4.43.1  Retail Industry (Cont. 5)

4.43.1.11 
Leases

4.43.1.11.8 
Other Information

4.43.1.11.8.2  (07-23-2009)
Lease Term

  1. When determining the lease term, retailers may include option periods for which failure to renew the lease imposes a penalty on the retailer, in such an amount that a renewal appears, at the inception of the lease, to be reasonably assured. The primary penalty to which a retailer may be subject is the economic detriment associated with the existence of leasehold improvements which might be impaired if it chooses not to continue the use of the leased property.

4.43.1.11.8.3  (07-23-2009)
Lease Structure

  1. Executory costs are ownership costs such as property taxes, insurance, and operating expenses such as utilities and maintenance. The economic burden of executory costs usually falls on the lessee even though the lessor may share or even pay all of the costs. Accordingly, most leases require retailers to pay executory costs.

  2. A retailer can pay its share of executory costs in one of two ways. A retail lease may be either a gross lease or a triple net (or net) lease. The distinguishing feature between these two types of leases is who directly pays the property’s taxes, insurance, and operating expenses.

    1. Under a gross lease, the tenant pays the landlord a gross amount for rent. The landlord absorbs (and includes in the base rent) the property costs. Tenants typically reimburse a landlord for normal inflationary type cost increases that may occur in later years.

    2. Under a triple net lease, the tenant pays the landlord a base rent, which is net of property costs. The property costs are allocated and charged directly to the tenants proportionately. Triple net leases are commonly used for leased retail space because retailers have greater control over their leased space without having to own the building.

4.43.1.11.8.4  (07-23-2009)
Capital Leases

  1. FASB 13 requires some leases to be treated as capital assets.

  2. Applying FASB 13, the present value of the total lease payments is capitalized and depreciated and the lease payments are treated as installment payments plus interest instead of rent expense.

  3. Whether a capital lease for financial reporting purposes can be treated as an operating lease for tax reporting purposes depends on the facts and circumstances of each transaction. Rev. Proc. 2001-29 lists the facts the examiner needs to consider in arriving at the proper treatment. If the lease represents an operating lease for tax reporting, the lease payments will appear on Schedule M as follows:

    1. Taxable income will increase by the amount of book depreciation and interest expense.

    2. Taxable income will decrease by the amount of lease payments treated as rent expense.

    3. It is usually more advantageous to treat the lease as an operating lease for tax purposes.

4.43.1.12  (07-23-2009)
Liabilities and Reserves

  1. This section provides general background information about accrued liabilities reported by retailers and the general accounting practices for such liabilities reported.

  2. For financial reporting purposes, GAAP requires the reflection of contingent obligations as expenses on financial statements. For tax reporting purposes, however, no deduction is allowed for liabilities that might never occur. The contingency element is a very strict consideration in assessing whether the liability is fixed for tax reporting purposes. Consequently, a liability does not accrue for tax purposes as long as it remains contingent.

  3. Retailers regularly set up reserves to cover contingent liabilities. These liabilities normally arise in the ordinary course of business.

4.43.1.12.1  (07-23-2009)
Potential Compliance Risks

  1. Is the reported liability associated with a deductible or nondeductible expense?

  2. If deductible, when is the liability fixed and determinable (and the related expense deductible)? In other words, did the retailer accrue the liability and deduct the related expense prematurely?

  3. If nondeductible or not currently deductible, is the amount reported properly on Schedule M?

  4. If the related expense is deductible and recognized in the proper tax year, is the amount of liability reasonably accurate?

  5. If a nondeductible capital expenditure, does the statute provide for a systematic cost recovery of the expenditure?

4.43.1.12.2  (07-23-2009)
General Tax Principles

  1. A deduction is allowed for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

  2. Under Treas. Reg. 1.461-1(a)(3) deductions must be taken into account for the tax year which is the proper tax year under the taxpayer’s method of accounting. Expenses, liabilities, or losses of one year cannot be used to reduce the income of a subsequent year.

  3. Taxpayers using the accrual method of accounting are entitled to deduct expenses in the year incurred, regardless of when paid.

  4. The all events test governs whether an expense has been incurred. Under this test, all events that establish the fact of the liability must have occurred, and the amount of the liability must be capable of being determined with reasonable accuracy. Further, in determining whether a liability has been incurred, the all events test is not treated as met any earlier than when economic performance with respect to such liability occurs.

  5. For liabilities arising out of the provision of services or property to the taxpayer by another person, economic performance occurs as the services or property is provided. For liabilities arising out of the use of property provided to the taxpayer, economic performance occurs ratably over the period of time the taxpayer is entitled to use the property. For services or property provided by the taxpayer, economic performance occurs as the taxpayer incurs costs in connection with the satisfaction of the liability. Economic performance for all other liabilities (including workers compensation, torts, breach of contract, violation of law, rebates, refunds, awards, prizes, jackpots, insurance, warranty contracts, service contracts, and taxes) occurs when the taxpayer makes payment to the person to whom the liability is owed.

  6. The recurring item exception to the economic performance test applies to certain liabilities and provides that an item shall be treated as incurred during any taxable year if:

    1. The all events test (but for economic performance) is met,

    2. Economic performance occurs within the shorter of a reasonable time after the close of the taxable year or 8 1/2 months after the close of such year,

    3. Such item is recurring in nature, and the taxpayer consistently treats items of such kind as incurred in the taxable year in which the requirements of the all events test are met, and

    4. The item is either immaterial or early recognition results in a more proper match against income than would accruing such item in the taxable year in which economic performance occurs.

  7. Where a deduction is properly accrued on the basis of a computation made with reasonable accuracy, and the exact amount is subsequently determined in a later taxable year, the difference, if any, between such amounts is taken into account for the later taxable year in which such determination is made.

  8. Whether a taxpayer has satisfied the all events test is a question of law.

4.43.1.12.3  (07-23-2009)
Key Considerations

  1. The primary consideration is the tax treatment of future liabilities by accrual basis retailers. A common aspect of tax planning is a taxpayer’s effort to accelerate the recognition of expenses. Future liabilities often create premature accruals, which provide an economic benefit to retailers from the time value of money. The time value of money factor is almost always involved with an accrual method retailer’s deductions if the deductions are incurred before payments. The longer the period between the date a liability is accrued and the date the liability is satisfied, the greater the economic benefit.

  2. The regulations define a liability as any item allowable as a deduction, cost, or expense, except for certain items for which the Internal Revenue Code provides alternative timing rules. The IRS interprets the definition to include both exclusions and deductions. Under this interpretation, an amount otherwise allowable as a capitalized cost or as a cost taken into account in computing cost of goods sold is included in the definition.

  3. Tax law is intended to prevent the premature accrual of deductions. Tax law imposes limitations on a taxpayer’s ability to claim deductions for items accrued now (i.e. reserves), but not payable until some future year(s). Tax law considers deductions of the full amount of obligations payable in the future to overstate the true cost of the expense by failing to take into account the time value of money.

  4. To satisfy the all events test for deducting an accrued liability, the liability must be final and definite in amount, fixed and absolute, and unconditional. The test is based on the legal obligations for the current period, not on future obligations. The principal requirement is that the taxpayer's liability be fixed, which occurs when payment is unconditionally due.

  5. A reserve is a deduction for a liability that is anticipated to be incurred, but will become fixed in a future period. Tax law is well-settled that regardless of how statistically certain that a liability will eventually be incurred, a reserve for expenses, which is acceptable in financial accounting, is not generally deductible unless specifically allowed by statute. Inventory is one area where reserves are specifically allowed. See IRM 4.43.1.5.

  6. If a taxpayer's liability for an expense is contingent on some event occurring in the future, the expense is not deductible until the contingency occurs or is resolved in some way. The IRS has relied upon United States v. General Dynamics, 481 U.S. 239 (1987) as a reiteration of the long-standing principle that a contingency will prevent the accrual of a liability where the contingency is more than a remote possibility. Until then, the expense does not meet the all events test since all the events determining the fact of the liability have not occurred.

  7. The basic rule for contested liabilities is that they are not deductible until the liability is determined, because until that happens, the taxpayer has not admitted liability and the liability is not fixed. This rule is contrary to the financial accounting treatment of contested liabilities, which provides that for pending or threatened litigation and actual or possible claims and assessments, an estimated loss should be accrued if it is probable that an asset has been impaired or a liability incurred, and the amount of the loss can be reasonably estimated.

  8. The frequency with which an item or similar items are incurred or are expected to be incurred is considered in determining whether a recurring item exists. An item is treated as recurring if it can generally be expected to be incurred from one taxable year to the next. A taxpayer may treat a liability as recurring in nature even if it is not incurred in each taxable year. A liability that has never previously been incurred by a taxpayer may be treated as recurring if it is reasonable to expect that the liability will be incurred on a recurring basis in the future. The recurring item exception does not apply to a liability for interest, workmen's compensation, tort, breach of contract, violation of law, or other liabilities described in Treas. Reg. 1.461-4(g)(7).

  9. In a going concern, certain overlapping deductions will occur. If these overlapping items do not materially distort income, they may be included in the years in which the taxpayer consistently takes them into account. In determining the correct year for a deduction, the examiner should consider the all events test and the economic performance test.

  10. The Supreme Court has held that a liability incurred by operation of law is fixed for tax accrual purposes.

4.43.1.12.4  (07-23-2009)
Retail Topics and Issues

  1. Accruals or reserves for sales returns and allowances are common in the retail industry. Retailers recognize that some sales are eventually returned for refund.

  2. Accruals or reserves for consumer sales incentives are common in the retail industry. Retailers use sales incentives such as price rebates, discounts, store coupons, loyalty points, and other promotional incentives as marketing tools to stimulate consumer spending and retain customer patronage. Sales incentives, which may be offered on a limited or continuous basis, provide retailers with opportunities to build price flexibility into their marketing strategies.

  3. Accruals or reserves to set aside funds for future expenses, losses, claims, and other liabilities are common in the retail industry. Common reserves include allowances for doubtful accounts and self-insurance reserves. Retailers typically self-insure for a number of risks including worker’s compensation, employee health care related benefits, automobile liability, product and general liability up to certain maximum liability amounts. General liability costs relate primarily to litigation that arises from store operations. Liabilities associated with risks retained by retailers are usually estimated considering historical claims experience, frequency and severity, a change in factors such as the business environment, benefit levels, medical costs, the regulatory environment and other actuarial assumptions. Third party coverage is usually obtained to limit exposure to these claims.

  4. Reserves for the estimated cost to close stores before lease expiration are common in the retail industry. Retailers close stores before lease expiration when they believe these locations are not generating acceptable profit levels. These reserves are generally established at the time a decision is reached to close such stores.

  5. Deferral of prepaid income items beyond the point of sale is common in the retail industry. Common prepaid income items include the sale of gift cards and certificates, layaway sales, club membership fees and extended service plans offered in connection with the sale of certain products (e.g. electronics).

4.43.1.12.5  (07-23-2009)
Financial Reporting

  1. A valued principle in financial accounting is that expenditures should be recognized in the same period as the income to which they relate.

  2. Costs and expenses directly identifiable with specific revenues are recognized in the period in which the revenues are recognized.

  3. Expenditures that produce benefits lasting multiple periods are treated as creating assets (for example tangible or intangible assets having an estimated useful life beyond one year, prepaid insurance, rent). The cost of these assets is allocated in a systematic manner over the actual or anticipated life of the assets so as to offset revenues over that period.

  4. If expenses give rise to a benefit that is exhausted in (or shortly after) the period in which paid or incurred, or if the period to which expenses relate is indeterminable, expenses are recognized when cash is paid or a liability incurred.

  5. If the precise amount of any costs or expenses is not determinable at the time they are chargeable against income, they should be recognized on the basis of reasonable estimates. Costs and expenses which cannot be determined with a reasonable degree of accuracy at the time they would otherwise be charged against income of a particular period should be deferred until such determination is possible.

  6. Liabilities and loss contingencies are recorded when it is probable that an asset is impaired or a liability incurred by the financial statement date and the amount is reasonably estimated. Examples include uncollectible receivables, product warranty costs, and pending or threatened litigation claims.

  7. Obligations associated with the retirement of long-lived tangible assets are recognized when incurred based on law, contract, or another identifiable event.

  8. Losses related to the impairment of long-lived assets are recognized when expected future cash flows are less than the asset’s carrying value. At the time a retailer closes a store or because of changes in circumstances that indicate that the carrying value of an asset may not be recoverable, a retailer will evaluate the carrying value of the asset in relation to its expected future cash flows.

4.43.1.12.6  (07-23-2009)
Retail Topics and Issues

  1. Retailers typically set aside funds for future anticipated expenses, losses, claims, and other liabilities. These accrued liabilities usually represent provisions for costs that are not immediately payable because the accounting period and the contractual or obligatory period do not coincide. For financial reporting, the accrued liabilities are recorded because the related expense has been incurred during the accounting period. The accruals usually require computation and are seldom substantiated currently or later by a specific invoice as in the case of accounts payable.

  2. Retailers typically defer income recognition of prepaid income items until earned. Alternatively, retailers may allocate a part of the total sales price of goods to reserves for future expenses.

  3. Tax accrual accounting generally results in an earlier reporting of income items and a later reporting of expense items than financial accrual accounting.

  4. The courts have applied several factors to deny a taxpayer's deductions for future estimated expenses and the resulting deferral of income. These various factors are reflected and embodied in the all events test. The regulations, which set forth the all events test for the accrual of deductions and the accrual of income, use nearly identical language in describing the test. For income accrual, Treas. Reg. 1.451-1(a) provides that income is includible in gross income "when all events have occurred which fix the right to receive income." For deduction accrual, Treas. Reg. 1.461-1(a)(2)(i) provides that "a liability is incurred, and generally taken into account for federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of liability." Compare IRC 451(a) and IRC 461(a), and see IRC 446.

  5. While technical distinctions exist between deferring prepaid income and deducting estimated future expenses, the net result is the same, and the same tax accounting principles should be applied to both items. Three Supreme Court decisions illustrate this principle and other principles discussed in this section of the manual. See Automobile Club of Michigan v. Commissioner, 353 U.S. 180 (1957); American Automobile Association v. United States, 367 U.S. 687 (1961); Schlude v. Commissioner , 372 U.S. 128 (1963).

4.43.1.12.6.1  (07-23-2009)
Sales Returns and Allowances

  1. Most retailers permit merchandise returns from customers under certain circumstances. Consequently, most retailers establish a reserve for sales returns and allowance. Technically, sales returns and allowances represent two distinct types of transactions, but are generally reported on the same tax return line. Sales returns occur when customers return defective, damaged, or otherwise undesirable products to the retailer. Sales allowances occur when customers agree to keep such merchandise in return for a reduction in the selling price.

  2. Most retailers, which have a December or January tax year end, earn a significant proportion of sales and operating income during the months of November and December. Retailers anticipate that a portion of these sales will be returned. Consequently, retailers normally record gross income net of actual and estimated sales returns and allowances.

  3. The corresponding entry for sales returns and allowances recorded as a deduction from sales or cost of sales is a credit to an accrued liability rather than as a deduction of an asset or a liability. This liability may be recorded to more than one account in the general ledger.

  4. The liability for sales returns and allowances represents the consumer purchases expected to be returned after the end of the accounting period. The estimate typically takes into account the retailer’s historical experience, current sales trends and other factors in the period in which the related goods and services are sold. The accrual is sometimes made by taking a percentage of year-end sales. Accruals for sales returns and allowances are common in the retail industry.

  5. There are many variations used to post accruals, but some common variations are:

    1. Adjusting journal entries debiting returns/allowances and crediting receivables directly without the use of a reserve account, or

    2. When reserves are credited, the corresponding debits are to either expense accounts or cost of sales.

  6. The primary audit consideration is whether the retailer accelerated a deduction for a future estimated expense. The issue is complicated by the fact that some accruals are proper for financial statement purposes, but not for tax purposes. Although a retailer can reasonably estimate its sales returns and allowances, until the merchandise is actually returned this amount is contingent and thus not deductible. Liabilities for sales returns and allowances should not be deductible until the goods have actually been returned or the allowances actually made.

  7. The examiner should consider the following audit techniques to address the issue of sales returns and allowances:

    1. Review Schedule M to identify book/tax differences reported for timing adjustments.

    2. Review Schedule L and general ledger accounts for returns and allowances and compare to Schedule M detail.

    3. Scan the general ledger account(s) for unusual entries or multiple entries made near the end of the fiscal year.

    4. Ask the retailer how the returned merchandise is booked back into inventory. While there usually is a system in place for actual returns, the taxpayer will probably not reduce cost of goods sold and increase ending inventory for accrued or anticipated returns.

    5. Ask the retailer to identify their refund policy. In particular, the examiner should identify whether the retailer issues cash refunds or credit vouchers/gift cards.

4.43.1.12.6.2  (07-23-2009)
Cash Rebates

  1. A rebate is one type of sales incentive offered to consumers to increase the odds of a product being purchased. Retailers regularly offer rebates as a sales incentive with the result that rebates have been offered on just about every product. Rebates may be offered in lieu of immediate discounts on the assumption that the customer will fail to take advantage of the rebate that prompted the actual purchase. For example, a consumer may be unwilling to purchase a product advertised for $149.99, but willing to purchase the product for $99.99 after rebate.

  2. Under a typical cash rebate program, customers pay the full price for a product at the point of sale, while also receiving a rebate offer for a stated amount. To receive a rebate, customers fill out the information required by the offer (e.g. rebate form), and otherwise comply with the terms of the rebate offer (e.g. UPC from the merchandise, copy of sales receipt) within the specified period of time. The retailer then issues the customer a check in the amount of the rebate offer. If the customer does not meet the terms of the offer, the rebate is not paid. The time between a customer’s submission of the required paperwork and the retailer’s mailing of the rebate check is usually not less than 60 days.

  3. The liability for rebates represents the consumer purchases for which the retailer expects to make a rebate payment after the end of the accounting period. The estimate typically takes into account the retailer’s historical experience, current sales trends and other factors in the period in which the related goods and services are sold. The accrual is sometimes made by taking a percentage of year-end sales. The corresponding entry for the debit to sales (or cost of sales) is a credit to an accrued liability. This liability may be recorded to more than one account in the general ledger. Retailers subsequently make adjustments to their gross receipts to account for expiring rebates and the difference between properly submitted rebates and estimated rebates.

  4. If the amount of future rebates or refunds cannot be reasonably and reliably estimated, a liability or deferred revenue should be recognized for the maximum potential amount of the refund or rebate (i.e., the liability should be recognized for all customers buying the product subject to the rebate). The ability to make a reasonable and reliable estimate of the amount of future rebates or refunds depends on many factors and circumstances that will vary from case to case. For financial reporting purposes, the following factors may impair a retailer's ability to make a reasonable and reliable estimate:

    1. Relatively long periods in which a particular rebate or refund may be claimed.

    2. The absence of historical experience with similar types of sales incentive programs with similar products or the inability to apply such experience because of changing circumstances.

    3. The absence of a large volume of relatively homogeneous transactions.

  5. The primary audit consideration is whether the retailer accelerated a deduction for a future estimated expense. The issue is complicated by the fact that some accruals are proper for financial statement purposes, but not for tax purposes. Although a retailer can reasonably estimate its cost of rebate payments, until the claims are filed by customers the amount is contingent and therefore not deductible.

  6. Treas. Reg. 1.461-4(g)(3) provides that in the case of a taxpayer who is liable to pay a rebate, refund, or similar payment to another person, economic performance occurs when payment is made to the person to whom the liability is owed. The most objective evidence of economic performance for a rebate is payment. Payment provides certainty for taxpayers and is administrable by the IRS. Cash rebates cannot be treated as premium coupons under Treas. Reg. 1.451-4. A single-coupon rebate is a discount coupon and not ordinarily considered a "premium coupon" (or trading stamp) within the meaning of Treas. Reg. 1.451-4.

  7. If the liability of a taxpayer is to pay a rebate, refund, or similar payment to another person (whether paid in property, money, or as a reduction in the price of goods or services to be provided in the future by the taxpayer), economic performance occurs as payment is made to the person to whom the liability is owed. Treas. Reg. 1.461-4 (g)(3) applies to all rebates, refunds, and payments or transfers in the nature of a rebate or refund regardless of whether they are characterized as a deduction from gross income, an adjustment to gross receipts or total sales, or an adjustment or addition to cost of goods sold. In the case of a rebate or refund made as a reduction in the price of goods or services to be provided in the future by the taxpayer, payment is deemed to occur as the taxpayer would otherwise be required to recognize income resulting from a disposition at an unreduced price.

  8. IRC 461(h)(3) and Treas. Reg. 1.461-5(b)(1) provide a recurring item exception to the general rule of economic performance. A retailer may not treat an obligation to pay cash rebates as incurred on the date a product was sold using the recurring item exception of IRC 461(h)(3), however, because liability to pay is not fixed until the customer complies with the rebate requirements. The mailing by a customer of a properly completed rebate form and attachments is the event that fixes liability, and the all events test is satisfied at that time. Under the all events test of IRC 461(h), a liability of an accrual method taxpayer is incurred, and is generally taken into account for federal income tax purposes, when all the events have occurred that establish: (1) the fact of the liability, (2) that the amount of the liability can be determined with reasonable accuracy, and (3) that economic performance has occurred regarding the liability.

  9. Treas. Reg. 1.461-4, specifically 1.461-4(g)(3), supports the conclusion that a taxpayer should not be deducting estimated redemptions from income for federal tax purposes until all the events have occurred which establish that it will actually have to pay the rebate, that is, until payment is made pursuant to the purchaser’s timely compliance with the terms of the rebate offer.

  10. This conclusion is consistent with the case of United States v. General Dynamics Corp., 481 U.S. 239 (1987) in which the Supreme Court ruled that the filing of claims was a condition precedent to liability for an accrual basis taxpayer providing medical benefits to its employees. The taxpayer could not deduct an estimate of its obligation to reimburse its employees for the costs of medical care. The last event necessary to fix the liability was the receipt of properly documented claim forms, and the fact that the taxpayer may have been able to make a reasonably accurate actuarial estimate of how many claims ultimately would be filed did not justify a deduction.

  11. A key consideration with cash rebates, rebate coupons, and similar items is the fact that the action of the consumers presenting their claims or coupons for redemption and acceptance by the retailer or its third party administrator is not a meaningless step to establishing the retailer’s liability. The actions are not ministerial, but rather necessary to meet the all events test. The possibility that consumers will not file a claim or redeem a coupon is more than remote.

  12. The examiner should consider the following audit techniques to address the issue of cash rebates:

    1. Review Schedule M to identify book/tax differences reported for timing adjustments.

    2. Review Schedule L and general ledger accounts for returns and allowances and compare to Schedule M detail.

    3. Scan the general ledger account(s) for unusual entries or multiple entries made near the end of the fiscal year.

4.43.1.12.6.3  (07-23-2009)
Discount Store Coupons

  1. A discount store coupon, which is ordinarily redeemable individually, is a sales promotion device used to encourage the purchase of a specific product by allowing a purchaser of that product to receive a discount on its purchase price. The discount may be in the form of a percentage off, an amount off, or buy one and get one free. Conventional wisdom maintains that coupon discounts promote sales by lowering the economic cost to the consumer. An increase in sales is expected to make up for the reduced profitability of a single transaction. Discount store coupons are a long-standing promotional tool in the retail industry.

  2. For example, a retailer distributes a coupon in the local Sunday paper offering $300 off the price of a certain brand of computer. The retailer will not be reimbursed by the manufacturer for the reduction in the selling price resulting from the customers’ use of coupons. In this case, the coupon should be recognized at the time of sale of the computer to customers.

4.43.1.12.6.4  (07-23-2009)
Premium Coupons and Trading Stamps

  1. A premium coupon usually is issued in connection with the sale of some item and entitles the holder to redeem it in exchange for a product, often selected from a catalog, of the customer’s choosing. These coupons are used to promote the sale of the product with which the coupon is issued by allowing the consumer to collect coupons in order to acquire a different product of his or her own choosing.

  2. Treas. Reg. 1.451-4 provides for a different tax treatment for certain narrowly defined coupon programs. If an accrual basis retailer issues a coupon with a sale and such coupons are redeemable by consumers in merchandise, cash or other property, the taxpayer will be allowed a deduction for estimated redemption reserves. Rev. Rul. 78-212 explains that a taxpayer may deduct reserves only if the coupons are redeemable without any additional consideration from the consumer. Trading stamps or premium coupons must be unconditionally redeemable in merchandise, cash, or other property, without additional consideration.

  3. Many traditional coupon programs do not qualify under Treas. Reg. 1.451-4. For example, coupons that merely provide discounts on subsequent purchases do not qualify.

  4. Whether a coupon is a premium coupon or a discount coupon is determined by taking into account all of the facts and circumstances involving its issue and redemption. The exclusion may be available for certain targeted incentives used as part of special promotions or to build store traffic, such as frequent buyer-type programs rewarding selected customers with redeemable store credits for future purchases.

  5. Treas. Reg. 1.451-4(c)(2) provides for the utilization of prior redemption experience. If a retailer does not have sufficient redemption experience to make a reasonable determination of its estimated future redemption, or if because of a change in its mode of operation or other relevant factors the determination cannot reasonably be made completely on the basis of the retailer’s own experience, the experience of similarly situated taxpayers may be used to establish an experience factor.

  6. Treas. Reg. 1.451-4(c)(5) provides for the utilization of a 5-year rule as a permissible method of determining the estimated redemption percentage for a taxable year. This method determines the percentage which the total number of stamps redeemed in the current and 4 preceding taxable years bears to the total number of stamps issued in the 5-year period, and multiplies such percentage by an appropriate growth factor.

  7. Treas. Reg. 1.451-4(d) and (e) provides for consistency between financial reporting and information to be furnished with a return.

  8. The examiner should consider the following items if the retailer cites Treas. Reg. 1.451-4 to defer recognition of the full sales price of a product:

    1. Does the sales incentive program meet the criteria for a deduction under Treas. Reg. 1.451-4?

    2. Is the computation of estimated future redemption correct?

    3. Is the computation of cost correct?

4.43.1.12.6.5  (07-23-2009)
Loyalty (Reward) Programs

  1. Membership-based loyalty programs have long been an integral part of many companies' incentive and customer relationship management programs. Loyalty programs currently operating in the United States serve businesses as varied as retailers, telecommunications companies, airlines, hotels, automobile rental companies, and credit card issuers. Internet merchants and content providers also are increasingly launching and testing loyalty programs in an effort to retain their most valuable customers.

  2. The general purpose of a reward or loyalty program is to attract customers, build repeat business, and increase sales volume. Although multiple program permutations exists, under many retail loyalty programs, each time a customer or program member purchases a product or service, he or she earns points. Reward points are accumulated as some percentage of purchases. Once a specified minimum threshold is reached, a customer receives a reward card or certificate that can be used to purchase any item in a store, or sometimes online, for discounted merchandise or services. The reward card or certificate generally has no cash value and expires within one year or less of issuance. Frequent buyer type programs reward selected customers with redeemable store credits for future purchases. For example, a coupon is mailed with a billing statement to store credit card customers entitling them to free merchandise or a gift.

  3. For financial reporting purposes, retailers generally record a current liability for the estimated cost of anticipated redemptions, and the impact of adjustments to the liability is recorded in cost of sales.

  4. For tax reporting purposes, the proper tax treatment of points awarded customers is uncertain. The unsettled question is whether Treas. Reg. 1.451-4 or Treas. Reg. 1.461-1(a)(2) controls with respect to these programs. Treas. Reg. 1.461-4(g)(3) addresses the tax treatment of rebates and refunds and provides that economic performance occurs as payment is made to the person to whom the liability is owed. Treas. Reg. 1.451-4 addresses the redemption of trading stamps and premium coupons and provides that the estimated redemption costs of premium coupons issued in connection with the sale of merchandise may be deducted in the year of the merchandise sale even though reserves for future estimated redemption costs are not fixed and determinable and do not otherwise meet the economic performance rules of the all events test. This latter section provides a narrow regulatory exception to the all events test.

  5. Applying IRC 461 to loyalty points, one can argue that because not all club members redeem their points, all events have not occurred to fix the liability and no deduction should be allowed until the points are actually redeemed. Under this reasoning, the last event fixing the retailer’s liability occurs when a club member reaches the minimum number of points for redemption and actually redeems the points.

  6. The following issues may arise from a retailer’s accounting for its loyalty or reward program:

    1. When are future redemption costs deductible? In the year in which points are issued with sales or in the year in which the reward certificates are redeemed?

    2. How is the estimated future redemption rate determined?

    3. How is the minimum threshold accounted for in computing the estimated future redemption rate? Are points considered on a customer-by-customer basis, or aggregated for all customers in applying the minimum threshold to the computation?

    4. What is the cost of a point?

    5. Whether the retailer’s customers have a conditional or unconditional right to redemption.

4.43.1.12.6.6  (07-23-2009)
Allowance for Doubtful Accounts

  1. At the point of sale, a retailer is exposed to credit risk that the customer will not settle an obligation for full value. Checks may be returned if the payer’s institution chooses not to honor the presentation because of insufficient funds, forgery, fraud, or other payment irregularities. Bankcards have specific procedures for charge backs, which are amounts disputed by the cardholder and "charged back" or reversed out of the retailer’s account.

  2. The ordinary risks of nonpayment, which are present in all contractual business relationships, do not prevent accrual. The issue is the likelihood of ultimate payment, not whether the obligor is able to pay either at the time of entering into the agreement or at the time the amount is otherwise due.

  3. An estimate relevant to the retail industry that is significant to reported gross income is the allowance for doubtful accounts. An adequate allowance for doubtful accounts assumes increasing importance in a slow economy experiencing consumer loan payment delinquencies, and bankruptcies.

  4. Retailers establish a reserve for bad debts for all probable losses from accounts receivable. The reserve is normally based upon a percent of sales.

  5. The collectibility of accounts receivable is based on a combination of factors, including an analysis of historical trends, aging of accounts receivable, write-off experience and expectations of future performance. An account is generally considered delinquent if more than one scheduled minimum payment is missed.

  6. Delinquent accounts are generally written off automatically after the passage of 150 to 210 days without receiving a full scheduled monthly payment. Accounts are written off sooner in the event of customer bankruptcy or other circumstances that make further collection unlikely.

4.43.1.12.6.7  (07-23-2009)
Store Closing Reserves

  1. Retailers generally have significant investments in property and store-related assets. Retailers will close stores under long-term leases that do not meet profitability targets before lease expiration to improve the company’s bottom line. While ownership of store-related assets varies significantly among retailers, the impact of asset impairment and charges resulting from store closure is similar and often significant.

  2. In the event a store closes before a lease expires, retailers usually record a liability for store closing when the decision is made to close the store. Some retailers record a liability at the time of store closure. Store closings generally are completed within 1 year after a decision is made to close. The reserve segregates losses expected to be incurred as a result of store closures from the remainder of the retailer’s operations. Store lease exit costs are included as a component of operating and administrative expense and the liability may be recorded in accrued expenses and other liabilities.

  3. The store closing reserve includes an estimate of the following costs:

    1. The operating losses of the store through the anticipated closing date

    2. The loss on the sale or abandonment of the leasehold improvements, fixtures, and equipments

    3. The present value of future minimum, non-cancelable lease payments and related lease costs (e.g. real estate taxes, common area maintenance) from the date of closure through the end of the remaining lease term

    4. The lease termination costs

    5. The severance or relocation benefits of the employees at the store

    6. A write-off of the inventory at the store

    7. Third party liquidator costs

    8. Other costs incidental to store closings

  4. The store closing reserve takes into account any anticipated cost recoveries. Cost recoveries may be achieved through subletting or favorable lease terminations. The amounts are discounted using a risk-adjusted rate of interest.

  5. A retailer’s calculation of its store closing liability contains uncertainties because it requires management to make certain assumptions and apply judgment to estimate the timing and duration of future vacancy periods, the amount and timing of future settlement payments, and the amount and timing of potential future sublease rental income. When making these assumptions, retailers consider a number of factors, including historical settlement experience, the owner of the property, the location and condition of the property, the terms of the underlying lease, the specific marketplace demand and general economic conditions.

  6. Adjustments to closed store liabilities primarily relate to actual costs differing from original estimates. Adjustments are made for changes in estimates in the period in which the change becomes known. Any excess store closing liability remaining upon settlement of the obligation is reversed to income in the period that such settlement is determined.

  7. The potential compliance risk for store closing reserves is whether a retailer may deduct losses upon closure of a store that has not been sold or otherwise disposed of by the end of the tax year.

  8. For financial reporting purposes, FASB 144 (impairment of long-lived assets) requires an entity to recognize a loss when a long-lived asset’s income stream ceases.

  9. For tax accounting purposes, Treas. Reg. 1.167(a)-8 (abnormal retirement) provides that no loss is allowed until the property is disposed of, retired, or permanently withdrawn from the business. The mere closing of a store is not an event that qualifies as an actual disposition for tax purposes. The retailer is entitled to claim depreciation until the property is sold or otherwise disposed of. See IRM 4.43.1.9.6.13.

  10. The examiner should consider the following items in examining this issue:

    1. With respect to inventory, the examiner should allow a normal mark down to market, but not allow any inventory mark down made simply because a store closes. If market value has not declined, the loss should be reflected only when the goods are sold. If the goods are the same as those being offered for sale at other stores, then the inventory is being marked down only to save the retailer the expense of shipping it to another store.

    2. With respect to other estimates, the examiner should adjust any estimates to actual costs incurred before the deduction is allowed.

    3. With respect to assets written off, the examiner should verify that the assets were actually abandoned and disposed of and that the retailer did not transfer the assets to another location or to storage.

    4. With respect to leases written off, the examiner should verify that the leases were actually terminated and that the retailer is not trying to sublet the property. If a reserve was deducted in a prior year not under examination, the examiner should verify that the expenses related to the closing are being charged against the reserve and not being deducted again when incurred or paid. The examiner should also verify to see that any excess reserve amounts previously deducted were brought back into income.

4.43.1.12.6.8  (07-23-2009)
Product Warranties/Service Contracts

  1. A retailer that services its own product warranties and/or service contracts, may offer its customers a business arrangement to repair or replace property due to an inherent defect in that property in connection with the sale of certain products (e.g. electronics). In this situation, a retailer may claim an estimate of future repair costs at the time a product with a warranty or a service contract is sold on the basis that the existence of defects and its contractual obligation to correct those defects together fix its warranty liability at the time the product is sold to the customer. The retailer reasons that any future payments made for warranty repairs arise out of the enforceable promise made at the time of the initial sale, and out of a defect in materials or workmanship existing at the time of such sale.

  2. An obligation to honor warranties involves uncertainty. Financial reporting still requires the accrual of warranty expense and related liabilities if it is probable that customers will make claims under the provisions of the warranty and the amount of those claims can be estimated. A retailer may estimate its warranty liabilities based on its experience of extending warranties or the experience of other firms in the retail industry. The probability and amount of warranty claims may be considered on a sale-by-sale basis or as they relate to classes of products. The fact that the customers who will ultimately present warranty claims are unknown at the point of sale does not affect this requirement.

  3. For tax reporting purposes, a retailer’s warranty liability is contingent rather than fixed at the point of sale. At the time of sale, the retailer does not know when a customer may demand that it perform services. Unrealized or anticipated losses cannot be deducted, except where there are statutory provisions for deduction, such as a reserve for estimated inventory shrinkage.

  4. In circumstances involving an agreement for the performance of services, the performance of the services is, generally, the event that establishes the fact of liability. Consequently, a retailer should accrue a liability for repairs under a warranty when the repair services are provided. At the time the repair services are provided, the fact of the liability has been established, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. This conclusion is consistent with case law regarding future repair costs.

4.43.1.12.6.9  (07-23-2009)
Self Insurance

  1. Neither the Internal Revenue Code nor the regulations define the terms insurance or insurance contract. In Helvering v. LeGierse, 312 U.S. 531 (1941) explained that in order for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present. The risk transferred must be risk of economic loss. The risk must contemplate the unexpected occurrence of a stated contingency and must not be merely an investment or business risk.

  2. Retailers with a large number of store locations and employees have a high risk of exposure to fire, tort liabilities, worker’s compensation claims, and other hazards. To minimize the cost of insurance premiums, retailers frequently use a combination of insurance and self-insurance. Insurance policies often have a large deductible. Self-insurance reserves usually include both claims filed and claims incurred but not yet reported.

  3. Retailers purchase self-insurance policies for many types of coverage, including auto, general liability, product liability, worker’s compensation, business interruption and other coverage.

  4. Retailers use their best estimate to record the remaining cost to settle self-insured liabilities and losses. The estimated accruals are usually based on the frequency and severity of historical claims, the regulatory environment, changes in factors such as the business environment, benefit levels, medical costs, demographic factors, and other actuarial assumptions. These insurance arrangements also may be known as cash flow plans, excess loss coverage and other names. The contracts generally contain the following terms and conditions:

    1. Premiums are based on the experience of the insured during the policy period.

    2. The self-insured part of the premium is not due until claims are filed or until the insurance company pays the claims.

    3. A basic premium covering the insurance company's charge for administrative expenses, profit, contingencies, and the risk of loss that would result to the insurance company if the self-insured premium calculated under the formula exceeds the maximum limitation specified in the self-insured endorsement.

    4. An excess loss premium representing the insurance company's charge for covering any losses that exceed a stated limit.

    5. The self-insured part of the premium will be changed if loss experiences are different than expected.

    6. The policy generally covers a period of one year.

    7. Payments or refunds relating to a policy may be made years after the end of the policy year.

  5. Treas. Reg. 1.162-1(a) provides that among the items included in business expenses are insurance premiums against fire, storms, theft, accident, or other similar losses in the case of a business. While the cost of insurance premiums is recognized as an ordinary and necessary business expense, the IRS has consistently held that an amount set aside as a reserve for self-insurance, though equal to commercial insurance premiums, is not deductible under IRC 162 as an insurance premium. Self-insurance reserves lack the attributes of deductible insurance premiums, not only because there is no risk-shifting with respect to these amounts, but because the taxpayer retains the funds in its own possession and the reserves are merely accruals for future contingent liabilities. See Rev. Rul. 79-338. The fact that a retailer chooses to self-insure or underinsure against business risks does not, in itself, indicate that a loss has occurred.

  6. An accrual method retailer that is self-insured for worker’s compensation liabilities will usually claim a deduction for the amount of filed and uncontested claims. Under IRC 461(h)(2)(C), the IRS maintains that no deduction is allowable until a claim is settled and the claimant is actually paid.

  7. A policy may show a standard annual premium that is accrued by the taxpayer as a current expense; however, separate premium payment agreements and/or endorsements may reveal terms described above.

  8. The amount ultimately payable by the taxpayer under the self-insured arrangement is based on the actual losses of the taxpayer for that period, and where no risk of loss is shifted or distributed by the taxpayer, the portion of the amount billed that represents an estimate of losses expected to be incurred by the taxpayer is not an insurance premium deductible under IRC 162.

  9. In order to obtain a deduction under IRC 162 for amounts billed under the self-insured policy, taxpayer must establish the portion of the amount billed that is attributable to the insurance elements of the arrangement.

  10. Unpaid premiums that have been accrued will generally be found in the accrued insurance, other current liabilities, accrued protection expense, or some other general liability account. The composition of the accrual will be the cumulative excess of the estimated liabilities over the amounts paid for all open policy years.

  11. Retailers may be required to maintain a deposit with the insurance company to cover payments to claimants that are not due and owing. The insurance company considers the deposit a liability due to the insured. As a result, no deduction is currently allowable for the deposit.

  12. The examiner should consider the following audit techniques when indications of self-insurance is present:

    1. Review insurance policies to obtain policy and funding schedules.

    2. Verify coverage for each type of insurance to determine deductibility and areas of self-insurance.

    3. Trace source and payment of deductibles. Also trace payment for policies beyond the broker.

    4. If the retailer does not have a specific liability account for self-insured losses, the examiner should review the prepaid insurance account for unusual credits. These credits may represent reserves rather than the amortization of prepaid premiums.

    5. Some insurance companies provide rebates or reduce future premiums if a customer makes very few claims. This is known as retrospective rate insurance. If the examiner identifies such a rebate, he/she should verify that the income or offset to expense is recorded when it is earned. Some retailers may not book this as income until it has been received.

    6. Interview the taxpayer's risk management personnel to determine when the deposits are made. Obtain explanations for policy terms and the amount of interest earned on the account.

    7. Review Schedule M adjustments for offsets to the prepaid liability insurance account. The reserve is deductible for financial purposes but not for tax purposes.

4.43.1.12.6.10  (07-23-2009)
Accrued Taxes

  1. Many taxes, particularly property taxes, accrue on one date in the year when some definite event occurs, such as when the tax becomes a lien on the property, or personal liability for the tax arises, or some other definite event occurs.

  2. A deduction for specified taxes is generally allowed in the year in which they are paid or incurred under the rules of IRC 461. An exception to the all events test provides that any acceleration rule enacted after 1960 is not taken into account.

  3. Treas. Reg. 1.461-4(g)(6)(i) provides, in part, that if the liability of a taxpayer is to pay a tax, economic performance occurs as the tax is paid to the governmental authority that imposed the tax.

  4. Economic performance occurs as a tax is paid. The IRS asserts that economic performance for sales tax liability occurs only when the company makes payments in satisfaction of the liability.

  5. Real property taxes for most jurisdictions are accrued over the calendar year in which the lien date falls. Real property taxes for California are accrued over the fiscal year of the taxing jurisdiction.

  6. Some taxes may be taken into account in the year before payment under the recurring item exception. Real property taxes may be accounted for under the recurring item exception to the economic performance rules under IRC 461(h)(3) and Treas. Reg. 1.461-5(b)(1). The effect of these rules is to require taxpayers to pay any tax within 81/2 months of the close of the taxable year in which the all events test was met in order to be able to use the recurring item exception.

    1. For example, a personal property tax of $10,000 is imposed on a taxpayer, the lien for the tax attaching January 1, 2009, and the tax being paid is $6,000 on December 1, 2009 and $4,000 on July 1, 2010. The tax deductible amount is $6,000 in 2009 and $4,000 in 2010, unless the recurring item exception is adopted, making the $4,000 also deductible in 2009.

  7. IRC 461(c)(1), however, grants the taxpayer the right to elect to accrue any real property tax ratably over the definite period of time to which the tax is related. An election to accrue real property taxes ratably under IRC 461(c) is binding upon the taxpayer unless permission is secured to change the method of deducting real property taxes. Many retailers deduct property taxes in the year in which the lien is fixed provided the taxes are paid within 81/2 months after tax year end rather than accruing over the period to which the tax relates.

4.43.1.12.6.11  (07-23-2009)
Deferred Rent/Lease Credits

  1. Retailers usually anticipate remodeling leased space in some way and installing their own trade fixtures. As lessees, retailers are responsible for the build-out or finishing work of leased space they will occupy. Tenant improvement costs often represent a significant percentage of the total value of a retail lease. Negotiation of a construction allowance is a major part of many lease transactions. The purpose of a construction allowances is to offset the construction costs to the leased space. Allowances are normally based upon the square footage of the building and rarely exceed the tenant’s construction costs.

  2. For financial reporting purposes, leasehold improvement incentives are recorded in other current liabilities and other long-term liabilities. A receivable and liability (e.g. accrued rent, deferred rent credit) are normally recorded at the lease commencement date (date of initial possession of the store). The liability account(s) deferred rent credit is amortized on a straight-line basis as a reduction of rent expense over the term of the lease (including the pre-opening build-out period) and the receivable is reduced as amounts are received from the landlord. The deferred rent credit at tax year end represents the unamortized portion of construction allowances received from landlords related to a retailer’s stores.

  3. The primary audit consideration is whether the taxpayer receives an accession to wealth from the receipt of a construction allowance.

  4. The determining factor in the tax treatment of construction allowances and improvements is the tax ownership of the leasehold improvements. Tax ownership is distinct from legal ownership.

    1. If the tenant owns the improvements, the allowance is treated as income to the tenant and the tenant must depreciate the costs of the improvements over a 39-year period and the landlord should amortize the allowance ratably over the lease term.

    2. If the landlord owns the improvements, then the allowance (assuming it is all applied to costs of the real estate improvements) is not treated as income to the tenant and the landlord depreciates the cost of the improvements over a 39-year period.

4.43.1.12.6.12  (07-23-2009)
Deferred Revenue

  1. Once a retailer receives an income item, it must decide whether to give it tax effect at that time.

  2. Prepaid income items are amounts received before the retailer provides the corresponding consideration (e.g. goods or services).

  3. The tax consequences of income received in advance of selling goods or providing services has been an area of conflict between financial accounting standards and tax principles for many years.

  4. For undisputed prepaid income items, the primary issue is when the prepaid income item is taken into account. As a general rule, while the IRS maintains that the prepaid income is includible in gross income in the year of receipt, the retailer maintains that the prepaid income may be deferred beyond the year of receipt.

  5. In the context of the retail industry, prepaid income items typically occur in the ordinary course of business rather than a single transaction arranged to achieve a specific tax objective.

  6. IRM 4.43.1.4 provides general background information about gross income items reported by taxpayers in the retail industry as well as the general accounting practices for such items. Please refer to this section for more specific information about specific income items.

4.43.1.12.7  (07-23-2009)
Audit Techniques

  1. The primary audit consideration for accrued liabilities is the timing of the recognition of the related expense or the prepaid income. The examiner should concentrate the audit of liabilities on the identification of liabilities which create the premature deduction of the related expense. A premature deduction of unpaid costs and expenses can relate to a contingency or contest. The liability may be an estimate of an anticipated future payment. Contingencies include existing conditions, situations, or sets of circumstances that involve a degree of uncertainty as to whether a liability will be incurred.

  2. Procedures to test liability accounts are normally tests of the entire balance, not samples.

  3. Review Schedule M to determine which liabilities were reported differently for financial and tax reporting purposes. For most reserves, a schedule should be prepared showing the beginning and ending balances. If the reserve increases during the year, a Schedule M adjustment should be reported to increase taxable income. If the reserve decreases, a Schedule M adjustment should be reported to decrease taxable income.

  4. Scan liabilities reported on the balance sheet and supplemental schedules for accruals that may not be fixed under the all events test. Consider the description of the entries and titles of the accounts. Words such as advanced, estimated, anticipated, or reserve can be an indication of an accelerated deduction for tax reporting purposes.

  5. Identify general ledger accounts which report:

    1. Credit balances associated with the receipt of payments for future services. The payments may have been improperly deferred for tax reporting purposes.

    2. Long overdue balances. The liability may have ceased to exist for various reasons.

    3. Round or even balances (e.g. $500,000). The liability may represent a reserve for an estimated future expense. A computer audit specialist can assist the examiner with the analysis of potential reserve accounts or expense accounts by listing all postings that are evenly divisible by 1000 and that are above the materiality threshold. Miscellaneous Expenses and Other Liabilities accounts are frequently used to account for management reserves.

    4. Debit balances. The liability may represent deferred income.

    5. Significant year-end journal entries. Audit adjustments made to accrued expenses often come from these entries. Indications of a potential issue are postings of accruals for future months and two postings for the same expense in one month where one is not identified as a correcting entry.

    6. Unusual entries (e.g. entries that are contrary to normal entries for that account)

    7. Trends or changes in account activity that appears contrary to reasonable expectation.

  6. Identify the method used to compute the amount reported in the liability account. Obtain proper documentation to determine the propriety of the accrual. Contract terms are relevant in determining the events that establish the fact of a retailer’s liability and whether that fact is met at tax year end. The examiner should recompute the accrued balance if the reported accrual does not agree with the terms of the arrangement.

  7. Consider the possibility that reserves may be recorded in multiple accounts. A reserve recorded to several different accounts is more difficult to identify.

  8. Consider subsequent payment of accruals for compliance with the recurring item exception. Review invoices received after tax year end to verify the amount of the accrued expense.

  9. Compare two or more accounts that are related in some essential or significant way.

4.43.1.12.8  (07-23-2009)
Other Information

  1. Additional considerations are included in this section.

4.43.1.12.8.1  (07-23-2009)
Estimated Expenses

  1. A basic conflict exists between the financial and tax treatment of estimated liabilities. While financial accounting is hospitable to estimates, tax accounting principles generally do not allow the use of estimates.

  2. For financial reporting, any liability that can be reasonably estimated by using such criteria as past experience and current economic conditions should be accrued, and specific persons or amounts are not prerequisites for accrual. The financial accounting position on accrual of liabilities is taken in the interests of conservatism and a proper matching of revenue and expense.

  3. For tax accounting, in order for a liability to be deductible, the liability must be firmly established. An estimated expense cannot be deducted even though a prudent business person requires the establishment of a reserve. The tax accounting position is that estimated expenses are not based on the incurrence of actual expenses, but rather they are based on predicted expenses.

  4. A case involving the deduction of the estimated cost of a number of claims was Supermarkets General Corporation v. United States, 537 F.Supp. 759 (D.N.J. 1982). The taxpayer operated a chain of supermarkets and had insurance for personal injury and property damage claims that stipulated that the taxpayer was responsible for the first $10,000 per incident up to a maximum amount each year, based on the taxpayer's sales. This amount was referred to as a self-insurance ''cap.'' At each year-end, the satisfied and/or estimated claims always exceeded the ''cap.'' The court stated, ''[f]rom the vantage point of hindsight, it cannot be disputed that the plaintiff actually expended the maximum amount on the claims which arose in each of those years.'' Id. at 761. Nevertheless, the court held that the ''all events'' test had not been met, as the probability of reaching the ''cap'' was not equivalent to the certainty of liability on claims that is necessary in order to meet the ''all events'' test.

  5. A number of cases involving estimated liabilities deal with the proper treatment of the estimated costs of future actions that have arisen because of activities with respect to which income has already been reported. IRC 461(h) does not apply to items covered by specific statutory provisions for reserves for estimated expenses, such as vacation pay.

4.43.1.12.8.2  (07-23-2009)
Contested Liabilities

  1. Disputes and claims may arise in the normal course of operating a retail business. From time to time, retailers are defendants in ordinary, routine litigation and proceedings incidental to carrying on a retail business. Such proceedings may relate to employment related matters, infringement of intellectual property rights of others, product safety matters, including product recalls, personal injury claims, and real estate matters related to store leases. Pending lawsuits may give rise to recognition of a loss and contingent liability when it appears probable that damages will occur and the amount of the loss can be reasonably estimated.

  2. A contested liability by definition involves a contest. Treas. Reg. 1.461-2(b)(2) defines contest as any contest preventing accrual under IRC 461(a), such as any bona fide dispute as to the proper evaluation of the law or the facts necessary to determine the existence or correctness of the amount of an asserted liability.

  3. Any affirmative act, verbal or written, denying the validity or accuracy, or both, of an asserted liability is sufficient to prove that a liability is contested. Filing a lawsuit is not necessary. No contest exists, however, unless the taxpayer takes some action indicating that it does not admit liability.

  4. For pending or threatened litigation and actual or possible claims and assessments, financial reporting requires accrual of an estimated loss if it is probable that an asset has been impaired or a liability incurred and the amount of the loss can be reasonably estimated.

  5. For contested liabilities, the basic tax reporting rule is that no deduction is allowed a taxpayer as long as the taxpayer contests a liability and the amount remains unpaid. The reason is that the liability fails the first prong of the all-events test.

  6. The primary audit consideration is whether the retailer has claimed a current deduction for a contested liability.

    1. Under the general rule, a retailer is not entitled to claim a tax deduction for a liability to the extent the liability is contested and the amount remains unpaid.

    2. Where a retailer admits liability, makes an offer in compromise, and accrues the amount of the estimated liability on its books, no contest exists and the deduction is proper, even though the exact amount is determined later.

    3. IRC 461(f) provides an exception to the general rule and allows a retailer to deduct a contested liability in the year prior to the resolution of the contest if the four conditions listed in IRC 461(f) are met. This provision does not provide an independent basis for a deduction. Rather, the provision merely affects the timing of a deduction.

4.43.1.12.8.3  (07-23-2009)
Right to Reimbursement

  1. A retailer does not incur a liability if it is entitled to reimbursement of the related expense. In this situation, a retailer is not entitled to any deduction. The most common example in the retail industry is reimbursement of cooperative advertising expenses and insurance reimbursements.

  2. When losses from fire or other casualty are insured, questions arise as to whether the loss can be determined with reasonable accuracy in the year of the casualty. If there is, on one hand, no reasonable doubt as to the amount of insurance recovery or, on the other, no reasonable expectation of any recovery, the loss is deductible in the year of casualty. If there is reasonable doubt as to whether there will be any recovery, or serious doubt or controversy as to the amount of the recovery, the loss will not be deductible until the year of settlement of the insurance claim or other determination of the amount of loss with reasonable accuracy.

4.43.1.13  (07-23-2009)
Business Expenses

  1. This section provides general background information about business expenses reported by taxpayers in the retail industry and the general accounting practices for such expenses.

  2. Retailers incur various regular and recurring everyday costs in operating their principal business of selling goods and services to end-use consumers. In general, many of the costs associated with retailing are fixed in that they are not directly associated with any particular sale, but instead are incurred whether or not any given sales transaction is consummated.

  3. Fixed costs such as advertising, administration, depreciation, equipment costs, rent, utilities and supervision help to maintain and grow the business, which includes developing, sustaining, and hopefully increasing a customer base. These costs are generally very small in relation to the size of any particular transactions involved; in fact, they constitute only a very small percentage of the expected gross profit on the transaction.

4.43.1.13.1  (07-23-2009)
Potential Compliance Risks

  1. Is the reported business expense deductible or nondeductible?

  2. If the expense is deductible, is the liability fixed and determinable? In other words, did the retailer deduct the expense prematurely?

  3. If the expense is nondeductible, is the amount reported properly on Schedule M (e.g. penalty)?

  4. If the expense is a nondeductible capital expenditure, does the statute provide for a systematic cost recovery of the expenditure?

4.43.1.13.2  (07-23-2009)
General Tax Principles

  1. IRC 162 allows a current deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

  2. IRC 263 requires capitalization for any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate or any amount expended in restoring property to its original state.

  3. Similarly, Treas. Reg. 1.461-1(a)(2)(i) provides that any expenditure which results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year may not be deductible, or may be deductible only in part, for the taxable year in which incurred.

  4. IRC 161 provides that if a cost is a capital expenditure, the capitalization rules of IRC 263 take precedence over the deduction rules of IRC 162. An expense that is judged ordinary and necessary under IRC 162 can be deducted only if it also does not trigger any of the provisions beginning in IRC 261.

  5. Treas. Reg. 1.446-1(a)(4)(ii) requires taxpayers to properly categorize items between capital and expense.

  6. In INDOPCO v. Commissioner, 503 U.S. 79 (1992), the Supreme Court held that capitalization may be required if an expenditure results in a significant long-term benefit, as well as when an expenditure directly relates to the acquisition or improvement of a separate and distinct asset.

  7. As a result of controversy from INDOPCO, Treasury and the IRS issued final regulations on the capitalization of intangibles in January 2004. Treas. Reg. 1.263(a)-4 prescribes rules for the capitalization of amounts paid or incurred to acquire or create (or to facilitate the acquisition or creation of) certain intangibles, and Treas. Reg. 1.263(a)-5 prescribes rules for the capitalization of amounts paid or incurred to facilitate an acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions.

  8. Deductions are viewed as a matter of legislative grace and taxpayers bear the burden of proving their entitlement to any deduction claimed.

4.43.1.13.3  (07-23-2009)
Key Considerations

  1. During the review of business expenses, the examiner must differentiate costs between currently deductible costs under IRC 162 and nondeductible costs prescribed under various Internal Revenue Code sections or costs that must be capitalized under IRC 263.

  2. The key to the deductibility inquiry remains the statutory language of IRC 162(a) and IRC 263(a). The differences between capital costs and ordinary costs of doing business is sometimes difficult to articulate with clarity, and that line may be difficult to draw in some situations, in part, because IRC 263(a) does not provide a complete list of nondeductible capital expenditures.

  3. In applying the statute, the courts have rejected a bright line test, finding that the decisive distinction between currently deductible and capital expenditures are those of degree and not kind. This issue has received a great deal of judicial attention, with results that are not entirely consistent.

  4. The primary consequence of characterizing a payment as a business expense or a capital outlay concerns the timing of the taxpayer’s cost recovery. A business expense is currently deductible. A capital expenditure is not currently deductible, but is amortized or depreciated over the life of the relevant asset or, where no specific asset or useful life can be ascertained, is deducted upon its disposition or dissolution of the enterprise.

  5. IRC 162 represents, in one respect, an accommodation to administrative convenience. However, in order to demonstrate deductibility under IRC 162(a), the taxpayer must show that an item is ordinary, necessary, reasonable, and directly connected to the taxpayer's trade or business.

    1. To qualify as ordinary, an expense must relate to a transaction that is of common or frequent occurrence in the type of business involved. Ordinary has the connotation of normal, usual, or customary. Although an expense may be ordinary even though it occurred once in the taxpayer's lifetime, the transaction which gives rise to it must be of common or frequent occurrence in the type of business involved.

    2. To qualify as necessary, an expense must be helpful and appropriate in promoting and maintaining the taxpayer’s business.

    3. Even if an expense is ordinary and necessary, it is deductible under IRC 162 only to the extent that it is reasonable in amount. Reasonableness is inherent in the phrase ordinary and necessary.

    4. Finally, an expense must be directly connected to (or proximately result from) the taxpayer’s trade or business, not that of another.

  6. Almost all business expenditures produce a future benefit. The mere presence of an incidental future benefit may not warrant capitalization. However, the realization of significant benefits beyond the year in which the expenditure is incurred is important in determining the appropriate tax treatment.

  7. The courts and the IRS consider the recurring nature of costs to distinguish between capital and ordinary expenses. The distinction between recurring and nonrecurring business expenses provides a very simple but serviceable differentiation between a deductible business expense and a capital expenditure.

  8. The determination of whether an item is deductible currently or must be capitalized turns on the unique facts and circumstances of the item.

  9. Before the examiner considers proposing an adjustment which merely shifts a deduction from one year to the next or prior year, the examiner should determine whether the amount is material and the overall effect on the revenue is consequential.

4.43.1.13.4  (07-23-2009)
Industry Practices

  1. Tax accrual accounting generally results in an earlier reporting of income items and a later reporting of expense items than financial accrual accounting. Understandably, in most situations, the IRS usually takes the position that business expenses are deductible when paid and retailers take the position that business expenses are deductible in the period in which the related revenues are recognized.

4.43.1.13.5  (07-23-2009)
Financial Reporting

  1. A valued principle in financial accounting is that expenditures should be recognized in the same period as the income to which they relate.

  2. Costs and expenses directly identifiable with specific revenues are recognized in the period in which the revenues are recognized.

  3. Expenditures that produce benefits lasting multiple periods are treated as creating assets (for example tangible or intangible assets having an estimated useful life beyond one year, prepaid insurance, rent). The cost of these assets is allocated in a systematic manner over the actual or anticipated life of the assets so as to offset revenues over that period.

  4. If expenses give rise to a benefit that is exhausted in (or shortly after) the period in which paid or incurred, or if the period to which expenses relate is indeterminable, expenses are recognized when cash is paid or a liability incurred.

  5. If the precise amount of any costs or expenses is not determinable at the time they are chargeable against income, they should be recognized on the basis of reasonable estimates. Costs and expenses which cannot be determined with a reasonable degree of accuracy at the time they would otherwise be charged against income of a particular period should be deferred until such determination is possible.

  6. Liabilities and loss contingencies are recorded when it is probable that an asset is impaired or a liability incurred by the financial statement date and the amount is reasonably estimated. Examples include uncollectible receivables, product warranty costs, and pending or threatened litigation claims.

4.43.1.13.6  (07-23-2009)
Retail Topics and Issues

  1. Retailers incur a variety of common everyday expenses including but not limited to payroll and payroll-related expenses, occupancy-related expenses, advertising and promotion expenses, store operating expenses and corporate overhead expenses.

  2. Retailers generally attempt to deduct costs rather than capitalize them.

4.43.1.13.6.1  (07-23-2009)
Advertising Expenses

  1. Advertising costs primarily relate to current operations and cannot generally be associated with income of a particular period. While advertising may provide some long-term benefit, such costs are generally associated with creating immediate benefits. Retail advertising, in particular, is directed towards telling consumers:

    1. Where to find a product.

    2. How much the product costs.

    3. Why they should buy the product now (e.g. a sale or special event).

  2. Retailers use a wide variety of traditional media and non-media advertising types to attract and retain customers including, but not limited to:

    1. Newspaper & magazine ads

    2. Direct mail free-standing inserts (FSI), flyers, circulars

    3. Catalogs

    4. Radio and TV spots (FCC licensed stations and cable)

    5. Outdoor signs

    6. Promotional items (e.g. caps, T-shirts)

    7. In-store signage, displays, demonstrations and announcements

  3. Retailers typically have many advertising and marketing programs and often change these programs to respond to consumer preferences and spending patterns. Historically, advertising costs average around 2 percent of sales for traditional retailers. For pure e-commerce retailers advertising and promotion costs may average up to 50 percent of sales.

  4. For financial reporting purposes, advertising costs are generally expensed as incurred (i.e. when the advertising event takes place). Direct response advertising costs, which may consist of catalog production and postage costs, are generally deferred and amortized over the period of expected direct marketing revenue. This period is typically less than one year. Similarly, costs associated with the production of television advertising may be expensed over the life of the campaign. Advertising costs should be reported net of any cooperative advertising allowances.

  5. For tax reporting purposes, advertising expenses are normally deductible in the year in which paid or incurred, assuming a sufficient nexus between the expenditure and the taxpayer’s related business. Treas. Reg. 1.162-1(a) specifically provides that advertising and selling expenses are among the items included in deductible business expenses under IRC 162. Similarly, Treas. Reg. 1.162-20(a)(2) provides that expenditures for institutional or goodwill advertising which keeps the taxpayer’s name before the public are generally deductible under IRC 162 provided the expenditures relate to the patronage the taxpayer might reasonably expect in the future even though the expenditure may have some future effect on business activities.

  6. Only in the unusual circumstance where advertising is directed towards obtaining a future benefit significantly beyond those traditionally associated with ordinary product advertising, or with institutional or goodwill advertising, must the costs of that advertising be capitalized. As a general rule, the IRS does not challenge advertising deductions. As with most rules, there is an exception to the rule that advertising expenditures may be currently deducted. Simply stated, where the advertising expenditures result in an asset, other than the mere economic benefit derived from the advertising activities, the cost of the asset must be capitalized.

4.43.1.13.6.1.1  (07-23-2009)
Advertising Expense - Potential Compliance Risks

  1. Package Design Costs Package design costs are expenses incurred for graphic design (i.e. verbal information, styles of print, pictures or drawings, shapes, patterns, colors, and spacing that make up an overall visual display) and for package design (design of the physical construction of a package), and are currently deductible. In RJR Nabisco Inc. v. Commissioner, T.C. Memo. 1998-252, the IRS sought to capitalize package design costs, taking the position that such costs were intended primarily to produce a long-term benefit. The Tax Court disagreed with the IRS’s argument that package design costs were not the same as individual advertising executions such as television, radio, magazine and newspaper ads. The current regulations for intangible assets incorporate this decision for package design costs and generally allow the current deduction of these expenses.

  2. Catalogs Catalogs allow retailers to deal directly with consumers by identifying articles of merchandise available for sale and the related price. Catalogs, in a multi-channel retail environment, are an important tool for driving shoppers to other channels. Catalogs are often the first place customers see merchandise and, consequently, drive customer interest and generate internet, phone, and in-store sales. The catalog model is subject to certain costs including paper, printing, and postage. The Tax Court has ruled that these costs must be capitalized in Best Lock Corporation v. Commissioner, 31 T.C. 1217 (1959). Conversely, the Sixth Circuit has ruled that these costs are deductible in E.H. Sheldon & Company v. Commissioner, 214 F.2d 655 (6th Cir. 1954), rev’g 19 T.C. 481 (1952). The IRS follows the Tax Court decision in Best Lock Corporation. See Rev. Rul. 68-360.

  3. Payments to Charitable Organizations A retailer, as part of an advertising campaign designed to promote additional sales and net profits, may enter into an agreement with a charitable organization whereby the retailer pays the charitable organization a certain amount for each unit of a specified product sold (e.g. scrip programs). The retailer uses various media to advertise the program. In addition, the retailer may require that its name be used in materials printed by the charitable organizations whenever possible.

    1. The question is whether the payments in this situation are in the nature of contributions or gifts within the meaning of IRC 170, or ordinary and necessary expenses within the meaning of IRC 162. IRC 170 imposes percentage limits on the deductibility of charitable contributions.

    2. IRC 162(b) disallows deductions under IRC 162(a) for contributions or gifts that would qualify as deductible charitable contributions were it not for the percentage limitations of IRC 170. Similarly, Treas. Reg. 1.162-15(a) provides that no deduction is allowable under IRC 162(a) for a contribution or a gift by an individual or a corporation if any part thereof is deductible under IRC 170.

    3. For example, a retailer makes a $5000 contribution and only $4000 is deductible under IRC 170(a) whether because of the percentage limitation under either IRC 170(b)(1) or (2), the requirement as to time of payment, or both. The retailer is not allowed to claim a deduction under IRC 162(a) for the remaining $1000.

    4. Under Treas. Reg. 1.162-15(b) payments to organizations other than those described in IRC 170 which bear a direct relationship to the taxpayer’s business and are made with a reasonable expectation of a financial return commensurate with the amount of the donation may constitute allowable deductions as business expenses, provided the donation is not made for a purpose for which a deduction is not allowable by reason of the provisions of paragraph (b)(1)(i) or (c) of Treas. Reg. 1.162-20.

  4. Cooperative Advertising Allowances The question is whether advertising and promotional expenses were reported net of cooperative advertising allowances. To the extent a retailer has an expectation that a portion of its advertising costs will be reimbursed, it should deduct only the difference. The proper time to recognize a cooperative advertising allowance is when the retailer advertises the product, not when the retailer receives payment from the vendor.

4.43.1.13.6.2  (07-23-2009)
Contributions of Inventory

  1. A retailer must consider disposal options as inventory merchandise becomes old (e.g. shelf life expiration, new product introductions, fashion trend changes, seasonal changes, technical obsolescence, etc.). Inventory that remains unsold after all markdowns must either be scrapped, sold in any available after markets (e.g. jobbers or discounters), or donated to charities.

  2. In general, a current deduction is permitted under IRC 170 for charitable contributions subject to certain limitations that depend on the type of taxpayer, the property contributed, and the donee organization. The deduction for contributions of certain appreciated property is limited to the donor’s basis in the property.

  3. For tax reporting purposes, a retailer’s deduction for charitable contributions of inventory is generally limited to its basis (typically cost) in the inventory or, if less, the fair market value of the inventory. Additionally, in any taxable year, charitable contributions are not deductible to the extent the aggregate contributions exceed 10 percent of the corporation’s taxable income computed without regard to net operating loss or capital loss carrybacks.

  4. For certain contributions of inventory, C corporations may claim an enhanced deduction under IRC 170(e)(3). If certain requirements are met, a C corporation that contributes property may deduct an amount in excess of the property's basis. To be eligible for the enhanced deduction, the contributed property generally must be inventory of the taxpayer, contributed to a charitable organization described in IRC 501(c)(3), except for private non-operating foundations, and the donee must:

    1. Use the property consistent with the donee’s exempt purposes solely for the care of the ill, the needy, or infants,

    2. Not transfer the property in exchange for money other property, or services, and

    3. Provide the taxpayer a written statement that the donee’s use of the property will be consistent with such requirements.

  5. In the case of contributed property subject to the Federal Food, Drug and Cosmetic Act, the property must satisfy the applicable requirements of such Act on the date of transfer and for 180 days prior to the transfer.

  6. The 2005 Katrina Emergency Tax Relief Act provided that food inventory contributions by any type of taxpayer would qualify for the favorable tax treatment. This temporary provision could be extended in various extenders acts.

  7. The enhanced computation is equal to the lesser of:

    1. Basis plus one-half of the item’s appreciation (i.e. basis plus one-half of fair market value in excess of basis), or

    2. Two times basis.

  8. Computation Example. A retailer donates 100 cases of cereal. The retailer’s cost is $10/case ($1,000). The retailer’s selling price is $50/case ($5,000). Under these facts and circumstances, the enhanced deduction is computed as follows:

    1. $1,000 plus 1/2 x ($5,000 - $1000) = $3,000

    2. $1,000 x 2 = $2,000

    3. Charitable contribution deduction = $2,000

    4. Cost of Goods Sold reduction = $1,000

  9. A retailer making a charitable contribution of inventory must make a corresponding adjustment to cost of goods sold by decreasing the cost of goods sold by the lesser of (1) the fair market value of the property, or (2) the basis of the property under Treas. Reg. 1.170A-4A(c)(3). The contribution in excess of cost should be reflected on Schedule M. See Notice 2008-90 for temporary guidance in this area.

  10. Potential Compliance Risks

    1. Fair market value of the donated property is overstated.

    2. Cost of goods sold is not reduced by the basis of the donated property.

    3. Charitable contribution deduction exceeded two times cost.

    4. Charitable contribution deduction exceeded 10 percent limitation.

  11. Audit Techniques

    1. To establish fair market value (FMV), the examiner must determine the composition, nature, character, and condition of such inventory immediately before donation. Whether such inventory has marketability to a retailer's customers has a definite bearing on the worth of such merchandise for donation purposes when applying the guidelines of Treas. Reg. 1.170A-1(c)(2) and (3).

    2. A retailer may attempt to claim the last retail price, before close-out (including all permanent markdowns), as its FMV for contribution purposes. Treas. Reg. 1.170A-1(c)(2) states that if the contribution is made in property of a type which the retailer sells in the course of his business, the fair market value is the price which the retailer would have received if he had sold the contributed property in the usual market in which he customarily sells, at the time and place of the contribution, and, in the case of a contribution of goods in quantity, in the quantity contributed.

    3. Treas. Reg. 1.170A-1(c)(3) states that, if a donor makes a charitable contribution of property, such as stock in trade, at a time when he could not reasonably have expected to realize its usual selling price, the value of the gift is not the usual selling price but is the amount for which the quantity of property contributed would have been sold by the donor at the time of the contribution.

    4. In explaining the 1976 enactment of IRC 170(e)(3)(B), the Senate Finance Committee, in 1982 (regarding Section 222 of P.L. 97-34 and IRC 170(e)) commented that, at the same time, Congress also determined that the deduction allowed should not be such that the donor could be in a better after-tax situation by donating the property than by selling it.

    5. The examiner should look to the pattern of the retailer’s charitable contribution to help establish donative intent. The retailer may be motivated to give its merchandise to charities because it is truly benevolent as a donor to the ill and needy. However, the retailer's actions may be primarily business motivated, and the deduction for such disposal actions limited to inventory basis (i.e., an IRC 162 ordinary and necessary expense). Periodic donations of highly saleable inventory (items still being offered to its retail customers) may meet the donative intent test. Regular, routine, and recurring inventory reductions and donations of no longer saleable items may be an ordinary and necessary business practice. Technically obsolete inventory such as computers may have limited after markets. Damaged or refund merchandise may not be returned to the retail floor. Perishable products with limited shelf life may be sold in day-old shops.

    6. The examiner should verify the condition and quality of contributed inventory. The examiner should review all written company policy on inventory contribution procedures. Business versus benevolent practices may limit the deduction to basis. After market sales of similar inventory to vendors may establish FMV. The examiner should consider interviewing company employees who have hands-on knowledge of the donation process. Likewise, the examiner should consider third party discussions with donees to establish the condition and value of donated inventory. In verifying the retailer's FMV and actions relevant to donative intent, however, do not overlook the need to substantiate the basis of contributed property. Inventory cost records (i.e. LIFO or FIFO) should identify donated items. Substantiation of inventory maintained on the retail inventory method should include retention of the price tags or price lists for donated items.

    7. See the Food Industry Coordinated Issue Paper for specific details in this area.

4.43.1.13.6.3  (07-23-2009)
Credit Card Fees

  1. At the point of sale, a consumer has the choice of making payment for goods or services by cash, check, or electronic payment. Until recently, consumers used checks more often than any other retail payment instrument in the United States other than cash. Today, electronic payment is commonplace, outpacing check transactions.

  2. Consumers like the convenience of paying by plastic. Credit cards and signature debit cards allow consumers to acquire goods or services currently while deferring an actual outlay of cash for a period of time. Even when a cardholder uses a debit card or pays a credit card balance in full immediately upon being billed, that cardholder has enjoyed (with respect to the cardholder's own funds) the time value of some deferral for the interim period between the purchase transaction and payment.

  3. Unlike cash or check payments, on settlement retailers do not receive the full selling price of purchases that customers make with credit or debit cards because the merchant bank first subtracts a merchant discount fee from the settlement funds. Some of this discount reimburses the merchant bank for services provided to the retailer and some of the discount reflects the merchant bank’s interchange fee that is payable to the issuing bank.

  4. Interchange fees are fees that merchants through their merchant banks are charged for access to the extensive, global payment card infrastructure that has been built up over the last few decades. The merchant fee may cover the cost of renting the credit card terminal, customer service, and the interchange fee. Interchange fees generally are calculated as a percentage of a purchase transaction that merchant banks, in turn, typically recoup from their merchants that participate in the payment card network. The interchange fee is part of the terms of the merchant agreement that is made by the merchant bank with the merchant. Because of its pricing structure, the interchange fee generally increases as the amount of the transaction increases. The interchange fee accounts for the largest portion of the merchant discount fee charged to retailers by merchant banks. This fee is not directly passed on to cardholders but, like overhead, is passed to the retailer’s customers because it's included in the price of goods for sale. Credit card issuers often use this revenue stream to pay for the processing of credit card transactions, reward programs, fraud losses, and general operating costs.

  5. The prevalence of payment card transactions has resulted in this hidden cost becoming a more significant cost of operating a retail business. While interchange fees usually total around 2 percent of a transaction, some types of purchases can charge as much as 8 percent. For example, when a retailer cannot use the magnetic strip and has to use a key pad to complete the transaction, the retailer is usually charged a higher fee by the merchant bank.

  6. As a general rule, these fees represent an ordinary and necessary expense of a retailer’s business. Accordingly, despite the size of the amount, payment card transaction fees do not typically represent a potential compliance risk.

4.43.1.13.6.4  (07-23-2009)
Pre-Opening Store Expenses

  1. Multi-outlet retailers open new stores as part of their long-term expansion plans. New stores are often indistinguishable from one another, or from a retailer’s already established stores. Opening a new store usually takes only a brief period of time.

  2. A multi-outlet retailer’s stores typically receive various operating services from headquarters, including management information systems, accounting, financing, personnel, purchasing, inventory, management, advertising, payroll, and training services.

  3. Retailers incur a variety of pre-opening expenses in connection with new stores. Pre-opening expenses may include:

    1. Payroll and related costs for hiring and training new employees and managers to operate a new store

    2. Costs for maintenance, service and supplies

    3. Utility (e.g. electricity, gas, telephone, water) and occupancy (e.g. rent) costs preceding the opening of a store

    4. Office, non-selling, and janitorial supplies normally consumed within a few months

    5. Expenses for selling supplies such as paper and plastic bags

    6. Maintenance and incidental repairs incurred prior to opening a store

    7. Other normal and recurring store operating costs, including advertising, freight and postage, security, travel, employee relocation.

  4. As a general rule, pre-opening costs do not involve the acquisition of tangible assets. Rather, these costs result in a new store ready for operation. With employees in place and the shelves stocked, new stores open for business. The efforts to get the stores ready are intended to produce immediate benefits.

  5. For financial reporting purposes, retailers generally expense the costs incurred prior to opening a new store.

  6. Audit Considerations

    1. Whether pre-opening costs represent costs incurred to protect, promote, or expand a business (i.e. deductible business expansion costs) or whether such costs represent a new line of business (i.e. capital expenditure).

    2. Whether pre-opening costs produce a significant long-term benefit by allowing the retailer to open new stores that will produce income for an indefinite number of years.

    3. Whether the retailer uses a new subsidiary for a new store or a new chain of stores.

    4. Whether an existing trade or business is expanded or a new trade or business is acquired or created is based on the facts and circumstances of each case.

  7. Potential Compliance Risks

    1. To the extent pre-opening costs are normal and recurring costs that a retailer incurs in operating all of its stores, such costs are generally currently deductible under IRC 162. Even though some future incidental benefits would be realized, a better matching of income and expense results when such costs are deducted currently. Store opening costs produce short-term benefits because inventory will have to be restocked, new employees will have to be hired and trained to replace departures and so forth. The combination of short-term benefits and the recurring nature of the costs lead to the conclusion that such costs need not be capitalized.

    2. The use of a new subsidiary for a new store or new chain is common and frequently prudent. The use of subsidiaries can compartmentalize liability and sometimes assist in controlling state taxes. In this situation, the expenses incurred by a new subsidiary, even though reflected on the parent's consolidated return, are those of a separate tax entity that should be viewed as a separate entity, starting a new business. Accordingly, the amounts expended by a parent to get the new operation going should be treated as a capital contribution to the subsidiary and not expenses of the parent or the subsidiary.

4.43.1.13.6.5  (07-23-2009)
Professional Fees and Services

  1. Retailers, like other companies, incur various professional fees and services throughout their life. Professional fees and services are incurred for incorporating, purchasing another company, conducting routine business transactions, collecting delinquent receivables, reorganizing, restructuring or defending itself or its directors or officers in a lawsuit.

  2. When the amounts of professional fees and services are significant, their deductibility (or non-deductibility) can become an important tax consideration.

  3. An amount paid for legal and other professional services may, depending on the factual circumstances and the ability of the taxpayer to meet the applicable legal requirements for deduction, result in one of the following tax consequences:

    1. A deductible expense

    2. A personal expense

    3. A nondeductible capital expenditure, which may be subject to depreciation or amortization

    4. A deductible loss

    5. A combination of the above

  4. The deductibility of legal and other professional fees depends on the context in which they are incurred. Generally, professional fees, such as accountants and attorneys, are deductible when they relate to routine business transactions and expenses that are not incurred on the acquisition of capital assets. For example, professional fees incurred to collect accounts receivable or other trade receivables, audit the financial statements, prepare contracts for the sale of inventory, and monitor laws and regulations that affect business operations are deductible.

  5. Audit Considerations

    1. It is well established that when a taxpayer acquires an asset, its basis includes not only the purchase price of the asset, but also the direct costs of acquiring the asset. For example, external costs such as broker’s commission, legal fees, and the cost of title insurance must be capitalized to the basis of purchased land. See Treas. Reg. 1.263(a)-2(a) & (c).

    2. The circumstances in which professional fees may be attached to capital assets or significant long-term benefits are varied. Usually these fees are deductible over the life of the related asset or on the sale of the related asset.

    3. To determine if a legal or other professional fee is a personal, deductible, or capital expenditure, the examiner must consider the origin and character of the claim underlying the expense incurred. The origin and character of the claim with respect to which an expense is incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense is deductible. The origin of claim test is a judicially-developed test to determine deductibility. See U.S. v. Gilmore, 372 U.S. 39, 48 (1963) (holding expenses paid to protect ownership of stock in a divorce proceeding were personal and not deductible); Woodward v. Commissioner, 397 U.S. 572, 576-77 (1970) (holding legal fees expended in determining price of stock was a capital expenditure); U.S. v. Hilton Hotels, 397 U.S. 580, 583 (1970) (expenditures for valuation of shares on behalf of dissenting shareholders in merger were capital expenditures).

    4. The examiner must consider all of the facts of the case, including the fee arrangement, to determine the context of the expenditures and the services for which the professionals were paid.

    5. If the transaction in which a legal or other professional fee is incurred is partially allocable to a business activity and partially allocable to a capital expenditure, the retailer must allocate the fee between a deductible portion and a nondeductible portion. Since allocations are based on the facts and circumstances of a particular transaction, no bright-line tests exist to determine how an allocation can be made.

  6. Potential Compliance Risks

    1. Asset acquisitions

    2. Capital structure alterations (restructuring, recapitalization, reorganization)

    3. Bankruptcy

    4. Borrowing, including the issuance of debt

    5. Mergers & Acquisitions

  7. Bankruptcy Costs

    1. In challenging economic markets, corporations may utilize the bankruptcy procedures of Chapter 11 of the Bankruptcy Code to protect themselves from creditors while effecting major reorganizations of the corporate structure. The potential total Chapter 11 bankruptcy costs can be significant. Legal, accounting, investment banking, and other professional services are typically incurred during the course of a Chapter 11 proceeding.

    2. A bankrupt retailer has to deal with all of the usual problems of keeping employees, paying vendors, getting access to inventory and maintaining cash. Retailers that need to restructure outside of filing Chapter 11 bankruptcy have done so by closing stores, renegotiating debt, cutting expenses, or locating equity.

    3. Costs associated with a bankruptcy are generally deductible. See Rev. Rul. 77-204. In particular, expenses incurred by a trustee operating a debtor’s business generally are deductible as if there were no bankruptcy proceedings.

    4. To the extent the costs are incurred in the institution and administration of the bankruptcy proceeding, such costs are subject to capitalization under IRC 263(a). Alternatively, if the dominant aspect of the filing was to liquidate, such costs have been held to be deductible.

    5. To determine the deductibility of a legal fee, the examiner must consider the origin and character of the claim underlying the expense incurred. The origin and character of the claim with respect to which an expense is incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense is deductible.

  8. Mergers and Acquisitions

    1. Mergers and acquisitions are filled with complex issues that require dedicated expert attention. Effectively navigating the multiple tax, accounting, legal, regulatory, cultural and labor issues in cross-border transactions in particular is necessary to ensure that risks are minimized and returns maximized.

    2. Amounts that are inherently facilitative must be capitalized, regardless of when the activity for which the payment is made is performed.

    3. A fee that is contingent on the successful closing of any transaction to which Treas. Reg. 1.263(a)-5 applies is inherently facilitative. For example, a success-based fee, is presumed to facilitate a transaction.

    4. The presumption that applies to success-based payments can be rebutted with evidence that clearly demonstrates that some portion of the payment is allocable to activities that do not facilitate the acquisition.

4.43.1.13.6.6  (07-23-2009)
Settlement Payments

  1. In many situations, litigation is simply viewed as a cost of doing business. In this context, when a retailer is sued and pays an amount to settle the litigation, it generally expects the payment to be deductible for tax reporting purposes.

  2. Settlements usually involve compromises of claims. The settling party (e.g. retailer) who is accused of some wrongdoing usually does not admit any wrongdoing in the settlement. In line with the hazards of litigation, payments made by a settling party tend to fall between what each party originally hoped for at the initial stages of litigation. Otherwise, parties would not settle.

  3. For retailers, most settlements are currently deductible. For example, settlements involving customers (e.g. slip and fall cases, access for disabled shoppers, product safety), employees (e.g. race/gender discrimination, child labor law violations), shareholders and suppliers are generally currently deductible.

  4. Some types of payments raise the issue of capitalization. For example, a lawsuit involving title to property probably results in capitalization of the legal fees to the basis of the underlying property.

  5. Audit Considerations

    1. A settlement payment may represent a penalty that is not deductible for tax reporting purposes.

    2. The Internal Revenue Code clearly denies a deduction for any fine or similar penalty paid to a government for the violation of any law. See IRC 162(f). This includes criminal and civil penalties as well as sums paid in settlement of potential liability for a fine. The latter item often causes great controversy.

    3. Whether a settlement payment constitutes a fine or penalty may depend on the intent of the settling parties. If the intent is for the settlement to pay a fine or penalty provided for by law then the settlement amount is nondeductible.

    4. The taxpayer bears the burden of proving that it is entitled to a full or partial deduction of any settlement amount paid.

  6. Potential Compliance Risks

    1. Whether any portion of a settlement payment represents a nondeductible fine or penalty under IRC 162(f).

    2. Additionally, the same issues that arise with respect to legal and other professional fees generally arise for settlement payments.

4.43.1.13.6.7  (07-23-2009)
Non-Inventoriable Supplies

  1. Retailers generally incur costs for materials and supplies consumed in the course of business operations. Incidental supplies may be deducted when consumed or in the year of purchase provided the retailer meets certain conditions specified in the regulations. Such supplies are often replenished throughout the year.

  2. If materials and supplies do not constitute inventory, tax treatment is governed by Treas. Reg. 1.162-3.

  3. Treas. Reg. 1.162-3 allows the expensing of materials or supplies in the year of purchase if:

    1. They are incidental,

    2. No record of consumption is kept, and

    3. No physical inventories are taken.

  4. Incidental materials and supplies represent an ordinary and necessary expense of a retailer’s business. Accordingly, such costs on a retailer’s tax return do not typically represent a potential compliance risk.

4.43.1.13.6.8  (07-23-2009)
Repairs and Maintenance

  1. Retailers strive for the best return on investment. Consequently, retailers spend significant sums of money every year to build and renovate stores.

  2. Retailers generally establish a schedule for updating their stores. Retailers generally remodel stores every five to ten years to reflect changing consumer tastes and to compete with newer stores. Successful retailing requires periodic updates to maintain a fresh look, and also because of the need for general improvements such as energy-saving efforts.

  3. In a highly competitive marketplace, some retailers look at remodeling as a way to revitalize a failing store, but the anticipated return has to pay for the costs involved. Stores with higher sales volumes usually are updated faster than other stores because of wear and tear. Store updates are typically approved from a retailer’s capital improvement budget. Individual stores and districts typically must justify their planned projects and compete with one another for the budget.

  4. From 1984 through 1993, the depreciation period for improvements to nonresidential real estate was gradually increased from 15 to 39 years. Under a provision in the American Jobs Creation Act (AJCA) of 2004, the depreciation period was returned to 15 years, but only for leased property. See IRC 168(e)(3)(E)(iv). In many cases, retailers own their buildings and are placed at a competitive disadvantage compared with retailers that lease their stores. When costs must be written off over nearly four decades, it is much more difficult to make the decision to remodel.

  5. Under current law, repair and maintenance costs are deducted when incurred (i.e. expensed). Incidental repairs are not required to be capitalized, because they do not enhance the value of property or appreciably prolong its life. See Treas. Reg. 1.263(a)-1(b) and Treas. Reg. 1.162-4. The assumption is that ongoing repairs benefit current operations (i.e. merely keep property in ordinarily efficient operating condition), and result in only incidental future benefits.

  6. Conversely, substantial improvements that enhance the value of property must be capitalized and depreciated. The factors indicating capitalization are:

    1. Increase value of property

    2. Substantially prolong life of property

    3. Adapt property to a new or different use

  7. The primary question usually involves a determination whether a particular expenditure is a capital item or a deductible repair. Historically, this issue arises frequently and is controversial. Part of the reason for controversy is that there are no clear criteria on which to logically differentiate between a repair and an improvement; the legal distinction between the two often is one of degree and intention, and a difficult task to draw in practice.

  8. Audit Considerations

    1. A fundamental purpose of IRC 263(a) is to prevent the distortion of taxable income through current deduction of expenditures relating to the production of income in future taxable years. In reviewing costs deducted as repairs and maintenance consider the following: 1) Materiality – Is the expenditure relatively small or the future benefit incidental to the current benefit?; 2) Frequency – Is the expenditure incurred on a regular basis?; 3) Length of Future Benefit – Is the future benefit short-term or long-term in nature?; 4) Burden of Capitalization – Do the burdens of capitalization outweigh the general revenue benefits from capitalization of the item?

    2. Defining a unit of property is often a challenge in addressing a repair versus capital expenditure issue.

    3. The particular facts involved in each case receive a great deal of attention by the courts.

    4. Many of the criteria to distinguish deductible and capitalized costs are relatively subjective in nature (e.g. "incidental," "significant future benefit" ).

    5. The examiner may find cases that have relatively similar facts but come to entirely different conclusions.

  9. Potential compliance risks include store remodeling costs and asbestos removal costs.

  10. Store Remodeling Costs

    1. Are costs incurred in cyclical remodels, which occur more frequently than the MACRS recovery period under IRC 168, treated as freestanding assets and depreciated over the MACRS recovery period, over the recurrence period, or should such costs be deducted currently?

    2. Are costs incurred in cyclical remodels of leased and/or owned stores capital expenditures under IRC 263 or deductible repairs and maintenance costs under IRC 162?

    3. In reviewing remodeling costs, a threshold question is what is the appropriate unit of property? The examiner should consider industry practice, the extent to which lives of property are co-extensive, and the extent to which properties are functionally interdependent. Items that are capital in nature add value to the property, substantially prolong a property’s useful life, or adapt property to a new or different use. Incidental repairs do not materially add to a property’s value, do not appreciably prolong a property’s life, and do keep property in an ordinarily efficient operating condition.

  11. Asbestos Removal Costs

    1. Three methods are generally accepted for asbestos abatement: (1) encapsulation (2) removal and (3) enclosure.

    2. Costs incurred to treat asbestos within a reasonable time period after a property with a known asbestos problem is acquired should be capitalized as part of the cost of the acquired property subject to an impairment test for that property.

    3. Generally speaking, removal costs do not require capitalization when the removed asset is replaced. See Rev. Rul. 2000-7.

    4. The courts have held asbestos removal costs to be capital expenditures. Dominion Resources v. United States, 48 F.Supp. 2d 527 (E.D. Va. 1999); Norwest Corp. & Subsidiaries v. Commissioner, 108 T.C. 265 (1997).

    5. The IRS takes the position that Rev. Rul. 2000-7 does not apply to asbestos removal costs.

4.43.1.13.6.9  (07-23-2009)
Bad Debt Expense

  1. For many retailers, trade and other receivables represent some of the largest assets on the balance sheet. Retailers are subject to the risk that settlement of the payment received for sales transactions will not take place as expected. Accordingly, retailers incur bad debts in the ordinary course of business from returned checks, credit card charge backs, and related collection service fees.

    1. Checks and direct debit transfers can be returned if the payer’s institution chooses not to honor the presentation because the customer closed the account, the account has insufficient funds, the customer stopped payment on the check, the check contained a fraudulent signature, or other payment irregularities.

    2. For credit card issuers, credit losses (e.g. cardholder bankruptcy) and fraud losses are two of the most significant risks for non-payment of a transaction. While the issuing bank is generally the party at risk, credit cards have specific procedures for charge backs. Charge backs are "charged back" or reversed out of the retailer’s bank account. A retailer is required to cover the fraudulent transaction through the chargeback process if it does not follow the minimum procedures. Minimum procedures include obtaining an authorization, a cardholder’s signature, or an electronic imprint of the card (i.e. electronic information on the card at the POS).

  2. Retailers typically maintain an allowance for doubtful accounts (i.e. contra accounts receivable) to cover losses anticipated on non-cash sales and other debts outstanding at tax year end. The reserve at year end is based on such factors as general business conditions, past experience in collecting accounts and actual charge-offs. A current year addition is made only if the existing reserve balance is deemed inadequate to cover expected losses.

  3. For financial reporting, retailers recognize bad debt expense currently for losses that statistically will occur in the future. Delinquent accounts are typically written off after the passage of time without receipt of the full scheduled monthly payment. Standard industry practice is 180-210 days. Delinquent accounts may be written off sooner in the event of some other circumstance that suggests that collection is unlikely. An example is customer bankruptcy.

  4. The Tax Reform Act of 1986 repealed the provision contained in IRC 166(c) allowing a deduction for a reasonable addition to a reserve for bad debts for all years beginning after December 31, 1986. Consequently, except for certain banks, all accrual-basis taxpayers must use the specific charge-off method for receivables that become uncollectible in whole or part. IRC 166(a)(1) and (2) allows a deduction for any business debt which the taxpayer proves became partly or totally worthless within the taxable year.

  5. For tax reporting purposes, a bad debt deduction is allowed for all or part of bona fide debt that becomes worthless during the tax year. The specific charge-off method can accelerate bad debt deductions by allowing write-offs for partially worthless debts. Retailers that sustain losses on bad checks or credit card charges can benefit from using a less restrictive reasonably certain standard instead of the usual wholly worthless test. Unlike deductions for wholly worthless debts, Congress has granted the IRS discretion to decide whether to allow a deduction for partially worthless debts.

  6. Audit Considerations

    1. An uncollectible amount raises a question of when the retailer may claim a bad debt deduction for such amount.

    2. Whether an uncollectible amount is wholly or partially worthless is a question of fact. The burden of proving that an amount is worthless and the year in which the amount became worthless is on the retailer.

    3. When is an amount worthless? The Internal Revenue Code does not define the term worthless. Likewise, a standard test or formula does not exist to determine worthlessness of a debt within a given tax year. The test for worthlessness is objective, not subjective. All pertinent facts and circumstances must be considered. A retailer’s unsupported opinion alone is insufficient proof of worthlessness. Similarly, an amount is not worthless merely because collection is in doubt.

    4. To be worthless, the amount must not only be uncollectible at the time the retailer claims the deduction, but it must also appear to be uncollectible at any time in the future. A retailer must have taken reasonable steps to collect the debt. The taxpayer must exhaust all the usual and reasonable means of collecting a debt before worthlessness can be determined.

    5. The year of worthlessness is fixed by identifiable events that form the basis of reasonable grounds for abandoning any hope of recovery.

    6. Surrounding circumstances indicating that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment will generally be sufficient evidence of the worthlessness of the debt for purposes of the deduction under IRC 166. See Treas. Reg. 1.166-2(b)

    7. Whether a debt is worthless in whole or part is a question of fact. The IRS considers all pertinent evidence, including the value of the collateral, if any, securing the debt.

  7. Potential Compliance Risks

    1. Whether the amounts of specific receivables charged-off or written down during the tax year are proper. Under IRC 166(a)(2), the deduction for specific bad debts that become partially uncollectible is limited to the amount of actual charge-off or write-down of specific receivables during the tax year. The principal reason for this requirement is to prevent a retailer from taking advantage of the loss for tax purposes while continuing to carry the item as an asset on its financial statements.

    2. Whether any of the amounts charged off are amounts recoverable through bankruptcy reorganization or other means. A debtor's bankruptcy is generally an indication of the worthlessness of at least part of an unsecured debt. The institution of bankruptcy proceedings alone is not dispositive of whether debts become wholly worthless at that time. For example, when a Chapter 11 reorganization bankruptcy continues without objection from creditors, there is a presumption that there is some hope for recovery. A taxpayer can claim a bad debt expense for the portion of the receivable that is worthless in the year in which the debtor files for bankruptcy, provided the amount of partial worthlessness can be established with reasonable certainty. While subsequent events may be relevant to support the taxpayer's initial determination, the ultimate proof of worthlessness depends upon the facts and circumstances as they existed at the time the debt was claimed to have become worthless. The recoverable portion of the receivable, however, should not be written off in the year of bankruptcy.

  8. The burden of proving that debt is worthless and the year in which the debt became worthless is on the taxpayer.

4.43.1.13.6.10  (07-23-2009)
Prepaid Expense

  1. Retailers pay for certain expenses in advance of consumption. Retailers regularly incur certain normal and recurring costs related to prepaid services or property associated with the general operation of a retail business. Prepaid items may include such as items as marketing and advertising costs (e.g. catalogs), direct mail postage, insurance, supplies and service and maintenance contracts.

  2. For financial reporting purposes, prepaid expenses are usually capitalized and amortized over the expected period of future benefit. For example, catalog production costs may be amortized based on sales generated by each catalog or over a specific period of time.

  3. For tax reporting purposes, section 461 and the regulations provide general rules that govern the taxable year of deduction. Treas. Reg. 1.461-1(a)(1) provides that, for a cash method taxpayer, allowable deductions can be taken into account for the taxable year in which paid. For accrual taxpayers, Treas. Reg. 1.461-1(a)(2) provides that, a liability is incurred, and generally is taken into account for federal income tax purposes, in the taxable year in which all events have occurred that establish the fact of the liability, the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

  4. The issue of when a deduction can be claimed for prepaid expenses arises in many industries, including retail.

  5. For tax reporting purposes, if a taxpayer’s liability arises out of the provision of services to the taxpayer by another person, economic performance occurs as such person provides such services. See IRC 461(h)(2)(A).

  6. One exception to this rule is the so-called 3 1/2 month rule provided in Treas. Reg. 1.461-4(d)(6)(ii). Under this section, a deduction is allowed when payment is made and the services can reasonably be expected to be provided within 3 1/2 months of the payment. Although the regulation does not specifically state that all the services must be provided within 3 1/2 months, that conclusion is implicit in the language that requires the services (not a pro-rata amount, or portion of, services) to be provided within 3 1/2 months. The language of the regulation does not provide that taxpayers may use the rule to meet economic performance for a service liability ''to the extent of'' services provided. The IRS’s position is that the exception to the economic performance test found at Treas. Reg. 1.461-4(d)(6) is an "all or nothing rule." The 3 1/2 month rule should be limited to facts where the complete service or property is provided within 3 1/2 months. A taxpayer should not be allowed to pro-rate 3 1/2 months out of a longer period. See, e.g., IRS Legal Advice Memorandum 2007-009, at Westlaw IRS AM 2007-009.

  7. IRC 461(h)(3) provides that the recurring item exception is also an all or nothing rule with respect to a specific liability, and the same rationale applies. In order to claim a current deduction for prepaid services, for example, all of the services must be provided within 8 1/2 months of year end, Thus, the recurring item exception is not available, and the costs of the contracts in the following example would not be deductible in year 1:

    1. Example. At the end of Year 1, the taxpayer enters into a 12-month service contract with X. Under the contract, X will provide services to the taxpayer until the end of Year 2. At the end of Year 1, when the contract is executed, the taxpayer makes a prepayment to X for the portion of the services to be provided within the first three and one-half months of Year 2. The taxpayer deducted the amount of the prepayment in Year 1.

4.43.1.13.6.11  (07-23-2009)
Nondeductible Items

  1. IRC 162(a) allows taxpayers to deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business. Taxpayers seeking to minimize the size of their gross income for tax purposes have an incentive to deduct as much as possible from their pre-tax income. The Internal Revenue Code imposes some exceptions to the general allowance provision for certain public policy reasons. Thus, items such as fines and penalties, political contributions and lobbying expenses, and club dues represent a few potentially permanent book-tax reporting differences.

4.43.1.13.6.11.1  (07-23-2009)
Nondeductible Items- Fines and Penalties

  1. Retailers may incur fines and penalties for a variety of reasons. Retailers commonly incur fines and penalties associated with

    1. Environmental matters (e.g. storm water run-off, leaky refrigeration systems/ozone leakage)

    2. Safety matters (e.g. federal law prohibits anyone under 18 from operating certain machinery such as forklifts and paper balers)

    3. Employment matters (e.g. hiring illegal aliens)

    4. Sales-related matters (e.g. pricing inaccuracies/scanner overcharges; state departments of weight and measures infractions; cigarettes sold to underage customers).

  2. Fines and penalties can relate to overweight trucks, speeding, store licensing regulations, weights and measures, outdated foods/drugs on the shelf, and safety, sanitation, and sewage matters.

  3. For financial reporting purposes, fines and penalties are expensed as incurred.

  4. For tax reporting purposes, IRC 162(f) provides that no deduction is allowable under IRC 162(a) for any fine or similar penalty paid to a government for the violation of any law. Treas. Reg. 1.162-21(b)(1) defines a nondeductible fine or penalty as, inter alia, an amount paid as a civil penalty imposed by Federal, State, or local law or an amount paid in settlement of a taxpayer’s actual or potential liability for a fine or penalty (civil or criminal). Treas. Reg. 1.162-21(b)(2) makes clear, however, that compensatory damages paid to the government do not constitute a fine or penalty for purposes of IRC 162(f).

  5. If a settlement was made in lieu of a fine or penalty, the examiner should determine what part of the settlement is compensatory and deductible and what part is punitive damages and nondeductible as a fine or penalty.

  6. Ultimately, whether a payment constitutes a fine or a penalty (which is not deductible on a Federal income tax return) depends on the purpose the payment was meant to serve. Civil penalties imposed for purposes of enforcing the law and as punishment for violation of the law are not deductible for Federal income tax purposes. On the other hand, civil penalties imposed to encourage prompt compliance with a requirement of the law or as a remedial measure to compensate another party for expenses incurred as result of the violation, are deductible because they do not serve the same purpose as a criminal fine and are not similar to a fine within the meaning of IRC 162(f).

  7. If a settlement was made in lieu of a fine or penalty, the examiner should determine what part of the settlement is compensatory and deductible and what part is punitive damages and nondeductible as a fine or penalty.

  8. Potential Compliance Risk – Whether the retailer deducted any fines or penalties for tax reporting purposes.

4.43.1.13.6.11.2  (07-23-2009)
Nondeductible Items- Political Contributions and Lobbying Expenses

  1. Retailers work for legislation favorable to them and their industry (e.g. national sales tax).

  2. Retailers make contributions to financially support campaigns organized to encourage the public to vote a certain way and contact members of legislative bodies for the purpose of proposing, supporting, or opposing legislation.

  3. Retailers make contributions to various political candidates. In lieu of direct payments to politicians, a contribution may be in the form of an advertisement in a convention program, or admission to a dinner, inaugural ball, or similar event.

  4. Retailers pay annual dues to belong to one or more industry trade associations. Trade associations may use part of the annual dues to conduct lobbying efforts on behalf of its field of membership.

  5. For financial reporting purposes, trade association dues and lobbying expenses are expensed as incurred.

  6. For tax reporting purposes, IRC 162(e) denies a business expense deduction for lobbying or political activities (with exceptions). Generally, no deduction is allowed for amounts paid or incurred in connection with any of the following four activities:

    1. Influencing legislation (i.e. direct lobbying of the legislature)

    2. Participating in a political campaign of a candidate for public office

    3. Attempting to influence the public regarding elections, legislative matters, or referendums (i.e. grassroots lobbying)

    4. Communicating with "covered executive branch officials."

  7. Trade associations notify their membership under IRC 6033(e)(1)(A)(ii) of the amount of dues allocable to political expenditures.

  8. Potential Compliance Risk – Whether the retailer deducted any political contributions or lobbying expenses for tax reporting purposes. This inquiry should consider in-house lobbying costs, contributions to political action committees (PAC), and trade association dues used to lobby on behalf of the association’s field of membership.

  9. Audit Techniques should include the following below.

    1. The examiner should review Schedule M for permanent book-tax differences.

    2. The examiner should obtain detailed schedules for Schedule M adjustments (i.e. political contributions and lobbying expenditures).

    3. The examiner should ask if the retailer maintains a government liaison department and, if so, ask how the costs of the department are reported.

    4. The examiner should request copies of trade association IRC 6033(e) notifications confirming the nondeductible percentage for association dues.

4.43.1.13.6.11.3  (07-23-2009)
Nondeductible Items- Club Dues

  1. Retailers may join private clubs in connection with making business contacts and promoting their business. Associated with joining these clubs, retailers will incur an initial cost to join and recurring annual dues.

  2. For financial reporting purposes, these costs are usually expensed as incurred. To the extent the initiation fee is a refundable deposit, the cost is reflected in other assets.

  3. For tax reporting purposes, IRC 263 disallows a deduction for capital items. Since club membership and benefits are generally for an indefinite period, their cost is a capital expenditure and can not be currently deducted.

  4. IRC 274(a)(3) disallows a deduction for amounts paid or incurred after 1993 for membership in any club organized for business, pleasure, recreation, or other social purpose. The disallowance rule applies to any membership organization if the principal purpose is to conduct entertainment activities for members or their guests or to provide members or their guests with access to entertainment facilities. This rule applies to social, athletic, luncheon and sporting clubs.

  5. Treas. Reg. 1.162-15(b) allows a deduction for dues and other payments to organizations, which otherwise meet the requirements of the regulations under IRC 162. Organizations such as trade associations, business leagues and chambers of commerce are generally an exception to IRC 274(a)(3)’s disallowance rule if the ordinary and necessary expense test is satisfied.

4.43.1.13.7  (07-23-2009)
Audit Techniques

  1. In assessing audit risk, the examiner should scan the expenses per the return and consider those which are large, unusual or questionable.

  2. The examiner should scan the Schedule M for book-tax differences.

  3. The examiner should obtain detailed schedules of nondeductible items and compare to items found during the analysis of general ledger accounts.

  4. The examiner should trace the selected expenses back through the books to the original source documents.

  5. The examiner should verify the timing of the expense.

  6. The examiner should verify the amount of the expense.

  7. The examiner should be aware of possible technical issues discussed in this section.

  8. The examiner should consider the appropriate use of sampling techniques to enhance and improve the examination process for selected expenses.

4.43.1.13.8  (07-23-2009)
Other Information

  1. Payment of another’s expense and personal expenses should also be considered.

4.43.1.13.8.1  (07-23-2009)
Payment of Another’s Expense

  1. A fundamental rule spelled out in IRC 162 is that business expenses deductible from gross income include ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business. Sometimes, a taxpayer pays or reimburses the business expenses of another person.

  2. In the review of reported business expenses consider the possibility that the retailer may have deducted the business expenses of another person.

  3. In some circumstances, the retailer may be entitled to deduct the payment of another person’s obligations. Generally, a deduction is allowable if a taxpayer pays another person’s obligations to protect and promote its own business. The taxpayer must receive a direct rather than indirect benefit from such payment. Situations in which this circumstance can arise include the following:

    1. The repayment of loans made by a taxpayer’s employees to an officer when the directors, acting in good faith, authorize the payment to preserve the loyalty of the employees and goodwill of customers.

    2. The payment of legal fees of an officer-shareholder if the taxpayer can show it has a clear relationship to the litigation and would suffer a direct and adverse effect on its business as a result of the litigation.

    3. The payment of restitution even though it has no legal obligation if a taxpayer’s involvement with another person results in that person’s incurring an expense or a loss, provided its reasons are to preserve its goodwill among its customers and to protect its business reputation.

  4. The examiner should consider the following audit techniques to address the issue of deductibility when a taxpayer pays another’s expenses:

    1. Identify the motive or purpose that caused the taxpayer to pay the obligations of the other person.

    2. Determine whether the motive supports an ordinary and necessary expense of the taxpayer’s trade or business.

4.43.1.13.8.2  (07-23-2009)
Personal Expenses

  1. Retailers may improperly pay and deduct expenses which do not relate to the operation of the business or may withdraw merchandise from the business for their personal use. This is a difficult aspect of the examination because it involves the identification of the personal expenditure and the establishment of the amount. The following paragraphs describe some of the potential areas of abuse. Strong internal controls decrease the occurrence of such issues.


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