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Retail Industry ATG - Chapter 3: Examination Techniques for Specific Industries (Video/DVD Rental Business)

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.


Chapter 2 / Table of Contents / Chapter 4
Tax Code, Regulations and Official Guidance Search


Chapter 3: Examination Techniques for Specific Industries
(Video/DVD Rental Business)


Introduction

The video/DVD industry is partially made up of taxpayers who want to establish a store to rent video/DVDs to the public.  These "mom and pop" stores are present in both metropolitan and rural areas.  The size of these non-franchised businesses will generally run from gross receipts of $25,000 to $500,000.  The taxpayer purchases mass-produced copies of master versions of movies in the video/DVD format.

Income

Small rental activities are sometimes a sideline business in a grocery or convenience store and may be cash intensive.  The examiner should be alert to the existence of this type of activity in an existing business.
A helpful technique is to document the flow of receipts from the rental of a tape to the tax return, and tracing the income flow.  The examiner should include questions in the initial interview regarding exactly how the gross receipts were determined.
These tapes are purchased from wholesalers and are paid for generally by check and sometimes by cash. Watch out for illegal, bootlegged tapes/DVD.  These may be paid for in cash and will usually only occur in the smaller video/DVD rental locations.   As in all cases, the examiner should question any cash purchases over the threshold amount where no information reporting (Form 1099) was made to the supplier.

Cost of Goods Sold

Many businesses may deduct the cost of video/DVDs as purchases in cost of goods sold.  The taxpayers are not in the business of selling tapes.  They are in the business of renting tapes; therefore, the tapes must be depreciated.

Expenses

Damaged or Lost DVDs
The shelf life of a video/DVD varies depending on the frequency of use.  After several months of renting the video/DVD in the store, some taxpayers rent the video/DVD to groceries and/or convenience stores.  After extensive use of the video/DVD, they may be sold outright to customers.  The customers may damage some video/DVDs after several uses.  The taxpayers may claim the customers’ video/DVD machines may be defective or the video/DVD may be left in a hot or cold car before returning it to the video/DVD store.  Natural fatigue on the film stripe of the tape will also cause the tapes to be damaged.  The business should be able to specifically identify tapes that were destroyed and have a record of the date and type of damage. 

The business will also maintain a list of video/DVDs, which were rented but had not been returned to the store.  There will be records for collection attempts and this could be used to determine allowable write-offs.

The taxpayers must prove that the tapes were sold or disposed of within the year before they would be allowed a current year write off.  This may lead the examiner to unreported income from the sales of tapes.

Depreciation
Revenue Ruling 89-62 provides the proper methods of deducting the video/DVDs.  It was held that "video/DVDs are subject to section 167 of the Code and may be depreciated in accordance with the straight line method over the useful life of the video/DVDs in the particular taxpayer's business.  Alternatively, the income forecast method may be used."  Section 168(f) (3) of the Code provides that section 168 does not apply to "any motion picture film or video/DVD tape.

The primary position to take is to allow the tapes to be depreciated in accordance with the straight line method, using a 3 or 5 year life, depending upon the taxpayer's business, with a half-year convention.

Revenue Ruling 89-62 allows the income-forecast method as an alternative.  The taxpayers must maintain very detailed records to properly apply this method and is usually allowed only under those strict conditions. 

Video/DVD retailers sometimes deduct the purchases of tapes as purchases and then also depreciate the tapes.  In other words, they would double deduct the tape acquisitions, and in this case an adjustment will be made to disallow the purchase cost. 

Be alert to convoluted bookkeeping.  For instance, one example of this involved a taxpayer who deducted all of their tape acquisitions under purchases, depreciated the tapes and then indicated they backed out the deduction by listing all of the tapes purchased since they had been in business in ending inventory.  The examiner was able to establish that the taxpayer's ending inventory was overstated due to tape sales to customers, gasoline stations and grocery stores.

In a Technical Advice Memorandum, IRS said that movie and TV films and tapes are intangible property for the purposes of section 179 deduction.  Therefore, Section 179 deduction is not allowable.

Glossary

Bar Code  Information encoded into a pattern of varying-width parallel bars and spaces that can be read by a scanner/bar-code reader and interpreted as a numeric or alphanumeric identification code. Common symbologies used in retail are UPC-A for merchandise marking and Code 128 (also I 2 of 5) for shipping containers. Other symbologies used include: Code 39 and EAN. See 2-D Bar Code.

Bar Code Density  The number of data characters per inch (or other measure).

Bar Code Label  A label, generally both human- and machine-readable by an automatic scanning device. It is often used in shipping.

Bar Code Reader  Device that reads bar codes; implies an optical device such as CCD rather than laser.

Bar Code Scanner  Device that reads bar codes; implies a laser device.

Cards  A record of a customer's account kept on cards for ease of handling and tracking. This is a small version of the posting of ledger cards usually filed by date instead of by customer name to facilitate renewals. When a computer system is in use, this copy may be listed by computer instead of on a card.

Card Close  The total number of past-due customer accounts on a particular day usually expressed as the ratio of expired accounts to total.

Card File  The files where all of the store's rental agreement cards are kept.

Cash Drawer  The drawer where the cash and checks received from the day's business transactions is stored, until deposited in the bank.

Cash Flow  The amount of money generated by a business less the cash expenses of doing business.

DVD  Digital video disc player.

Credit Authorization and EDC Utilities 
Software integrated into a POS system to provide access to credit authorization, check authorization networks, and settlement banks.

POS  Point-of-Sale. Can refer to the location in a retail store where consumer sales transactions occur, and to the sales data collected there. Also called scan data.

POS Register  Incorporates products normally associated with POS systems (e.g., computer, printer, monitor, keyboard, scanner, cash drawer, card reader, etc.).

Promotional Product  A product subject to wide variations in sales because it is often sold with an incentive such as a price reduction. Often refers to products with difficult-to-forecast sales based on history.

Renewal Card  The back of the last copy of the rental agreement used for payment information previously called Collection or Route Card.

Renewal Date  The last day when a customer can make a renewal payment and keep the agreement in good standing.

Renewal Ratio  The percentage of agreements renewed to total agreements at the end of each day and calculated in units, dollars or both.

Returned Check  A check written by a customer for payment of a rental agreement that is refused by the bank for insufficient funds, closed account, etc.

Returned Check Log  A listing of the returned checks to the business per day or per week.

Shrinkage  Losses from theft and lost product. Refers to difference between actual inventory versus what the system says should be in a location.

Unit Yield  The total dollars of actual rental revenue plus any special charges (delivery, reinstatement, etc.) divided by the number of units on rent.

Units on Rent  The number of items on rent in a particular store at a particular time. Also known as Balance On Rent (B.O.R.).

Valid Rental Agreement  A rental agreement in good standing between a rental company and a customer for merchandise rental.

VCP  Acronym for a videocassette player. A machine that is designed for playback of videocassettes only and does not record.

VCR  Acronym for videocassette recorder. A machine that can both record and play back programs.

Vendor  A supply source that a business uses to acquire goods to rent.

Vertical Rack  Audio system housed in a vertical cabinet.

Video  Equipment for the reception, recording or playback of a television or videocassette picture.

Statistics

Bizstats.com shows that almost 49% of sole proprietors in the video tape and disc rental business report a net profit.


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Page Last Reviewed or Updated: 23-Sep-2014