rebates from vendors after the initial purchase of merchandise and fails to properly account for them, the effect will be understating gross profit or improperly reflecting a gross loss on the sale of merchandise.
The examiner should have the taxpayer explain the various types of allowances and rebates that they negotiate and how they account for these allowances for book as well as for tax purposes. The examiner must determine what accounts are used and review the accounting entries, determining how and who maintains the accounts throughout the year. The examiner will determine if amounts are recorded when earned or when paid, determine the magnitude of the rebates, determine how many vendors are involved, and secure a list of vendors that offer rebates to the taxpayer. The examiner must consider interviewing buyers or other appropriate personnel who have first hand knowledge of vendor allowances and rebates (in compliance with third party contact provisions), requesting selected vendor contracts or agreements as well as computation work papers. If appropriate, the examiner will consider a review of any significant allowances reported in the first months of the year to determine if, as of year-end, similar monies have been properly accrued or improperly deferred. All vendor accounts will be reviewed to determine if the entries relate in size and timeliness to the information secured.
Credit and Charge Backs
Sometimes the vendor determines the amount of the allowance or rebate and issues a purchase credit or charge-back to the retailer. In other instances the vendor sends a notice to the retailer, after the earning period has expired, which reflects the final computation of the rebate amount, possibly accompanied by payment. When amounts are in dispute, the retailer will in most instances shift the burden of proof to the vendor, simply by withholding payment for merchandise purchases.
Target Profit Percentage
Negotiation of the terms of the purchase of merchandise is a major aspect of the retail buyer. The buyer is responsible for assuring that the merchandise to be acquired can be sold at a retail price, which will generate the targeted profit percentage. Some retailers desire a no frills purchase for the lowest possible price. In most transactions, however, there are numerous incentive allowances or rebates offered or demanded as part of the overall negotiated price. These allowances may initially result in a higher purchase price for the merchandise ordered, but the retailer expects that this higher initial cost will be more than offset by the allowances. The details of the negotiated agreement will either be entered into the product data records or maintained by the retailer. It is obviously in the best interest of the retailer to monitor its progress in earning incentive allowances and rebates to ensure that all potential recoveries are earned.
Generally a contractual relationship will be established between the retailer and the vendor. This relationship can be evidenced by a formal contract or terms described in a letter, memo, or other less formal correspondence.
Generally, these allowances will be reported as an adjustment to purchases or as income. The key here is the association to the product purchased. In the case of a volume discount the rebate is directly associated to purchase, so inventory is discounted. In the case of advertising rebate, the amount is associated to sale of the product; therefore the rebate is other income.
Some of the more common vendor allowances and rebates are as follows:
With this type of discount, the retailer earns money when the quantity in terms of items or dollars of purchases relating either to specific products or all products exceeds certain levels. For example, the retailer may earn a recovery equal to one percent of total purchases when the total purchases reach 103 percent of last year's total.
Manufacturers often offer the retailer volume discounts in the form of prizes and awards.
This allowance also is based upon volume of purchases. The retailer generally does not have to submit advertising documentation or verification to receive this type of allowance, unlike cooperative advertising. It is not unusual for retailers to negotiate agreements to receive both types.
In cooperative advertising, a portion of the taxpayer's advertising costs is borne by certain vendors in accordance with cooperative advertising offers of the vendors. For example, a chain restaurant franchisor charges each individual franchise restaurant 3% of their gross receipts. This money is used for national advertising of the restaurant chain.
It is industry practice for many large vendors to open their cooperative advertising allowance program to most customers. Allowances from some vendors will be limited to a percentage of purchases, which will vary from vendor to vendor, and will sometimes fluctuate according to the volume of purchases. Other allowances may be negotiated between the vendors and the taxpayer's buyers or advertising department personnel. Such agreements generally stipulate the advertising media to be used, conditions relative to the advertising as to the specific product, vendor's name and logo usage, when the advertising is to be performed, size or length of ad, and the amount to be paid or credited to the retailer by the vendor. While it is common for vendors to make the rebate or credit after the retailer submits proof of meeting the required advertising criteria, some vendors make the rebates or credits in advance of the retailer placing the advertising.
Both the program and negotiated cooperative advertising agreements generally address the retailer‘s qualification criteria and documentation requirements to be submitted with the retailer’s claims for payment or credit. Qualification requirements will specify the term of the offer, eligibility of the retailer, qualifying merchandise, earned accrual, reimbursement percentage, and art and copy requirements. The documentation of the claim will generally consist of proof of advertising, including tear sheets, and the advertiser's invoice to the taxpayer.
The retailer's right to the cooperative advertising allowance will generally arise when the advertising is performed and not at the time documentation is provided to the vendor, or when payment is received by the retailer.
Generally, an accrual method taxpayer that has a right to reimbursement for a portion of its advertising costs by the vendor of the advertised goods, in accordance with a cooperative advertising agreement, accrues the reimbursement under the all events test when the taxpayer places the advertising.
This allowance, usually based on a percentage of purchases, covers the cost of defective merchandise or the handling costs related to it.
Vendors agree to reimburse all or a portion of product markdowns taken on a specific product, in order to instill confidence in the buyer that the product will perform as predicted.
Shelving or Fixture Allowance
The vendor may either provide product shelving or money for the purchase of product shelving. For example, a Retailer may receive a display case from a vendor on condition that it is strategically placed and used to market the designated product for a certain period of time. In either situation the value [or money] is other income. If the shelving remains the property of the vendor there is no allowance involved.
The vendor desires to have its product displayed in a prominent location, which will help generate sales. The vendor may offer, or the retailer may demand, payment to secure an agreement for specific space.
New Store Allowance
The vendor may offer free or reduced price merchandise, or non-inventory prize merchandise which would be raffled to store customers, in conjunction with the opening of a new store.
The vendor may have a promotion for a specific time period during which the Retailer may receive free merchandise, after purchasing similar merchandise. As an example, for every 100 golf bags purchased, the vendor will provide an additional 10 bags at no extra cost.
The retailer may receive funds from vendors to offset certain costs of handling merchandise, such as the cost of removing ornaments from boxes and placing each item on a shelf.
Some vendors allow retailers to retain holiday merchandise, but reduce the following month‘s billings by the remaining holiday inventory. The holiday inventory is then re-billed the following holiday season. This is done for all holidays, such as Christmas, Easter, Mother‘s Day and even Halloween.
Deferred Income - Gift Certificates and Gift Cards
Retailers may issue gift certificates or gift cards. The area of gift certificates and gift cards is one where an examiner may find the retailer deferring income beyond the point where it should be reported. Unless the taxpayer elects the deferral rules of Treas. Reg. section 1.451-5 or Rev. Proc. 2004-34, this income must be reported when received.
Election to Defer Income- If an election is made to defer the income under the Treasury regulation, the general rule is that the income from substantial advanced payments must be reported at the earliest of:
the time the income is earned under the all events test;
the time the income is recognized under the taxpayer's accounting system, including consolidated financial statements to the shareholders or reports for credit purposes; or the last day of the second taxable year following the year of receipt of a substantial advance payment-*
*- [Per Treas. Reg. section 1.451-5(c)(3) any payment received pursuant to a certificate is a substantial advance payment]
Deferred Income and Approval for Change of Accounting Method - Treas. Reg. section 1.451-5(e) states that the deferral of income under this section is considered a method of accounting and approval of the Commissioner is required to switch to it.
Deferral beyond Second Year- The most likely situation that will be encountered is where the retailer is deferring the recognition beyond the second year following the receipt of the cash. This might occur due to poor recordkeeping where no tracking of the outstanding gift certificates is made. However it should be noted that Treas. Reg. section 1.451-5(d) requires the taxpayer to file an information schedule with its return that shows (a) the total amount of advanced payments received in the taxable year; (b) the total amount of advanced payments received in prior years that were included in gross receipts of the current year; and (c) the total amount of advanced payments received in prior years that have yet to be included in income.
The deferral period under Rev. Proc. 2004-34 is a one-year deferral. In order to defer gift certificate or gift card income under either method of accounting, the taxpayer must maintain records to provide the information contained in Treas. Reg. 1.451.5(d).
Gift Certificate - Deferred Income - Balance Sheet Liabilities
Because the income from certificates must be reported no later than it is for book purposes; it is not likely that the examiner will see this on the Schedule M. The examiner is more likely to find this issue on the balance sheet as a liability identified as certificates, customer credits or customer deposits. In addition to requesting an explanation or written documentation of their certificate issuance and record keeping procedures, the examiner should request samples of the certificates. Most will bear a serial number that will aid in determining how long the certificates have been outstanding. The taxpayer should also have some internal controls to prevent employees from abusing the certificates and to prevent counterfeiting. The examiner should get descriptions of these procedures and/or manuals as well as any internal audit or security reports dealing with certificates.
Deferral for Up to Two Years- Although Treas. Reg. section 1.451-5 allows for the deferral of recognition for up to two years, the examiner must keep in mind that the all events test under Treas. Reg. section 1.451-1 needs to be applied first. Certificate income is recognized "when all events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy." The regulations do not permit deferral if the income has already been earned. The examiner should therefore examine the retailer's redemption policy. If no cash refunds are permitted or if the certificates expire before the end of the second year, the income may have to be recognized sooner.
Deferred Income - Treas. Reg. section 1.451-5(c) (1) (iii)- Because the merchandise for which certificates can be redeemed generally is not identifiable until the gift certificate has actually been redeemed, no deduction is allowed for the cost of the merchandise at the point the income is recognized under Treas. Reg. section 1.451-5(c)(1)(iii). A deduction is allowed only when the merchandise to be redeemed becomes identifiable, that is, when the certificate is actually redeemed. If the certificates are redeemable for either goods or services (for example, at a department store with a Retailer) the regulations should still be applicable. Gift certificates strictly redeemable for services are governed by Rev. Proc. 2004-34, 2004-22 I.R.B. 991, which has rules that are very similar.
Other Retail Income Sources
Income from Service-Related Activities
Many retailer establishments will have departments which are designed to support sales and are not a major source of income or expense to the retailer, but which are incidental to the primary business of the store. For example, a retail craft store may have a separate service available for matting and framing. Or, a florist will have some method of arranging bouquets for customers or will sell small gifts. Often these services will be performed in-house.
Methods of detecting other services offered include a tour of the facility, or telephoning the sales location and asking what services are available. Accounts of retailers should be analyzed to determine whether income from service departments exists and, if so, how income and expense is booked. Often, income and expense may be netted into the same account, where a growing credit balance in a balance sheet account may signal an improper deferral of income.
Another area to consider in relation to service departments is how the taxpayer treats them in its cost of sales calculation. Many taxpayers will treat them as a cost of sales for book purposes, and as a period cost for tax. The Service contends that both income and expense should be treated as part of the cost of sales calculation. Prior to the removal of IRC section 453A deferred gross profit in 1986, the difference in treatment was an area of some concern, as the amount of deferred income was directly affected by the gross profit percentage. The issue was addressed in Marcor, Inc. v. Commissioner, 89 TC 181 (1987), nonacq., 1990-2 C.B. 1., where it was decided that service department cost was not an item which should be included in cost of sales. However the Commissioner has non-acquiesced to this decision.
Promotional allowances are sometimes received before the taxpayer has met all the criteria for earning them. The examiner should apply the all-events test before permitting a deferral of income. Only the unearned portion qualifies for deferral. The examiner should be aware that examination of accounts with titles such as Accounts Receivable Credit Balances or Unearned Promotional Allowances, or which refer to rebates, promotional advertising, bill backs, allowances, discounts, or similar wording are likely to result in adjustments to improperly deferred income.
Prizes and Trips
Retailer owners may receive prizes and/or trips from vendors or manufacturers. Since these types of items fall outside the normal data stream, they are easily omitted from income. Similar situations apply to free merchandise received from vendors as part of promotions. If such transactions are booked at all, they may be run through cost of sales. Interviews with the retailer, manager, officer or shareholders regarding trips taken, prizes won, meetings attended, etc., can be a productive examination technique.
Retailers may receive as well as send out merchandise on consignment. Consignments of merchandise to others to sell are not sales since the title of merchandise remains with the consignor (Treas. Reg. section 1.471-1). It does not matter who holds possession of the merchandise. Therefore, if goods are shipped on consignment, the consignor (Retailer) has no profit or loss until the consignee sells the merchandise. Merchandise that has been shipped out on consignment is included in the consignor‘s inventory until it is sold.
Merchandise that is received by the retailer on consignment is not included in the retailer’s inventory. The profit or commission on merchandise consigned to the retailer is included in the retailer‘s income when the merchandise is sold. Therefore, include in inventory goods out on consignment. Do not include in inventory goods received on consignment.
The examiner will question the retailer owner regarding items out on consignment at another location. Owners often display merchandise at malls, flea markets, and antique shows. Income from these sales should be included in gross receipts.
Sale of Accounts Receivables
Many issues can arise from the sale of a business. Among them is how to handle the outstanding accounts receivables. The contract for sale must be secured and inspected in order to consider the various issues that may be present. Generally for a corporation, the sale of accounts receivable should be considered income to a corporation and a dividend to the shareholders. Look to IRC sections 301(c) and 311(b).
Most state lotteries provide monthly activity reports to account for a retailer’s lottery sales, commissions and bonuses.
Scratch off lottery tickets are usually purchased at a discount from the state representative, and then sold for $1 each. In this case, all proceeds from the sales belong to the retailer, since the discount is the profit. In this case, the retailer pays out winnings, which are part of the discount computation.
Lottery or “lotto” machines installed in the retailer's store are provided by the state. When sales are made, the retailer collects the funds and the state withdraws the funds periodically from the retailer’s bank account. In many cases the state will require a retailer to maintain a separate bank account for these funds. For calendar year taxpayers, the Form 1099 issued by the State Commission should be reconciled to lottery income reported.
When a retailer allows vending machines in the business, the examiner must determine how the retailer accounts for the income received. In some cases the retailer rents the space to the vendor and will receive a monthly payment, but most likely the retailer will have a contract that pays a percentage of the receipts of the machines.
If the retailer owns the machines, the examiner can inspect the records for the periodic influx of coin currency. This would be the coins from the vending machines being deposited.
The examiner is required to determine if bartering exists and if so, to determine if the value of bartered goods is properly recorded in income.
A barter exchange operates in much the same manner as a commercial bank. A business owner will complete a membership application, pay a fee and deposit funds in the exchange, which opens a barter account in the business’s name. This account provides barter script which may be used, like a check, at other participating barter businesses. The bartering organization will publish periodic catalogs from which participants may also locate items. When another participant purchases goods from the retailer by barter, the value of the goods is added to the retailer’s barter account.
Bartering in this manner is helpful to a retailer because they can trade away unused inventory or excess resources, and acquire needed business goods or personal items without affecting the cash flow. Because the business is listed in a barter catalog, this is also an advertising bonus.
Bartering can also be done on a less formal basis by simply trading work with friendly business associates. In these cases the examiner must determine the extent of the bartering and ensure the value of goods provided is included in gross receipts.
Cost of Goods Sold
Retail Inventory: IRM 4.43.1
In all cases, a minimum inventory examination is required according the Internal Revenue Manual.
The cost of goods sold will be one of the largest dollar item expenses on the return. The two major components of Cost of Goods Sold are inventory and purchases. Inventories are usually the most significant asset a retail business owns. Thus, an adjustment to cost of goods sold may be quite significant.
Review the accounting method for recording all inventory inputs, including sales, purchases, markdowns, and so on, at their retail values. Ensure that purchased items are recorded at cost.
Personal Consumption of Inventory
Since retail store owners are in a position of control, it is imperative that the examiner interview the owner regarding the practice of paying for the inventory consumed personally. An owner "buys" inventory from their own store, as they would be able to consume the kinds of inventory they desire at a cost less than retail. There are several ways owners account for the inventory they personally consume. These include: (1) paying for their own inventory by writing personal checks, (2) account for their personal use by making adjusting entries in their books and records, (3) treat the amounts as "loans" to them from the business, (4) provided as "fringe benefits" to the owners, (5) consider them additional wages at the end of the year, or (6) not account for their personal use at all.
If the taxpayer indicated the inventory was paid for by personal check, verification of checks from the personal bank account would be in order. If the method of making adjusting entries was indicated, the accounting books and records should be verified as to whether they reflect this method. If the owner treated the amounts as loans, verify that interest is being accrued on the personal consumption account. In one situation, it was found that the shareholder of a retail store (a corporation) had used coupon checks received from a coupon redemption center to reduce his account balance of the corporate accounts receivable. This account was where the shareholder's personal use of inventory was posted.
If the amounts are treated as fringe benefits, verify they are added to the wages at the end of the year. In completing this verification, it would be advantageous to verify the payment plan used by related parties for payment of their personal retailer consumption. In determining the amount of inventory which is "accounted for" by any method, the examiner should keep in mind there may be employment tax considerations which may need to be addressed. This is especially true in situations where the retail store operates as a corporation.
The arrangement by which the taxpayers treat the "purchase" of their own inventory may vary in scope. Consideration should also be made to purchases made by unrelated parties and the potential that a bartering situation exists.
Retail Inventory Method (RIM): IRM 184.108.40.206.1
Retail operations may determine the cost, or the lower of cost or market, by using the retail inventory method (RIM). The RIM uses the relationship of retail price to cost to determine the cost of merchandise in inventory. The retail method is an averaging method and has historically been more convenient for most types of merchandise, especially as volume increases. If a perpetual inventory is also maintained, a retailer can determine profits, other than shrinkage, without taking frequent physical inventories. Grocery store operations primarily use the retail method of estimating the cost of inventories, as authorized by Treas. Reg. § 1.471-8. The use of such method must be designated on the return, accurate accounts must be kept, and the method must be consistently used. The retail inventory method takes the recorded sales for one year from the goods available for sale during that year to obtain the estimated closing inventory level at retail prices. Some uses of the retail method of estimating the cost of inventories are:
To verify the reasonableness of the cost of inventories at the end of the tax year. By using a different set of data from that used in pricing inventories, you can establish that the valuation of inventories is reasonable.
To estimate the cost of inventories for the tax years without taking physical inventories.
To permit the valuation of inventories when selling prices are the only available data. The use of this method allows the taxpayer to mark only the selling prices on the merchandise and eliminates the need for referring to specific purchase invoices.
To determine gross profits and operating income each month without taking a physical inventory.
A comparison of the computed inventory total with the physical inventory total, both at retail prices, will disclose the extent of inventory shortages and the consequent need for corrective measures.
Under the retail method, records are kept of goods available for sale at retail prices, and sales for the tax year are deducted from this total to determine the ending inventory at retail prices. The ending inventory valued at retail prices then is reduced to estimate average cost by multiplying the inventory at retail prices by the markup percentage computed for the tax year.
The following information must be accumulated in the accounting records to perform the necessary computations:
The beginning inventory valued at both cost and retail amounts
Net purchases priced at both cost ant retail; and
Net sales for the tax year.
Retail merchants are authorized to arrive at cost of inventories or the lower of cost or market by means of the "retail method." Under this method, the retail value of the closing inventory is reduced by a mark-on percentage; the difference is the cost or the lower of cost or market value of the closing inventory. The mark-on percentage is determined by:
Subtracting the cost of opening inventory and purchases from
The retail value of the opening inventory and purchases, and
Dividing this difference by the amount arrived at in 2.
Beginning inventory .................................... $ 15,810 $ 27,000
Net purchases for year ...........................… 75,190 110,000
Additional markups (*)............................... 5,000
Markup cancellations (*)............................ (2,000)
Markdowns (*).......................................... (10,875)
Markdowns cancellations (*)...................... ________ __875
Merchandise available for sale ................... $ 91,000 $130,000
Mark-up percentage (*) ($91,000/$130,000=70%)
Less: Net sales (90,000)
Ending inventory, at retail ...................... $ 40,000
Ending inventory, at estimated average cost ($40,000 x 70%) $ 28,000
The result should represent as accurately as possible the amounts added to the cost price of the goods to cover selling and other expenses of doing business and for the margin of profits.
If valuation at the lower of cost or market is desired, the adjustment is for mark-ups only. If valuation at cost is desired, the adjustment is both for mark-ups and markdowns.
If more than one department is maintained or the taxpayer deals in classes of goods carrying different percentages of gross profits, the mark-up percentage should be computed for each department or each class of goods.
Arbitrary markdowns for depreciation and obsolescence of the goods will be recognized only if the goods are actually offered to the customers at the prices so reduced.
The retail method may be used in conjunction with the last-in, first-out method of identifying the goods considered to be in the closing inventory. (However, if the retail method is used in conjunction with the LIFO method, the taxpayer must value its inventory at cost (i.e., lower of cost or market method is unavailable to the taxpayer).
The uniform capitalization rules per Internal Revenue Code Section 263A apply to the determination of cost of property purchased for resale, whether real or personal property, in the tax years beginning after 1986. The rules apply to retailers and wholesalers when they have average annual gross receipts for the preceding three tax years of $10,000,000 or more. For a thorough explanation of the uniform capitalization rules and how they apply to retailers and wholesalers, refer to Treas. Reg. §§ 1.263A-1 and 1.263A-3.
Last In, First Out (LIFO): IRM 220.127.116.11.1.3
Many larger retailers, such as auto sellers, will elect to use the dollar-value LIFO inventory valuation method. The use of the inventory price index valuation method is detailed at Reg. 1.472-8(e) (3). For each pool the index indicates the level of price change that occurs from the beginning of the first fiscal year under the LIFO method. An appropriate index must be used. Most department stores and large discount chains use the price indices published by the Bureau of Labor Statistics (BLS), which has IRS approval.
Computations of the retail LIFO inventory method are shown in the Internal Revenue Manual Retail Chapter of the Audit Techniques Handbook for Specialized Industries.
Stock Ledger (INVENTORY): IRM 18.104.22.168.2.5.4
This is the principal inventory record used by retailers. It is the perpetual inventory record. It contains a roll-up of summary data from the purchases journal or accounts payable system, the price change records, and the sales journal. It will also contain original entry information pertaining to the adjustment of the book inventory to the actual physical inventory. In some cases it will also reflect, between inventories, a manual or automatic entry to accumulate an estimate of the shrinkage to date. As a “memo” inventory it will usually show a roll-up of merchandise which has been received but not yet charged to the stock ledger.
Point of Sale Perpetual Inventory Control System
Retailers will use an automated retail system where the store cash registers are linked to computer processing systems. Merchandise is ticketed with colored bar code tags, which are read with want readers at the checkout counter. The computer accumulates sales transaction information on magnetic tape for daily input into the computer memory bank or storage system. It is input into the sales journal, which is rolled up into the stock ledger.
Valuation Of An Acquired Retailers Inventory (PDF) (Coordinated Issue)
When the comparative sales method of Rev. Proc. 77-12 is used as a basis for valuing a retailer's inventory, the cost of the reproduction method is less susceptible to error and therefore more appropriate to use than the comparative sales method.
If a taxpayer uses the "comparative sales" or "net realizable value" method, all expenses attributable to the disposition of the acquired inventory must be included in the taxpayer’s computation, not just direct disposition costs. Consideration must also be given to the time that would be required to dispose of the inventory, the part of the expected selling price that is attributable to going concern and to a profit that is commensurate with the amount of investment and degree of risk.
In making the inventory value determination, the Service will take into account a fair division of the inventory profit between the seller and buyer of the bulk inventory.
Purchases will be one of the largest accounts on the income statement for a business with cost of goods sold. As with income, the Internal Revenue Manual requires an examination of each element of Cost of Goods Sold.
The examiner will select a sample period and conduct the following tests:
Look for nondeductible expenditures in purchases.
Scan the account for vendors not associated with the products or services handled by the taxpayer. For example, question the taxpayer regarding the purchase of bedroom furniture invoices found in the COGS for a convenience store.
If the examination is extended to the owner’s return, look for an absence of personal expenditures. For example, if the taxpayer’s business is a retail grocery store, and no payments are made from the personal account for food purchases, consider personal withdrawals to the recipient.
Scan the account for unusual payees and amounts.
Test the purchases for a sample period with vendor's invoices and cancelled checks.
In addition to the personal consumption issue, review other expense accounts for personal items, including but not limited to, office expense, supplies, travel, meals, entertainment, vehicle, dues, etc.
A retailer who purchases a franchise will generally be able to deduct franchise payments as a business expense. Many times the amount due is contingent on productivity or use, such as a percentage of sales. A deduction by the franchisee is allowed as a business expense only if the payments are part of a series of payments that are payable not less frequently than annually over the term of the agreement and are either equal in amount or payable under a fixed formula. Other amounts paid or incurred on account of a transfer, sale, or other disposition of a franchise must be capitalized and amortized over the useful life of the franchise, trademark or trade name. See IRC Sec. 1253 for more information.
For some retail businesses a manufacturer may pay a percentage of the cost of ads placed by the retailer. The retailer must either (1) recognize the amount that will be reimbursed as income and take the full amount paid as advertising or (2) accrue the payment from the manufacturer at the time the "tearsheet" is mailed to the manufacturer. It was found that some of these retailers are reporting the payments on the cash basis.
Charitable Contributions and Promotions
Many retail grocery businesses give money, inventory, and other donations to charitable organizations to promote their store's image and goodwill in the community. Some stores may deduct this as an advertising expense.
In other instances a retail business that purchased stock for holidays may discount the items after the holiday. If the holiday merchandise is still unsold after a second discount, the retailer may donate some or all of the holiday merchandise to a charity.
Generally the amount of a charitable deduction is the fair market value of the item contributed, reduced by the amount of ordinary income the donor would have recognized if the item were sold (or, in other words, the retailer’s basis in the item). For example, a retailer donates inventory to a qualified charitable organization, with a fair market value of $1,000 and a cost of $400. If the retailer had sold the donated inventory, he would have recognized $600 of ordinary income. Therefore, the amount of charitable contribution is limited to $400, his basis in the donated inventory. IRC 170(b).
A current trend is for grocery stores to allow volunteers to clip and place coupons on various products in the grocery store. These coupons would be marked or somehow identified as to the source of the coupon so that the grocer can readily identify which coupons are for the "charitable purpose." In turn, these products are sold to customers, who pay the full price for the product at the cash register. The retail grocer then submits the coupons to a clearinghouse that pays the grocers for all of the coupons being redeemed, including a handling fee. The grocer, after receiving the redemption check, pays the proceeds (either including the handling fee or not) to a charitable organization as its "service" to the volunteers who clip and place the coupons on the products. Many dollars are being paid to charitable organizations by these means. The examiner should be verifying that if the retail grocer has implemented the above processes, that the payout procedures are being followed. Verify that the retailer is submitting all of these coupon redemption checks to the charitable organizations. Verify that the retailer is not retaining the handling fee portion of the redemption checks without reporting the amount as income. The examiner will have to make a determination as to whether this is an allowable contribution deduction per IRC § 170, or a promotion expense deduction allowable per IRC § 162. If the contributing retail grocer is a corporation, the contribution may be limited to a percentage of taxable income.
Another source of contributions by retail grocers is their inventory from the store. Inventory donated may include day-old bakery items, dented cans of food, old produce and other outdated items to food pantries and other charitable organizations. It is necessary for the examiner to identify the food being donated and to verify the contribution was actually made to the organization.
Verification of the food donation is important as it may be taken out of inventory without the appropriate write-off. Thus, it would be expensed at year-end, in addition to being written off as a charitable deduction, promotion expense, or food spoilage. Food being written off in this way may also be a way for the grocer to disguise personal groceries.
When an examiner is looking into the area of charitable contributions of retailers, consider not only verifying the deduction to see if the deduction is allowable, but make sure the procedures the retailer explained, actually did occur.
Ordinarily, charitable deductions for inventory items are limited to basis (see the example above). A special rule, however, provides for a larger deduction for C-corporations that contribute food inventory, if certain requirements are met, under Section 170 (e) (3). One of the requirements is that the property must be used by the charitable donee solely for the care of the ill, needy, or infants. Treas. Reg. Sec. 1.170A-4A.
If this section applies, the deduction is equal to the basis of the property contributed plus one half of the appreciation, not to exceed twice the basis. The amount would be treated as a contribution and cost of goods sold would be reduced by the amount of the contribution.
Inspection of end-of-year accruals should be made to ensure proper cutoffs were made in compliance with IRC § 441 (period for computation of taxable income). In the case of any taxpayer who has made the election provided by IRC § 441(f), the fiscal year could be the annual period, varying from 52 to 53 weeks, if so elected. For example, stores may be turning in weekly sales and expense reports for accounting purposes. At year-end the accounting service may be cutting off the year as of the last day of the weekly report. However, the last day of the weekly report may be December 29, 30, 31, January 1, 2, 3 etc., and does not coincide with the stores tax year. This is particularly true when the wholesaler is providing the accounting service, and someone else prepares the tax return.
Depreciation and Cost Segregation see Cost Segregation ATG
Buildings that are owned by the business can be depreciated under the Modified Accelerated Cost Recovery System (MACRS) for 39 years. Some elements of buildings, however, can be separated and identified as tangible personal property. This practice is called cost segregation, which allows recovery of the personal property elements of a building over a five-year period using the 200-percent declining balance method. The personal property elements qualify for IRC section 179 expense deductions and bonus depreciation under IRC section 168(k). This separate valuation of real and personal property can also reduce state and local taxes imposed on real property.
The portions of the building that are classified as structural components are considered real property and are included in the depreciable basis. The portions of the building that are classified as personal property are separately depreciated.
Depreciation and Cost Segregation Studies Update:
Cost Segregation ATG:
A cross functional team developed an Audit Technique Guide (ATG) for the preparation and examination of cost segregation studies. The primary goal is to provide examiners with an understanding of why cost segregation studies are performed by taxpayers, how such studies are prepared, and what to look for in the review and examination of these studies. This guide will also assist taxpayers and practitioners in understanding some of the items the Service will consider to support property allocations based on these studies.
It should be noted that this ATG is not an official Service pronouncement and may not be cited as authority.
Field Directive on the Planning and Examination of Cost Segregation Issues in the Restaurant Industry:
A joint SB/SE and LMSB Industry Directive for the depreciation classification of various assets in the restaurant industry was issued on December 8, 2003 and it was updated on December 27, 2004. The new guidelines provide guidance on the determination of whether restaurant assets are IRC Section 1245 property (shorter cost recovery period) or Section 1250 property (longer cost recovery period) property. Prior to this guidance, there had been some controversy on audits as to the appropriate recovery periods used in computing the depreciation deduction for certain depreciable assets.
The IRS issued this Industry Directive after soliciting input from IRS examiners, the restaurant industry, and the practitioner community. The anticipated benefits of the guidance include reducing costs and burden for both taxpayers and the IRS since the Directive should lesson some areas of disagreement regarding tax treatments of certain restaurant assets. Although Industry Directives are not official pronouncements of the law or the IRS’s position, their purpose is to provide guidelines on the efficient use of audit time and resources.
IRS has instructed examiners not to make adjustments to the categorization and lives of the asset if a taxpayer’s classification is consistent with the recommendations in the Industry Directive.
Suspended Acoustical Ceilings (PDF) (Coordinated Issue)
When installed in a building, a suspended acoustical ceiling becomes a structural component of the building. The suspended ceiling is not viewed as a temporary covering for the ceiling; it is the ceiling. The regulations, revenue rulings and court cases previously cited, all point to the fact that suspended acoustical ceilings are structural components ineligible for classification as Section 1245 property, and do not qualify for the ACRS deduction as 3 or 5-year property or for the investment tax credit.
Heating, Ventilating and Air Conditioning (HVAC) In Grocery Stores (PDF) (Coordinated Issue)
It is the position of the Internal Revenue Service that HVAC units located in retail grocery stores or supermarkets which service the building as well as the freezers and refrigerators within the store are structural components of the building since they fail to meet the "sole justification" test specified in the regulations. The HVAC units are not Section 38 property and do not qualify for either the investment tax credit or the ACRS 3 and 5-year recover categories.
Excise Tax Issues
A retailer may be liable for excise tax on its sale of certain articles of sports fishing equipment and archery equipment if it imports the articles in the United States. IRC section 4161(a) imposes a tax on the sale of articles of sport fishing equipment specifically enumerated in IRC section 4162, including any parts or accessories of the article sold on or in connection therewith or with the sale thereof. IRC section 4161(b) imposes a tax on bows, certain bow parts and accessories, certain quivers, and certain arrow components.
Employment Tax Issues/Information Returns
The examiner should be alert to employment tax issues between family members and a retail store business.
Consideration should also be given as to whether “contract labor“or fringe benefits are taxable to the recipient. Some businesses set up temporary stores in various locations and utilize individuals who are regular employees to organize and set up these stores. The payments to these individuals are sometimes classified as other expense, set up expense, contract labor, travel, etc., but if the services are performed by employees, this compensation should be included in the Form W-2 wages. If the payments are, in fact, to independent contractors who come in and set up the store, verify that Form 1099 has been filed.
If an employment tax issue is raised, Section 530 and CSP must be considered.
Any retail business can be largely a cash business. As a result, many owners pay people for services rendered in cash. Two areas to consider in auditing these entities are cash paid to employees and cash paid to vendors. Make sure the cash paid to the employees have employment taxes paid on it. The cash paid to vendors must be reported to the vendors on Form 1099.
In the Restaurant and bar industry another area involves the requirement that the tipped employees in the establishment report their tips received to the employer at least monthly. The Omnibus Budget Reconciliation Act of 1987, revised IRC section 3121(q) to require the Employer to match the FICA Taxes of the employee for tips reported.
Remember when opening an employment tax examination, other return statutes need to be protected. A Form SS-10 would be required for employment tax in addition to the appropriate Form 872 or Form 872A for income tax.