4.43.1  Retail Industry

4.43.1.1  (07-23-2009)
Overview

  1. A nationwide Retail Industry Program was established in 1988 in the legacy IRS large case program.

  2. The Retail Industry Handbook (the Handbook), first published in the Internal Revenue Manual (IRM) in 1994, supports the Retail Industry Program.

4.43.1.1.1  (07-23-2009)
Purpose

  1. The Handbook is a resource tool designed to provide the examiner with general knowledge about:

    1. Standard retail industry business practices

    2. Accounting policies and practices unique to this specialty area

  2. The Handbook will help the examiner:

    1. Understand key terms and accounting operations unique to the retail industry

    2. Identify potential tax compliance issues that may arise from conducting and reporting retail business operations

    3. Assess the potential audit risk(s) of an issue

    4. Identify pertinent accounting records and supporting documentation

  3. The Handbook can minimize the time the examiner needs to acquire:

    1. General knowledge about the retail industry

    2. Audit skills to examine a retailer

  4. The Handbook is also intended to facilitate service-wide communication and coordination in identifying and investigating common or emerging retail industry issues so that these issues are handled in the most effective and consistent manner possible.

4.43.1.1.2  (07-23-2009)
Guiding Principles

  1. The function of the IRS is to administer the Internal Revenue Code.

  2. To properly accomplish this function, it is important for the examiner to:

    1. Understand the nature of a potential issue in the context of the retail industry

    2. Administer the applicable law in a reasonable, practical manner

    3. Develop an issue of merit and never arbitrarily or for trading purposes

    4. Promote fair and consistent treatment of all similarly situated taxpayers in the retail industry

    5. Consider all available issue management strategies in an effort to resolve issues at the examination level

    6. Consider opportunities to reduce resources, burden, and/or time spent by both the taxpayer and the IRS

4.43.1.1.3  (07-23-2009)
Content

  1. This Handbook emphasizes audit issues and procedures unique to the retail industry.

  2. The Handbook offers audit procedures and techniques to identify potential compliance risks associated with these unique areas.

  3. The Handbook cannot cover all possible issues, procedures, or techniques in an industry as complex and diverse as the retail industry.

  4. The audit procedures and techniques in this Handbook are not intended to be mandatory.

  5. The examiner is encouraged to improve upon these procedures and techniques and to use the examiner’s own initiative and ingenuity in managing the rapid changes taking place within the retail industry.

  6. The retail industry is subject to a large number of substantive tax law provisions. The tax law references are general and brief in nature. The examiner should not rely upon these references for a complete understanding of the law.

  7. The Handbook does not alter existing technical or procedural instructions contained elsewhere in the IRM. If this Handbook conflicts with the basic IRM text, the latter will prevail. Procedural statements in this Handbook are for emphasis and clarity and are not to be taken as authority for administrative action.

  8. The examiner can only acquire a working knowledge of tax law and potential issues affecting the retail industry through study and several years of examination experience in the industry. The examiner should study, consider, and apply the Handbook material where it is appropriate, to ensure an efficient and effective examination.

  9. The content of the document is current through the publication date. Changes occurring after the publication date may affect the Handbook’s accuracy.

  10. This Handbook was updated under the direction of the Retailers, Food, Pharmaceutical & Healthcare Industry within the Large and Mid-Size Business (LMSB) Operating Division.

4.43.1.1.4  (07-23-2009)
Technical Advisor Program

  1. The examiner is encouraged to remain in frequent contact with the Retail Industry Technical Advisor(s). The role of the Retail Industry Technical Advisor includes the following:

    1. Assist field personnel in identifying, developing, and resolving specific-industry and cross-industry technical issues

    2. Ensure uniform and consistent treatment of issues nationwide

    3. Provide a vehicle for coordination of technical issues

    4. Ensure all Tiered issues are identified, coordinated, and properly developed

    5. Provide educational opportunities to internal and external customers

    6. Maintain/develop industry and issue expertise

4.43.1.2  (07-23-2009)
General Industry

  1. This section provides general background information about the retail industry.

4.43.1.2.1  (07-23-2009)
Description of Retailing

  1. The retail industry consists of businesses selling goods, generally without transformation, and providing services incidental to the sale of goods.

  2. Some retail businesses engage in the provision of after-sales services, such as repair and installation.

  3. Retailers are organized to sell goods in small quantities to the general public for personal or family use.

  4. Retailing is the final step in the distribution of goods linking suppliers and consumers.

4.43.1.2.2  (07-23-2009)
Nature of Retail Industry

  1. The nature of the retail industry is wide-spread and can be described in the following manner:

4.43.1.2.2.1  (07-23-2009)
Size

  1. Retail is the second largest industry in the United States.

  2. Retail sales account for about 10 percent of the U.S. gross national product.

  3. Retail employs one out of every nine American workers, or about 12 percent of U.S. employment.

4.43.1.2.2.2  (07-23-2009)
Competition

  1. Retail is intensely competitive with few barriers to entry.

  2. Retailers compete against many other national, regional, and local retailers for:

    1. Customers

    2. Employees

    3. Locations

    4. Merchandise

    5. Other important aspects of retailing

  3. Competition is characterized by many factors, including:

    1. Merchandise assortment

    2. Advertising

    3. Price

    4. Quality

    5. Service

    6. Location

    7. Reputation

    8. Credit availability

  4. The ability to attract and retain customers depends on a combination of these factors.

4.43.1.2.2.3  (07-23-2009)
Composition

  1. Retail’s largest segment consists of small, independent stores usually operated by the owner.

  2. Single store retail businesses account for over 95 percent of all U.S. retailers, but generate less than 50 percent of all retail store sales.

  3. Some retailers are both wholesalers and retailers because they sell to consumers and other businesses.

  4. Some retailers are both manufacturers and retailers because they produce the products they sell.

  5. The blurring of the lines between different types of retail formats has fundamentally changed the industry.

  6. Retailers, regardless of other functions they perform, are still retailers when they interact with the final user of the product or service.

4.43.1.2.2.4  (07-23-2009)
Consolidation

  1. Retail is a mature, slow growth industry.

  2. The industry has consolidated over the past two decades.

4.43.1.2.2.5  (07-23-2009)
Profitability

  1. Gross margin typically runs between 31 and 33 percent of sales.

  2. Gross margins, however, vary widely by segment.

4.43.1.2.2.6  (07-23-2009)
Scale

  1. Large scale chains dominate the retail industry.

  2. By its very nature, the industry is biased in favor of retailers that are larger and more efficient than their competitors

  3. A retailer with a large store base has a greater ability to leverage cost benefits across a number of areas.

  4. Most retailers focus on a single segment of retailing electing to build scale and depth.

4.43.1.2.2.7  (07-23-2009)
Seasonality

  1. Most retail business is seasonal in nature.

  2. Seasonality causes operating results to vary considerably from quarter to quarter.

  3. For many retailers, the peak selling season includes the fall and winter holiday seasons. Consequently, the fourth quarter historically contributes a significant portion of profitability for many retailers.

  4. A retailer’s overall profitability depends to a great extent on the results of operations for the last quarter of the fiscal year. Any factors negatively affecting fourth quarter sales may have a material adverse effect on profitability for the entire year.

4.43.1.2.2.8  (07-23-2009)
Supply Chain Trends

  1. Retailers now act as designers, suppliers, and importers.

  2. Merchandise is globally-sourced from low-cost countries.

  3. Products are customized, which provides a point of competitive differentiation.

  4. E-commerce continues to get bigger and take a large share of retail sales.

4.43.1.2.3  (07-23-2009)
Retail Industry Demographics

  1. Retail industry demographics are different from many other industries in the following respects:

    1. Finished goods are purchased for resale.

    2. Multiple channels, such as in-store, catalog, and internet are used to make sales.

    3. A large number of sales transactions involve small quantities of merchandise purchased by the general public.

    4. A broad assortment of merchandise carried by product line and/or department.

    5. Consumer preferences are not constant.

    6. Merchandise assortment and presentation are constantly changing.

    7. Merchandise is spread among numerous locations for chain stores.

    8. A large number of employees are involved directly with customers.

4.43.1.2.4  (07-23-2009)
Retail Industry Classification

  1. The North American Industry Classification System (NAICS) groups businesses into industries based on the activity in which they are primarily engaged. All economic activity is categorized into twenty industry sectors, one of which is retail. Retail trade is included in sectors 44 and 45.

  2. Retail consists of two principal types of establishments: store retailers and non-store retailers.

4.43.1.2.4.1  (07-23-2009)
Store Retailers

  1. Store retailers utilize fixed point-of-sale locations, located and designed to attract a high volume of walk-in customers.

  2. Store retailers often utilize extensive merchandise displays and mass media advertising to attract customers.

  3. Store retailers sell merchandise to the general public for personal or household consumption, but some also serve business and institutional customers.

  4. Store retailers are typically grouped by the merchandise line or lines carried by the store. The categories can include:

    1. Automotive Parts, Accessories, and Tire Stores

    2. Furniture and Home Furnishings Stores

    3. Electronic and Appliance Stores

    4. Building Material and Garden Equipment and Supplies Dealers

    5. Food and Beverage Stores (e.g. grocery stores)

    6. Health and Personal Care Stores (e.g. drug stores)

    7. Clothing and Clothing Accessories Stores (includes shoe, jewelry, luggage, and leather goods stores)

    8. Sporting Goods, Hobby, Book and Music Stores

    9. General merchandise stores (e.g. department and discount stores)

    10. Miscellaneous store retailers (e.g. florist, office supplies, pet supplies)

4.43.1.2.4.2  (07-23-2009)
Non-Store Retailers

  1. Non-store retailers are similar to a store retailer, which is organized to serve the general public, but their retailing methods differ.

  2. Non-store retailers are typically grouped as follows:

    1. Electronic commerce (E-commerce)

    2. Catalog and mail-order retailers (i.e. paper and electronic catalogs)

    3. Direct retailers (e.g. door-to-door solicitation)

  3. Retailers serviced by other Technical Advisor Programs include:

    1. Auto and recreational dealerships (Motor Vehicle)

    2. Food wholesalers and restaurants (Food and Beverage)

    3. Gasoline stations, convenience stores (Petroleum)

    4. Book stores (Media)

4.43.1.2.5  (07-23-2009)
Merchandise Classification

  1. Types of merchandise sold at retail establishments today are classified as either soft or hard goods. General merchandise is the umbrella term comprising both lines.

  2. Hard goods include electronics, hardware, paint, small appliances, stationery/office supplies, candy, tobacco, and impulse merchandise.

  3. Consumable hard goods include health and beauty aids (HABA), over-the-counter medicines, cosmetics, paper goods, and pet supplies.

  4. Seasonal hard goods include sporting goods, toys, lawn and garden equipment, automotive supplies, and seasonal/holiday merchandise.

  5. Soft goods include apparel, accessories, sheets, towels, and other linens.

4.43.1.2.6  (07-23-2009)
Key Sales Periods

  1. Holidays include:

    1. Valentine's Day

    2. Easter

    3. Mother's Day

    4. Father's Day

    5. Halloween

    6. Christmas

  2. Others include:

    1. Back-to-School

    2. Bridal and wedding

4.43.1.2.7  (07-23-2009)
Legal and Regulatory Issues

  1. The retail industry is subject to various federal, state, local, and foreign laws, regulations, and administrative practices affecting business operations. Various government agencies are empowered to see that retail businesses follow such laws. Retailers must comply with numerous provisions regulating the importation, promotion, and sale of merchandise, consumer and employee protection, and the operation of retail stores and warehouse facilities.

4.43.1.2.7.1  (07-23-2009)
Federal Requirements

  1. There are numerous federal requirements, which include the following.

4.43.1.2.7.1.1  (07-23-2009)
Product Distribution

  1. The Sherman Act (1890) prohibits under-pricing or selling at a loss as a continuous practice with the aim of eliminating all competition.

  2. The Clayton Act (1914) prohibits unfair trade practices such as exclusive dealing and tying contracts.

    1. Exclusive dealing includes providing an intermediary exclusive rights to a territory.

    2. "Tying" requires a customer to take less desirable products from a product line to gain access to desirable products.

    3. The Act excludes short-term store promotions that are meant to increase customer traffic from the reach of the Sherman Act.

  3. The Robinson-Patman Act (1936) protects retailers from unfair and preferential trading practices between manufacturers and retailers.

    1. Absent this law, suppliers could decide with whom they wished to conduct business, to the exclusion of others.

    2. This law also prevents a supplier from colluding with one or more retailers against the retailer’s competition.

    3. The law protects individual competitors from price discrimination in favor of large chain stores by their suppliers.

    4. The law applies to cooperative advertising, among other matters.

    5. The Act restricts statements and claims that firms may claim about competing firms and products.

4.43.1.2.7.1.2  (07-23-2009)
Consumer Protection

  1. The Federal Trade Commission Act (1914) prohibits fraudulent and misleading product information.

  2. The Wheeler-Lea Amendment (1938) protects consumers from the retailing practice of enticing a consumer with a low price for one product and then pressuring the customer to buy a different product at a higher price.

  3. The Magnuson-Moss Act (1975) codified most of the warranty information that must be disclosed to the consumer. The law allows the consumer to have information about the warranty from the manufacturer as well as the seller.

  4. The Consumer Credit Protection Act (1968) requires written disclosure to the borrower of the true cost of credit.

  5. The Fair Credit Reporting Act (originally enacted in 1970) requires retailers to respond to inquiries by consumers on credit card and other charge accounts where the debtor believes an improper or incorrect charge is made on a bill.

  6. The American with Disabilities Act or ADA (1990) requires businesses to have adequate space for customers with disabilities.

4.43.1.2.7.1.3  (07-23-2009)
Employee Protection

  1. The OSHA Reform Act requires an employer to furnish a work environment that is free of recognized hazards causing or likely to cause death or serious injury, as well as to comply with government safety and health standards.

  2. ADA is designed to remove barriers to individuals with disabilities and to ensure equal access to employment activities.

4.43.1.2.7.1.4  (07-23-2009)
Environmental Protection

  1. The Clean Air Act (1970) and Clean Water Act (1972) safeguard the natural environment.

  2. The Energy Policy Act (2005) sets national commercial equipment efficiency standards and provides tax incentives for advanced energy saving technologies and practices.

4.43.1.2.7.1.5  (07-23-2009)
Bankruptcy

  1. The new Bankruptcy Code (Bankruptcy Reform Act of 2005) effective October 17, 2005 makes it more difficult for a retailer to consider bankruptcy. The new law provides that debtors have a maximum of 210 days after filing to keep or relinquish leases, down substantially from prior law. The exclusivity period afforded debtors is not limited to 18 months after filing and suppliers can now reclaim their goods from the debtor within 45 days of bankruptcy as opposed to the previous 10-day limit.

4.43.1.2.7.2  (07-23-2009)
Federal Agencies

  1. Federal Trade Commission (FTC) prohibits practices harmful to competition and, through a series of legislative acts, has established guidelines for allowances provided by manufacturers to program participants with whom they conduct business, either directly or indirectly, in the U.S.

  2. The Environmental Protection Agency (EPA) regulates environmental practices by way of various acts like the Pollution Prevention Act and the Resource Conservation and Recovery Act.

  3. Department of Justice (DOJ) enforces the False Claims Act, which covers improper government billing for dispensing partial prescriptions to patients in Medicaid and other federal programs.

  4. Food and Drug Administration (FDA) administers federal laws regarding the purity of food, the truthfulness of labels, and the safety and honesty of packaging.

  5. Occupational Safety and Health Administration (OSHA) is responsible for developing and enforcing regulations that promote a safe work environment.

4.43.1.2.7.3  (07-23-2009)
State Requirements

  1. Economic Development

    1. Subsidies are used to encourage the growth of business activity within the state’s borders.

  2. Consumer Protection

    1. States check the accuracy of weight, volume, length and size of consumer products.

    2. States check the accuracy of scanned prices against price tags.

  3. Unclaimed Property

    1. Most states require retailers to submit the proceeds of unredeemed gift certificates and cards to the state after a specified number of years under their escheatment rules.

  4. Liquor laws control a number of items including pricing and discounts.

  5. Employee Protection

    1. Each state has its own worker’s compensation laws and second injury fund

4.43.1.2.7.4  (07-23-2009)
Local Requirements

  1. Various zoning, building, and occupancy ordinances regulate the operation of retail stores and warehouse facilities.

4.43.1.2.8  (07-23-2009)
Technology

  1. Technology’s role in shaping retailing has evolved and become a powerful competitive tool. The pace of technological advance is rapid and as the cost of technology declines, its use will become even more widespread. Technological advances have made it feasible to manage and operate efficiently in larger sizes than previously, often on a global basis.

  2. Retailing has long been held to be more of an art than a science. The intuitive ability to correctly anticipate consumer interests will always be a key, and a distinctly human skill needed in the industry.

  3. Key technologies used in retail include point of sale systems, inventory management systems, and customer relations.

4.43.1.2.8.1  (07-23-2009)
Key Technologies

  1. Point of Sale Systems (POS)

    1. Barcoding and scanning devices for product identification, used to provide real time, accurate information on which products are selling at the point of sale.

    2. Mechanical cash registers have been replaced by personal computers and built in credit card swipe machines for credit card transactions.

    3. Sales information is captured at the cash register and used to adjust inventory records and reorder merchandise automatically.

  2. Inventory Management Systems

    1. Ambient technology, especially radio frequency, allows for tracking product movement throughout the supply chain.

    2. The primary use of radio frequency technology employs RFID tags and readers.

    3. Technology is being used to record accurate information on retail prices, stock keeping units (SKUs) or individual items in inventory, and the aging of inventory.

  3. Customer Relations

    1. With each point of sale transaction, retailers have an opportunity to gain information about their customers. Retailers are using this information to focus on relationship marketing as a way to gain market share.

4.43.1.2.9  (07-23-2009)
Electronic Commerce (E-commerce)

  1. E-commerce is economic activity defined as the value of goods and services sold online.

  2. The internet, like technology, has made fundamental changes in the retail industry.

  3. E-commerce plays a key role in acting as both a sales channel and a consumer communication tool.

  4. Almost every category of merchandise is offered for sale online.

  5. On-line retailers bring together an assortment of merchandise for consumers to buy in the same way as traditional store retailers.

  6. Multi-channel retailing is an integral part of the retail industry. Store retailers and catalog retailers are using the internet to become multi-channel retailers.

  7. Consumers are increasingly likely to shop across multiple channels.

  8. IRM 4.10.4.3.6 provides the following information about e-commerce:

    1. Reviewing websites

    2. Interviewing taxpayers regarding e-commerce activities

    3. Evaluating electronic books and records

    4. Identifying income from e-commerce activities.

4.43.1.2.10  (07-23-2009)
Coordinated Issue Papers

  1. Coordinated issue papers:

    1. Identify key industry or cross-industry issues

    2. Provide guidance to address compliance issues.

    3. Express position of the Large and Mid-Size Business Division (LMSB) Commissioner to ensure uniform treatment of taxpayers.

    4. Establish a consistent compliance position.

    5. Do not represent the official position of the Service with respect to legal position.

    6. May impact more than one industry and/or operating division.

    7. Are binding on all IRS examiners.

  2. Deviation from position(s) stated in a Coordinated Issue Paper requires the concurrence of the Technical Advisor Team.

  3. Exhibit 4.43.1-2 lists coordinated issues unique to the retail industry.

4.43.1.2.11  (07-23-2009)
Industry Director's Directives (IDD)

  1. IDDs provide guidelines and instructions to examiners on procedures and administrative aspects of compliance activities to ensure consistent treatment of taxpayers.

  2. IDDs are not an official pronouncement of the law or the position of the Service and cannot be used, cited or relied upon as such.

  3. LMSB Examiners are expected to follow IDD guidelines and instructions.

  4. Exhibit 4.43.1-3 lists IDDs unique to the retail industry.

4.43.1.2.12  (07-23-2009)
Audit Techniques Guides (ATG)

  1. The objective of an ATG is to capture a unique business practice of a particular segment or issue studied.

  2. The intent of an ATG is to provide examination techniques found to be useful when examining a unique business practice, but does not provide legal analysis or resolve positions on controversial or unusual legal issues.

  3. The Retail Industry Audit Technique Guide can be accessed at: http://www.irs.gov/pub/irs-mssp/retail_industry_102005_final.pdf

4.43.1.2.13  (07-23-2009)
Issue Focus Tiered Issues

  1. The objective of this approach is to strengthen the industry focus on significant LMSB compliance issues. The extent to which these issues are controlled and the operation of the rules of engagement will depend largely on the importance or impact of the issue.

  2. Industry issues will be designated as follows:

    1. Tier I – High Strategic Importance Tier I issues are of high strategic importance to LMSB and have significant impact on one or more industries. Tier I issues include areas involving a large number of taxpayers, significant dollar risk, substantial compliance risk or high visibility, where there are established legal positions and/or LMSB direction.

    2. Tier II – Significant Compliance Risk Tier II issues reflect areas of potential high non-compliance and/or significant compliance risk to LMSB or an industry. Tier II includes emerging issues, where the law is fairly well established, but there is a need for further development, clarification, direction and guidance on LMSB’s position.

    3. Tier III – Industry Importance Tier III issues typically are industry-related, and have been identified as issues that should be considered by LMSB teams when conducting their risk analyses.

  3. For more information, examiners should consult IRM 4.51.5, Industry Focus and Control of LMSB Compliance Issues.

  4. Specific tiered issues are posted on the IRS web site.

4.43.1.2.14  (07-23-2009)
Retail Industry Resources

  1. Additional information about the retail industry is available from multiple sources. Sources of additional information include:

    1. Retail Trade Associations are listed in Exhibit 4.43.1-4.

    2. Retail Trade Books, Journals, Magazines and Other Publications are listed in Exhibit 4.43.1-5 and Exhibit 4.43.1-6.

    3. Relevant Websites are listed in Exhibit 4.43.1-7.

    4. Universities and Institutes Researching Retailers are listed in Exhibit 4.43.1-8.

    5. A glossary of Retail Terminology is provided in Exhibit 4.43.1-11.

4.43.1.3  (07-23-2009)
General Accounting

  1. Accounting is essential to the effective functioning of any business organization, particularly the corporate form.

  2. This section provides an overview of accounting periods, methods, and records used by retailers.

4.43.1.3.1  (07-23-2009)
Annual Accounting Period

  1. A taxpayer’s tax year must correspond with its annual accounting period, which is defined as the period on the basis of which a taxpayer regularly computes income in keeping its books.

  2. Taxpayers have some flexibility in choosing a year-end. An annual accounting period can be a calendar or fiscal year.

    1. A calendar year is 12 consecutive months beginning January 1 and ending December 31.

    2. A fiscal year is 12 consecutive months ending on the last day of any month except December.

  3. Many retailers elect to use a unique accounting period known as a 52/53 week fiscal year as provided by Treas. Reg. 1.441-2(a)(1).

    1. A 52/53 week tax year is a special type of tax year which ends on the same day of the week within a month instead of the last day of that month. For example, the last Friday in January instead of January 31. This results in some tax years being 52 weeks long and some being 53 weeks long. A 53-week tax year will occur about once every seven years.

    2. Many retailers use a January year-end because inventories are low after the holidays and returned merchandise is minimal.

    3. A 52/53 week tax year normally has little effect from a tax standpoint, but can provide certain business advantages. The most important advantage of a 52/53 week tax year is a solid base for comparative statistical and budgetary purposes. While a regular year-end comparison is often misleading because some months have more weekends than others, a 52-53 week tax year uses four-week blocks, which are easily compared with one another. Using a year-end tied to a specific date can also eliminate many accruals which might otherwise be needed, such as weekly wages.

  4. The examiner should identify the accounting period used for each period under examination to determine the proper treatment of timing or allocation issues.

4.43.1.3.2  (07-23-2009)
Accounting Methods

  1. A retailer’s gross income for a year will depend on its method of accounting.

  2. Financial and tax reporting have different objectives when measuring the recognition of income and expense and, as a result, frequently adopt differing accounting methods.

  3. In Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542 (1979), the Supreme Court emphasized the primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and others properly interested; the major responsibility of the accountant is to protect these parties from being misled. The primary goal of the income tax system, in contrast, is the equitable collection of revenue; the major responsibility of the Internal Revenue Service is to protect the public’s interest.

  4. Generally Accepted Accounting Principles (GAAP) allow a range of reasonable treatments, leaving the choice among alternatives to management. The flexibility of acceptable choices inherent in financial reporting is unenforceable in a tax system designed to ensure as far as possible that similarly situated taxpayers pay the same tax. To achieve this goal, the tax system uses "rules" rather than broad "standards."

  5. In all cases, the accounting method used must be consistently used and it must clearly reflect income. A retailer’s consistent use of an accounting method strengthens its position that the method over a period of years clearly reflects income.

  6. The IRS has broad authority to see that gross income is clearly reflected.

4.43.1.3.2.1  (07-23-2009)
Financial Accounting Methods

  1. Financial statements are prepared in accordance with GAAP in the United States. They are subject to interpretation by various governing bodies, including the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC), which create and interpret accounting standards.

  2. The preparation of financial statements, in conformity with GAAP, requires retailers to make estimates and assumptions that affect the reported amounts of assets, liabilities, income and expenses for a reporting period. Similarly certain accounting methods used by retailers involve estimates or assumptions; the nature of which are material due to the levels of subjectivity and judgment necessary to account for uncertain matters or susceptibility of such matters to change. In some situations, retailers may exercise judgment in selecting acceptable principles and methods for specific circumstances of diverse and complex economic activities.

4.43.1.3.2.2  (07-23-2009)
Tax Accounting Methods

  1. The Internal Revenue Code does not specifically define an "accounting method." However, Treas. Reg. 1.446-1(e)(2)(ii)(a) provides that a change in accounting method includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. The essential element of a material item is that it involves the proper time for the inclusion of the item in income or the taking of a deduction. If the practice does not permanently affect the taxpayer's lifetime taxable income, but does or could change the taxable year in which taxable income is reported, it involves timing and is therefore considered a method of accounting.

  2. Issues which do not involve a question of timing:

    1. Personal vs. business expense issues

    2. Correction of mathematical or bookkeeping errors

    3. Revision in the treatment of an item resulting from a change in the underlying facts

  3. A method of accounting is not established in most instances without the consistent treatment of an item.

  4. Taxpayers generally use accounting methods similar to those of other taxpayers. Some methods, including Retail LIFO, computing inventory shrinkage, and reporting income from advertising allowances and coupons are primarily retail in nature.

  5. The following situations represent examples of how a change in the taxpayer's method of accounting might occur:

    1. The taxpayer filed Form 3115 (Request for Approval of Change in Method of Accounting) with the National Office.

    2. The taxpayer made an unauthorized change in method on its tax return.

    3. The examiner makes adjustments which constitute a change in method.

  6. Rev. Proc. 97-27 and Rev. Proc. 2008-52 contain comprehensive IRS guidelines relative to changes in methods of accounting. These revenue procedures and any subsequent revenue procedures dealing with changes in method should be consulted in all cases which have a change in method of accounting issue.

  7. Audit Considerations

    1. The examiner should be alert to changes in a retailer’s method of accounting.

    2. The examiner should request copies of all Forms 3115 filed by the retailer, whether closed or pending, which affect the tax years under examination as well as subsequent years, and consider the following.

    3. Does the retailer qualify to file Form 3115? Except during certain window periods, a taxpayer under examination may not file a Form 3115 without the approval of the authorized IRS official. Also, a retailer under examination may not request to change an impermissible method of accounting if the year in which the taxpayer adopted the method is a year under examination; or if the year under examination is a year in which a taxpayer made an unauthorized change in method. The examiner may need to revise both the year of the change and the IRC 481(a) adjustment.

    4. Does the retailer’s method comply with tax law? The examiner should request information pertinent to the issue during the audit if the requested method appears questionable. When considering a Form 3115, the National Office generally relies on information submitted by the retailer which may be lacking in detail. The examiner should determine whether the various books, records and other information available would provide a more complete and objective perspective to the National Office. Access to all applicable information regarding a Form 3115 may result in the National Office making a different determination than would occur if only the retailer-provided information was reviewed, and future problems resulting from inappropriate approval may be circumvented.

    5. The examiner should determine whether the retailer has made any premature or other unauthorized changes in method of accounting. Withdrawn, denied, and pending Forms 3115 should be considered to determine if the retailer made unauthorized changes prior to a decision by the National Office. Schedule M provides a resource to assist the examiner in determining whether any unauthorized changes exist. In the event of an unauthorized change, the examiner may disallow the unauthorized change and place the retailer back on its prior method.

    6. Proposed examination adjustments may constitute a change in method. If they do, the examiner must determine the appropriate year of change and the IRC 481(a) adjustment and spread.

    7. See IRM 4.11.6 Change in Accounting Methods and/or contact the Change in Accounting Method Technical Advisor when appropriate.

4.43.1.3.2.3  (07-23-2009)
Significant Accounting Methods

  1. For retailers, significant accounting methods generally fall into the following categories:

    1. Income recognition, which may include advance payments for goods and services, vendor and landlord incentives, and promotional activities

    2. Inventory, related reserves and gross margin recognition, including the application of the retail inventory method for certain retailers

    3. Inventory capitalization under the uniform inventory capitalization rules ("UNICAP" )

    4. Accounts receivable and related reserves, particularly for retailers with proprietary credit businesses

    5. Property and long-lived assets, particularly their classification for cost recovery, including store and distribution center assets, leasehold improvements, computer hardware and software, and other intangible assets

    6. Debt, including off-balance sheet arrangements such as leases

4.43.1.3.2.4  (07-23-2009)
Financial and Tax Accounting Methods Conformity

  1. Under IRC 446(a) and Treas. Reg. 1.446-1(a)(1), taxable income is computed using the method that the taxpayer regularly uses to compute its income in keeping its books. Financial accounting and tax accounting, however, are distinct systems of reporting information.

  2. If the taxpayer’s financial practice conforms to GAAP, then, ordinarily, the practice may be acceptable for tax purposes.

  3. Where tax and GAAP provisions differ, provisions of the Internal Revenue Code or regulations prevail over GAAP. In the final analysis, a tax accounting method must conform to principles of tax accounting, not GAAP, in order to clearly reflect income.

  4. There are many instances where tax accounting principles are fundamentally different from GAAP, so that compliance with GAAP will not mean compliance with IRC 446(a) for tax accounting purposes. In the context of the retail industry, reporting differences often occur in the following areas:

    1. Income recognition

    2. Inventory

    3. Property cost recovery

4.43.1.3.3  (07-23-2009)
Schedule M Reconciliation

  1. Retailers have different objectives when they prepare the financial statements and when they complete their tax return. The result of these different objectives is a disparity between book and taxable income.

  2. A book-tax difference is simply a difference in any year between how an item of income, gain, expense, or loss is treated in determining a corporation’s federal taxable income and how it is treated in determining its pre-tax income on its GAAP financial statements.

  3. Schedule M to the IRS Form 1120 is the reconciliation between the books and records of a corporation and its income tax return. Schedule M is a critical schedule for identifying potential tax issues resulting from both temporary and permanent differences between financial and tax accounting. Consequently, the documentation supporting Schedule M adjustments is important in determining compliance with tax law.

  4. Audit Considerations include the following:

    1. Review the Schedule M on the return, including attached schedules, which reflect detail of the differences between book and tax reporting. The materiality of an item may not be transparent from the examiner’s review of the Schedule M due to the netting of similar or dissimilar items.

    2. Request complete workpapers and all pertinent documentation to substantiate the computation of the Schedule M entries. Pertinent documentation includes books of original entry, audited financial statements, schedules and source documents such as invoices, contracts, and agreements.

    3. Review the balance sheet and income statement for possible omissions from Schedule M. Ask the taxpayer to explain the accounting treatment of such items for financial and tax purposes if the expected items are not listed on Schedule M.

    4. The failure to reconcile the books to the tax return early in the examination could result in unnecessary expenditures of time reviewing areas that ultimately were properly treated for tax purposes. The failure to identify items that were not reported for tax, or items that were deducted only for tax purposes, could result in overlooking potential adjustments to taxable income.

    5. The difference between GAAP and tax standards will often result in recognizing taxable income sooner and recognizing tax deductions later than the corresponding book treatment.

4.43.1.3.4  (07-23-2009)
Income Recognition

  1. Gross income includes consideration received for merchandise sold for cash or credit and for services that are incidental to the sale of merchandise.

  2. Retailers generally record income at the time of sale when payment is made, delivery has occurred, and the sales price is fixed. In some situations (e.g. e-commerce and catalog sales), income may be recorded at the time of delivery (i.e. customer receipt).

  3. For financial reporting, retailers may report gross income net of estimated and actual sales deductions such as sales returns, rebates, discounts, sales allowances, loyalty or reward points, coupons and other promotions. Reserves for these various sales deductions are often computed as a percentage of sales based on historical return percentages.

  4. While retailers generally include shipping and handling revenue as items of gross income, sales tax collected from customers is generally excluded from gross income and included as part of accrued income and other taxes.

  5. Retailers, which have leased departments, generally include sales from such departments in gross income.

  6. For financial reporting purposes, advance customer payments for goods and services are generally deferred beyond the date of payment. Common prepaid income items in retailing include gift card sales, layaway sales, club memberships, and extended service plans. Prepaid income items are typically credited to a current liability account at the time of cash receipt. Income is recognized at some later date, which may be a different tax year.

    1. Gift card sales are generally deferred until the card is redeemed for merchandise.

    2. Layaway sales are generally deferred until the customer satisfies all payment obligations and takes possession of the merchandise.

    3. Club membership fees are generally deferred and recognized ratably over the term of the membership. Most memberships are for 12 months.

    4. Extended service plans are generally deferred and recognized ratably over the life of the plan.

  7. The IRS is primarily concerned with the tax treatment given to prepaid income items. For tax purposes prepaid items are generally included in income upon receipt, unless a deferral provision applies.

4.43.1.3.5  (07-23-2009)
Inventory

  1. This section briefly reviews the topic of inventory. See IRM 4.43.1.5 for more information on inventory.

4.43.1.3.5.1  (07-23-2009)
Inventories and Cost of Sales

  1. Inventories, which consist primarily of finished goods, play a significant role in the computation of taxable income. Inventories represent a capitalized cost that is "deducted" through cost of goods sold in the year of sale. The purpose of an inventory accounting method is to provide an appropriate measure of costs to match to a period’s income in order to determine profit.

  2. Inventories generally represent the most significant asset on the balance sheet. Similarly, cost of sales generally represents the largest single item of expense on the income statement. At the same time, inventory is arguably the asset with the highest probability of being incorrectly valued because of the judgments and estimates required in determining the appropriate valuation at taxable year-end.

  3. The methods of valuation may vary according to the accounting practices of each retailer. Inventory accounting methods are cost flow assumptions and, with some exceptions, will have no direct relation to the underlying management of physical inventory. Most retailers prefer to use RIM rather than the cost method in determining the value of inventory.

  4. A combination of the above methods for different classes of goods is acceptable as long as the method is applied consistently.

  5. A switch from one method to another for any class of goods, for example, from the First-in, First-Out (FIFO) method to the specific identification method, is considered a change in accounting method that requires the Commissioner's approval.

  6. This subsection explains the different accounting methods used to determine the value of inventory.

4.43.1.3.5.2  (07-23-2009)
Valuation of Inventories

  1. Taxpayers must value their inventories using a proper method: Cost or the Lower of Cost or Market (LCM)

    1. Inventory is valued at its acquisition cost. Acquisition cost includes all of the costs associated with taking possession of merchandise. Acquisition costs include invoice price, inbound freight costs, import fees and duties, commissions and other similar acquisition costs. Acquisition cost should be reduced for trade discounts received. Cash discounts (for early payment of invoice) may be deducted or not deducted at the taxpayer's option as long as the method is consistent. Retailers must also add to the value of the inventory the UNICAP cost allocation determined under IRC 263A unless they meet the $ 10,000,000 or less gross receipts exception of IRC 263A(b)(2)(B).

    2. When a retailer using the cost method takes an inventory count, the goods on hand must be matched against or traced to the stock ledger to determine the cost. Because of the recordkeeping requirements involved, most retailers have elected the retail inventory method which does not require such tracing. Due to advances in technology, including bar codes and POS terminals, retailers now have the capability to use the cost method with little or no increased recordkeeping costs.

    3. In associating costs with the physical inventory, the taxpayer may use specific identification or may adopt an accounting assumption.

  2. Lower of Cost or Market (LCM)

    1. Inventory is initially valued at cost. Under Treas. Reg. 1.471-4, taxpayers are allowed to reduce ending inventory (thereby reducing taxable income) to its market value if this value is less than cost.

    2. The definition of market is important. Under LCM, "market" generally refers to replacement cost for the same goods in the same quantities that the taxpayer would normally acquire. For retailers, the market will often be the retail sales price after markdowns and discounts because retail goods tend to have a high obsolescence or change of style factor.

    3. Goods must be inventoried at cost to any goods on hand or in process of manufacture for delivery upon firm sales contracts (i.e. those not legally subject to cancellation by either party) at fixed prices entered into before the date of the inventory, under which the taxpayer is protected against actual loss. An illustration of a fixed price contract in retail can be found in Treasury Regulation 1.471-4(a)(3) Example (2).

    4. Where no open market exists, the taxpayer must use other evidence to substantiate a fair market price. In the case of purchased goods, market means the bid price prevailing at the date of the inventory for the particular merchandise in the volume in which usually purchased by the taxpayer.

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

    6. It is important to remember that the market value cannot be estimated. The taxpayer must actually offer those goods for sale at that price in order to call it market. For retailers, this usually means the price of the goods on the shelf. If the offer is not a bona fide offer, or if only a small portion of the goods are offered for sale, such a price should not be accepted as market.

    7. Taxpayers generally use the LCM method because it can provide a loss before the taxpayer has sold the property.

4.43.1.3.5.3  (07-23-2009)
Cost Flow Assumptions

  1. Specific Identification

    1. Absent cost flow assumptions, specific identification of cost may be used to value inventory. As a general rule, the regulations require that the actual cost of goods remaining in inventory is the inventoriable cost. This would normally require matching the goods in inventory to their specific invoices.

    2. Specific identification involves tracing the actual costs for a particular piece of inventory. This method is usually practiced only for high dollar-value goods like appliances, furniture, televisions, etc.

  2. First-In, First-Out (FIFO)

    1. Treas. Reg. 1.471-2(d) provides that goods taken in inventory which have been so intermingled that they cannot be identified with specific invoices will be deemed to be the goods most recently purchased or produced. Consequently, the first goods purchased are the first ones deemed sold and the costs for the goods in inventory at the end of the year are the amounts paid for those goods most recently purchased.

  3. Last-In, First-Out (LIFO)

    1. Under IRC 472 , a taxpayer is allowed to treat those goods remaining on hand at the close of the tax year as being those included in opening inventory of the taxable year in the order of acquisition and those goods acquired during the tax year. A condition placed upon such an election is that it must also be used for the valuation of inventory in financial statements.

    2. LIFO is popular in certain industries among larger companies, including retail. The primary advantage of the LIFO method is that, in most cases, it generates the lowest inventory value, by eliminating the increase in inventory due to price changes caused by inflation or other factors. The primary disadvantage of the LIFO method is the additional computations and the fact that inventories must be valued at cost. LCM is not permitted under LIFO.

    3. Retailers typically do not use LIFO for all merchandise inventories.

    4. Most LIFO retailers use the dollar-value method. Treas. Reg. 1.472-8(a) allows any taxpayer to elect the dollar-value LIFO method to determine the cost of inventory. Under the dollar-value method of LIFO valuation, changes in inventory are measured in dollars and not units. Under this method, the goods contained in the inventory are grouped into a pool or pools as explained below.

    5. Retailers use either the double extension method or an index method for each pool. Where the retailer can demonstrate that these methods are impractical, the link-chain method may be approved. Any method of computing the LIFO value of a dollar-value pool must be used for the year of adoption and for all subsequent years, unless permission to change is received.

    6. The term "base-year cost" is the aggregate of the cost of all items in the pool, as of the beginning of the taxable year LIFO was adopted. Subsequent to the initial year, each inventory period will result in an increment ("layer" ) or decrement to the prior cumulative inventory measured in terms of base-year costs. At any year-end, the cumulative inventory value of all layers will reflect the true growth in inventory rather than increased dollars relating to the same inventory size caused by price increases.

    7. Treas. Reg. 1 .472-8(c) provides the principal rules for establishing pools. The separation of goods into pools is fundamental to dollar-value LIFO. Within each pool are different items. Items of inventory in the hands of wholesalers, retailers, jobbers, and distributors must be placed into pools by major lines, types or classes of goods unless the retailer elects to use IPIC-method pools. In determining such groupings, customary business classifications of the trade will be an important consideration. The regulations providing for the natural business unit method of pooling may be employed only with the permission of the Commissioner of the IRS. The appropriateness of the number and composition of the pools used, as well as all computations incidental to such pools, are to be determined by the examination of the taxpayer's return. The pools selected must be used consistently for all subsequent years unless permission to change is granted by the Commissioner.

    8. Treas. Reg. 1.472-8(e)(2) explains the double-extension method. The quantity of each item in the pool at the close of the year is extended at both base-year unit cost and current-year unit cost. The two costs are then each totaled. Specific rules are to be used in determining those costs. Example 1 in Treas. Reg. 1.472-8(e)(2) illustrates the computation.

    9. Treas. Reg. 1.472-8(e)(3) explains the use of the inventory price index computation (IPIC). For each pool, the index indicates the level of price change that occurs from the beginning of the first taxable year under the LIFO method. An appropriate index must be used for each pool. See 4.43.1.5.6.8.3 for more information.

  4. Retail Inventory Method (RIM)

    1. Under Treas. Reg. 1.471-8, retailers can use RIM to determine the approximate cost of their inventories. Under this method, the total retail value of its ending inventory is reduced to approximate cost through the application of cost complements. The method takes into account permanent mark-ups and permanent mark-downs and in general facilities the calculation of the inventories of retailers.

    2. RIM is a periodic averaging method that is widely used in the retail industry due to its practicality, especially as volume increases. RIM can be used with FIFO or LIFO. The retail inventory method can be used to determine cost or lower of cost or market.

    3. RIM uses the relationship of cost to retail price to determine the cost of merchandise inventory. Specifically, the valuation of inventory at cost and the resulting gross margins are computed by applying a calculated cost-to-retail ratio to the retail value of ending inventories.

    4. The use of RIM values inventories at lower of cost or market if permanent markdowns are not subtracted from total retail selling prices when computing the denominator of cost complements.

    5. The RIM calculation naturally requires certain management judgments and estimates, including merchandise markon, markups, markdowns, and shrinkage, which significantly impact the ending inventory valuation at cost, as well as resulting gross margins. The failure to take appropriate markdowns currently can result in an overstatement of inventory under the lower of cost or market principle.

    6. If a perpetual inventory is maintained in conjunction with the retail inventory method, a retailer can determine profits, other than shrinkage, without taking frequent physical inventories.

    7. A retailer's inventory is usually carried on the books at the retail selling price of the various items. The year-end inventory value of those goods on hand at cost or market is determined by Treas. Reg. 1.471-8(a) or (d). LCM normally generates an inventory value that is lower than that determined by using the cost method; therefore, it is more likely to be used. Treas. Reg. 1.471-8(d) states that this method is limited to non-LIFO taxpayers who have consistently used the practice of adjusting the retail price in the computation for markups but not markdowns, in conjunction with the retail inventory method. Treas. Reg. 1.471-8(f) states that if this method was not used, a taxpayer may adopt such method provided that permission to do so is obtained from the Commissioner as described in Treas. Reg. 1.446-1(c).

    8. Under RIM, an alternative approach to valuing inventory is cost under Treas. Reg. 1.471-8(a), rather than the LCM as detailed above. This method, which normally generates a higher inventory valuation, is less likely to be used. When it is used, all permanent markup and permanent markdown adjustments are made in determining the retail value.

    9. RIM requires taxpayers to value their inventory on a department-by-department basis. This basis is required because profit margins may be materially different for departments or classes of goods. Treas. Reg. 1.471-8(c) states that a taxpayer maintaining more than one department in a store or dealing in classes of goods carrying different percentages of gross profit should not use a percentage of profit based on an average for the entire business, but should compute and use in valuing inventory the proper percentages for the respective departments or classes of goods. Consequently, the departments or classes of goods will often correspond to the pools for LIFO purposes.


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