4.43.1  Retail Industry (Cont. 2)

4.43.1.5 
Inventory

4.43.1.5.6 
Retail Topics and Issues

4.43.1.5.6.2  (07-23-2009)
Cost Method

  1. The cost method of accounting requires inventory to be valued at its acquisition cost. Acquisition cost includes all of the costs associated with taking possession of merchandise. The cost should be reduced for trade discounts received. Cash discounts (for early payment of the invoice) may be deducted or not deducted at the taxpayer’s option as long as the method used by the taxpayer is consistent.

  2. Retailers must also add to the value of inventory the allocable share of additional costs under the Uniform Capitalization Rules (UNICAP) determined under IRC 263A unless the taxpayer meets the $10,000,000 or less gross receipts exception of IRC 263A(b)(2)(B).

  3. When a retailer using the cost method takes an inventory count, the goods on hand must be matched against or traced to the stock ledger to determine the cost. Because of the recordkeeping involved, some retailers use the retail inventory method which does not require such tracing. However, with computers, bar codes and POS terminals, many retailers now have the capability to use the cost method with little or no increased recordkeeping costs.

  4. Accounting methods used to determine the current cost of goods on hand at the end of the year and involved in associating costs include:

    1. Specific identification involves tracing the actual costs for a particular piece of inventory. This method is generally practiced for high value goods.

    2. FIFO whereby the costs for the goods on hand at the end of the year are the amounts paid for those goods most recently purchased.

    3. Replacement cost whereby the costs of the goods on hand are valued at their costs to acquire if they were purchased on the last day of the year. Currently, this method is allowed only for the parts inventory of automobile dealers and heavy equipment dealers. See Rev. Proc. 2006-14 and Rev. Proc. 2002-17.

    4. Rolling-Average costing whereby the inventory value is determined by the average cost of the goods on hand at any point in time. See Rev. Proc. 2008-43.

    5. Earliest acquisition cost whereby the inventory value is determined by the actual cost of the first items acquired during the year (LIFO method only).

    6. Average cost whereby the inventory value is determined by the annual average cost to acquire the inventory during the year (LIFO method only).

    7. Most Recent Purchase cost whereby the inventory value is determined by the actual cost of the last items acquired during the year (LIFO method only).

  5. Once a taxpayer determines which of the above methods it will use to determine current cost, then the taxpayer must determine whether or not it will use the LIFO method cost flow assumption. If the taxpayer elects the LIFO method, additional computations are necessary. Additional information on the LIFO method is included below.

  6. Any change from one method to another (e.g., from FIFO to specific identification) constitutes a change of accounting method that requires the consent of the Commissioner.

4.43.1.5.6.3  (07-23-2009)
Lower of Cost or Market

  1. Many taxpayers use the lower of cost or market (LCM) method because of its potential advantages over the cost method. When the replacement cost of a retailer’s merchandise falls below cost, the retailer is allowed to recognize that difference even though the loss has not been realized.

  2. There are two methods allowed for arriving at the amount of the LCM. One method is for normal goods and is found in Treas. Reg. 1.471-4. The other method is for subnormal goods and is found in Treas. Reg. 1.471-2(c).

  3. For normal goods, market generally refers to replacement cost for the same goods in the same quantities the taxpayer would normally acquire them. If the taxpayer uses the retail inventory method described below, the computation of inventory value will result in the valuation of inventory at cost or market, whichever is lower.

  4. Subnormal goods are defined as those goods that are unsaleable at normal prices or unusable in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes. Subnormal goods may be valued at their bona fide selling price less direct cost of disposition. Bona fide selling price means actual offering of goods during a period ending not later than 30 days after inventory date. The burden of proof will rest upon the taxpayer to show that such exceptional goods as are valued come within the classifications indicated and the taxpayer will maintain such records of the disposition of the goods as will enable a verification of the inventory to be made.

  5. The LCM reduction is determined on an item by item basis. The retailer will usually have a separate report computing the LCM reduction which lists each item, the number on hand plus the cost and market value. The LCM reduction is usually recorded in a separate reserve or contra-asset account rather than directly to inventory.

  6. It should be noted that market value cannot be estimated. The goods must be actually offered for sale at that price in order to call the value market. For retailers, this means the price of the goods on the shelf.

4.43.1.5.6.4  (07-23-2009)
Retail Inventory Method

  1. Retailers may determine cost or LCM by using the retail inventory method (RIM). RIM uses the relationship of cost to retail price to determine the cost of merchandise in inventory. This method is an averaging method and historically has been more convenient to use for most types of goods, especially as volume increases. If a perpetual inventory is maintained in conjunction with the use of RIM, a retailer can determine profits without taking frequent physical inventories.

  2. A retailer usually carries its inventory on the books at the retail selling price of the various items held for resale. The year-end retail price of the goods on hand or its market value is determined by Treas. Reg. 1.471-8(a) or (d). Since the LCM method can generate an inventory value lower than cost, it is more frequently used.

  3. Treas. Reg. 1.471-8(d) provides that the LCM method is limited to non-LIFO taxpayers who have consistently used the practice of adjusting the retail price in the computation for markups but not markdowns, in conjunction with RIM.

  4. Treas. Reg. 1.471-8(f) provides that if the LCM method was not used, a taxpayer may adopt such method upon filing a change of accounting method request and obtaining the permission of the Commissioner.

  5. Under RIM, the LCM value of ending inventory is determined as follows:

    1. Add the cost of the goods in the beginning inventory to the cost of the total purchases for the year.

    2. Add the retail value of the goods in the beginning inventory to the retail value of the total purchases for the year. The retail value of each item must be adjusted to reflect the retail price, as marked up from cost plus additional permanent markups less markup cancellations.

    3. Divide the total cost of the goods available for sale as determined in "a." above by the total retail value of the goods available for sale during the year as determined in "b." above. The percentage, the ratio of cost to retail, is also known as the cost complement.

    4. Subtract sales plus net permanent markdowns from the total retail value of the goods available for sale as discussed in "b" above to determine the retail value of the ending inventory. Markdowns are a reduction to the selling price below the original sale price. Markdown cancellations increase a previously marked down sales price no higher than the original retail price (with any excess being considered a markup). Net markdowns are markdowns less markdown cancellations.

    5. Multiply the retail value of the ending inventory as determined in "d." above by the cost complement ratio as determined in "c." above. The result is the LCM value of the ending inventory.

  6. Under RIM, inventory may be valued at cost as defined in Treas. Reg. 1.471-8(a) rather than LCM as detailed in the preceding. Valuing the inventory at cost rather than LCM will generally result in a higher inventory value. When cost is used, all permanent markup and markdown adjustments are made in determining the retail value.

  7. RIM requires retailers to value inventory on a department-by-department basis, because profit margins may be materially different for departments or classes of goods. The requirement as set forth in Treas. Reg. 1.471-8(c) specifically prohibits the use of a percentage of profit based upon an average of the entire business but rather requires the computation and use of the percentages of profit for each respective department or class of goods. These departments or classes of goods often correspond to pools for LIFO purposes.

4.43.1.5.6.5  (07-23-2009)
Last-in First-out (LIFO)

  1. Many taxpayers elect to use the dollar-value LIFO inventory valuation method. Such an election is conditioned on the requirement that it will also be used for the valuation of inventory in financial statements (financial statement conformity). The LIFO method is preferred by taxpayers because it will, in most instances, generate the lowest inventory value by eliminating the increase in inventory due to price changes caused by inflation. Its disadvantages include additional computations plus the requirement to value inventory at cost, not LCM.

  2. Retailers will use either the double-extension method or an index method for each pool. If the retailer can demonstrate that these methods, double-extension or an index method, are impractical, then the link-chain method may be approved. Any method of computing the LIFO value of a dollar-value pool must be used for the year of adoption of the LIFO methodology and for all subsequent years unless permission to change the method is requested and received. Many retailers also use the IPIC LIFO method under Treas. Regs. 1.472-8(e)(3). See IRM 4.43.1.5.7.7.

  3. Dollar-value LIFO determines cost by using base-year data expressed in terms of total dollars as a unit of measure rather than the quantity and price of specific goods. Under this method, goods contained in inventory are grouped into a pool or pools.

  4. Base-year cost as referenced in the preceding paragraph is the aggregate of the cost of all items in the pools as of the beginning of the taxable year in which LIFO was adopted. The year of adoption could be as early as 1948 when the LIFO regulations were amended to permit retailers to use the dollar-value LIFO method. The Form 970 and subsequent Forms 3115 will provide documentation of the retailer’s elections relative to its LIFO methodology.

  5. Treas. Reg. 1.472-8(c) provides the principal rules for establishing pools. Items of inventory in the hands of wholesalers, retailers, jobbers, and distributors shall be placed into pools by major lines, types, or classes of goods. In determining such groupings, customary business classifications of the trade will be an important consideration. For example, the customary business classification in a department store is the department.

  6. If a wholesaler or retailer is also engaged in the manufacturing or processing of goods, the pooling of the LIFO inventory for the manufacturing or processing operations is determined by the rules set forth in Treas. Reg. 1.472-8(b).

4.43.1.5.6.6  (07-23-2009)
Retail LIFO Inventory Method

  1. The computation of the retail LIFO inventory method involves the following steps and is made separately for each pool:

    1. Determine year-end inventory in retail dollars at the permanent marked price, including the retail price of the in-transit merchandise.

    2. Divide the amount determined in "a." above by the price index factor. The resulting amount equals retail in base-period prices. Compare the amount determined with the prior year’s total in base-period dollars. If the current year’s total is greater than the prior year’s total, the excess amount represents an increment or layer for the current year. The excess amount is multiplied by the same index factor to restate it in current period prices.

    3. If the current year’s total is less than the prior year’s total, the difference represents a decrement. The decrement is used to reduce the most recent prior year layer, in terms of base-period prices. To the extent any decrement remains after reduction of the first layer, the second prior incremental layer is reduced. The reduction process continues until the entire decrement is exhausted.

  2. The amount in each layer is converted back to current period prices based upon the index for each respective current period.

  3. If there was an increment, all prior periods or layers would remain the same and the computation would only be necessary for the current layer.

  4. If there was a decrement, only the last partially reduced layer would have to be recalculated since the intervening layers would have been eliminated by application of the decrement to the layer(s).

  5. The cost complement for each LIFO pool is computed in the manner described in IRM 4.43.1.5.7.4 with two key differences:

    1. The beginning inventory at cost and retail does not enter into the calculation. Only data pertaining to current year purchases are used to determine the cost complement.

    2. Since LIFO inventory is based on cost, permanent markdowns taken during the year and applicable to merchandise purchased during the year, must be taken into account in computing the cost complement.

  6. The examples shown on the subsequent pages demonstrate the differences in the cost complement calculations between non-LIFO retail valued at Cost, non-LIFO Retail valued at LCM and LIFO retail.

  7. Computation of non-LIFO Retail Cost Complement Valued at Cost

      Retail Value Cost
    Beginning inventory $39,000 $22,000
    Purchases 60,000 35,000
    Mark-ups (permanent) 1,500  
    Mark-ups Cancellations 500  
    Mark-downs (permanent) 2,400  
    Mark-downs cancellations 400  
    Sales 88,000  
    Retail value and cost Are determined as follows:  
      Retail Value Cost
    Beginning inventory $39,000 $22,000
    Purchases 60,000 35,000
    Net Mark-ups:    
    Mark-ups 1,500  
    Less mark-up cancellations 500  
      1,000  
    Mark-downs applicable 2,400  
    Mark-down cancellations 400  
      2,000  
    Total available $98,000 $57,000
  8. The cost complement ratio equals 58.16 % ($57,000/$98,000)

  9. Computation of non-LIFO Retail Cost Complement Valued at LCM

      Retail Value Cost
    Beginning inventory $39,000 $22,000
    Purchases 60,000 35,000
    Mark-ups (permanent) 1,500  
    Mark-ups Cancellations 500  
    Mark-downs (permanent) 2,400  
    Mark-downs Cancellations 400  
    Sales 88,000  
    Retail value and cost Are determined as follows:  
      Retail Value Cost
    Beginning inventory $39,000 $22,000
    Purchases 60,000 35,000
    Net Mark-ups:    
    Mark-ups 1,500  
    Less mark-up cancellations 500  
      1,000  
    Mark-downs applicable    
    Mark-down cancellations    
         
    Total available $100,000 $57,000
  10. The cost complement ratio equals 57.0% ($57,000/$100,000).

  11. Computation of LIFO Retail Cost Complement

      Retail Value Cost
    Beginning inventory $39,000 $22,000
    Purchases 60,000 35,000
    Mark-ups (permanent) 1,500  
    Mark-ups Cancellations 500  
    Mark-downs (permanent) 2,400  
    Mark-down Cancellations 400  
    Sales $88,000  
    Retail value and cost Are determined as follows:  
      Retail Value Cost
    Beginning inventory N/A N/A
    Purchases $60,000 $35,000
    Net Mark-ups:    
    Mark-ups (permanent) 1,500  
    Less mark-up cancellations 500  
      1,000  
    Mark-downs applicable 2,400  
    Mark-downs cancellations 400  
      2,000  
    Total available $59,000 $35,000
  12. The cost complement ratio equals 59.32 % ($35,000/$59,000)

4.43.1.5.6.7  (07-23-2009)
Inventory Price Index Computation (IPIC)

  1. The IRS and the Department of the Treasury prescribed the inventory price index computation (IPIC) method in Treas. Reg. 1.472-8(e)(3) to simplify the use of the dollar-value LIFO method, as more fully described below.

4.43.1.5.6.7.1  (07-23-2009)
Overview

  1. The IPIC method was designed to simplify the use of the dollar-value LIFO method, so that the LIFO method could be used by more taxpayers. Under the IPIC method, the taxpayer sorts its inventory by the United States Bureau of Labor Statistics (BLS) commodity codes and then applies BLS indexes to the items in its inventory. This simplifies the process of computing an index for a dollar-value pool because the taxpayer does not have to develop its own internal indexes.

  2. Final regulations relative to the IPIC methodology were effective on December 31, 2001.

  3. Treas. Reg. 1.472-8(c)(2) provides that a retailer that elects to use the IPIC method described in Treas. Reg. 1.472-8(e)(3) may elect to establish dollar-value pools for those items accounted for using the IPIC method based on either one of the following:

    1. The general expenditure categories (i.e., major groups) in Table 3 (Consumer Price Index for all urban Consumers (CPI-U): U.S. city average, detailed expenditure categories) of the "CPI Detailed Report," or

    2. The 2-digit commodity codes (i.e., major commodity groups) in Table 6 (Producer price indexes and percent changes for commodity groupings and individual items, not seasonally adjusted) of the "PPI Detailed Report."

  4. The "CPI Detailed Report" and the "PPI Detailed Report" are published monthly by the BLS. These reports are available on the BLS website at http://www.BLS.gov .

  5. A taxpayer electing to establish dollar-value pools under Treas. Reg. 1.472-8 (c)(2) may combine IPIC pools that comprise less than 5 percent of the total current-year cost of all dollar-value pools to form a single miscellaneous IPIC pool. In addition, a taxpayer electing to establish pools under Treas. Reg. 1.472-8(c)(2) may combine a miscellaneous IPIC pool that comprises less than 5 percent of the total current-year cost of all dollar-value pools with the largest IPIC pool. Each of these 5 percent rules is a method of accounting.

  6. A taxpayer may not change to, or cease using, either 5-percent rule without obtaining the Commissioner's prior consent. Whether a specific IPIC pool or the miscellaneous IPIC pool satisfies the applicable 5-percent rule must be determined in the year of adoption or year of change (whichever is applicable) and redetermined every third taxable year counting the year of adoption or change as the first year. Any change in pooling required or permitted under a 5-percent rule is a change in method of accounting. A taxpayer must secure the consent of the Commissioner pursuant to Treas. Reg. 1.446-1(e) before combining or separating pools and must combine or separate its IPIC pools in accordance with Treas. Reg. 1.472-8(g)(2).

  7. The adequacy of the number and the composition of the pools used by the taxpayer, as well as the computations incident to the use of such pools, will be determined in connection with the examination of the taxpayer’s income tax returns. Records must be maintained to support the base-year unit cost as well as the current-year unit cost for all items priced on the dollar-value LIFO inventory method.

  8. Treas. Reg. 1.472-8(e)(3) describes the IPIC method by stating that it is an elective method of determining the LIFO value of a dollar-value pool using consumer or producer price indexes published by the BLS. A taxpayer using the IPIC method must compute a separate inventory price index (IPI) for each dollar-value pool. This IPI is used to convert the total current-year cost of the items in a dollar-value pool to base-year cost in order to determine whether there is an increment or liquidation (decrement) in terms of base-year cost and, if there is an increment, to determine the LIFO inventory value of the current year's increment (layer).

  9. Using one IPI to compute the base-year cost of a dollar-value pool for the current taxable year and using a different IPI to compute the LIFO inventory value of the current taxable year's layer is not permitted under the IPIC method. The IPIC method will be accepted by the Commissioner as an appropriate method of computing an index, and the use of that index to compute the LIFO value of a dollar-value pool will be accepted as accurate and reliable. The appropriateness of a taxpayer's computation of an IPI, which includes all the steps described in Treas. Reg. 1.472-8 (e)(3)(iii), will be determined in connection with an examination of the taxpayer's federal income tax return. A taxpayer using the IPIC method may elect to establish dollar-value pools according to the special rules in paragraphs Treas. Reg. 1.472-8(b)(4) and (c)(2) or according to the general rules in Treas. Reg. 1.472-8 (b) and (c).

  10. Any taxpayer electing to use the dollar-value LIFO method may elect to use the IPIC method. A taxpayer that elects to use the IPIC method for a specific trade or business must use that method to account for all items of dollar-value LIFO inventory. However, a taxpayer that uses the retail price indexes computed by the BLS and published in "Department Store Inventory Price Indexes" (available from the BLS by calling (202) 606-6325 and entering document code 2415) may elect to use the IPIC method for items that do not fall within any of the major groups listed in "Department Store Inventory Price Indexes."

4.43.1.5.6.7.2  (07-23-2009)
Computation of the Inventory Price Index (IPI)

  1. The computation of an inventory price index (IPI) for a dollar-value pool requires the following four steps:

    1. Selection of a BLS table and an appropriate month,

    2. Assignment of items in a dollar-value pool to BLS categories (selected BLS categories),

    3. Computation of category inflation indexes for selected BLS categories, and

    4. Computation of the IPI. A taxpayer may compute the IPI for each dollar-value pool using either the double-extension method (double-extension IPIC method) or the link-chain method (link-chain IPIC method), without regard to whether the use of a double-extension method is impractical or unsuitable. The use of either the double-extension IPIC method or the link-chain IPIC method is a method of accounting, and the adopted method must be applied consistently to all dollar-value pools within a trade or business accounted for under the IPIC method. A taxpayer that wants to change from the double-extension IPIC method to the link-chain IPIC method, or vice versa, must secure the consent of the Commissioner under Treas. Reg. 1.446-1(e). This change must be made with a new base year as described in Treas. Reg. 1.472-8(e)(3)(iv)(B)(1).

4.43.1.5.6.7.3  (07-23-2009)
Selection of a BLS table and an Appropriate Month

  1. Under the IPIC method, an IPI is computed using the consumer or producer price indexes for certain categories (BLS price indexes and BLS categories, respectively) listed in the selected BLS table of the "CPI Detailed Report" or the "PPI Detailed Report" for the appropriate month.

  2. Retailers may select BLS price indexes from either of the following sources:

    1. Table 3 (Consumer Price Index for all Urban Consumers (CPI-U): U.S. city average, detailed expenditure categories) of the "CPI Detailed Report," or

    2. Table 6 (or another more appropriate table) of the "PPI Detailed Report."

  3. In the case of a retailer using RIM, the appropriate month is the last month of the retailer's taxable year. A taxpayer not using RIM may annually select an appropriate month for each dollar-value pool or make an election on Form 970, "Application to Use LIFO Inventory Method," to use a representative appropriate month (representative month). An election to use a representative month is a method of accounting and the month elected must be used for the taxable year of the election and all subsequent taxable years, unless the taxpayer obtains the Commissioner's consent under Treas. Reg. 1.446-1(e) to change or revoke its election.

4.43.1.5.6.7.4  (07-23-2009)
Assignment of Items in a Dollar-Value Pool to BLS Categories (selected BLS categories)

  1. A taxpayer must assign each item in a dollar-value pool to the most-detailed BLS category of the selected BLS table that contains that item. For example, in Table 6 of the "PPI Detailed Report" for a given month, the commodity codes for the various BLS categories run from 2 to 8 digits, with the least-detailed BLS categories having a 2-digit code and the most-detailed BLS categories usually (but not always) having an 8-digit code.

  2. Treas. Reg. 1.472-8(e)(3)(iii)(C)(2) provides for a 10 percent method to assign items to BLS categories using a three-step procedure in lieu of assigning each item in a dollar-value pool to the most detailed BLS categories. The 10 percent method is a method of accounting and a taxpayer that wants to change its method of selecting BLS categories (i.e., to or from the 10 percent method) must secure the Commissioner’s consent in accordance with Treas. Reg. 1.446-1(e). A taxpayer that voluntarily changes its method of selecting BLS categories or of selecting a BLS category for a specific item must establish a new base year in the year of change.

4.43.1.5.6.7.5  (07-23-2009)
Computation of Category Inflation Indexes for Selected BLS Categories

  1. A category inflation index reflects the inflation that occurs in the BLS price indexes for a selected BLS category (or, if applicable, 10 percent BLS category) during the relevant measurement period.

  2. The BLS price indexes are the cumulative indexes published in the selected BLS table for the appropriate month. A taxpayer may elect to use either preliminary or final BLS price indexes for the appropriate month, provided that the selected BLS price indexes are used consistently. However, a taxpayer that elects to use final BLS price indexes for the appropriate month must use preliminary BLS price indexes for any taxable year for which the taxpayer files its original federal income tax return before the BLS publishes final BLS price indexes for the appropriate month.

  3. If a BLS price index for a most-detailed or 10 percent BLS category is not otherwise available for the appropriate or representative month (but not because the BLS categories in the BLS table have been revised), the taxpayer must use the BLS price index for the next most-detailed BLS category that includes the specific item(s) in the most-detailed or 10 percent BLS category. If a BLS price index is not otherwise available for the appropriate or representative month because the BLS categories in the BLS table have been revised, the rules of Treas. Reg. 1.472-(e)(3)(iii)(D)(4) apply.

4.43.1.5.6.7.6  (07-23-2009)
Double-extension IPIC Method

  1. If the taxpayer is using the double-extension IPIC method, the category inflation index for a BLS category is the quotient of the BLS price index for the appropriate or representative month of the current year divided by the BLS price index for the appropriate month of the taxable year preceding the base year (base month).

  2. However, if the taxpayer did not have an opening inventory in the year that its election to use the dollar-value LIFO method and double-extension IPIC method became effective, the category inflation index for a BLS category is the quotient of the BLS price index for the appropriate or representative month of the current year divided by the BLS price index for the month immediately preceding the month of the taxpayer's first inventory production or purchase.

4.43.1.5.6.7.7  (07-23-2009)
Link-chain IPIC Method

  1. If the taxpayer is using the link-chain IPIC method, the category inflation index for a BLS category is the quotient of the BLS price index for the appropriate or representative month of the current year divided by the BLS price index for the appropriate month used for the immediately preceding taxable year.

  2. However, if the taxpayer did not have an opening inventory in the year that its election to use the dollar-value LIFO method and link-chain IPIC method became effective, the category inflation index for a BLS category for the year of election is the quotient of the BLS price index for the appropriate or representative month of the current year divided by the BLS price index for the month immediately preceding the month of the taxpayer's first inventory production or purchase.

4.43.1.5.6.7.8  (07-23-2009)
Computation of the Inventory Price Index (IPI)

  1. The following sections provide details regarding the computation of the IPI under the double-extension and link-chain IPIC method.

4.43.1.5.6.7.8.1  (07-23-2009)
Double-extension IPIC Method

  1. Under the double-extension IPIC method, the IPI for a dollar-value pool is the weighted harmonic mean of the category inflation indexes (or, if applicable, compound category inflation indexes) determined under Treas. Reg. 1.472-8(e)(3)(iii)(D) for each selected BLS category (or, if applicable 10 percent BLS category) represented in the taxpayer's dollar-value pool at the end of the taxable year.

  2. The formula for computing the weighted harmonic mean of the category inflation indexes is: [Sum of Weights/Sum of (Weight/Category Inflation Index)].

  3. The weights to be used when computing this weighted harmonic mean are the current-year costs (or, in the case of a retailer using RIM, the retail selling prices) in each selected BLS category represented in the dollar-value pool at the end of the taxable year.

4.43.1.5.6.7.8.2  (07-23-2009)
Link-chain IPIC Method

  1. Under the link-chain IPIC method, the IPI for a dollar-value pool is the product of the weighted harmonic mean of the category inflation indexes (or, if applicable, the compound category inflation indexes) determined under Treas. Reg. 1.472-8(e)(3)(iii)(D) for each selected BLS category (or, if applicable, 10 percent BLS category) represented in the taxpayer's dollar-value pool at the end of the taxable year multiplied by the IPI for the immediately preceding taxable year.

  2. The formula for computing the weighted harmonic mean of the category inflation indexes is the following: [Sum of Weights/Sum of (Weight/Category Inflation Index)].

  3. The weights to be used when computing this weighted harmonic mean are the current-year costs (or, in the case of a retailer using the retail inventory method, the retail selling prices) in each selected BLS category represented in the dollar-value pool at the end of the taxable year.

  4. Examples that illustrate the IPIC rules as discussed in this section are contained in the IPIC Treasury Regulations which begin at Treas. Reg. 1.472-8(e)(3).

4.43.1.5.6.8  (07-23-2009)
Goods Included in Inventory

  1. Treas. Reg. 1.471-1 provides that merchandise should be included in inventory only if title thereto is vested in the taxpayer.

  2. The regulation further states "[a]ccordingly, the seller should include in his inventory goods under contract for sale but not yet segregated and applied to the contract and goods out upon consignment, but should exclude from inventory goods sold (including containers), title to which has passed to the purchaser. A purchaser should include in inventory merchandise purchased (including containers), title to which has passed to him, although such merchandise is in transit or for other reasons has not been reduced to physical possession, but should not include goods orders for future delivery, transfer of title to which has not yet been effected."

4.43.1.5.6.8.1  (07-23-2009)
Cash on Delivery (COD) Goods

  1. For COD cash (or collection) on delivery goods, title to such goods remains with the seller and such goods must be included in the seller’s inventory until the purchaser accepts the goods and pays for them.

4.43.1.5.6.8.2  (07-23-2009)
Inventory Shrinkage

  1. Inventory shrinkage is a term used to describe the difference between the inventory records (i.e. book value) and the amount verified by a physical count. Inventory shrinkage is a common problem in the retail industry.

  2. Causes of shrinkage include employee theft, shoplifting, damage, spoilage, administrative and paperwork errors, and vendor errors/issues.

  3. Cycle counting is a widely accepted practice in the retail industry and is considered more accurate, less expensive, and less disruptive than conducting a year-end physical inventory. Cycle counting is a means of conducting physical inventories at each store, in rotation, throughout the year.

  4. Large retailers typically rely on historical information to estimate the amount of shrinkage between the physical inventory date and the end of the tax year. In part due to their size, large retailers are able to compile statistical data to measure their rate of shrinkage as a percentage of sales.

  5. Shrinkage arises with respect to perpetual inventories. Under a perpetual inventory system, inventory is updated with every purchase and sale. Since individual purchases and sales of goods are tracked through detailed accounting records, a retailer knows at all times the value of its inventory. Because of inventory shrinkage, a physical inventory is taken at intervals to verify the accuracy of the amounts shown in the inventory records. To the extent of inventory shrinkage, the inventory account is adjusted to bring it to actual.

  6. Example. A retailer shows in its accounting records a value of $65,000 for certain inventory goods, which consists of multiple stock-keeping units (SKUs) totaling 5,600 units. The aggregate value of these goods is recorded on the company's books as a financial asset. At the annual physical inventory, where each item is physically counted and double-checked, the total items counted equal 5,200 with an aggregate cost value of $60,250. Inventory has "shrunk" by 400 units with a value of $4,750.

  7. IRC 471 permits estimates for inventory shrinkage. Rev. Proc. 98-29 provides guidance on computing the amount of shrinkage and provides a safe harbor method that taxpayers may use to compute shrinkage.

  8. A potential compliance risk involves retailers that perform their physical inventories at periods other than a tax year-end and do not elect the safe harbor method described in Rev. Proc. 98-29. For these taxpayers, an opportunity exists to adjust the year-end perpetual book inventory by an un-supportable shrinkage factor. Consequently, the determination of the accuracy of a retailer's method of estimating shrinkage is heavily dependent on the particular facts in each case.

  9. The requirement that a LIFO taxpayer value its inventory at cost does not limit the allowance of a shrinkage reserve. A shrinkage reserve is based upon the quantity of goods on hand. It is not a reserve for the value of the goods on hand, which is not allowed for those taxpayers electing to use the LIFO method.

4.43.1.5.6.8.3  (07-23-2009)
BLS Indexes for Department Stores

  1. Rev. Proc. 86-46 applies to retail department stores that (1) have elected to use the LIFO inventory identification method in conjunction with the retail inventory method of valuing inventories, and (2) have elected to use the BLS department store price indexes published monthly by the IRS.

  2. The acceptability of the department store index figures is based upon specific arrangements with the BLS to compute statistically sound index figures for retail department stores.

  3. The use of the BLS department store method has been in decline since 2001. Many taxpayers that previously used this method are now using the IPIC method.

4.43.1.5.6.9  (07-23-2009)
The Inventory Step-Up Issue

  1. If a retailer has engaged in an asset acquisition, i.e., if the assets of a business have been purchased for a lump sum, or if the retailer has acquired the stock of another corporation and has made an election pursuant to IRC 338 with respect to the acquisition, an inventory step-up issue may exist on the tax return.

4.43.1.5.6.9.1  (07-23-2009)
Inventory Step-Up

  1. An inventory step-up generally occurs when the taxpayer makes a fair market value determination for inventory items acquired when it has purchased the assets of a business for a lump-sum or when a taxpayer-corporation acquires the stock of another corporation and makes an election pursuant to IRC 338.

  2. The step-up is the increase to fair market value of the inventory acquired. Any step-up reflected on the tax return most likely would appear as a "favorable to the taxpayer" Schedule M item and would mean that book fair market value of inventory and tax fair market value of inventory differ.

4.43.1.5.6.9.2  (07-23-2009)
Book Tax Conformity with Regard to FMV of Inventory Items

  1. According to FAS 141, "a business combination occurs when an entity acquires net assets that constitute a business or acquires equity interests of one or more other entities and obtains control over that entity or entities." Further, FAS 141 requires that all business combinations in the scope of the statement be accounted for by a single method—the purchase method. According to the pronouncement, the purchase method records the net assets acquired in a business combination at their fair values.

  2. In allocating the cost of an acquired entity to assets acquired and liabilities assumed, FAS 141 states the following: "Following the process described in paragraphs 36-46 (commonly referred to as the purchase price allocation), an acquiring entity shall allocate the cost of an acquired entity to the assets acquired and liabilities assumed based on their estimated fair values at date of acquisition (refer to paragraph 48)…."

  3. Paragraph 37 of FAS 141 provides general guidance for assigning amounts to assets acquired and liabilities assumed, except goodwill. The guidance for inventories as contained in paragraph 37 indicates the following.

    1. Finished goods and merchandise at estimated selling prices less the sum of (a) costs of disposal and (b) a reasonable profit allowance for the selling effort of the acquiring entity.

    2. Work in process at estimated selling prices of finished goods less the sum of (a) costs to complete, (b) costs of disposal, and (c) a reasonable profit allowance for the completing and selling effort of the acquiring entity based on profit for similar finished goods.

    3. Raw materials at current replacement costs.

  4. Based on the foregoing, the guidance for assigning fair value to inventory as contained in FAS 141 mirrors precisely one of the methods a taxpayer or the examiner may use to determine the fair market value of inventory items—the comparative sales method—as set forth in Rev. Proc. 2003-51.

4.43.1.5.6.9.3  (07-23-2009)
Rev. Proc. 2003-51

  1. Rev. Proc. 2003-51 describes three methods that a taxpayer or the examiner may use to determine the FMV of inventory items for purposes of a purchase price allocation when the assets of a business have been purchased for a lump sum or if a corporation has acquired the stock of another corporation and made an election pursuant to IRC 338 with respect to the stock acquisition. The methods described to allocate the purchase price (actual or deemed) of the assets acquired are the replacement cost method, the comparative sales method, and the income method. Allocation of the purchase price is required to determine the basis of each asset.

  2. The revenue procedure acknowledges that in making an inventory valuation determination, it is necessary to allow for a division between the buyer and the seller of the profit on the inventory, taking into account that the quantity of inventory purchased may be greater than the quantity of inventory usually purchased. See Knapp King-Size Corp. v. U.S., 527 F.2d 1392 (Ct. Cl. 1975) and to Nestle Holdings Inc. v. Commissioner, T.C. Memo. 1995-441.

4.43.1.5.6.10  (07-23-2009)
Retail Industry Coordinated Issue Paper

  1. For the retail industry, a coordinated issue paper relative to the inventory step-up issue was issued on October 31, 1991 and has not been de-coordinated. According to the Coordinated Issue Paper, when valuing retailers' inventories, the cost of reproduction method which values inventories at replacement cost, i.e., what it would cost to assemble identical inventories under prevailing market conditions, is less susceptible to error and therefore more appropriate to use than the comparative sales method.

  2. If, however, a taxpayer uses the "comparative sales" or "net realizable value" method, all expenses attributable to the disposition of the acquired inventory, not just direct disposition costs, must be included in the taxpayer's computation. 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.

  3. In making the inventory value determination, the IRS will take into account a fair division of the inventory profit between the seller and buyer of the bulk inventory.

  4. The replacement cost method as discussed in Rev. Proc. 2003-51 is another name for the cost of reproduction method contained in the Retail Industry Coordinated Issue Paper. Like the Coordinated Issue Paper, Rev. Proc. 2003-51 indicates that the replacement cost method generally provides a good indication of FMV if inventory is readily replaceable in a wholesale or retail business, but generally should not be used for a manufacturing concern.

  5. A significant book/tax difference in valuing the FMV of an acquired inventory requires review. This difference should be found on the Schedule M-3. If the taxpayer has used the comparative sales method to value tax inventory, which is the method required by GAAP for book valuation, there should not be a significant book /tax valuation difference.

  6. Correctly applied, the cost of reproduction method, the preferred method for retailers, and the comparative sales method should arrive at the same value. Therefore, there should not be a significant book /tax valuation difference under the cost of reproduction methodology.

4.43.1.5.6.11  (07-23-2009)
Inventory Coordinated Issues

  1. A coordinated issue provides guidance to examiners on significant issues that are not being examined and resolved consistently. Coordinated issues establish uniform positions within industry or issue areas. Examiners cannot deviate from such positions without the concurrence of Industry/Issue Teams. The coordinated issues involving inventory are as listed below.

  2. Dollar-Value LIFO: Bargain Purchase Inventory – 09-09-95 (UIL 472.15-01)

    1. Whether goods purchased in bulk at discounted amounts (bargain purchase inventory) are separate items from goods purchased or produced subsequently for purposes of calculating the value of the taxpayer's inventory under the dollar-value LIFO method authorized by Treas. Reg. 1.472-8.

    2. Whether the change in the definition of an inventory item is a change in a method of accounting within the meaning of IRC 446 and the regulations thereunder, subject to the provisions of IRC 481.

    3. If the inventories purchased at discount constitute separate items, whether the taxpayer has the burden of proof to demonstrate with inventory records that such items were on hand at the end of the year.

  3. Dollar-Value LIFO: Earliest Acquisition Method - 10-23-95 (UIL 472.08-10 )

    1. Whether a taxpayer, electing the earliest acquisition method of determining the current year cost of items making up a dollar-value LIFO pool, can determine the index used to value an increment without double-extending the actual cost of the goods purchased or produced during the year in the order of acquisition.

  4. Dollar-Value LIFO: Segment of Inventory Excluded for the Computation of the LIFO Index – 6-26-95 (UIL 472.08-09)

    1. Whether a LIFO index developed by double-extending one segment of the inventory can be applied to another segment of the inventory that was not double-extended.

4.43.1.5.6.12  (07-23-2009)
Other Inventory Issues

  1. Has the taxpayer included all merchandise, including goods in-transit, in its ending inventory computations?

  2. Is the taxpayer using a dual index method? Historically, most taxpayers maintain their inventory records using the cost of items most recently purchased. However, if LIFO is elected, the taxpayer oftentimes has elected to use the earliest acquisition method to determine the current year cost without changing the record keeping system, hence the use of a dual index method. One index (the deflator index) is used to convert current-year cost to base-year cost and a second index (the increment valuation index) is used to value the increment. The Form 970, used to elect LIFO, will indicate if the taxpayer has elected the earliest acquisition method to determine current year cost. See the coordinated issue section regarding Dollar-Value LIFO earliest acquisition method contained in IRM 4.43.1.5.7.11 as this issue has been designated a coordinated issue.

  3. Has the taxpayer included temporary or promotional markdowns in determining the retail price of goods on hand? 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 of the cost complement.

  4. The IRS's position is the following:

    1. A taxpayer using the LIFO retail inventory method may not exclude the cost and estimated retail selling price of inventory in transit from the numerator and denominator of the cost complement ratio.

    2. A taxpayer using the LIFO retail inventory method may not gross up the cost of inventory in transit by dividing it by the cost complements determined for merchandise previously recorded in the taxpayer's stock ledger.

  5. Retailers are reducing the selling value of display merchandise (e.g., big screen TVs and computers) because the goods are removed from their boxes and placed on display. Generally, the reduced retail price of the display merchandise is not marked on the item until the last closed box is sold. Retailers have been accelerating deductions solely upon the placement of goods on display.

  6. The IRS's position is the following:

    1. Having elected to use the dollar-value LIFO method under Treas. Reg.1.472-8, a taxpayer must use the LIFO method to account for all items that fall within its dollar-value pools.

  7. Bargain purchase. See the coordinated issue section regarding Dollar-Value LIFO: Bargain Purchase Inventory contained in IRM 4.43.1.5.7.11.

  8. Treas. Reg. 1.471-2(f) identifies certain methods that are not acceptable for purposes of the IRC 471 inventory valuation:

    1. Deducting from the inventory a reserve for price changes or an estimated depreciation in the value thereof

    2. Taking work in process, or other parts of the inventory, at a nominal price or at less than its proper value

    3. Omitting portions of the stock on hand

    4. Using a constant price or nominal value for so-called normal quantity of materials or goods in stock

    5. Including stock in transit, shipped either to or from the taxpayer, the title to which is not vested in the taxpayer

    6. Segregating indirect production costs into fixed and variable production cost classifications and allocating only the variable costs to the cost of goods produced while treating fixed costs as period costs which are currently deductible. This method is commonly referred to as the "direct cost" method.

    7. Treating all or substantially all indirect production costs (whether classified as fixed or variable) as period costs which are currently deducible. This method is generally referred to as the "prime cost" method.

4.43.1.5.7  (07-23-2009)
Audit Techniques

  1. If the examination of a retailer includes inventory or cost of goods sold, the examiner should obtain the following:

    1. A copy of the Form 970 whereby the taxpayer first elected the LIFO Method if LIFO has been designated on the return as the methodology used to value inventory for tax purposes.

    2. Copies of all Forms 3115, Change of Accounting Method Requests, involving inventory changes/computations, inclusive of consent agreements and all correspondence between the parties relative to the method change(s).

    3. Copies of all appropriate internal procedures of the taxpayer regarding the physical movement of merchandise as well as a discussion of the associated paperwork and data entry to record transactions. Any clarification of the procedures should be discussed with the appropriate taxpayer personnel. An on-site tour of the various facilities where this paperwork and merchandise is physically processed is the most effective method of understanding the taxpayer’s merchandise system.

    4. A copy of the schedule of the dates on which the merchandise at each location was counted during the year.

    5. A copy of the physical inventory procedures and instructions in effect for the years under examination for both stores and distribution centers, if different. Any indications of an incomplete or inaccurate inventory should be discussed with the taxpayer.

    6. A copy of the layer and/or historical LIFO lapse schedules. These schedules will provide the complete historical detail of the taxpayer’s LIFO computations. These schedules may provide indications of changes made to pools, business emphasis changes, the pattern of the cost complement factors, and the propriety of the price index figures used.

    7. The detail of all computations supporting the quantification of ending inventory for book and for tax inclusive of all reconciliation computations between book and tax and the computations supporting the development of the index used.

    8. Summary Stock Ledger information.

4.43.1.5.8  (07-23-2009)
Other Information

  1. The information contained in the preceding sections is to provide agents a fundamental overview of the topics discussed. In addition, many technical discussions of inventory methodologies and issues can be accessed through both Lexis-Nexis and Westlaw research.

  2. The Inventory Technical Advisors are available to advise and assist agents with respect to their examination of inventory issues.

4.43.1.6  (07-23-2009)
Inventory Capitalization (IRC 263A)

  1. This section provides general background information about the IRC 263A Uniform Capitalization Rules (UNICAP) and the application of these rules to inventories maintained by retailers.

  2. This section also provides the general accounting practices reported by retailers in applying the UNICAP rules.

  3. For retailers, inventories play a significant role in the computation of taxable income. Goods in inventory generally represent the most significant asset on a retailer’s balance sheet. Similarly, the cost of goods sold (COGS) generally represents the largest single item of expense (as an offset to sales revenue) on a retailer’s income statement.

  4. Consequently, the application of the UNICAP rules to inventories will significantly impact a retailer’s tax liability.

4.43.1.6.1  (07-23-2009)
Potential Compliance Risks

  1. Is the retailer required to capitalize in accordance with IRC 263A indirect costs associated with property acquired for resale? Small resellers of the following are excepted:

    1. Personal property. See Treas. Reg. 1.263A-3(b).

    2. De minimis production activities. See Treas. Reg. 1.263A-3(a)(2)(ii).

    3. Property produced under contract. See Treas. Reg. 1.263A-3(a)(3).

  2. If the retailer is subject to the UNICAP rules, did the retailer capitalize costs to property acquired for resale in accordance with IRC 263A and the regulations thereunder? Did the retailer properly characterize and capitalize the most common indirect costs it incurs, which include the following:

    1. All purchasing costs

    2. All capitalizable handling costs

    3. All off-site storage costs

    4. All capitalizable service costs including both capitalizable storage costs and the capitalizable portion of mixed service costs?

  3. Does the retailer have production activities which are determined to be more than de minimis as defined in Treas. Reg. 1.263A-3(a)(2)(iii)?

  4. Has the retailer made a proper determination as to whether it is a producer or reseller if it produces property or has property produced for it under contract? (i.e., contract manufacturing of other than private label goods)?

  5. Is the retailer using a proper cost allocation method for determining additional IRC 263A costs properly allocable to the property acquired for resale and to property it produces? Proper cost allocation methods include the following:

    1. Simplified resale method without historic absorption ratio election

    2. Simplified resale method with historic absorption ratio election

    3. Simplified production method without historic absorption ratio election

    4. Simplified production method with historic absorption ratio election

    5. A facts and circumstances allocation

  6. Has the retailer properly classified and capitalized service costs and capitalizable mixed service costs?

  7. Did the retailer use book purchases in lieu of tax purchases in computing its absorption ratios under the simplified resale method?

  8. Has the retailer taken an inconsistent position relative to its production activities with respect to IRC 263A and IRC 199?

4.43.1.6.2  (07-23-2009)
General Tax Principles

  1. IRC 471 provides the general rules for inventory and authorizes the Secretary to determine when the use of inventories is necessary to clearly reflect income and to determine the valuation methods that are acceptable for tax purposes.

  2. Treas. Reg. 1.471-1 provides that 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.

  3. IRC 263A, enacted under the Tax Reform Act of 1986, prescribes uniform capitalization rules for property produced or held for resale.

  4. Under IRC 263A, resellers of personal property must capitalize the acquisition costs of property acquired for resale and all indirect costs properly allocable to property produced and property acquired for resale.

  5. Additional IRC 263A costs generally are those costs, other than interest, that were not capitalized under the taxpayer’s method of accounting immediately prior to the effective date of IRC 263A, but that are required to be capitalized under IRC 263A.

  6. IRC 263A costs are defined as the costs that a taxpayer must capitalize under IRC 263A. IRC 263A costs are the sum of a taxpayer’s IRC 471 costs, its additional IRC 263A costs, and interest capitalizable under IRC 263A(f).

  7. Treas. Reg. 1.263A-1(f) sets forth various detailed or specific (facts and circumstances) cost allocation methods that taxpayers may use to allocate direct and indirect costs to property produced and property acquired for resale.

  8. Treas. Reg. 1.263A-1(g) provides general rules for applying cost allocation methods to the various categories of costs.

  9. Treas. Reg. 1.263A-2(b) and 1.263A-3(d) provide simplified methods to allocate additional 263A costs to eligible property produced or eligible property acquired for resale.

  10. Treas. Reg. 1.263A-1(h) provides a simplified method for determining capitalizable mixed service costs incurred during the taxable year with respect to eligible property (i.e., the aggregate portion of mixed service costs that are properly allocable to the taxpayer’s production or resale activities).

4.43.1.6.3  (07-23-2009)
Key Considerations

  1. The Tax Reform Act of 1986 enacted IRC 263A to provide a single comprehensive set of rules to govern the capitalization of the costs of producing, acquiring, and holding property, subject to appropriate exceptions.

  2. Retailers’ and wholesalers’ inventories were not subject to any indirect costing rules and, as such, indirect costs incurred by retailers and wholesalers to acquire goods for resale were not capitalized prior to the enactment of IRC 263A.

  3. IRC 263A established new rules for the capitalization of costs in inventories for tax purposes. Both producers and resellers of tangible personal and real property are required to capitalize costs under the provisions of IRC 263A. In addition, IRC 263A applies to the resale of intangible property. For retailers:

    1. The rules require the capitalization of direct costs of acquiring the property and the property’s properly allocable share of indirect costs. IRC 263A(b)(2)(B) excepts personal property acquired for resale by a small reseller from the capitalization rules of IRC 263A.

    2. Although retailers and wholesalers have always had to treat the net invoice price (invoice price less trade or other discounts, except discounts approximating a fair interest rate) as an inventory cost including transportation costs and other costs associated with acquiring possession of the goods that are added to the net invoice price, most of the indirect costs incurred to acquire the goods for resale were charged to expense for both financial and tax purposes prior to the law change.

  4. Although a cost is subject to capitalization under IRC 263A, it may not be proper to capitalize such cost for financial reporting (GAAP) purposes.

  5. The legislative history to IRC 263A indicates that Congress wanted the IRS to adopt a flexible approach in the accompanying regulations by providing simplified methods and assumptions when the costs and burdens of compliance outweigh the benefits especially since retailers did not have cost accounting procedures in place prior to the adoption of the uniform capitalization rules.

  6. In enacting IRC 263A, Congress intended that full-absorption type rules apply to retailers that, prior to these rules, were required to include in inventory only invoice price plus freight less discounts. Now, large retailers, those with more than $10 million in gross receipts, have to include additional costs (e.g., purchasing, handling, off-site storage, and applicable general and administrative costs) in their inventory cost calculations.

  7. The IRC 263A regulations respect the flexibility provided by traditional cost accounting principles by permitting taxpayers to allocate direct and indirect costs to property produced and property acquired for resale using a variety of cost allocation methods. See Treas. Reg. 1.263A-1(f)(1).

  8. Like the full absorption method of IRC 471, additional IRC 263A costs are added to the retailer’s book cost of inventory. In addition to the cost allocation methods provided in Treas. Reg. 1.263A-1(f)(2) and (3), any other reasonable method may be used to properly allocate direct and indirect costs among units of property produced or acquired for resale. See Treas. Reg. 1.263A-1(f)(4).

  9. The simplified resale method, the simplified production method, and the simplified service cost method are allocation methods intended to alleviate some of the administrative burden of complying with the IRC 263A capitalization rules.

  10. A taxpayer can allocate mixed service costs required to be capitalized to eligible property using the simplified service cost method. See Treas. Reg. 1.263A-1(h). The simplified service cost method may be used in conjunction with either a facts and circumstances approach or a simplified method of allocating costs to eligible property produced or eligible property acquired for resale.

4.43.1.6.4  (07-23-2009)
Industry Practices

  1. The following sections describe practices commonly followed in the retail sector.

4.43.1.6.4.1  (07-23-2009)
Buyers/Merchandisers

  1. Retailers employ buyers, assistant buyers, merchandise managers and analysts, general merchandise managers and other personnel engaged in purchasing merchandise or goods (merchandising employees). Merchandising employees in a retail context purchase the goods for resale (inventoriable goods). Merchandising employees are assigned to various product lines or categories of goods (e.g., women’s shoes, men’s shoes, home furnishings, house-wares, lingerie, infants, etc.).

  2. Other personnel, such as administrative support, provide services adjunct to buyers and other employees who purchase goods for resale and/or maintain the inventory of goods for resale.

  3. Purchasing activities of buyers and/or merchandising employees include (but are not limited to):

    1. Selection of merchandise

    2. Maintenance of stock assortment and volume

    3. Placement of purchase orders

    4. Establishment and maintenance of vendor contracts and

    5. Comparison and testing of merchandise.

  4. Buyers also manage inventory, negotiate costs, evaluate competition, establish replenishment strategies, execute the development and maintenance of purchase orders, manage markdown projection processes and the projection of vendor allowances, manage the negotiation and collection of vendor allowances, develop inventory exit strategies, execute stock ledger reviews and purchase journal reviews.

  5. Buyers also establish and approve pricing strategies while evaluating the financial impact of price changes.

  6. Buyers may plan and approve all advertising and marketing strategies.

  7. Buyers may also be responsible for the development and training of the buying team, including assistant buyers and/or merchandising analysts.

  8. Many large retailers have centralized purchasing departments that are located in the corporate headquarters. Decentralized buying procedures use buyers that are assigned to specific stores or geographic locations.

4.43.1.6.4.2  (07-23-2009)
Private Label (Store) Brands

  1. Some retailers design virtually all of their goods held for resale. Other retailers may design only a portion of their goods held for resale which are known as private label goods (e.g., a department store’s (store) label goods). In these circumstances, the retailer typically has an in-house design group that develops the private (store) label goods. Oftentimes, private label goods are produced by independent parties under contract. As a general rule, these independent parties are located in countries overseas.

  2. The recent elimination of import quotas has created an opportunity for retailers to directly source production of private label goods with contractors located in low labor cost countries.

4.43.1.6.4.3  (07-23-2009)
Marketing Exclusive Designer/Celebrity Brands

  1. Since the retail industry is highly competitive, retailers must provide consumers with a wide variety of shopping options and/or merchandise selections. To survive in today's economy, retailers need to be distinguishable from the competition. Carrying exclusive merchandise provides retailers an opportunity to differentiate its merchandise assortment from its competition.

  2. Some retailers enter into exclusive licensing and/or royalty agreements with major celebrities and/or designers to provide for differentiated merchandise assortments and to compete in the industry on a basis other than price.

  3. Licensing and/or royalty costs include fees incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe or other similar right associated with property produced or property acquired for resale. These costs include the otherwise deductible portion (e.g., amortization) of the initial fees incurred to obtain the license and any minimum annual payments and royalties that are incurred by a licensee. Treas. Reg. 1.263A-1(e)(3)(ii)(U).

  4. In addition to the initial fee, a celebrity and/or designer will also receive financial compensation in exchange for granting certain property rights to the retailer in the form of royalty payments. The royalty rate varies depending on the type of merchandise licensed and may be established as a percentage of retailer’s sales price or the purchase price of the licensed merchandise.

  5. As a general rule, royalty rates vary between 3% and 7%.

  6. Licensing and franchise costs are indirect costs required to be capitalized to the extent they are properly allocable to property produced or property acquired for resale. See Treas. Reg. 1.263A-1(e)(3)(ii)(U).

  7. Frequently, a retailer reports royalties paid or incurred in connection with a licensing arrangement as an IRC 162 cost, contending the royalty payments are marketing, selling, and advertising expenses (or similar in nature to such expenses).

4.43.1.6.5  (07-23-2009)
Financial Reporting

  1. Statement of Financial Accounting Standards (SFAS) No.151, effective for inventory costs incurred during fiscal years beginning June 15, 2005, amended the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter 4, regarding costs included in inventory.

  2. For GAAP purposes, absorption costing of inventory is required for external reporting. For producers/manufacturers, Treas. Reg. 1.471-11 requires the use of the full absorption method of inventory costing whereby both direct (materials and labor) and indirect production costs must be taken into account in the computations of inventoriable costs. Absorption costing for book purposes can and oftentimes does differ from the full absorption method as required for tax.

  3. For retailers, the cost of merchandise is the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. To the net price, transportation and other necessary charges incurred in acquiring possession of the goods should be added. See Treas. Reg. 1.471-3(b).

  4. IRC 263A is broader than both GAAP and the full absorption rules of Treas. Reg. 1.471-11 and, as a result, a retailer may not be required to capitalize for financial reporting purposes certain additional costs that are required to be capitalized for tax reporting purposes.

  5. Whether capitalization is required for financial reporting purposes depends on factors such as the nature of the business operations and industry practice. The individual facts and circumstances will control the determination. See the Emerging Issues Task Force (EITF) Issue No. 86-46.

  6. As a general rule, retailers do not capitalize additional IRC 263A costs to inventory for financial statement purposes.

4.43.1.6.6  (07-23-2009)
Retail Topics and Issues

  1. This section covers potential tax issues and key terms and concepts involving IRC 263A.

4.43.1.6.6.1  (07-23-2009)
Treatment of Merchandising Department Costs and Reclassification of Indirect Costs

  1. The IRS has addressed the issue of whether the costs incurred by a retailer's merchandising department are mixed service costs as defined by Treas. Reg. 1.263A-1(e)(4)(ii)(C). The IRS's position is that, since the costs incurred in the merchandising department includes the costs of purchasing goods for resale, the merchandising department does not constitute a service department. Consequently, the IRS has concluded that the purchasing costs incurred in the merchandising department are properly capitalizable indirect costs in accordance with Treas. Reg. 1.263A-1(e)(3)(ii)(F).

  2. A retailer may attempt to reclassify as capitalizable service costs or as indirect costs not subject to capitalization its indirect costs incurred to acquire property for resale. Reclassifications such as these attempt to eliminate from capitalization the indirect costs as described in Treas. Reg. 1.263A-1(e)(3) which are costs properly allocable to property acquired for resale. Included in such indirect costs requiring capitalization are purchasing, handling and storage costs which are the indirect costs most often incurred by retailers/resellers. Purchasing, handling, off-site storage costs and the allocable general and administrative costs pertaining to these costs are generally required by statute to be capitalized to inventory.

4.43.1.6.6.2  (07-23-2009)
Resellers with Production Activity

  1. A retailer/ reseller with production activity and a small reseller with more than de minimis production activity:

    1. Must capitalize all direct costs and certain indirect costs associated with the tangible personal property it produces.

    2. Must use the simplified production method and may not use the simplified resale method for the capitalization of additional IRC 263A costs.

  2. A retailer/reseller with de minimis production activities must capitalize the de minimis production activity costs but may use the simplified resale method.

  3. A small retailer/reseller is not required to capitalize additional IRC 263A costs associated with any personal property that is produced incident to its resale activities, provided the production activities are de minimis in accordance with Treas. Reg. 1.263A-3(a)(2)(iii).

  4. Property produced under contract is treated as property produced by the taxpayer.

  5. A small retailer/reseller is not required to capitalize additional IRC 263A costs to property produced for it under contract with an unrelated person if the contract is entered into incident to the resale activities of the small reseller and the property is sold to its customers.

  6. In general, a retailer/reseller engaged in both production and resale activities with respect to inventory property (e.g., stock in trade or other property properly includible in the inventory of the retailer) and non-inventory property held for sale to customers in the ordinary course of the retailers’ business may elect the simplified production method but may not elect the simplified resale method unless:

    1. Its production activities with respect to its eligible property, under Treas. Reg. 1.263A-2(b)(2), are de minimis and incident to its resale of its stock in trade or other property of a kind which would properly be included in inventory or property held primarily for sale to customers in the ordinary course of business. See Treas. Reg. 1.263A-3(a)(2)(ii)

    2. The personal property (e.g., private label goods) produced under a contract with an unrelated person and the contract is entered into incident to its resale activities and the property is sold to its customers. See Treas. Reg. 1.263A-3(a)(4)(iii).

4.43.1.6.6.3  (07-23-2009)
Negative Additional IRC 263A Costs

  1. Notice 2007-29 contains interim guidance relative to negative additional IRC 263A costs in conjunction with the use of a simplified method.

  2. At issue is whether negative amounts may be included with additional IRC 263A costs and whether aggregate additional IRC 263A costs may be a negative number.

  3. A negative amount may occur, for example, when a taxpayer includes book costs greater than those required for tax purposes in the IRC 471 cost of inventory (e.g., book depreciation greater than tax depreciation) and the taxpayer does not adjust its IRC 471 costs to remove this excess depreciation amount but instead makes a negative adjustment to its additional IRC 263A costs.

  4. Significant distortions, including undercapitalization, may result when a retailer treats negative amounts as additional IRC 263A costs.

  5. Pending issuance of additional published guidance subsequent to Notice 2007-29, the IRS will not challenge the inclusion of negative amounts in computing additional costs under IRC 263A which represent IRC 471 costs that were capitalized to inventory using a facts and circumstances method such as a burden rate or a standard cost rate.

  6. The IRS will not, however, approve any change in method of accounting to change the costs capitalized under IRC 471 to begin capitalizing a cost under IRC 471 and to remove the same cost from ending inventory by treating it as a negative additional IRC 263A cost.

  7. Any taxpayer previously granted consent to change its method of accounting for the inclusion of negative amounts in computing additional costs under IRC 263A will be required to conform its method of accounting to any future published guidance.

4.43.1.6.6.4  (07-23-2009)
Royalty Capitalization Costs

  1. Refer to IRM 4.43.1.6.4.3, Marketing Exclusive Designer/Celebrity Brands, in this section which contains a discussion of this topic.

4.43.1.6.6.5  (07-23-2009)
Tax Purchases vs. Financial Purchases

  1. An income tax issue may exist if a retailer’s book purchases and tax purchases differ. This circumstance can occur if a retailer reduces its purchases by vendor allowances or some other reduction for tax purposes but does not reduce its purchases by the same amounts for book purposes.

  2. If book purchases exceed tax purchases and the retailer uses book purchases to compute its storage and handling costs absorption ratio and its purchasing costs absorption ratio under the simplified resale method, both ratios will be understated as a result of which the combined absorption ratio will be understated, which in turn will under-capitalize additional IRC 263A costs to ending inventory.

  3. Current year purchases are defined in both Treas. Reg. 1.263A-3(d)(3)(D)(2) and 1.263A-3(d)(E)(2) and generally mean the taxpayer’s IRC 471 costs incurred with respect to purchases of property acquired for resale during the current taxable year.

4.43.1.6.6.6  (07-23-2009)
Key Terms and Definitions

  1. IRC 471 costs are costs, other than interest, that were capitalized under the taxpayer’s method of accounting immediately prior to the enactment of IRC 263A. See Treas. Reg. 1.263A-1(d)(2). For a reseller, IRC 471 costs would include the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may, or may not, be deducted at the option of the taxpayer, provided a consistent course is followed, plus transportation or other necessary costs incurred in acquiring possession of the goods. See Treas. Reg. 1.471-3(b).

  2. Additional IRC 263A costs are defined as the costs, other than interest, that were not capitalized under the taxpayer’s method of accounting immediately prior to the effective date of IRC 263A, but that are required to be capitalized under IRC 263A. See Treas. Reg. 1.263A-1(d)(3).

  3. IRC 263A costs are defined as the costs that a taxpayer must capitalize under IRC 263A. IRC 263A costs are the sum of a taxpayer’s IRC 471 costs, its additional IRC 263A costs, and interest capitalizable under IRC 263A(f). See Treas. Reg. 1.263A-1(d)(4).

  4. Capitalize means, in the case of property that is inventory in the hands of a taxpayer, to include in inventory costs and, in the case of other property, to charge to a capital account or basis. See Treas. Reg. 1.263A-1(c)(3).

  5. Small reseller is defined as a reseller that acquires personal property for resale during the taxable year whose (or its predecessors’) average annual gross receipts do not exceed for the three previous taxable years (test period) $10,000,000. See Treas. Reg. 1.263A-3(a)(1) and 1.263A-3(b)(1). However, taxpayers that acquire real property for resale are subject to IRC 263A with respect to real property regardless of their gross receipts. See IRC 263A(b)(2).

  6. Service costs are defined as a type of indirect costs (e.g., general and administrative costs) that can be identified specifically with a service department or function or that directly benefit or are incurred by reason of a service department or function. See Treas. Reg. 1.263A-1(e)(4)(i)(A).

  7. Capitalizable service costs are defined as service costs that directly benefit or are incurred by reason of the performance of the production or resale activities of the taxpayer. Therefore, these costs are required to be capitalized under IRC 263A. See Treas. Reg. 1.263A-1(e)(4)(ii)(A).

  8. Deductible service costs are defined as service costs that do not directly benefit or are not incurred by reason of the performance of the production or resale activities of the taxpayer, and therefore, are not required to be capitalized under IRC 263A. Deductible service costs include costs incurred by reason of the marketing, selling, advertising, and distribution activities of the taxpayer. See Treas. Reg. 1.263A-1(e)(4)(ii)(B) and 1.263A-1(e)(4)(iv).

  9. Mixed service costs are defined as service costs that are partially allocable to production or resale activities (capitalizable mixed service costs) and partially allocable to non-production or non-resale activities (deductible mixed service costs). See Treas. Reg. 1.263A-1(e)(4)(ii)(C).

  10. Total mixed service costs are defined as the total costs incurred during the taxable year in all departments or functions of the taxpayer’s trade or business that perform mixed service activities. In determining the total mixed service costs of a trade or business, the taxpayer must include all costs incurred in its mixed service departments and cannot exclude any otherwise deductible service costs. For example, if the accounting department within a trade or business is a mixed service department, then in determining the total mixed service costs of the trade or business, the taxpayer cannot exclude the costs of personnel in the accounting department that perform services relating to non-resale activities. Instead, the entire cost of the accounting department must be included in the total mixed service costs. See Treas. Reg. 1.263A-1(h)(6).

  11. Purchasing costs include the costs attributable to purchasing activities. See Treas. Reg. 1.263A-1(e)(3)(ii)(F) and 1.263A-3(c)(3)(i). Purchasing costs are costs associated with operating a purchasing department or office within a trade or business, including personnel costs (e.g., of buyers, assistant buyers, and clerical workers), relating to the following:

    1. The selection of merchandise

    2. The maintenance of stock assortment and volume

    3. The placement of purchase orders

    4. The establishment and maintenance of vendor contracts

    5. The comparison and testing of merchandise.

  12. Storage costs include the costs of carrying, storing, or warehousing property. Storage costs are capitalized under IRC 263A to the extent they are attributable to the operation of an off-site storage or warehousing facility (an off-site storage facility). See Treas. Reg. 1.263A-1(e)(3)(ii)(H). However, storage costs attributable to the operation of an on-site storage facility as defined in Treas. Reg. 1.263A-3(c)(5)(ii)(A) are not required to be capitalized under IRC 263A. Storage costs attributable to a dual-function storage facility as defined in Treas. Reg. 1.263A-3(c)(5)(ii)(G) must be capitalized to the extent that the facility’s costs are allocable to off-site storage. See Treas. Reg. 1.263A-3(c)(5)(i).

  13. Handling costs include costs attributable to processing, assembling, repackaging, and transporting goods, and other similar activities with respect to property acquired for resale, provided the activities do not come within the meaning of the term produce as defined in Treas. Reg. 1.263A-2(a)(1). Handling costs are generally required to be capitalized under IRC 263A. However, handling costs incurred at a retail sales facility with respect to property sold to retail customers at the facility are not required to be capitalized. Thus, handling costs incurred at a retail sales facility to unload, unpack, mark, and tag goods sold to retail customers at the facility are not required to be capitalized. In addition, handling costs incurred at a dual-function storage facility with respect to property sold to customers from the facility are not required to be capitalized to the extent that the costs are incurred with respect to property sold in on-site sales. See Treas. Reg. 1.263A-1(e)(3)(ii)(G) and 1.263A-3(c)(4)(i).

4.43.1.6.7  (07-23-2009)
Audit Techniques

  1. The five steps to approaching an IRC 263A issue include the following:

    1. Identify the taxpayer’s production or resale activities in the year(s) under examination. Some considerations include whether the retailer engages in any production activities, whether the personal property is private label property and whether the production activities were contracted out.

    2. Determine if the application of any special rules or exemptions exist such as the small reseller exception; the 90/10 exception for mixed service costs (Treas. Reg. 1.263A-1(h)(8)); the 90/10 exception for storage costs (Treas. Reg. 1.263A-3(c)(5)(iii)(c)); or the 1/3 – 2/3 exception for buyers (Treas. Reg. 1.263A-3(c)(3) (ii)(A).

    3. Identify the additional IRC 263A costs subject to capitalization. See Treas. Reg. 1.263-1(e)(3) and 1.263A-3(c).

    4. Determine the costs the taxpayer identified as mixed service costs and how the taxpayer allocated the mixed service costs to production or resale activities. See Treas. Reg. 1.263A-1(h) and 1.263-1(g)(4).

    5. Determine the method(s) of allocation used to allocate all the direct and indirect costs, including mixed service costs that directly benefited or were incurred by reason of production or resale activities to the property produced or acquired for resale, (i.e., ending inventory). See Treas. Reg. 1.263A-1(f), 1.263A-2(b) and 1.263A-3(d).

4.43.1.6.7.1  (07-23-2009)
Documentation

  1. To examine an IRC 263A issue, the examiner should obtain the following documents:

    1. All IRC 263A workpapers inclusive of all computations.

    2. Internal control workpapers for cost accounting purposes. These workpapers are essential if the retailer engages exclusively in production activities.

    3. Any Forms 3115 that requested a change in method of accounting with respect to additional IRC 263A costs and/or IRC 263A absorption ratio calculations and/or methods and/or IRC 471 costs.

4.43.1.6.8  (07-23-2009)
Other Information

  1. For additional information, an IRC 263A reference guide, Section 263A,Uniform Capitalization, Document 10822, Catalogue No. 25981E, is available.

  2. Contact the IRC 263A Technical Advisor team for assistance.

4.43.1.7  (07-23-2009)
Interest and Self-Constructed Asset Capitalization (IRC 263A)

  1. This section provides guidance on how IRC 263A affects retailers that self-construct assets used in their trade or business. This section also provides guidance regarding situations in which retailers are required to capitalize interest under IRC 263A(f).

  2. Self-constructed assets are assets produced by the taxpayer for use by the taxpayer in its trade or business.

  3. In general, IRC 263A(f) limits the capitalization of interest to interest that is paid or incurred during the production period of certain property referred to as designated property.

  4. Designated property includes all real property produced by the taxpayer and tangible personal property produced by the taxpayer which has:

    • a long useful life

    • an estimated production period exceeding two years, or

    • an estimated production period exceeding one year and a cost exceeding $1,000,000.

  5. Interest capitalized under IRC 263A(f) is treated as a cost of the designated property and is recovered in accordance with Treas. Reg. 1.263A-1(c)(4) through depreciation, amortization, cost of goods sold, or by an adjustment to basis at the time the property is used, sold, placed in service or otherwise disposed of by the taxpayer.

  6. Cost recoveries are determined by the applicable IRC sections and regulation provisions relating to the use, sale, or disposition of property.

4.43.1.7.1  (07-23-2009)
Potential Compliance Risks

  1. The retailer fails to capitalize indirect costs altogether or omits certain costs that directly benefit or are incurred by reason of its production activity.

  2. The retailer inappropriately treats certain self-constructed assets (e.g., stores) as property produced on a "routine and repetitive" basis. Stores are neither mass-produced nor do they have a high turnover. See Rev. Rul. 2005-53 and Treas. Reg. 1.263A-1 and Treas. Reg. 1.263A-2 for rules regarding self-constructed assets produced on a routine and repetitive basis.

  3. The retailer does not capitalize any interest (or capitalizes an insufficient amount of interest) during the production period.

  4. The retailer does not treat real property or applicable tangible property that is produced for it by a contractor under a contract with it or an intermediary as designated property. The retailer for whom property is being constructed under a contract is subject to the interest capitalization rules on payments made to the contractor, and the contractor is subject to the rules on any costs that it incurs in excess of payments received by it to date.

  5. The retailer nets interest income with interest expense. Rev. Rul. 90-40 provides that interest expense required to be capitalized by IRC 263A(f) may not be reduced by interest income earned from temporarily investing unexpended debt proceeds.

  6. The retailer improperly treats functionally interdependent property as separate units of property. See Treas. Reg. 1.263A-10(b)(1) and Treas. Reg. 1.263A-10(b)(2).

  7. The retailer fails to use the avoided cost method of interest capitalization. See Treas. Reg. 1.263A-9.

  8. The retailer incorrectly determines accumulated production expenditures. See Treas. Reg. 1.263A-11.

  9. The retailer incorrectly determines the computation periods and/or the production period of a unit of designated property. See Treas. Reg. 1.263A-9(f)(1) and Treas. Reg. 1.263A-12.

  10. The retailer fails to capitalize all other direct or indirect costs, such as insurance, taxes, and storage, that directly benefit or are incurred by reason of the production of property without regard to whether they are incurred during a period in which production activity occurs.

4.43.1.7.2  (07-23-2009)
General Tax Principles

  1. IRC 263A(g)(1) defines the term "produce" to include construct, build, install, manufacture, develop, or improve. See S. Rept. 99-313, at 140 (1986), 1986-3 C.B. (Vol. 3) 1, 140; Von-Lusk v. Commissioner, 104 T.C. 207, 214-216 (1995).

  2. IRC 263A(g)(2) provides that a taxpayer shall be treated as producing any property produced for the taxpayer under a contract with the taxpayer. See Suzy’s Zoo v. Commissioner, 273 F.3d 875, 879 (9th Cir. 2001), affg. 114 T.C. 1 (2000).

  3. Treas. Reg. 1.263A-1(a)(3)(ii) provides that taxpayers that produce real property and tangible personal property (producers) must capitalize all the direct costs of producing the property and the property’s properly allocable share of indirect costs as described in Treas. Reg. 1.263A-1(e)(2)(i)(A) and (B) and in Treas. Reg. 1.263A-1(e)(3)(i) and (ii) regardless of whether the property is sold or used in the taxpayer trade or business.

  4. Treas. Reg. 1.263A-2 provides the rules relating to property produced by the taxpayer.

  5. Treas. Reg. 1.263A-2(a)(3) provides that, except as specifically provided in IRC 263A(f) with respect to interest costs, producers must capitalize direct and indirect costs properly allocable to property produced under IRC 263A, without regard to whether those costs are incurred before, during, or after the production period (as defined in IRC 263A(f)(4)(B)).

  6. Treas. Reg. 1.263A-8 through 1.263A-15 provide guidance with respect to the capitalization of interest under IRC 263A(f).

  7. T.D. 8584 dated December 29, 1994 and effective January 1, 1995 provides the final regulations relating to the requirement to capitalize interest with respect to the production of property. The final regulations provide guidance necessary for taxpayers to comply with the requirement to capitalize interest with respect to certain produced property.

4.43.1.7.3  (07-23-2009)
Key Considerations

  1. IRC 263A was enacted as part of the Tax Reform Act of 1986, Pub. L. 99- 514, Sec. 803(a), 100 Stat. 2350. In enacting IRC 263A, Congress intended that a single, comprehensive set of rules generally should govern the capitalization of costs of producing property in order to more accurately reflect income and make the tax system more neutral.

  2. The purpose of the IRC 263A cost identification and cost capitalization, as well as the IRC 263A(f) interest capitalization, provisions is to maintain parity among taxpayers.

  3. Interest capitalization results in deduction of the interest incurred to finance an asset’s production in the years in which income from the asset is realized.

  4. Prior to the enactment of IRC 263A, neither the Code nor the regulations identified all of the indirect costs required to be capitalized in connection with self-constructed assets. Such costs were identified through published revenue rulings on specific costs and various court cases that addressed specific costs.

  5. Simplified allocation methods are generally not available for the determination of capitalizable mixed service costs or to allocate costs to self-constructed assets. However, there are two exceptions. The exceptions are for self-constructed assets produced by a taxpayer that are substantially identical in nature to, and produced in the same manner as, inventory property or non-inventory property that is produced for sale that the taxpayer is also producing and self-constructed assets produced on a "routine and repetitive" basis.

  6. All costs associated with self-constructed assets must be accumulated and capitalized. The capitalized costs are written off through depreciation and amortization according to the type of fixed asset. No depreciation is allowed for land. Buildings are depreciable over its real property lives. Furnishings and fixtures used in operations, known as retail trade assets, are depreciable over its personal property lives.

  7. The self-constructed asset records may be substantiated by only one invoice. On the other hand, a complicated trail, which can include allocation studies, drawings, bid proposals, and planning documents to tie back to invoices, may exist. More complex trails tend to be the result of new construction or a major remodel of an existing store.

  8. In general, any improvement to property described in Treas. Reg. 1.263(a)-1(b) constitutes a production of property. See Treas. Reg. 1.263A-8(d)(3)(i). Generally, any improvement to designated property constitutes the production of designated property. See Treas. Reg. 1.263A-8(d)(3)(i).

  9. A retailer may make the avoided cost calculation on the basis of either a full taxable year or a shorter period. A retailer must use the same computation periods for all designated property produced during a single taxable year. The choice of a computation period is a method of accounting. Any change in the computation period is a change in method of accounting requiring the consent of the Commissioner under IRC 446(e) and Treas. Reg. 1.446-1(e). See Treas. Reg. 1.263A-9(f)(1).

  10. Costs are generally taken into account in the computation of accumulated production expenditures at the time and to the extent they would otherwise be taken into account under the retailer's method of accounting (e.g., after applying the requirements of IRC 461, including the economic performance requirement of IRC 461(h)).

4.43.1.7.4  (07-23-2009)
Industry Practices

  1. The remodeling of existing stores and new construction of stores are common occurrences in the retail industry.

  2. Most retailers produce such projects either by paying outside contractors or by using their own employees to perform the construction.

  3. It is important that a retailer involved in production activities use the same standards to measure the cost of a project as a retailer that purchases a completed asset outright.


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