- 4.43.1 Retail Industry
- 22.214.171.124 Overview
- 126.96.36.199.1 Purpose
- 188.8.131.52.2 Guiding Principles
- 184.108.40.206.3 Content
- 220.127.116.11.4 Technical Advisor Program
- 18.104.22.168 General Industry
- 22.214.171.124.1 Description of Retailing
- 126.96.36.199.2 Nature of Retail Industry
- 188.8.131.52.2.1 Size
- 184.108.40.206.2.2 Competition
- 220.127.116.11.2.3 Composition
- 18.104.22.168.2.4 Consolidation
- 22.214.171.124.2.5 Profitability
- 126.96.36.199.2.6 Scale
- 188.8.131.52.2.7 Seasonality
- 184.108.40.206.2.8 Supply Chain Trends
- 220.127.116.11.3 Retail Industry Demographics
- 18.104.22.168.4 Retail Industry Classification
- 22.214.171.124.5 Merchandise Classification
- 126.96.36.199.6 Key Sales Periods
- 188.8.131.52.7 Legal and Regulatory Issues
- 184.108.40.206.7.1 Federal Requirements
- 220.127.116.11.7.1.1 Product Distribution
- 18.104.22.168.7.1.2 Consumer Protection
- 22.214.171.124.7.1.3 Employee Protection
- 126.96.36.199.7.1.4 Environmental Protection
- 188.8.131.52.7.1.5 Bankruptcy
- 184.108.40.206.7.2 Federal Agencies
- 220.127.116.11.7.3 State Requirements
- 18.104.22.168.7.4 Local Requirements
- 22.214.171.124.8 Technology
- 126.96.36.199.8.1 Key Technologies
- 188.8.131.52.9 Electronic Commerce (E-commerce)
- 184.108.40.206.10 Coordinated Issue Papers
- 220.127.116.11.11 Industry Director's Directives (IDD)
- 18.104.22.168.12 Audit Techniques Guides (ATG)
- 22.214.171.124.13 Issue Focus Tiered Issues
- 126.96.36.199.14 Retail Industry Resources
- 188.8.131.52 General Accounting
- 184.108.40.206.1 Annual Accounting Period
- 220.127.116.11.2 Accounting Methods
- 18.104.22.168.2.1 Financial Accounting Methods
- 22.214.171.124.2.2 Tax Accounting Methods
- 126.96.36.199.2.3 Significant Accounting Methods
- 188.8.131.52.2.4 Financial and Tax Accounting Methods Conformity
- 184.108.40.206.3 Schedule M Reconciliation
- 220.127.116.11.4 Income Recognition
- 18.104.22.168.5 Inventory
- 22.214.171.124.5.1 Inventories and Cost of Sales
- 126.96.36.199.5.2 Valuation of Inventories
- 188.8.131.52.5.3 Cost Flow Assumptions
- 184.108.40.206.6 Vendor Allowances
- 220.127.116.11.7 Tangible Property
- 18.104.22.168.8 Goodwill and Other Intangible Property
- 22.214.171.124.9 Lease Accounting
- 126.96.36.199.10 Liabilities and Reserves
- 188.8.131.52.11 Advertising
- 184.108.40.206.12 New Store Opening
- 220.127.116.11.13 Accounting Records
- 18.104.22.168.13.1 General Records Maintenance
- 22.214.171.124 Gross Income
- 126.96.36.199.1 Potential Compliance Risks
- 188.8.131.52.2 General Tax Principles
- 184.108.40.206.3 Key Considerations
- 220.127.116.11.4 Industry Practices
- 18.104.22.168.5 Financial Reporting
- 22.214.171.124.6 Retail Topics and Issues
- 126.96.36.199.6.1 Gift Cards and Certificates
- 188.8.131.52.6.2 Layaway Sales
- 184.108.40.206.6.3 Warranties and Extended Service Plans
- 220.127.116.11.6.4 Club Memberships
- 18.104.22.168.6.5 Leased or Licensed Departments
- 22.214.171.124.6.6 Credit Card Fee Income
- 126.96.36.199.6.7 Factoring Accounts Receivable
- 188.8.131.52.6.8 Sale on Approval
- 184.108.40.206.6.9 Sale with Unconditional Right to Return Merchandise
- 220.127.116.11.6.10 Barter Transactions
- 18.104.22.168.7 Audit Techniques
- 22.214.171.124.8 Other Information
- 126.96.36.199 Inventory
- 188.8.131.52.1 Potential Compliance Risks
- 184.108.40.206.2 General Tax Principles
- 220.127.116.11.3 Key Considerations
- 18.104.22.168.4 Industry Practices
- 22.214.171.124.4.1 Purchasing Process
- 126.96.36.199.4.2 Vendor Database Information
- 188.8.131.52.4.3 Purchase Journal and Price Change Records
- 184.108.40.206.4.3.1 The Purchase Journal
- 220.127.116.11.4.3.2 The Price Change Records and Categories
- 18.104.22.168.4.4 The Stock Ledger
- 22.214.171.124.5 Financial Reporting
- 126.96.36.199.5.1 Generally Accepted Accounting Principles (GAAP)
- 188.8.131.52.5.2 International Financial Reporting Standards (IFRS)
- 184.108.40.206.6 Retail Topics and Issues
- 220.127.116.11.6.1 Valuation of Inventories
- 18.104.22.168.6.2 Cost Method
- 22.214.171.124.6.3 Lower of Cost or Market
- 126.96.36.199.6.4 Retail Inventory Method
- 188.8.131.52.6.5 Last-in First-out (LIFO)
- 184.108.40.206.6.6 Retail LIFO Inventory Method
- 220.127.116.11.6.7 Inventory Price Index Computation (IPIC)
- 18.104.22.168.6.7.1 Overview
- 22.214.171.124.6.7.2 Computation of the Inventory Price Index (IPI)
- 126.96.36.199.6.7.3 Selection of a BLS table and an Appropriate Month
- 188.8.131.52.6.7.4 Assignment of Items in a Dollar-Value Pool to BLS Categories (selected BLS categories)
- 184.108.40.206.6.7.5 Computation of Category Inflation Indexes for Selected BLS Categories
- 220.127.116.11.6.7.6 Double-extension IPIC Method
- 18.104.22.168.6.7.7 Link-chain IPIC Method
- 22.214.171.124.6.7.8 Computation of the Inventory Price Index (IPI)
- 126.96.36.199.6.8 Goods Included in Inventory
- 188.8.131.52.6.8.1 Cash on Delivery (COD) Goods
- 184.108.40.206.6.8.2 Inventory Shrinkage
- 220.127.116.11.6.8.3 BLS Indexes for Department Stores
- 18.104.22.168.6.9 The Inventory Step-Up Issue
- 22.214.171.124.6.9.1 Inventory Step-Up
- 126.96.36.199.6.9.2 Book Tax Conformity with Regard to FMV of Inventory Items
- 188.8.131.52.6.9.3 Rev. Proc. 2003-51
- 184.108.40.206.6.10 Retail Industry Coordinated Issue Paper
- 220.127.116.11.6.11 Inventory Coordinated Issues
- 18.104.22.168.6.12 Other Inventory Issues
- 22.214.171.124.7 Audit Techniques
- 126.96.36.199.8 Other Information
- 188.8.131.52 Inventory Capitalization (IRC 263A)
- 184.108.40.206.1 Potential Compliance Risks
- 220.127.116.11.2 General Tax Principles
- 18.104.22.168.3 Key Considerations
- 22.214.171.124.4 Industry Practices
- 126.96.36.199.4.1 Buyers/Merchandisers
- 188.8.131.52.4.2 Private Label (Store) Brands
- 184.108.40.206.4.3 Marketing Exclusive Designer/Celebrity Brands
- 220.127.116.11.5 Financial Reporting
- 18.104.22.168.6 Retail Topics and Issues
- 22.214.171.124.6.1 Treatment of Merchandising Department Costs and Reclassification of Indirect Costs
- 126.96.36.199.6.2 Resellers with Production Activity
- 188.8.131.52.6.3 Negative Additional IRC 263A Costs
- 184.108.40.206.6.4 Royalty Capitalization Costs
- 220.127.116.11.6.5 Tax Purchases vs. Financial Purchases
- 18.104.22.168.6.6 Key Terms and Definitions
- 22.214.171.124.7 Audit Techniques
- 126.96.36.199.7.1 Documentation
- 188.8.131.52.8 Other Information
- 184.108.40.206 Interest and Self-Constructed Asset Capitalization (IRC 263A)
- 220.127.116.11.1 Potential Compliance Risks
- 18.104.22.168.2 General Tax Principles
- 22.214.171.124.3 Key Considerations
- 126.96.36.199.4 Industry Practices
- 188.8.131.52.5 Financial Reporting
- 184.108.40.206.6 Retail Topics and Issues
- 220.127.116.11.6.1 Key Terms and Concepts
- 18.104.22.168.7 Audit Techniques
- 22.214.171.124.8 Other Information
- 126.96.36.199 Vendor Allowances
- 188.8.131.52.1 Potential Compliance Risks
- 184.108.40.206.2 General Tax Principles
- 220.127.116.11.3 Key Considerations
- 18.104.22.168.4 Industry Practices
- 22.214.171.124.5 Financial Reporting
- 126.96.36.199.6 Retail Topics and Issues
- 188.8.131.52.6.1 Buying Allowances
- 184.108.40.206.6.2 Merchandise Display Allowances
- 220.127.116.11.6.3 Performance-Based Allowances
- 18.104.22.168.6.4 Cooperative Advertising
- 22.214.171.124.6.5 Salary or Payroll Allowances
- 126.96.36.199.6.6 Up-front Cash Payments and Long-Term Agreements
- 188.8.131.52.6.7 Slotting Allowances
- 184.108.40.206.6.8 Margin Protection or Markdown Participation Allowances
- 220.127.116.11.6.9 Defective or Damaged Merchandise Allowances
- 18.104.22.168.6.10 Sales-Based Allowances
- 22.214.171.124.7 Audit Techniques
- 126.96.36.199.8 Other Information
- 188.8.131.52 Tangible Assets and Depreciation
- 184.108.40.206.1 Potential Compliance Risks
- 220.127.116.11.2 General Tax Principles
- 18.104.22.168.3 Key Considerations
- 22.214.171.124.4 Industry Practices
- 126.96.36.199.5 Financial Reporting
- 188.8.131.52.6 Retail Topics and Issues
- 184.108.40.206.6.1 Key Terms and Definitions
- 220.127.116.11.6.2 Asset Classification Issues
- 18.104.22.168.6.3 Rev. Proc. 87-56
- 22.214.171.124.6.4 Fixed Asset Depreciation
- 126.96.36.199.6.5 Land Improvements
- 188.8.131.52.6.6 Retail Site Selection
- 184.108.40.206.6.7 Constructed Facilities
- 220.127.116.11.6.8 Acquired Facilities
- 18.104.22.168.6.9 Remodeled Facilities
- 22.214.171.124.6.9.1 Improvements to Retail Space
- 126.96.36.199.6.10 Repair Expense vs. Capital Improvements Issues
- 188.8.131.52.6.11 Asbestos Removal Costs
- 184.108.40.206.6.12 Gas Stations and Convenience Stores
- 220.127.116.11.6.13 Store Closing Loss
- 18.104.22.168.6.14 Cost Segregation Studies
- 22.214.171.124.6.14.1 Documentation for Cost Segregation studies
- 126.96.36.199.7 Audit Techniques
- 188.8.131.52 Intangible Assets
- 184.108.40.206.1 Potential Compliance Risks
- 220.127.116.11.2 General Tax Principles
- 18.104.22.168.3 Key Considerations
- 22.214.171.124.4 Industry Practices
- 126.96.36.199.5 Financial Reporting
- 188.8.131.52.6 Retail Topics and Issues
- 184.108.40.206.6.1 Examples of IRC 197 Intangibles
- 220.127.116.11.6.1.1 Goodwill
- 18.104.22.168.6.1.2 Going Concern Value
- 22.214.171.124.6.1.3 Workforce in Place
- 126.96.36.199.6.1.4 Information Base
- 188.8.131.52.6.1.5 Know-how
- 184.108.40.206.6.1.6 Customer-based Intangible
- 220.127.116.11.6.1.7 Supplier-based Intangible
- 18.104.22.168.6.1.8 License, Permit, or Other Rights
- 22.214.171.124.6.1.9 Covenant Not To Compete
- 126.96.36.199.6.1.10 Franchise, Trademark, or Trade Name
- 188.8.131.52.6.2 Exceptions to IRC 197
- 184.108.40.206.6.3 Disposition Under IRC 197 General Rule
- 220.127.116.11.6.4 Disposition under IRC 197 Loss Disallowance Rules
- 18.104.22.168.6.5 Amounts Paid to Acquire or Create Intangibles
- 22.214.171.124.6.6 Allocation of Purchase Price
- 126.96.36.199.6.7 Package Design Costs
- 188.8.131.52.6.8 Private Label Design and Development
- 184.108.40.206.6.9 Favorable Portion of Operating Leases
- 220.127.116.11.6.10 Website Development Costs
- 18.104.22.168.6.11 Internet Domain Names
- 22.214.171.124.6.12 Computer Software
- 126.96.36.199.6.13 Documentation
- 188.8.131.52.7 Audit Techniques
- 184.108.40.206 Leases
- 220.127.116.11.1 Potential Compliance Risks
- 18.104.22.168.2 General Tax Principles
- 22.214.171.124.3 Key Considerations
- 126.96.36.199.4 Industry Practices
- 188.8.131.52.5 Financial Reporting
- 184.108.40.206.6 Retail Topics and Issues
- 220.127.116.11.6.1 Rent Escalation Clauses
- 18.104.22.168.6.2 Section 467 Rental Agreements (Potential for Rent Leveling)
- 22.214.171.124.6.3 Percentage Rent
- 126.96.36.199.6.4 Anchor Store Inducements
- 188.8.131.52.6.5 Tenant Construction or Improvement Allowances
- 184.108.40.206.6.6 Sale and Leaseback
- 220.127.116.11.6.7 Common Area Maintenance (CAM) Charges
- 18.104.22.168.7 Audit Techniques
- 22.214.171.124.8 Other Information
- 126.96.36.199 Liabilities and Reserves
- 188.8.131.52.1 Potential Compliance Risks
- 184.108.40.206.2 General Tax Principles
- 220.127.116.11.3 Key Considerations
- 18.104.22.168.4 Retail Topics and Issues
- 22.214.171.124.5 Financial Reporting
- 126.96.36.199.6 Retail Topics and Issues
- 188.8.131.52.6.1 Sales Returns and Allowances
- 184.108.40.206.6.2 Cash Rebates
- 220.127.116.11.6.3 Discount Store Coupons
- 18.104.22.168.6.4 Premium Coupons and Trading Stamps
- 22.214.171.124.6.5 Loyalty (Reward) Programs
- 126.96.36.199.6.6 Allowance for Doubtful Accounts
- 188.8.131.52.6.7 Store Closing Reserves
- 184.108.40.206.6.8 Product Warranties/Service Contracts
- 220.127.116.11.6.9 Self Insurance
- 18.104.22.168.6.10 Accrued Taxes
- 22.214.171.124.6.11 Deferred Rent/Lease Credits
- 126.96.36.199.6.12 Deferred Revenue
- 188.8.131.52.7 Audit Techniques
- 184.108.40.206.8 Other Information
- 220.127.116.11 Business Expenses
- 18.104.22.168.1 Potential Compliance Risks
- 22.214.171.124.2 General Tax Principles
- 126.96.36.199.3 Key Considerations
- 188.8.131.52.4 Industry Practices
- 184.108.40.206.5 Financial Reporting
- 220.127.116.11.6 Retail Topics and Issues
- 18.104.22.168.6.1 Advertising Expenses
- 22.214.171.124.6.1.1 Advertising Expense - Potential Compliance Risks
- 126.96.36.199.6.2 Contributions of Inventory
- 188.8.131.52.6.3 Credit Card Fees
- 184.108.40.206.6.4 Pre-Opening Store Expenses
- 220.127.116.11.6.5 Professional Fees and Services
- 18.104.22.168.6.6 Settlement Payments
- 22.214.171.124.6.7 Non-Inventoriable Supplies
- 126.96.36.199.6.8 Repairs and Maintenance
- 188.8.131.52.6.9 Bad Debt Expense
- 184.108.40.206.6.10 Prepaid Expense
- 220.127.116.11.6.11 Nondeductible Items
- 18.104.22.168.6.11.1 Nondeductible Items- Fines and Penalties
- 22.214.171.124.6.11.2 Nondeductible Items- Political Contributions and Lobbying Expenses
- 126.96.36.199.6.11.3 Nondeductible Items- Club Dues
- 188.8.131.52.7 Audit Techniques
- 184.108.40.206.8 Other Information
- 220.127.116.11 Business Tax Credits
- 18.104.22.168.1 Potential Compliance Risks
- 22.214.171.124.2 General Tax Principles
- 126.96.36.199.3 Key Considerations
- 188.8.131.52.4 Industry Practices
- 184.108.40.206.5 Financial Reporting
- 220.127.116.11.6 Retail Topics and Issues
- 18.104.22.168.6.1 Research and Experimental (R&E)
- 22.214.171.124.6.2 Investment Credit
- 126.96.36.199.6.3 Work Opportunity Tax Credit (WOTC)
- 188.8.131.52.6.4 Welfare-to-Work Credit (W-t-W)
- 184.108.40.206.6.5 New Market Tax Credit
- 220.127.116.11.6.6 Empowerment Zone Credit
- 18.104.22.168.6.7 Indian Employment Credit
- 22.214.171.124.6.8 Audit Techniques
- 126.96.36.199.6.9 Other Information
- 188.8.131.52 Electronic Commerce
- 184.108.40.206 Field Specialists
- 220.127.116.11.1 International
- 18.104.22.168.1.1 CFCs Operating as Buying Agents
- 22.214.171.124.1.2 Product Pricing by the CFC or the Foreign Controlled Corporation (FCC)
- 126.96.36.199.1.3 Advance Pricing Agreements (APA)
- 188.8.131.52.1.4 Foreign Base Company Sales Income
- 184.108.40.206.1.5 Other International Areas
- 220.127.116.11.2 Computer Assisted Audit Techniques Programs
- 18.104.22.168.2.1 Specific Retail Areas
- 22.214.171.124.2.1.1 Inventory In-transit (02-14-2008)
- 126.96.36.199.2.1.2 Capital Assets
- 188.8.131.52.2.1.3 Accounts Receivable
- 184.108.40.206.2.1.4 Reserves
- 220.127.116.11.2.2 Compliance Programs
- 18.104.22.168.3 Engineering Program
- 22.214.171.124.3.1 Fixed/Capital Assets, Depreciation, Capital vs. Expense
- 126.96.36.199.3.2 Acquisitions, Leases and Intangibles
- 188.8.131.52.3.3 Credits
- 184.108.40.206.3.4 Charitable Contributions
- 220.127.116.11.3.5 IRC 199 Domestic Product Deduction (DPD)
- 18.104.22.168.3.6 Valuation for IRC 409A Enforcement
- 22.214.171.124.3.7 International Issues in the Engineer Program
- 126.96.36.199.4 Financial Products
- 188.8.131.52.5 Employment Tax
- Exhibit 4.43.1-1 Store Closing
- Exhibit 4.43.1-2 List of Coordinated Issues
- Exhibit 4.43.1-3 Industry Director Directives
- Exhibit 4.43.1-4 List of Trade References - Trade Associations
- Exhibit 4.43.1-5 Index of Trade References - Books
- Exhibit 4.43.1-6 Index of Trade References - Periodicals and Journals
- Exhibit 4.43.1-7 List of Trade References - Websites
- Exhibit 4.43.1-8 Index of Trade References - List of Universities and Institutes
- Exhibit 4.43.1-9 List of Retail UIL
- Exhibit 4.43.1-10 Referral/Recommendation Form
- Exhibit 4.43.1-11 Glossary of Retail Terminology
Part 4. Examining Process
Chapter 43. Retail Industry
Section 1. Retail Industry
A nationwide Retail Industry Program was established in 1988 in the legacy IRS large case program.
The Retail Industry Handbook (the Handbook), first published in the Internal Revenue Manual (IRM) in 1994, supports the Retail Industry Program.
The Handbook is a resource tool designed to provide the examiner with general knowledge about:
Standard retail industry business practices
Accounting policies and practices unique to this specialty area
The Handbook will help the examiner:
Understand key terms and accounting operations unique to the retail industry
Identify potential tax compliance issues that may arise from conducting and reporting retail business operations
Assess the potential audit risk(s) of an issue
Identify pertinent accounting records and supporting documentation
The Handbook can minimize the time the examiner needs to acquire:
General knowledge about the retail industry
Audit skills to examine a retailer
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.
The function of the IRS is to administer the Internal Revenue Code.
To properly accomplish this function, it is important for the examiner to:
Understand the nature of a potential issue in the context of the retail industry
Administer the applicable law in a reasonable, practical manner
Develop an issue of merit and never arbitrarily or for trading purposes
Promote fair and consistent treatment of all similarly situated taxpayers in the retail industry
Consider all available issue management strategies in an effort to resolve issues at the examination level
Consider opportunities to reduce resources, burden, and/or time spent by both the taxpayer and the IRS
This Handbook emphasizes audit issues and procedures unique to the retail industry.
The Handbook offers audit procedures and techniques to identify potential compliance risks associated with these unique areas.
The Handbook cannot cover all possible issues, procedures, or techniques in an industry as complex and diverse as the retail industry.
The audit procedures and techniques in this Handbook are not intended to be mandatory.
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.
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.
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.
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.
The content of the document is current through the publication date. Changes occurring after the publication date may affect the Handbook’s accuracy.
This Handbook was updated under the direction of the Retailers, Food, Pharmaceutical & Healthcare Industry within the Large and Mid-Size Business (LMSB) Operating Division.
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:
Assist field personnel in identifying, developing, and resolving specific-industry and cross-industry technical issues
Ensure uniform and consistent treatment of issues nationwide
Provide a vehicle for coordination of technical issues
Ensure all Tiered issues are identified, coordinated, and properly developed
Provide educational opportunities to internal and external customers
Maintain/develop industry and issue expertise
This section provides general background information about the retail industry.
The retail industry consists of businesses selling goods, generally without transformation, and providing services incidental to the sale of goods.
Some retail businesses engage in the provision of after-sales services, such as repair and installation.
Retailers are organized to sell goods in small quantities to the general public for personal or family use.
Retailing is the final step in the distribution of goods linking suppliers and consumers.
The nature of the retail industry is wide-spread and can be described in the following manner:
Retail is the second largest industry in the United States.
Retail sales account for about 10 percent of the U.S. gross national product.
Retail employs one out of every nine American workers, or about 12 percent of U.S. employment.
Retail is intensely competitive with few barriers to entry.
Retailers compete against many other national, regional, and local retailers for:
Other important aspects of retailing
Competition is characterized by many factors, including:
The ability to attract and retain customers depends on a combination of these factors.
Retail’s largest segment consists of small, independent stores usually operated by the owner.
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.
Some retailers are both wholesalers and retailers because they sell to consumers and other businesses.
Some retailers are both manufacturers and retailers because they produce the products they sell.
The blurring of the lines between different types of retail formats has fundamentally changed the industry.
Retailers, regardless of other functions they perform, are still retailers when they interact with the final user of the product or service.
Retail is a mature, slow growth industry.
The industry has consolidated over the past two decades.
Gross margin typically runs between 31 and 33 percent of sales.
Gross margins, however, vary widely by segment.
Large scale chains dominate the retail industry.
By its very nature, the industry is biased in favor of retailers that are larger and more efficient than their competitors
A retailer with a large store base has a greater ability to leverage cost benefits across a number of areas.
Most retailers focus on a single segment of retailing electing to build scale and depth.
Most retail business is seasonal in nature.
Seasonality causes operating results to vary considerably from quarter to quarter.
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.
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.
Retailers now act as designers, suppliers, and importers.
Merchandise is globally-sourced from low-cost countries.
Products are customized, which provides a point of competitive differentiation.
E-commerce continues to get bigger and take a large share of retail sales.
Retail industry demographics are different from many other industries in the following respects:
Finished goods are purchased for resale.
Multiple channels, such as in-store, catalog, and internet are used to make sales.
A large number of sales transactions involve small quantities of merchandise purchased by the general public.
A broad assortment of merchandise carried by product line and/or department.
Consumer preferences are not constant.
Merchandise assortment and presentation are constantly changing.
Merchandise is spread among numerous locations for chain stores.
A large number of employees are involved directly with customers.
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.
Retail consists of two principal types of establishments: store retailers and non-store retailers.
Store retailers utilize fixed point-of-sale locations, located and designed to attract a high volume of walk-in customers.
Store retailers often utilize extensive merchandise displays and mass media advertising to attract customers.
Store retailers sell merchandise to the general public for personal or household consumption, but some also serve business and institutional customers.
Store retailers are typically grouped by the merchandise line or lines carried by the store. The categories can include:
Automotive Parts, Accessories, and Tire Stores
Furniture and Home Furnishings Stores
Electronic and Appliance Stores
Building Material and Garden Equipment and Supplies Dealers
Food and Beverage Stores (e.g. grocery stores)
Health and Personal Care Stores (e.g. drug stores)
Clothing and Clothing Accessories Stores (includes shoe, jewelry, luggage, and leather goods stores)
Sporting Goods, Hobby, Book and Music Stores
General merchandise stores (e.g. department and discount stores)
Miscellaneous store retailers (e.g. florist, office supplies, pet supplies)
Non-store retailers are similar to a store retailer, which is organized to serve the general public, but their retailing methods differ.
Non-store retailers are typically grouped as follows:
Electronic commerce (E-commerce)
Catalog and mail-order retailers (i.e. paper and electronic catalogs)
Direct retailers (e.g. door-to-door solicitation)
Retailers serviced by other Technical Advisor Programs include:
Auto and recreational dealerships (Motor Vehicle)
Food wholesalers and restaurants (Food and Beverage)
Gasoline stations, convenience stores (Petroleum)
Book stores (Media)
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.
Hard goods include electronics, hardware, paint, small appliances, stationery/office supplies, candy, tobacco, and impulse merchandise.
Consumable hard goods include health and beauty aids (HABA), over-the-counter medicines, cosmetics, paper goods, and pet supplies.
Seasonal hard goods include sporting goods, toys, lawn and garden equipment, automotive supplies, and seasonal/holiday merchandise.
Soft goods include apparel, accessories, sheets, towels, and other linens.
Bridal and wedding
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.
There are numerous federal requirements, which include the following.
The Sherman Act (1890) prohibits under-pricing or selling at a loss as a continuous practice with the aim of eliminating all competition.
The Clayton Act (1914) prohibits unfair trade practices such as exclusive dealing and tying contracts.
Exclusive dealing includes providing an intermediary exclusive rights to a territory.
"Tying" requires a customer to take less desirable products from a product line to gain access to desirable products.
The Act excludes short-term store promotions that are meant to increase customer traffic from the reach of the Sherman Act.
The Robinson-Patman Act (1936) protects retailers from unfair and preferential trading practices between manufacturers and retailers.
Absent this law, suppliers could decide with whom they wished to conduct business, to the exclusion of others.
This law also prevents a supplier from colluding with one or more retailers against the retailer’s competition.
The law protects individual competitors from price discrimination in favor of large chain stores by their suppliers.
The law applies to cooperative advertising, among other matters.
The Act restricts statements and claims that firms may claim about competing firms and products.
The Federal Trade Commission Act (1914) prohibits fraudulent and misleading product information.
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.
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.
The Consumer Credit Protection Act (1968) requires written disclosure to the borrower of the true cost of credit.
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.
The American with Disabilities Act or ADA (1990) requires businesses to have adequate space for customers with disabilities.
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.
ADA is designed to remove barriers to individuals with disabilities and to ensure equal access to employment activities.
The Clean Air Act (1970) and Clean Water Act (1972) safeguard the natural environment.
The Energy Policy Act (2005) sets national commercial equipment efficiency standards and provides tax incentives for advanced energy saving technologies and practices.
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.
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.
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.
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.
Food and Drug Administration (FDA) administers federal laws regarding the purity of food, the truthfulness of labels, and the safety and honesty of packaging.
Occupational Safety and Health Administration (OSHA) is responsible for developing and enforcing regulations that promote a safe work environment.
Subsidies are used to encourage the growth of business activity within the state’s borders.
States check the accuracy of weight, volume, length and size of consumer products.
States check the accuracy of scanned prices against price tags.
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.
Liquor laws control a number of items including pricing and discounts.
Each state has its own worker’s compensation laws and second injury fund
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.
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.
Key technologies used in retail include point of sale systems, inventory management systems, and customer relations.
Point of Sale Systems (POS)
Barcoding and scanning devices for product identification, used to provide real time, accurate information on which products are selling at the point of sale.
Mechanical cash registers have been replaced by personal computers and built in credit card swipe machines for credit card transactions.
Sales information is captured at the cash register and used to adjust inventory records and reorder merchandise automatically.
Inventory Management Systems
Ambient technology, especially radio frequency, allows for tracking product movement throughout the supply chain.
The primary use of radio frequency technology employs RFID tags and readers.
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.
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.
E-commerce is economic activity defined as the value of goods and services sold online.
The internet, like technology, has made fundamental changes in the retail industry.
E-commerce plays a key role in acting as both a sales channel and a consumer communication tool.
Almost every category of merchandise is offered for sale online.
On-line retailers bring together an assortment of merchandise for consumers to buy in the same way as traditional store retailers.
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.
Consumers are increasingly likely to shop across multiple channels.
IRM 184.108.40.206.6 provides the following information about e-commerce:
Interviewing taxpayers regarding e-commerce activities
Evaluating electronic books and records
Identifying income from e-commerce activities.
Coordinated issue papers:
Identify key industry or cross-industry issues
Provide guidance to address compliance issues.
Express position of the Large and Mid-Size Business Division (LMSB) Commissioner to ensure uniform treatment of taxpayers.
Establish a consistent compliance position.
Do not represent the official position of the Service with respect to legal position.
May impact more than one industry and/or operating division.
Are binding on all IRS examiners.
Deviation from position(s) stated in a Coordinated Issue Paper requires the concurrence of the Technical Advisor Team.
Exhibit 4.43.1-2 lists coordinated issues unique to the retail industry.
IDDs provide guidelines and instructions to examiners on procedures and administrative aspects of compliance activities to ensure consistent treatment of taxpayers.
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.
LMSB Examiners are expected to follow IDD guidelines and instructions.
Exhibit 4.43.1-3 lists IDDs unique to the retail industry.
The objective of an ATG is to capture a unique business practice of a particular segment or issue studied.
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.
The Retail Industry Audit Technique Guide can be accessed at: http://www.irs.gov/pub/irs-mssp/retail_industry_102005_final.pdf
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.
Industry issues will be designated as follows:
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.
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.
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.
For more information, examiners should consult IRM 4.51.5, Industry Focus and Control of LMSB Compliance Issues.
Specific tiered issues are posted on the IRS web site.
Additional information about the retail industry is available from multiple sources. Sources of additional information include:
Retail Trade Associations are listed in Exhibit 4.43.1-4.
Retail Trade Books, Journals, Magazines and Other Publications are listed in Exhibit 4.43.1-5 and Exhibit 4.43.1-6.
Relevant Websites are listed in Exhibit 4.43.1-7.
Universities and Institutes Researching Retailers are listed in Exhibit 4.43.1-8.
A glossary of Retail Terminology is provided in Exhibit 4.43.1-11.
Accounting is essential to the effective functioning of any business organization, particularly the corporate form.
This section provides an overview of accounting periods, methods, and records used by retailers.
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.
Taxpayers have some flexibility in choosing a year-end. An annual accounting period can be a calendar or fiscal year.
A calendar year is 12 consecutive months beginning January 1 and ending December 31.
A fiscal year is 12 consecutive months ending on the last day of any month except December.
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).
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.
Many retailers use a January year-end because inventories are low after the holidays and returned merchandise is minimal.
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.
The examiner should identify the accounting period used for each period under examination to determine the proper treatment of timing or allocation issues.
A retailer’s gross income for a year will depend on its method of accounting.
Financial and tax reporting have different objectives when measuring the recognition of income and expense and, as a result, frequently adopt differing accounting methods.
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.
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."
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.
The IRS has broad authority to see that gross income is clearly reflected.
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.
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.
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.
Issues which do not involve a question of timing:
Personal vs. business expense issues
Correction of mathematical or bookkeeping errors
Revision in the treatment of an item resulting from a change in the underlying facts
A method of accounting is not established in most instances without the consistent treatment of an item.
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.
The following situations represent examples of how a change in the taxpayer's method of accounting might occur:
The taxpayer filed Form 3115 (Request for Approval of Change in Method of Accounting) with the National Office.
The taxpayer made an unauthorized change in method on its tax return.
The examiner makes adjustments which constitute a change in method.
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.
The examiner should be alert to changes in a retailer’s method of accounting.
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.
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.
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.
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.
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.
See IRM 4.11.6 Change in Accounting Methods and/or contact the Change in Accounting Method Technical Advisor when appropriate.
For retailers, significant accounting methods generally fall into the following categories:
Income recognition, which may include advance payments for goods and services, vendor and landlord incentives, and promotional activities
Inventory, related reserves and gross margin recognition, including the application of the retail inventory method for certain retailers
Inventory capitalization under the uniform inventory capitalization rules ("UNICAP" )
Accounts receivable and related reserves, particularly for retailers with proprietary credit businesses
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
Debt, including off-balance sheet arrangements such as leases
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.
If the taxpayer’s financial practice conforms to GAAP, then, ordinarily, the practice may be acceptable for tax purposes.
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.
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:
Property cost recovery
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.
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.
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.
Audit Considerations include the following:
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.
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.
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.
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.
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.
Gross income includes consideration received for merchandise sold for cash or credit and for services that are incidental to the sale of merchandise.
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).
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.
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.
Retailers, which have leased departments, generally include sales from such departments in gross income.
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.
Gift card sales are generally deferred until the card is redeemed for merchandise.
Layaway sales are generally deferred until the customer satisfies all payment obligations and takes possession of the merchandise.
Club membership fees are generally deferred and recognized ratably over the term of the membership. Most memberships are for 12 months.
Extended service plans are generally deferred and recognized ratably over the life of the plan.
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.
This section briefly reviews the topic of inventory. See IRM 220.127.116.11 for more information on inventory.
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.
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.
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.
A combination of the above methods for different classes of goods is acceptable as long as the method is applied consistently.
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.
This subsection explains the different accounting methods used to determine the value of inventory.
Taxpayers must value their inventories using a proper method: Cost or the Lower of Cost or Market (LCM)
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).
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.
In associating costs with the physical inventory, the taxpayer may use specific identification or may adopt an accounting assumption.
Lower of Cost or Market (LCM)
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.
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.
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).
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.
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.
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.
Taxpayers generally use the LCM method because it can provide a loss before the taxpayer has sold the property.
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.
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.
First-In, First-Out (FIFO)
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.
Last-In, First-Out (LIFO)
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.
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.
Retailers typically do not use LIFO for all merchandise inventories.
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.
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.
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.
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.
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.
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 18.104.22.168.6.8.3 for more information.
Retail Inventory Method (RIM)
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.
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.
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.
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.
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.
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.
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).
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.
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.
Retailers receive allowances from vendors through a variety of programs and arrangements. Vendor allowances are generally intended to offset the retailer’s costs of selling the vendors’ products in its stores. These allowances can be grouped into the following broad categories: buying allowances and promotional allowances.
Most vendor allowances are accounted for as a reduction of the cost of the merchandise inventory and recorded at the time the allowances are earned. The allowances are generally recognized as a reduction in cost of goods sold at the time the related inventory is sold.
Some vendor allowances are accounted for as other income or as a reduction to a particular expense at the time the retailer incurs the expense eligible for reimbursement. For example, a retailer may record the receipt of a cooperative advertising allowance for a qualifying advertising or similar promotional expense as a credit to advertising expense.
An examiner's primary focus should be the tax treatment given to promotional allowances.
See also IRM 22.214.171.124 for further information on vendor allowances.
Property owned by retailers generally consists of stores, warehouses, distribution and fulfillment centers, and corporate offices. For most retailers, stores are owned outright, leased, or operated under arrangements where the retailer owns the building and leases the land. The tangible property generally consists of land, buildings, leasehold improvements and furniture, fixtures, and equipment (FF&E).
Tangible property owned by retailers is stated at cost less accumulated depreciation.
For financial reporting purposes, depreciation is generally recorded using the straight-line method and, in certain circumstances, accelerated methods over the shorter of estimated asset lives or related lease terms.
For financial reporting purposes, retailers review long-lived assets for indicators of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable.
The evaluation is performed at the lowest level of identifiable cash flows, which is typically at the individual store level.
A retailer’s review of factors present and the resulting appropriate carrying value of long-lived assets are subject to judgments and estimates that the retailer is required to make.
An examiner's primary focus is with the classification assigned units of property and the resulting cost recovery.
See also IRM 126.96.36.199 for further information on tangible property.
Intangible property owned by retailers generally consists of goodwill, trademarks, trade names, package design and software (purchased and developed).
Intangible property owned by retailers is stated at cost less accumulated amortization. Intangible property identified as "amortizable IRC 197 intangibles" are amortized over 15 years. Other acquired intangible assets are amortized under IRC 167 on a straight-line basis over the periods during which the particular asset may reasonably be expected to be useful to the taxpayer in its business.
For financial reporting purposes, goodwill and other intangibles with indefinite lives that are not amortized are evaluated for impairment annually or more frequently when triggering events or changes in circumstances occur. Important factors, which can trigger impairment, include significant:
Under-performance relative to historical or projected operating results
Changes in the use of the acquired assets or the overall business strategy
Negative industry or economic trends
Decline in stock value for a sustained period
For financial reporting purposes, retailers review intangibles for indicators of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable.
If a potential impairment is identified, the amount of the impairment loss recognized would be determined by estimating the fair value of the assets and recording a loss if the fair value was less than the book value.
Fair value will be determined based on appraisal values assessed by third parties, if deemed necessary, or a discounted future cash flows analysis.
A retailer’s review of factors present and the resulting appropriate carrying value of goodwill and other intangibles are subject to judgment and estimates.
An examiner's primary focus is the classification assigned to units of property and the resulting cost recovery.
See IRM 188.8.131.52 for further information on intangible property.
The retail industry is an asset-intensive business. Retailers may own and/or lease the property needed to operate in the normal course of business.
Retailers often finance their property by operating leases. More frequently than other industries, retailers make leasehold improvements on top of leased property. This practice is not as common in other industries.
Retailers generally estimate the expected term of a lease by assuming the exercise of renewal options where an economic penalty exists that would preclude the abandonment of the lease at the end of the initial non-cancelable term and the exercise of such renewal is at the sole discretion of the retailer. This expected term is used in the determination of whether a store lease is a capital or operating lease and in the calculation of straight-line rent expense.
Rent abatements (i.e. holidays) and escalations are considered in calculating straight-line rent expense for operating leases. Consequently, rent expense is recognized for financial reporting purposes at the earlier of the first rent payment or the date of possession of the leased property. The difference between the amounts charged to rent expense and the rent paid is recorded as deferred lease incentive and amortized over the lease term.
As part of certain lease agreements, retailers receive construction allowances from landlords. A construction allowance is used to defray the cost of constructing a store the retailer intends to operate. Historically, for financial accounting purposes, retailers recorded construction allowances as a reduction to the cost of the leasehold improvements and depreciated the credits over the useful life of the leasehold improvements. Due to SEC guidance issued in 2005, retailers now record construction allowances as a deferred liability and amortize the allowances on a straight-line basis over the life of the lease as a reduction to rent expense.
For financial accounting purposes, the useful life of leasehold improvements is generally limited by the expected lease term. If significant expenditures are made for leasehold improvements late in the expected term of a lease, judgment is applied to determine if the leasehold improvements have a useful life that extends beyond the original expected lease term or if the leasehold improvements have a useful life that is bound by the end of the original expected lease term.
See IRM 184.108.40.206 for further information on leases.
Retailers regularly set up reserves to cover contingent liabilities that arise in the ordinary course of business.
Retailers generally accrue for estimated sales returns and allowances. The estimate may take into consideration the retailer’s historical experience, current sales trends and other factors in the period in which the related products are sold.
Retailers regularly establish reserves for self-insured liabilities such as worker's compensation and general liability risks. These estimates may be based on the results of an independent study and may consider historical claim frequency and severity as well as changes in factors such as its business environment, benefit levels, medical costs, and the regulatory environment.
See IRM 220.127.116.11 for further information on liabilities and reserves.
Advertising costs are expensed as incurred (i.e., under the all events test). Advertising costs consist primarily of print costs, point of sale advertising and marketing promotions.
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.
Costs associated with the production of television advertising may be expensed over the life of the campaign.
Advertising costs are net of cooperative advertisement allowances.
The opening of new stores is dependent upon, among other things, the availability of desirable locations, the negotiation of acceptable lease terms and general economic and business conditions affecting consumer spending in areas targeted for expansion.
Generally, no deduction is permitted for the cost of start-up activities, including organizational costs and store openings. However, a taxpayer may elect to deduct start-up expenditures incurred after October 22, 2004, in the year in which the active trade or business to which the expenditures relates begins. The amount that may be deducted in that year is the lesser of the amount of the start-up expenditures or $5,000, reduced (but not below zero) by the amount by which the start-up expenditures exceed $50,000. Any start-up expenditures that are not deductible may be deducted by the taxpayer ratably over the 180-month period beginning with the month in which the active trade or business begins. All start-up expenditures incurred by the taxpayer that relate to the active trade or business are considered in determining whether the start-up expenditures exceed $50,000.
For start-up expenditures incurred on or before October 22, 2004, a taxpayer may only elect to amortize these expenditures over a period determined by the taxpayer that is at least 60 months.
For start-up expenditures paid or incurred after September 8, 2008, a taxpayer is deemed to make an election under IRC 195 to deduct start-up expenditures for the taxable year in which the active trade or business to which the expenditures relates begins. Therefore, a taxpayer is no longer required to attach a statement to the return or specifically identify the deducted amount as start-up expenditures for the IRC 195 election to be effective. A taxpayer may choose to forego the deemed election by clearly electing to capitalize its start-up expenditures on a timely filed Federal income tax return (including extensions) for the taxable year in which the active trade or business begins.
Accounting records maintained by most retailers include the basic journals and ledgers of any business. In addition, there are a number of different record systems maintained by retailers which deal exclusively with the acquisition, level, and disposition of inventory. Larger retailers should also have records detailing their compliance with the uniform capitalization requirements.
IRC 7602 empowers the examiner to review any books, records, papers, records, or other data which may be relevant to determining a taxpayer’s tax liability.
The IRS has generally exercised restraint in requesting tax accrual workpapers (TAW) and other audit workpapers. The examiner may request tax accrual workpapers and other audit workpapers in certain limited situations. See IRM 4.10.20. For technical questions for TAW, contact the TAW technical advisor team.
This section describes many of the records maintained by retailers, although the names, format and content of these records may vary.
A retailer should maintain the basic records required of any business. A number of these records are briefly described below.
Year-End Trial Balance
The taxpayer's year-end trial balance shows each general ledger account and its year-end balance. The content of this record will usually include the prior year's balance and sometimes the budgeted balance.
A comparative trial balance including the current and several prior years will assist the examiner in identifying accounts which are unusual in nature or amount.
In conjunction with the trial balance, the examiner should request adjusting and reclassifying entries including explanations, and the number of the income tax return line onto which each account was entered.
Monthly Detailed Trial Balances
The activity within any general ledger account can be analyzed by reviewing the monthly detailed trial balance or equivalent, which should show the detail of all entries made to each general ledger account
The detail should identify the source journal and document number for each general journal entry. A limited description of the entry may also be included.
If the detail is voluminous and computerized information is available, consideration should be given to using a Computer Audit Specialist (a CAS). The CAS can assist in obtaining:
The monthly net activity of each account, with sub-totals by source of entry.
The monthly total debit and credit entries for each account, showing the number of entries. The monthly totals should be scanned for accounts which contain entries which are abnormal in size or source. Unusual contra-entries or year-end entries can quickly be identified. The total year's activity detailed chronologically by entry, stratified by dollar amount and/or entry type.
The details of all transactions over a certain dollar limit, or of every nth transaction.
Some retailers include details of all entries in the general ledger, in effect combining ledger and journal into one document. Others show only net debits and credits for each month, with the specifics recorded elsewhere. Review of the ledger can provide a quick overview of the activity of the account during the year.
Entries can include routine monthly accruals, standard journal entries, (computations made the same way each month on standardized journal entry forms), reversals, correcting entries, etc. Not all of these entries will necessarily flow through to the tax return.
In many cases the transaction numbering system used will indicate the source and type of each entry. There will generally be a brief explanation of the entry shown in the journal.
Taxpayers on computerized systems may use a combination general ledger/general journal.
Accounts Payable Ledger
This document has historically been very useful to agents during the examination of retail taxpayers. Most of the ledger entries reflect either the establishment of a payable for a future payment or the elimination of the payable when the subsequent payment is made.
Most retailers utilize an automated system to record and monitor the payables since there are numerous products, vendors, discounts and payment terms involved in merchandise acquisition, plus many expenditures associated with operating and expanding the business.
The payable entry will reflect substantial information, including vendor name and number, purchase invoice number, and amount. These records could be reviewed using a number of different techniques.
The list of vendors with which the taxpayer conducts business can be analyzed. The examiner may identify certain vendors whose transactions with the taxpayer have significant audit potential. These transactions can be isolated by vendor.
A discovery sample approach can identify expenditures which have been improperly classified.
Selected accounts can be isolated, stratified by dollar amount, and statistically sampled.
Some taxpayers will fragment an invoice by item or destination. Larger dollar expenditures may therefore have a higher probability of being improperly classified.
See IRM 18.104.22.168.4.1 for related information regarding records involving the acquisition of merchandise.
For retailers who do not have an in-house charge system, accounts receivable should not be unusual. The amounts reflected in the receivable could be monies due from third party credit cards; from banks on installment contract paper which was sold; from customers whose checks were not accepted by the bank; or from vendors as a result of overpayments, rebates, or renegotiated items.
Retailers which utilize some form of in-house customer charge account will have much more extensive records and systems in place to record purchases and payments on account, to periodically send out bills, and to enforce collection.
In conjunction with the review of these records, the examiner should consider reviewing the taxpayer's criteria for writing off receivables it considers totally or partially worthless. Depending on the number, nature, and amount, a barometer of the reasonableness of the taxpayer's current write-offs may be the collection history of previously written off accounts. See IRM 22.214.171.124.6.9 for additional information on audit techniques pertaining to bad debts.
This section provides general background information about gross income items reported by taxpayers in the retail industry and the general accounting practices for such items.
Gross income recognition rules impact retail businesses every day. Gross income is generally the largest line item in the tax return. Gross income includes merchandise sales, leased department income and other income such as shipping and handling fees.
The receipt of prepayments for goods and services is a common situation in retailing. Prepaid income transactions typically occur in the ordinary course of business rather than a result of a structured tax strategy.
Is the item includible in gross income?
If the item is includible in gross income, is the item included in the proper tax year?
Did the retailer defer the income item improperly?
If the item is includible in gross income and it is included in the proper tax year, is the amount of income reasonably accurate?
IRC 61 provides that gross income for purposes of calculating taxable income means all income from whatever source derived. IRC 61(a)(3) expressly includes gains derived from dealings in property. Treas. Reg. 1.61-3(a) provides that in a merchandising business, gross income means total sales, less the cost of goods sold.
Treas. Reg. 1.61-1(a). provides gross income includes income realized in any form, whether in money, property, or services.
Treas. Reg. 1.61-2(d)(1) provides that income paid in property or services is the fair market value of the property or services.
Treas. Reg. 1.446-1(c)(1)(ii)(C) requires that the method used by a taxpayer in determining when income is to be accounted for generally be acceptable if it accords with GAAP, is consistently used by the taxpayer from year to year, and is consistent with the income tax regulations. Even if a taxpayer follows GAAP for financial reporting purposes, the IRS may require different treatment for tax purposes.
Income is generally recognized at the point in time at which a sale occurs. The term "sale" is given its ordinary meaning for Federal income tax purposes and is generally defined as a transfer of property for money or a promise to pay money.
IRC 451(a) provides that the amount of any item of gross income must be included in gross income for the taxable year in which received by the taxpayer, unless under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.
Treas. Reg. 1.451-1(a) provides that items of income are includible in gross income in the taxable year in which all the events have occurred that fix the right to receive such income and the amount can be determined with reasonable accuracy.
Treas. Reg. 1.451-5(b) provides that advance payments for goods are to be included in income in the year of receipt, or in the earlier of:
the taxable year the payments are accruable in income under the taxpayer's method of tax accounting, or
the year the payments are includible in gross receipts on the taxpayer's financial reports.
Treas. Reg. 1.451-5(c) provides advance payments for inventoriable goods must be included in income in the second taxable year following the year in which cumulative advance payments exceed the estimated cost of the goods to be delivered.
Under both the general rule and the special rule for inventoriable goods, provision is made for offsetting the cost of goods sold. If the general rule is followed, and the advance payments are included in income in the year accrued either for tax or financial statement purposes, proper matching of revenue and costs will insure that the cost of goods sold has been taken into account. If the inventoriable goods rule is applicable, Treas. Reg. 1.451-5 has a specific provision for taking into account matching costs of goods sold under certain situations.
The Internal Revenue Code provides a very general definition for the meaning of gross income. The Supreme Court has given a liberal construction to the term in recognition of the intent of Congress to tax all gains except those specifically exempted. Consequently, any statutory exclusion from income must be narrowly construed.
In the retail industry, the primary consideration in the area of income is the tax treatment of prepaid income items received by accrual basis retailers. Specifically, when is income received in advance of selling goods or performing services includible in gross income? A common aspect of tax planning is a taxpayer’s effort to defer the recognition of income items. Deferring items of income provides an economic benefit to retailers from the time value of money. The longer the period between the date an item is received and the date the item is included in gross income, the greater the economic benefit.
Under accrual basis accounting, the right to receive, not actual receipt, triggers the inclusion of an item in income. Rev. Rul. 84-31 provides the right to receive becomes fixed at the earlier of any of the following three events:
Required performance happens
Payment is due
Payment is received
An accrual basis retailer must report income in the year in which the right to such income accrues, despite the necessity for mathematical computations or ministerial acts. The fact that the retailer cannot presently compel payment of the money is not controlling. In applying the all events test, the various courts have distinguished between conditions precedent, which must occur before the right to income arises, and conditions subsequent, the occurrence of which will terminate an existing right to income, but the presence of which does not preclude the accrual of income. Consequently, a retailer that receives payment for goods or services must accrue the amount unless the receipt is subject to substantial limitations or restrictions, or is a deposit or a loan.
The determination of when a sale occurs (and the right to receive income is fixed) requires consideration of all the facts and circumstances of a particular transaction or arrangement. The terms of a retailer’s sales agreement represent the legal rights and obligations of the parties and are relevant in determining when the all events test is met. Several factors are considered, but no single factor is controlling.
Passage of title is perhaps the most conclusive circumstance.
Transfer of possession is also significant.
Other factors include the existence of conditions precedent or subsequent and whether the right to receive is contested.
Certainty of receipt, however, has never been a requirement for the accrual of income. Otherwise, an accrual method taxpayer could shift at will the reporting of income from one year to another.
Absent a specific provision authorizing deferral, prepaid income must be included in income upon receipt.
Rev. Proc. 2004-34 provides specific rules for deferring prepaid income in some circumstances.
Treas. Reg. 1.451-5(c) provides specific rules for deferring advance payments for the sale of goods.
The facts, not actual bookkeeping entries, control the determination of whether an income item is includible in gross income.
The examiner generally should not propose an adjustment which merely shifts an item of income from one year to the next or prior year if the amount is not material and the overall effect on the revenue is inconsequential.
Gross income includes merchandise sold for cash or credit and services that are incidental to the sale of merchandise. Shipping and handling revenue is also included in gross income.
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).
Retailers generally defer income recognition of advance customer payments for goods and services beyond the date of receipt. 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.
Sales are generally recorded net of estimated and actual returns and allowances as well as sales incentives such as rebates, discounts, 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 percentages.
Sales taxes collected from customers may be considered revenue. Alternatively, sales taxes collected from customers may not be considered income and included in accounts payable or accrued liabilities until remitted to the taxing authorities.
Retailers which have leased departments generally include sales from such departments in gross income (e.g. cosmetics, jewelry).
Retailers have offered some form of store credit for many years (e.g. returned merchandise). Store credits for returned merchandise may be offered in the form of gift cards.
Income must be earned and realized (or realizable) before financial statement recognition.
Revenue is earned when an entity has substantially performed the actions necessary to be entitled to the benefits of the revenue.
Revenue is earned for merchandise when title and risk of ownership pass to the buyer.
Revenue is earned for services when a single significant act is performed, when the final act is performed if a series of acts are required over a period of time, through the passage of time (e.g. rent, interest), or on collection if significant uncertainty exists.
Revenue is realized when products (goods or services), merchandise, services, or other assets are exchanged for cash or claims to cash.
Revenue is realizable when related assets received or held are readily converted to known amounts of cash or claims to cash.
Revenue is recognized at the time of sale only if all of the following criteria are met:
The price is substantially fixed or determinable at the date of sale.
The buyer has paid the seller or is obligated to pay the seller and the obligation is not contingent on resale of the product.
The buyer’s obligation would not change in the event of theft or physical destruction or damage of the product.
A buyer acquiring the product for resale has economic substance apart from that provided by the seller.
The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer.
The amount of future returns can be reasonably estimated.
The Securities and Exchange Commission ("SEC" ) criteria for revenue recognition include:
Persuasive evidence exists of an arrangement determined by customary business practices and processes.
Delivery has occurred or services rendered.
Seller’s price to buyer is fixed and determinable.
Collectibility is reasonably assured.
Advance payments generally are not recognized until the period in which the income is earned, for example when merchandise is provided (advance payments for goods), or when services are provided (prepaid fees for services).
In the interim, prepaid amounts are treated as a liability until the revenue is earned, reflecting an obligation to provide something of value in the future.
Payment prior to performance is common in the retail industry. Gift cards, extended service plans, and club memberships are just a few examples of items for which payment usually precedes performance.
Tax accrual accounting generally results in an earlier reporting of income items and a later reporting of expense items than financial accrual accounting. Consequently, the IRS generally takes the position that prepaid income is includible in gross income in the year of receipt while retailers take the position that prepaid income is includible in a subsequent year or years when performance takes place.
Historically, the IRS has been successful with its position that prepaid income is taxable in the year of receipt, notwithstanding that the amount may be refundable in certain circumstances or that the retailer is required to provide goods or services in the future.
In some transactions, a retailer may effectively defer recognition of an income item by creating a current deduction or loss to offset a portion of the income item.
In the normal course of business, retailers have offered gift certificates for a number of years to increase their sales of goods and cash flow. In the 1990s, many retailers replaced their gift certificates with gift cards. For retailers, gift cards offer flexibility in promoting customer loyalty because they make it easier to track purchases and thus offer opportunities to enhance future sales. Gift cards are generally non-refundable unless required by state law.
The sale of a gift certificate or gift card is recognized as income when redeemed for financial reporting purposes. Proceeds from the sale of gift cards are recorded at the time of sale as a liability. Gross income is reported and the liability is relieved when the holder redeems the gift card for merchandise. In some situations, gift card sales are recognized when the likelihood of redemption by the customer is remote (i.e. gift card breakage) and the retailer determines that it does not have a legal obligation to remit the unredeemed gift cards to the relevant jurisdiction(s) under escheatment rules.
The sale of a gift certificate or a gift card is treated as an advance payment for tax purposes under Treas. Reg. 1.451-5(a)(2)(i).
Unless a retailer complies with the deferral rules under Treas. Reg. 1.451-5 or Rev. Proc. 2004-34, gift card income must be reported when received.
Under Treas. Reg. 1.451-5(c) gift card income may be deferred until the last day of the second taxable year following the year of sale.
Under Rev. Proc. 2004-34, gift card income may be deferred until the last day of the first year following the year of sale.
Under Treas. Reg. 1.451-5(b)(1)(ii), advance payments for tax purposes cannot be reported later than they are for financial accounting purposes.
Audit Techniques may include the following.
Scan the general ledger accounts for deferred income items.
Review Schedule M to determine the existence of any adjustments reconciling book-tax reporting differences for income items.
Ask the taxpayer to identify when gift card income is recognized for book and for tax purposes. If revenue recognition differs between book and tax, ask the retailer to address how such differences are reconciled and reported on the Schedule M.
If the retailer indicates that gift card income is deferred, ask the retailer to identify: (1) the method used to defer gift card income for both financial and tax reporting purposes; (2) how the method was elected; (3) how unredeemed gift cards are tracked; (4) whether an estimate is used to record the liability for unredeemed gift cards at tax year end; (5) whether an outside service provider is used and to provide a copy of the service contract; and (6) whether an estimated cost of goods sold deduction is recognized to the extent unredeemed gift cards are recognized as income for tax purposes.
Request a description of the accounting and record-keeping policies and procedures for the retailer’s gift card/certificate program.
Request a list of the book and tax accounting entries the retailer makes to record gift cards, including sales, redemptions, expirations, escheatments, discounts, dormancy or other fees, and any other transactions.
Obtain copies of the retailer’s accounting manual and all internal audit reports issued for gift cards. Inquire about the following: 1) whether the gift cards are issued in lieu of cash refunds; 2) whether the gift cards are reloadable and if so, how reloads are tracked; and 3) whether the retailer uses a separate legal entity to manage its gift card program and if so to provide details of the arrangement. The detail requested should include the name and the type (e.g., C-corp., LLC, S-corp.) of the entity created, when it was created, where it is chartered, if applicable, and generally how the program works.
Ask the retailer to identify and describe any restrictions listed on the gift card.
Obtain a photocopy of the front and back of the gift card(s) which the retailer and any of its subsidiaries issued for the tax years under audit. Ask if the retailer imposes any restrictions not otherwise listed on the gift card.
Potential Compliance Risks
Indefinite Deferral The examiner may encounter a situation whereby the retailer is deferring the recognition of gift card sales beyond the second year following the receipt of the cash. In this situation, the method used for tax reporting is the same method used for financial reporting (i.e. income deferral until redemption). The absence of a Schedule M adjustment reconciling reporting differences indicates the retailer may be using an improper method of accounting for tax reporting purposes.
All Events Test Although Treas. Reg. 1.451-5(c) allows for the deferral of recognition for up to two years, the examiner must keep in mind that the all events test under Treas. Reg. 1.446-1 and Treas. Reg. 1.451-1 needs to be applied first. Gift card income is recognized when all events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. The regulations do not permit deferral if the income has already been earned. If gift cards expire before the end of the second year following the year of receipt, the income may have to be recognized sooner under the all events test.
Reloadable Cards When the holder of a gift card is able to add value or increase the worth of the gift card, it is commonly called reloadable. If a retailer’s gift cards are reloadable, the examiner should verify that the retailer’s accounting system and software takes into account the actual dates when money is added to the card for purposes of computing the limited deferral period.
Service Charges or Fees Service charges or fees relative to gift cards, including dormancy fees, latency fees, or other administrative fees, that have the effect of reducing the total amount for which the holder of the gift card may redeem the gift card until the expiration date on the card has expired may not be properly reported as income by the retailer when charged against the gift card. The examiner needs to verify that the income is properly reported when dormancy fees, latency fees, or other administrative fees can be incurred relative to a taxpayer’s gift cards/certificates.
Estimated Cost of Sales Treas. Reg. 1.451-5(c)(1)(ii) provides that a retailer must take into account the cost of sales, either on an actual or estimated basis, in the year in which the taxpayer is required to include the advance payments. However, Treas. Reg. 1.451-5(c)(1)(iii) provides that the reduction for cost of sales does not apply if the goods with respect to which the advance payment is received are not identifiable. Consequently, a deduction is allowed only when the merchandise is identified (i.e. when the gift card is actually redeemed).
Bulk Sales Discounts Direct expenses are not deductible until the year in which the related income items are actually earned. Sales discounts on gift cards should be expensed in direct relationship to the recognition of income from the gift cards. A retailer which expenses discounts while deferring income from the related gift card sales is improperly accelerating a deduction..
A layaway sale is a sale of any goods in which the goods are offered for sale to the public on terms which permit periodic payment for the goods, and with respect to which delivery is deferred until completion of payment of the entire purchase price.
Some retailers offer layaway sales to their customers. As a general rule, retailers that offer layaway sales do not require customers to enter into an installment note or other fixed payment arrangement when the down payment is received. Retailers retain the merchandise, set it aside in inventory and release the merchandise to the customer when the customer has paid the full purchase price.
For financial reporting purposes, a layaway sale is not immediately recognized as income. The advance payments from customers are recorded as a liability at the time they are received even if the payments are subject to forfeiture. Gross income is reported and the liability is relieved when the customer pays the full purchase price and the merchandise is delivered to the customer.
The advanced payments from layaway sales are reported as income at the time of receipt unless the retailer elects the deferral method under Treas. Reg. 1.451-5. Because IRC 453(b)(2)(B) revoked the installment sales method for dealers in personal property, layaway sales now are under the same general rules as gift cards. The deferral method is explained in IRM 126.96.36.199.6.1.
Unlike gift cards, the merchandise sold under a layaway plan is usually identifiable before the customer takes possession. A substantial advance payment is therefore not deemed to have occurred until the last day of the taxable year in which layaway payments received equal or exceed the reasonable costs of the goods sold. The two-year deferral period provided by Treas. Reg. 1.451-5(c)(1)(i) begins on this date.
For layaway sales, the retailer is allowed a deduction for the cost of goods at the time the income is recognized under Treas. Reg. 1.451-5(c)(1)(i) when the goods can be identified. This deduction (or estimate of cost of goods sold) must be claimed at this time even if no goods are on hand when the income is recognized. The deduction for the cost of goods sold is lost if it is not claimed at this time. Any variance between the actual costs and the deduction claimed is corrected at the completion of the installment obligation.
The examiner should review the audit techniques for gift cards when examining layaway sales.
A manufacturer generally provides consumers with a limited warranty of product quality. Some retailers sell extended warranties or service contracts, such as electronics, which are in addition to the warranty provided by the manufacturer. The coverage provided is usually for a number of years and the consumer usually pays the entire cost of the coverage up-front.
The mechanics of the agreements may vary from one retailer to another. Some retailers may perform the covered-service work themselves while others may have a third party perform the work. Some retailers are principals of the plan, retaining the contingent liabilities which arise from the coverage, or possibly paying a third party to assume total or partial responsibility. Other retailers are acting as the agents of a third party, which is the principal of the plan. As an agent, the retailer's involvement could be limited to selling the service contract to its customers, for which it would receive a commission. The third party, who is paid to assume the risk, increasingly involves a contract written with an off-shore insurance company.
For tax reporting purposes, an accrual method retailer that receives payments for services to be performed in the future generally must include the payments in gross income in the taxable year of receipt. Consequently, any income received from the sale of extended warranties or service contracts is normally recognized in the year the contract is sold. Any expenses related to providing services under the warranties or service contracts are allowed only in the year in which incurred.
Rev. Proc. 2004-34 allows an election to defer the service contract income to the next succeeding taxable year to the extent the prepaid income is not recognized in revenue in the taxable year of receipt.
Rev. Proc. 92-98 allows retailers an election to defer the service contract income in certain situations where the taxpayer purchases an insurance policy to cover its service contract obligations. This method is known as the service warranty income method ("SWIM " ) and provides for a better matching of income and expenses. If this method is not elected, then the income is recognized when received and the costs of the insurance must be amortized over the life of the policy.
SWIM is available to retailers of durable consumer goods with respect to qualified advance payment amounts received on service warranty contracts when:
The service agreements are fixed-term agreements with respect to durable consumer goods purchased by a customer.
The service agreements are separately priced, such that customers have the option to purchase the service warranty contract for an expressly stated amount separate from the price of the underlying durable goods.
The service period begins in the taxable year the advance payment is received or upon expiration of a fixed-term manufacturer’s warranty beginning in the taxable year the advance payment is received.
The retailer purchases a policy that constitutes insurance for federal income tax purposes from an unrelated third party to insure its obligation under the service warranty contract and
The retailer makes payment to the unrelated third party insurer within 60 days after receipt of the advance payment for the entire amount of the insurance costs associated with the policy insuring its obligation under the service warranty contract.
The primary audit consideration is when a retailer should report revenue from the sale of extended warranty or service contracts. The examiner is unlikely to encounter a reporting issue when the retailer is merely an agent which retains or receives commissions generated by the sale of extended product warranties or service agreements. Any potential issue would relate to the normal year-end timing issues. In situations where the retailer is the principal of the agreement sold to the customer, a number of potential issues may exist. The retailer may be improperly deferring income received for the sale of the agreement. The sale price may be reflected on the books as a prepaid liability recognized as income ratably over the life of the agreement. The possibility also exists that the retailer may defer income recognition, or even the inclusion as a prepaid, in situations involving multiple payments.
The examiner should request and review all documents pertaining to the contracts and agreements. The examiner should also secure the procedural guide stating how the taxpayer accounts for these monies.
Some retailers generate income from annual membership fees. A typical arrangement requires customers to prepay the entire membership fee. Customers have a unilateral right to cancel their membership at any time during the term and receive a partial refund of the fee paid.
For financial reporting purposes, annual club membership fees are not immediately recognized as income. The advance payments from customers are recorded as a liability at the time they are received. Gross income is reported and the liability is relieved over the term of the membership. Most terms are for a period of 12 months and income is recognized ratably over this period.
For tax reporting purposes, the advanced payments from club memberships are reported as income at the time of receipt unless the retailer elects the method under Rev. Proc. 2004-34. This revenue procedure allows retailers an opportunity to defer annual membership fees to the next succeeding taxable year to the extent the prepaid income is not recognized in revenue in the taxable year of receipt.
Retailers (e.g. department stores) might lease or license departments to unrelated parties. These retailers generally receive commissions based on a percentage of sales. The commissions are recognized as income at the time merchandise is sold to customers.
Department stores and other retailers customarily include the sales of leased or licensed departments in the amount reported as total revenue. The SEC does not object to retailers presenting sales of leased or licensed departments in the amount reported as total revenue because of industry practice.
Generally, this arrangement is not a lease but rather a service arrangement that provides for payment of a fee or commission. As such, a retailer should recognize the fee or commission as revenue is earned.
Retailers have offered some form of store credit for many years. Some retailers operate a private label or an in-house credit card program to facilitate sales in their stores and generate additional revenue from fees related to extending credit. Retailers typically establish a federally chartered bank as a wholly-owned subsidiary to hold and service the card accounts. These captive banks act as the merchant bank and issuing bank with respect to the card transactions. Such store cards bear the insignia of the issuing chain. Other retailers form marketing arrangements with financial institutions that issue general purpose cards that bear the retailer’s name on the front of the card.
Unlike cash or check payments, retailers do not receive the full selling price of transactions that customers make with general purpose credit or debit cards because the merchant bank subtracts a merchant discount fee for services rendered in connection with retailers accepting electronic payment from customers. 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. For a private label card, the retailer’s captive bank receives the merchant discount and the retailer’s retail operations pay the merchant discount.
For financial reporting purposes, credit card fees are generally recognized at the time they are charged to a cardholder’s account.
Prior to a 1997 tax law change, credit card fees generally were recognized at the earliest of when paid, due, or earned under IRC 446 and IRC 451. A 1997 tax law change added subsection (iii) to IRC 1272(a)(6)(C). The application of this change in law to those credit card fees that are properly treated as giving rise to original issue discount (OID) results in the recognition of the income attributable to the fees in accordance with the constant yield method described in IRC 1272(a)(6) for pools of loans.
Many issuing and merchant banks have taken the position that interchange and merchant discount fees give rise to OID, relying on IRC 1272(a)(6) to defer income recognition for such fees. In addition to merchant discount, in-house card programs treat fees earned for late payment and insufficient funds as OID.
The primary compliance risk is the deferral of merchant discount fees beyond the year of receipt because of the improper application of the OID rules. Merchant discount fees are a charge for services, which must be recognized in income currently. Alternative issues include the application of the matching rule for intercompany transactions and the methodology used to compute the amount of deferred income properly accounted for as OID.
Audit Considerations include the following:
Do merchant discount fees give rise to OID?
If merchant discount is treated as OID, is it subject to the intercompany transaction rules of Treas. Reg. 1.1502-13?
How should a credit card fee, if otherwise treated as OID, and not subject to the intercompany transaction rules, be included in gross income under IRC1272(a)(6)(C)? The deferral calculation must be examined as well.
The examiner should request and review the following information to examine this issue:
Credit card agreement, including all amendments
Merchant agreement, including all amendments
Processing agreement, including all amendments
Sale of receivables agreement, including all amendments
Detailed computation workpapers for any IRC 481(a) adjustment and current year adjustment related to fees treated as OID
Schedule M book and tax reconciliation workpapers
Standard journal entries for a credit card transaction
Factoring transactions involve the sale of accounts receivable to a factoring company (or factor), which purchases all rights, title and interest in the accounts receivable and undertakes to assume the risk of their collection. A factor is a financial intermediary who purchases the accounts receivable. Factoring provides techniques for companies to manage their accounts receivable and/or provide financing.
Factoring is a common business practice in the retail industry. Retailers generate accounts receivable by selling goods and services to their customers on credit and then sell or assign their accounts receivable to a factor in exchange for a cash advance.
Numerous types of factoring arrangements exist. Some of the basic types vary the treatment of credit risk assumption and customer or debtor notification. In many arrangements, factoring agreements provide for accounts to be purchased on both a recourse and non-recourse basis depending on the credit worthiness of the customers or the debtors.
The price the factor pays for the accounts receivable is discounted from the face amount to take into account the likelihood of uncollectibility of some of the receivables. For example, if receivables have a total face amount of $1,000, and the factor charges a 2% discount, the retailer receives $980 for the receivables. The discount rate represents the factor’s assumption of credit and other capital risks on the outstanding receivables. The discount represents an ordinary loss.
Although valid economic reasons exist for factoring, the examiner should be aware of arrangements that may lack valid economic reasons:
A domestic factor that is related to the retailer and that was created solely to factor the retailer’s receivables.
A foreign factor where the retailer and factor have a common parent so that the retailer is a brother-sister corporation of the foreign factor. The factor is capitalized through a contribution by the parent.
A pass-thru factoring entity (which is related to the retailer and which was created solely to factor the retailer's receivables), which is also purportedly owned in small part by foreign and/or tax exempt entities to which it allocates a large amount of income but a small amount of expenses, losses and/or deductions.
The examiner should consult with a Financial Products Specialist when warranted.
A sale occurs for tax purposes when the seller relinquishes the benefits and burdens of ownership of the goods. The determination of when a sale takes place depends on the totality of circumstances including when title passes and when possession is transferred. The objective is to determine when the seller acquired an unconditional right to receive payment under the contract.
A sale by an accrual basis retailer cannot be regarded as complete, or the consideration accruable, until the liability of the purchaser to make payment of the purchase price to the retailer has become fixed. If the sales contract contains a condition precedent, the sale is not complete or the purchase price accruable until the condition is satisfied.
For example, a sales contract which makes acceptance of the subject matter dependent upon inspection or testing by the purchaser creates a condition precedent and prevents accrual of the purchase price by the seller until such tests and inspections have been made.
Customer acceptance provisions may be included in a contract, among other reasons, to enforce a customer’s right to test the delivered product, require the seller to perform additional services subsequent to delivery (e.g. installation). The customer acceptance provision should be substantive and bargained for.
Potential tax issues may include the following:
Whether an item of gross income may be deferred on the theory that a defined acceptance period for product shipped to customers at the end of the tax year had not lapsed by the end of such tax year.
For example, can a retailer defer the sale of merchandise that a customer has paid for and taken possession of at the time of sale because the sales invoice contains a stipulation that title and risk of loss do not pass to the customer until 30 days after the invoice date.
In the situation of a sale on acceptance contract, the determination of when the right to receive income is fixed will depend on the importance of the acceptance provision in the standard sales contract.
If an unconditional right to return the merchandise to the taxpayer without penalty in conjunction with the fact that title did not pass to the buyer until a later year exists, a retailer may not be required to recognize income on the shipment date. The fact that customers rarely exercise this right is of no consequence. It is the existence of the right which controls.
The examiner should determine if the buyer has the right to return the product and the buyer does not pay the seller at the time of sale and the buyer is not obligated to pay the seller at a specified date or dates.
The examiner should also determine what happens in the event the product, while in the hands of the buyer, is stolen or damaged.
In a barter transaction involving barter credits, a retailer enters into a transaction to exchange a non-monetary asset (e.g. inventory) for barter credits (e.g. advertising). A barter transaction typically occurs directly between a retailer and the other party to the transaction. In some situations, however, a third party, such as a barter company may facilitate the barter transaction.
A barter contract typically specifies the goods and services to be purchased. Barter credits may have a contractual expiration date at which time they become worthless.
E-commerce retailers commonly enter into transactions in which they exchange rights to place advertisements on each others' websites. Traditional retailers may also enter into advertising barter transactions (e.g. inventory goods for advertising).
A barter transaction generally results in recording an equal amount of income and expense. However, the recognition of income and expense may occur in different tax years. For example, a supermarket barters inventory for media credits. The retailer redeems the media credits in a year subsequent to the year the inventory is provided to the media company.
For financial reporting purposes, the Emerging Issues Task Force (EITF) 93-11 and EITF 99-17 provide guidance for reporting advertising barter transactions.
For tax reporting purposes, the fair market value of the barter credits are includible in gross income in the year of the barter transaction.
The examiner should scan liabilities reported on the balance sheet and supplemental schedules for deferral of income items. Consider the description of the entries and titles of the accounts.
The examiner should scrutinize the accounts receivable subsidiary ledger for credit balances.
The examiner should review Schedule M to determine if the retailer reported any book-tax differences associated with deferred income items.
The examiner should obtain written agreements to determine the terms and conditions of the sales arrangement resulting in deferred income.
Additional gross income information is included in this section.
Most retail transactions are made by cash, checks, or credit/debit card transactions.
Most large retailers have a system in place which records the sale at the cash register as it occurs. In many cases the cash register is a computer terminal from which data is directly entered into the computer. This automated retail system is known as a Point of Sale (POS) inventory system.
These electronic cash registers accumulate various sales data. They identify the type of transaction, the method of payment (including credit card types and numbers), authorization codes and employee codes. Sales detail by product, department, store, date, and time is immediately available to management personnel using these sophisticated systems.
Promotional sale prices are recorded at the point of sale, thus eliminating the need for the retailer to physically remark price tags at the beginning and end of each sales promotion. When the product code is scanned, an immediate interaction with the product data base occurs, generating both the full retail price (net of prior permanent markups and markdowns) and the promotional markdown. The customer is charged the net reduced price. These price changes can be entered into the system in advance of the effective date. For example, the database can be programmed to reflect that product X, which carries a normal retail price of 99 cents, will be on sale for 79 cents for a specified seven-day period.
In other less sophisticated systems, the retailer's sales personnel would enter the full price and then enter the promotional markdown separately. The recording of the complete sales transaction is more time consuming and generally contains less detailed information.
The information from the sales journal may be analyzed by the examiner if there are indications that not all sales for a period, a specific product or a specific location have been reported. In addition, if a certain type of sale is being improperly deferred these records could be searched for data by transaction code. Before commencing a review of sales, the examiner should request and become familiar with the retailer's internal standard procedures for recording sales, including definitions of input codes.
Advance payments are loans.
Borrowed money is not taxable income because of the corresponding obligation to repay.
The examiner should request the note or other evidence of indebtedness if the retailer takes this position.
Advance Payments are deposits.
Like borrowed money, a deposit is not includible in gross income when received.
The fact that an amount received may be refundable is not sufficient to make the payment a deposit. The rationale is that most items are refundable.
The distinction between an advance payment and a deposit is one of degree rather than kind. An advance payment and deposit are similar in that both protect the seller (e.g. retailer) against the risk that it will be unable to collect money owed it after it has furnished goods. An advance payment and deposit are dissimilar in that an advance payment assures the seller that so long as it fulfills its contractual obligation, it can keep the money. The customer or supplier who makes an advance payment retains no right to insist upon the return of such funds. An advance payment essentially protects a seller (i.e. retailer) against the risk that the purchaser will back out of the deal before the seller (i.e. retailer) performs.
An examiner should focus on the rights of the parties at the time payment is made if the retailer takes this position.
A right to income that is contested is not required to be accrued prior to resolution of the dispute concerning the amount. See Rev. Rul. 73-385.
Treas. Reg. 1.451-1(a) provides that income is includible "when all the events have occurred which fix the right to receive such income..." . If a taxpayer's claim to income is being contested, and the controversy is unsettled at the close of the taxable year, the item of income is not includible in that year, since the taxpayer's right to receive the income is not fixed. Even when the other party to the transaction stands ready to pay the amount claimed it will not be income to the taxpayer if the funds are impounded or otherwise tied up so that they are not available to the taxpayer until the contest is settled.
If some or all of the contested income is paid to the taxpayer, it is taxable at the time of receipt, even if the contest is not settled. The receipt of payment is one of the three basic events that may fix the taxpayer's right to receive, even if a contest is continuing.
Contested income is includible in a taxpayer's income in the year in which the contest is settled. If the matter is litigated, the year of settlement is the year in which a court makes a decision that becomes final. A trial court's decision must become final, either through affirmation on appeal or through expiration of the right to appeal.
If a taxpayer's right to income is contested, but there is no litigation, the income is to be accrued in the year in which the parties settle the controversy. Many taxpayers' claims for income under government contracts are contested administratively without any litigation, and these cases follow the general rule of income in the year of settlement.
The IRS has taken the position that as long as the taxpayer's income from a contract is disputed by the obligor, all events have not occurred to fix the right to the income. The all events test is not satisfied until the dispute is resolved. Resolution of the dispute occurs when either the liability is acknowledged by the obligor, or the liability is finally determined by the court or other ''forum of last resort'' and is not subject to further appeal or contest. The IRS has adopted the rule of law first established in H. Liebes & Co. v. Commissioner, 90 F.2d 932 (9th Cir. 1937), that even when a claim has been reduced to judgment and no appeal has been filed, the right to receive proceeds or income does not accrue for tax purposes until the time to appeal expires.
Admission of liability to the taxpayer is a necessary event to fix the taxpayer's right to receive income.
In Rev. Rul. 2003-10, the IRS addressed the proper tax year in which a vendor using an accrual method should recognize gross income if the vendor's customer disputes its liability to the vendor. The ruling discusses three different situations.
Situation 1. The taxpayer over billed a customer due to a clerical error. The customer discovered the error in the following year and disputed its liability for the over billed amount. The taxpayer should recognize income in the year of sale for the correct amount. The taxpayer had a fixed right to receive this correct amount
Situation 2. The taxpayer shipped the wrong goods to the customer and during the year of sale the customer disputed its liability. In this fact pattern, the taxpayer does not recognize any income in the year of sale because the taxpayer did not have a fixed right to receive payment for the incorrect goods.
Situation 3. The taxpayer shipped excess quantities of goods to the customer, but the customer agreed to pay for the excess quantities. The taxpayer must recognize all the income in the year of sale. There was never a dispute with the customer, so the taxpayer had a fixed right to receive the entire amount of income.
Potential Compliance Risk
If the dispute arises prior to tax year end, the income is adjusted in the year of sale.
If the dispute arises after tax year end, the income is adjusted in the year of dispute. The rationale is that the dispute is a new event.
Under an accrual method, it is the right to receive income and not the actual receipt of income that determines the inclusion of the amount in gross income. When the right to receive an amount becomes fixed, the right accrues. The right to receive rather than the earning of the income is important. The right to receive may often occur prior to the actual earning of the income, depending on the relevant agreement between the parties as well as other attendant circumstances. It is not necessary in all circumstances that the right to receive be legally enforceable. Enforceability of the right often pertains more to whether a debt may be collected than to whether the right to receive exists.
Example 1. A retailer had the right to reimbursement of a portion of its advertising costs by vendors of advertised goods. The IRS ruled that the taxpayer should accrue the reimbursement when it placed the advertising, and not at a later date when it filed a claim.
Example 2. The purchase of obligations, such as accounts receivable, at a discount from face value has been held not to result in the receipt of income. None of the three basic events fixing the right to receive occurs at the time of purchase merely because assets have been purchased for less than face value, and income is thus considered realized at the time of collection. See Rhodes-Jennings Furniture Co. v. Commissioner, 192 F.2d 1022 (6th Cir. 1951).
The receipt of payment does not always satisfy the all events test in fixing the right to receive. The IRS stated that the all events test is not satisfied when the payment received is in the nature of a deposit. The taxpayer received a payment from its customer at the end of Year 1 in exchange for the taxpayer's agreement to provide drivers for the customer's trucking operations for the first three months of Year 2. The memo stated that the payment received would be treated as a deposit and not taxable if the customer had the right to back out of the purchase and could get a refund of the payment. In this particular case, the service contract with the customer did not provide for the possibility of a refund, so the advance receipt had to be recognized as income in Year 1.
In determining whether an accrual basis taxpayer has a right to receive an item, and whether the taxpayer must include it in income, the examiner must understand the distinction between a condition precedent and a condition subsequent.
A condition precedent has been defined as a "condition that must be fulfilled before a party's promise becomes absolute." The condition precedes an absolute duty to perform. If a taxpayer does not have a duty to perform until the condition has been fulfilled, no right to receive occurs until the condition has been satisfied and, as a result, no accrual of income is required.
A condition precedent to a sale or exchange leaves one or both of the parties to a transaction free to withdraw unless the condition is timely satisfied.
Example. Merchandise shipped C.O.D. (i.e. cash on delivery) is not a sale until payment is made by the customer. For goods shipped COD, title does not pass (and a sale is not made) until the goods are delivered, accepted, and payment simultaneously rendered.
A condition subsequent has been defined as a condition that operates to terminate a party's absolute promise to perform. The condition arises after the fixing of the absolute duty to perform. The right to receive income arises even though that right may be reduced or eliminated by some subsequent event. Such contingencies are considered in the same light as anticipated losses, or estimated or contingent liabilities. None of these items result in current deductions, the approach under the tax law being to "wait and see" until the event occurs, and if it does, to give it some tax effect at that time.
A frequently encountered condition subsequent is the possibility of a refund based on the occurrence of some future event. The possibility of refunds is a condition subsequent not affecting the accrual of income. The Supreme Court has ruled that unearned commissions are subject to refund if the related premiums are not paid because the possibility of a refund is a condition subsequent not affecting the accrual of income. See Brown v. Helvering, 291 U.S. 193 (1934).
The possibility of a subsequent price adjustment is a condition subsequent much like the possibility of a refund and is treated similarly for tax purposes. The cases and rulings have uniformly held that the taxability of the sales price is not affected by the possibility of a subsequent price adjustment.
Generally, the delivery of goods or services is not very important in determining the accrual of income. Delivery is not listed as one of the three events giving rise to a right to receive.
A number of cases have held that income accrued in the year before delivery, because there was transfer of title, or payment received, or both, so that one of the actions creating a right to receive had occurred. For example in Pacific Grape Products Co. v. Commissioner, 219 F.2d 862 (9th Cir. 1955) a shipment of goods was delayed at the buyer's request. However the seller billed for the unshipped goods and the buyer paid for such goods by year-end. The court held that it was proper to accrue income at year-end. On the other hand, in the case of Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26 (1988), the calendar year taxpayer delivered seasonal merchandise, such as Valentine's Day cards, substantially before the end of the calendar year in order to smooth out its production over the year and avoid warehousing the merchandise. The terms of the sale, however, were that title to the goods and risk of loss did not pass to the buyer until January 1. Although the customers were in physical possession of the merchandise at December 31, they did not own it, were not required to include it in year-end inventory, or pay personal property taxes on it. The court held that the all events test was not satisfied until January 1, and, therefore, the taxpayer could accrue income from these sales at that time.
This section provides general background information about inventory in the retail industry and general accounting practices for such inventory as reported by retailers.
In general, inventories can be defined as the goods held for sale to customers in the ordinary course of the retailer’s trade or business.
For retailers, inventories play a significant role in the computation of taxable income. Goods in inventory generally represent the most significant asset on a retailer’s balance sheet. Similarly, the cost of goods sold (COGS) generally represents the largest single item of expense on a retailer’s income statement.
Inventory is arguably the asset with the highest probability of being incorrectly valued because of the judgments and estimates involved in such determinations.
Have all goods been included in inventory?
Is the stated value of inventory correct?
Has the inventory method employed been used consistently from year to year?
Does the inventory method employed clearly reflect income?
Has the taxpayer filed any change of accounting method requests relative to inventory?
Treas. Reg. 1.61-3 provides that gross income means total sales less cost of goods sold.
IRC 471 provides that whenever the use of inventories is necessary in order to clearly determine the income of any taxpayer, inventories shall be taken on such basis as the Secretary may prescribe as conforms as nearly as may be to the best accounting practice in the trade or business and as most clearly reflects the income. To reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.
Treas. Reg. 1.471-2(c) states the bases for valuation of inventories most commonly used by business concerns and which meet the requirements of IRC 471 are:
Cost or market, whichever is lower.
Treas. Reg. 1.471-2(d) provides that if the taxpayer maintains book inventories in accordance with a sound accounting system in which the respective inventory accounts are charged with the actual cost of the goods purchased or produced and are credited with the value of the goods used, transferred or sold, calculated on the basis of the actual cost of the goods acquired during the year (including the inventory at the beginning of the year), the net value as shown by such inventory accounts will be deemed to be the cost of the goods on hand. Treas. Reg. 1.471-2(d) further provides that the balances of the book inventories should be verified by physical inventories at reasonable intervals and adjusted to conform therewith.
Treas. Reg. 1.471-2(e) provides that inventories should be recorded in a legible manner, properly computed and summarized, and should be preserved as a part of the accounting records of the taxpayer.
Treas. Reg. 1.471-3(b) defines cost, in the case of merchandise purchased since the beginning of the taxable year, as the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. The transportation or other necessary charges incurred in acquiring possession of the goods should be added to this net invoice price.
Treas. Reg. 1.471-3(d) provides that in any industry in which the usual rules for computation of cost of production are inapplicable, costs may be approximated upon such basis as may be reasonable and in conformity with established trade practice in the particular industry.
Treas. Reg. 1.471-8 provides that retailers can use what is known as the "retail method" in ascertaining approximate cost of their inventories.
Treas. Reg. 1.472-1(a) provides that any taxpayer permitted or required to take inventories pursuant to the provisions of IRC 471 and pursuant to the provisions of Treas. Regs. 1.471-1 to 1.471-9 inclusive, may elect with respect to those goods specified in the application and properly subject to inventory to compute the opening and closing inventories in accordance with the method provided by IRC 472 and Treas. Reg. 1.472-2.
IRC 472 provides that a taxpayer may use the LIFO method in inventorying goods specified in an application to use such method at such time and in such manner as the Secretary may prescribe.
What goods should be included in inventory for income tax purposes under Treas. Reg. 1.471-1?
All goods that have been purchased and for which title has passed including in-transit goods
Goods that are under contract for sale but have not yet been applied to the contract
Goods that are consigned out to other locations for which title or ownership has not been transferred
Goods that are sold cash on delivery (COD)
While inventory rules cannot be uniform, they must give effect to trade customs which come within the scope of the best accounting practice in the particular trade or business. See Treas. Reg. 1.471-2(a)(1).
In order to clearly reflect income, the inventory practice of a taxpayer should be consistent from year to year, and greater weight is to be given to consistency than to any particular method of inventorying or basis of valuation, so long as the method or basis used is in accord with Treas. Regs. 1.471-1 through 1.471-11.
COGS is not treated as a deduction on an income tax return and is not subject to the limitations on deductions contained in IRC 162 and IRC 274.
Any amount claimed as COGS must be substantiated and taxpayers are required to maintain records sufficient for this purpose. If a taxpayer does not have adequate records, but the record suggests that they are incurred as an offset to gross receipts, courts may estimate the offset based on the evidence.
The following sections highlight and discuss the steps and practices commonly performed by retail taxpayers in obtaining their inventoriable goods. Key record- keeping documents will also be identified.
Retailers may have a centralized merchandise (or goods) purchasing department at its corporate headquarters with many buyers assigned to various product lines for the entire company, or decentralized buying procedures with buyers assigned to specific stores or geographical locales. Assistant buyers, administrative support, accounts payable clerks and inventory control personnel aid the head buyer in the purchasing process. Management and secretarial staff also are involved peripherally in the buying function. A company directory or a detailed organizational chart can be used to identify the taxpayer’s personnel involved in purchasing the goods for resale.
The purchasing process includes the selection of vendors and merchandise/goods as well as the negotiation of cost. Vendor criteria include reliability and quality control. Merchandise selection addresses consumer demand, quality, color, size, quantity, and delivery date. Buyers negotiate wholesale cost including the various discounts (e.g., volume discounts) and allowances. Buyers also negotiate marketing allowances for performance by the retailer, including cooperative advertising and shelving allowances. Certain merchandise-based vendor allowances do not qualify as reductions to inventory value and include the following:
Opening Order Discount
Market Development Funds
New Store Allowance
Price Increase Allowance
Product Placement Allowance
See IRM 188.8.131.52 for additional information on vendor allowances.
The purchasing process generally consists of the five following steps:
Identifying the various vendors
Contacting the vendors
Evaluating the vendors
Negotiating with the vendors
Purchasing from the vendors
Buyers may also be responsible for the merchandising of the goods they purchase. Merchandising tasks include involvement in markups and markdowns, the display of the goods (planograms) and advertising.
A more detailed overview of the steps involved in purchasing specific goods includes the following:
Interest in the product
Investigation of the product
Decision to purchase the product
Establishment of profit margin for the product
Determination of quantities to be ordered
Buyer/vendor negotiation for price and terms
Establishment and maintenance of an item file for the product which includes purchase cost and retail selling price, payment terms, shipping location and arrangements, and vendor information
To purchase goods, the following actions are generally taken:
A purchase order (PO) is prepared.
The PO is sent to the vendor, manually or electronically, with the record retained in the unfilled PO file.
The receiving area is notified by the vendor or the retailer’s transportation agent to schedule dock time for delivery. An employee in receiving pulls a copy of the PO or a check-in document.
The employee in receiving matches the product(s) received with the product(s) ordered. A confirmation is sent to the invoice processing department or entered into the computer system.
The vendor submits an invoice, manually or electronically, to the invoice processing area where it is entered into the computer for an automated reconciliation with other document information.
After the reconciliation, the invoice is recorded in the accounts payable system and subsequently paid.
Because retail operations may require interaction with thousands of vendors, the taxpayer will usually set up a vendor database. The following information is contained in the vendor database:
Vendor name and address
Name and telephone number of vendor’s representative(s)
Buyer(s) representing the taxpayer/ retailer
Vendor number assigned by the taxpayer/retailer
Product names, codes such as the Stock Keeping Unit (SKU) or the Universal Product Code (UPC) number and descriptions
Desired minimum and maximum product inventory on hand
Automated reorder point data
Product purchase price by quantity
Payment terms and discounts
Shipping information, including carrier and origin
Historical cost data
Retail selling price as established by the buyer
Historical retail pricing data
Cumulative purchase information
Schedule of markdowns for seasonal or fashion merchandise
Cooperative advertising agreements
Details of various other rebates or purchase incentives offered
The factual development of various inventory issues such as the tax treatment of discounts, vendor allowances, rebates, purchase incentives, cooperative advertising, markdowns, shipping information, cost data, retail selling price data, and other similar information can be obtained from the vendor database.
Other records such as the stock ledger system or merchandise record will detail all merchandise purchase orders. The unfilled order file is one of the records a buyer will use to determine an "open to buy" limit which is the budgeted amount a buyer is permitted to order for a specific period of time.
The following sections discuss the purchase journal and price change records and categories.
The taxpayer’s merchandise purchase journal will contain all of the entries related to the purchase of merchandise. This journal is a subsidiary of the accounts payable system. All documents entering the payables system are coded to reflect the nature of the transaction such as a regular merchandise transaction, a chargeback issued to a vendor, or a payment of an unearned discount.
The purchase journal can be used to document the transfer of merchandise between the warehouse and a store or between two stores. Merchandise physically returned to a vendor is another type of transaction reflected in the purchase journal.
The retail price of a product is initially established at or before the time of purchase, usually as part of the overall purchase negotiation process between the buyer and vendor. If the buyer enters the original purchase price of the product into the retailer’s retained copy of the purchase order, that retail price would then become part of the internal data base for that item and that vendor.
The original retail price of an item is subject to numerous changes and only certain employees within the organization, such as a buyer, have the authority to change the price of merchandise and only with the approval of another party. Such authorizations and procedures are contained in the retailer’s internal procedures manual which will also specify entry codes and descriptions used for the various price changes.
Markups. Markups increase the retail selling price of an item from the price at which it was initially marked.
Markup cancellations. Markup cancellations reduce the selling price of an item that was previously marked up to a point not lower than the original retail price established for the item.
Markdowns. Markdowns are the most common adjustments to the retail selling price of an item. A markdown reduces the original retail price established for the item on the purchase order or product database. There are numerous types of markdowns including:
Temporary or promotional markdowns which are used to increase store traffic. These markdowns are taken at the sales register or Point of Sale (POS) terminal. Usually the marked price of the item is not changed.
Competitive pricing markdowns which are used to keep the price of a high profile item in line with a competitor’s price.
Soiled, damaged, or one of a kind merchandise markdowns which may be entered into a markdown log book by a store manager for subsequent entry into the retailer’s computerized records.
Scheduled permanent markdowns on excess seasonal or trendy merchandise items. These markdowns initiated by the buyer are scheduled at the time of purchase of the goods to insure the items purchased will be off the shelves by an established date. These markdowns are tracked separately since the buyer may have an agreement with the vendor for a partial or complete reimbursement of the markdown.
Other permanent markdowns which are taken to expedite the sale of certain merchandise items.
Markdown cancellations. After an item has been marked down (or reduced) from its original marked price, a markdown cancellation restores the item to a higher price. Only the increase back to the original retail price is considered a markdown cancellation. To the extent the price increase results in a new price which exceeds the original retail price, the excess portion which exceeds the original retail price is a markup.
Both markup and markdown cancellations occur infrequently because most retailers have a computer system in place which records temporary or promotional markdowns at the point of sale making the practice of markup and markdown cancellations unnecessary.
The stock ledger is the principal inventory record used by retailers. This can be called a variety of names, depending on the retailer. The stock ledger in a perpetual inventory system contains a roll-up of summary data from the purchases journal or accounts payable system, the price change records, and the sales journal. It also contains the original entry information reflecting the adjustment of the book inventory to the actual physical inventory. It can also reflect the entry, either manual or automatic, to accumulate an estimate of the shrinkage to date. It will usually show a roll-up of merchandise items which have been received but not yet charged to the stock ledger.
The stock ledger contains information regarding each item of inventory at each location since a retailer needs to know the number of each item of merchandise in stock and the location at which the item of merchandise is available. Updating the vendor database at the time of purchase and receipt of the goods in conjunction with the use of scanning devices for transfers or sales allows for a detailed tracking system of the retailer’s goods.
Generally the complete stock ledger detail is not printed often due to its size. Summary information from the stock ledger is printed periodically. The information contained in the stock ledger and the operation therefrom is as follows:
Beginning inventory at both retail and cost
Purchases at both retail and cost including freight, as rolled up from the purchases journal
Retail markups, less cancellations
Transfers of merchandise between the warehouse or distribution centers and store(s) or between stores are accounted for as an addition or subtraction (if not part of the purchases journal record).
A cost complement percentage is determined by comparing beginning inventory at cost plus goods/merchandise received at cost to beginning inventory at retail plus merchandise/goods received at retail (including markups).
This section provides general information of the various financial reporting systems.
The three accounting methods widely used by both public and private companies to determine the costs of inventory are:
First-In, First-Out (FIFO)
Last-In, First-Out (LIFO)
Under Generally Accepted Accounting Principles (GAAP), inventory is to be stated at the lower of cost or market value, and inventory that has declined in value must be written down. The write-downs, however, cannot be reversed even if the inventory subsequently rises in value.
Under GAAP, market valuation takes into account the quantity and condition of the inventory. Market means replacement cost. Market, however, should not exceed "net realizable value" defined as the estimated selling price minus the direct costs of disposing of the inventory. Market should not be less than the net realizable value reduced by an allowance for a normal profit margin. For tax purposes, however, only actual sales prices are considered.
Under both GAAP and tax accounting, the LIFO inventory method is permitted. If LIFO is used for tax purposes, LIFO must also be used for GAAP.
Accounting Research Bulletins (ARB) No. 43, Chapter 4, "Inventory Pricing," discusses the general principles applicable to the pricing of inventory for GAAP purposes. Under ARB 43, the primary basis of accounting for inventory is cost.
Financial Accounting Standards (FAS) No. 151, issued in November 2004 and effective for inventory costs incurred during fiscal years beginning after June 15, 2005 and thus applied prospectively, amended the guidance in ARB No. 43, Chapter 4, "Inventory Pricing," to clarify that the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) requires recognizing such items as current-period charges.
Although a taxpayer’s inventory methodologies conform to GAAP principles and pronouncements and are acceptable for financial accounting purposes, unless such methodologies clearly reflect a taxpayer’s income, the Commissioner of the IRS (Commissioner) may challenge such methodologies for tax purposes. Treas. Reg. 1.446-1(a)(2) provides that no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. IRC 471 establishes two tests to which an inventory method must adhere:
The method must conform as nearly as may be to GAAP.
The method must clearly reflect income. (Treas. Reg. 1.471-2(a))
The Supreme Court in Thor Power Tool Co. v. Commissioner , 439 US 522 (1979) noted the Commissioner is vested in accordance with IRC 446 and IRC 471 with "wide discretion" in determining whether a particular method of inventory accounting should be disallowed as not clearly reflecting income.
Many countries around the world, including the European Union, have adopted the International Financial Reporting Standards (IFRS) in support of global accounting standards. Although the United States’ accounting rules and regulations are based on GAAP, the Securities and Exchange Commission approved a plan in August 2008 to allow some U.S. companies to apply International Accounting Standards (IAS), beginning with their 2009 financial statements, and for all U.S. companies to follow by 2016.
Relative to the differences in treatment of inventory under GAAP and IFRS, the following material is excerpted from Wiley IFRS 2008: Interpretation and Application of International Financial Reporting Standards:
Inventory Treatment under GAAP Inventory Treatment under IFRS Allowable costing methods include:
LIFO costing is banned under IFRS There are no special rules for biological inventory (e.g., growing crops, livestock) IAS 41 on agriculture specifies use of fair value less estimated selling costs for biological assets, with changes in value reported in income Presentation is required at lower of cost or market Presentation at lower of cost or net realizable value Only in rare instances (mining of gold, etc.) is presentation at fair value in excess of cost permitted Certain defined situations, including agricultural products, for reporting at fair value in excess of actual cost Certain costs (idle capacity, spoilage) cannot be added to overhead charge in inventory cost, conforming to IFRS rule Certain costs (idle capacity, spoilage) cannot be added to overhead charge in inventory cost Lower of cost or market adjustment cannot be reversed Lower of cost or market adjustments must be reversed under defined conditions Recognition in interim periods of inventory Losses from market declines that reasonably can be expected to be restored in the fiscal year not required Recognition in interim periods of inventory Losses from market declines that reasonably can be expected to be restored in the fiscal year is required; guidance in the areas of disclosure and accounting for inventories of service providers offered
This section covers specific inventory applications in the Retail industry.
Some retailers prefer to use the retail inventory method of accounting in determining the value of inventory rather than the cost method which requires inventory to be valued at its acquisition cost. The retail inventory method uses the relationship of cost to retail price to determine the cost of merchandise in inventory. This method is an averaging method and its use has historically been more convenient to compute for most types of merchandise, especially as volume increases.
If a perpetual inventory is maintained in conjunction with the retail inventory method, a retailer can determine profits without taking frequent physical inventories.
The use of the LIFO method in the Supermarket Segment is probably more common than for almost any other industry. Use of the LIFO method is high because of the consistency of inflation for supermarket merchandise over many years together with significant inventory balances (single store cost inventory balances ranging from $300,000 to $2,000,000).
The cost method of accounting requires inventory to be valued at its acquisition cost. Acquisition cost includes all of the costs associated with taking possession of merchandise. The cost should be reduced for trade discounts received. Cash discounts (for early payment of the invoice) may be deducted or not deducted at the taxpayer’s option as long as the method used by the taxpayer is consistent.
Retailers must also add to the value of inventory the allocable share of additional costs under the Uniform Capitalization Rules (UNICAP) determined under IRC 263A unless the taxpayer meets the $10,000,000 or less gross receipts exception of IRC 263A(b)(2)(B).
When a retailer using the cost method takes an inventory count, the goods on hand must be matched against or traced to the stock ledger to determine the cost. Because of the recordkeeping involved, some retailers use the retail inventory method which does not require such tracing. However, with computers, bar codes and POS terminals, many retailers now have the capability to use the cost method with little or no increased recordkeeping costs.
Accounting methods used to determine the current cost of goods on hand at the end of the year and involved in associating costs include:
Specific identification involves tracing the actual costs for a particular piece of inventory. This method is generally practiced for high value goods.
FIFO whereby the costs for the goods on hand at the end of the year are the amounts paid for those goods most recently purchased.
Replacement cost whereby the costs of the goods on hand are valued at their costs to acquire if they were purchased on the last day of the year. Currently, this method is allowed only for the parts inventory of automobile dealers and heavy equipment dealers. See Rev. Proc. 2006-14 and Rev. Proc. 2002-17.
Rolling-Average costing whereby the inventory value is determined by the average cost of the goods on hand at any point in time. See Rev. Proc. 2008-43.
Earliest acquisition cost whereby the inventory value is determined by the actual cost of the first items acquired during the year (LIFO method only).
Average cost whereby the inventory value is determined by the annual average cost to acquire the inventory during the year (LIFO method only).
Most Recent Purchase cost whereby the inventory value is determined by the actual cost of the last items acquired during the year (LIFO method only).
Once a taxpayer determines which of the above methods it will use to determine current cost, then the taxpayer must determine whether or not it will use the LIFO method cost flow assumption. If the taxpayer elects the LIFO method, additional computations are necessary. Additional information on the LIFO method is included below.
Any change from one method to another (e.g., from FIFO to specific identification) constitutes a change of accounting method that requires the consent of the Commissioner.
Many taxpayers use the lower of cost or market (LCM) method because of its potential advantages over the cost method. When the replacement cost of a retailer’s merchandise falls below cost, the retailer is allowed to recognize that difference even though the loss has not been realized.
There are two methods allowed for arriving at the amount of the LCM. One method is for normal goods and is found in Treas. Reg. 1.471-4. The other method is for subnormal goods and is found in Treas. Reg. 1.471-2(c).
For normal goods, market generally refers to replacement cost for the same goods in the same quantities the taxpayer would normally acquire them. If the taxpayer uses the retail inventory method described below, the computation of inventory value will result in the valuation of inventory at cost or market, whichever is lower.
Subnormal goods are defined as those goods that are unsaleable at normal prices or unusable in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes. Subnormal goods may be valued at their bona fide selling price less direct cost of disposition. Bona fide selling price means actual offering of goods during a period ending not later than 30 days after inventory date. The burden of proof will rest upon the taxpayer to show that such exceptional goods as are valued come within the classifications indicated and the taxpayer will maintain such records of the disposition of the goods as will enable a verification of the inventory to be made.
The LCM reduction is determined on an item by item basis. The retailer will usually have a separate report computing the LCM reduction which lists each item, the number on hand plus the cost and market value. The LCM reduction is usually recorded in a separate reserve or contra-asset account rather than directly to inventory.
It should be noted that market value cannot be estimated. The goods must be actually offered for sale at that price in order to call the value market. For retailers, this means the price of the goods on the shelf.
Retailers may determine cost or LCM by using the retail inventory method (RIM). RIM uses the relationship of cost to retail price to determine the cost of merchandise in inventory. This method is an averaging method and historically has been more convenient to use for most types of goods, especially as volume increases. If a perpetual inventory is maintained in conjunction with the use of RIM, a retailer can determine profits without taking frequent physical inventories.
A retailer usually carries its inventory on the books at the retail selling price of the various items held for resale. The year-end retail price of the goods on hand or its market value is determined by Treas. Reg. 1.471-8(a) or (d). Since the LCM method can generate an inventory value lower than cost, it is more frequently used.
Treas. Reg. 1.471-8(d) provides that the LCM method is limited to non-LIFO taxpayers who have consistently used the practice of adjusting the retail price in the computation for markups but not markdowns, in conjunction with RIM.
Treas. Reg. 1.471-8(f) provides that if the LCM method was not used, a taxpayer may adopt such method upon filing a change of accounting method request and obtaining the permission of the Commissioner.
Under RIM, the LCM value of ending inventory is determined as follows:
Add the cost of the goods in the beginning inventory to the cost of the total purchases for the year.
Add the retail value of the goods in the beginning inventory to the retail value of the total purchases for the year. The retail value of each item must be adjusted to reflect the retail price, as marked up from cost plus additional permanent markups less markup cancellations.
Divide the total cost of the goods available for sale as determined in "a." above by the total retail value of the goods available for sale during the year as determined in "b." above. The percentage, the ratio of cost to retail, is also known as the cost complement.
Subtract sales plus net permanent markdowns from the total retail value of the goods available for sale as discussed in "b" above to determine the retail value of the ending inventory. Markdowns are a reduction to the selling price below the original sale price. Markdown cancellations increase a previously marked down sales price no higher than the original retail price (with any excess being considered a markup). Net markdowns are markdowns less markdown cancellations.
Multiply the retail value of the ending inventory as determined in "d." above by the cost complement ratio as determined in "c." above. The result is the LCM value of the ending inventory.
Under RIM, inventory may be valued at cost as defined in Treas. Reg. 1.471-8(a) rather than LCM as detailed in the preceding. Valuing the inventory at cost rather than LCM will generally result in a higher inventory value. When cost is used, all permanent markup and markdown adjustments are made in determining the retail value.
RIM requires retailers to value inventory on a department-by-department basis, because profit margins may be materially different for departments or classes of goods. The requirement as set forth in Treas. Reg. 1.471-8(c) specifically prohibits the use of a percentage of profit based upon an average of the entire business but rather requires the computation and use of the percentages of profit for each respective department or class of goods. These departments or classes of goods often correspond to pools for LIFO purposes.
Many taxpayers elect to use the dollar-value LIFO inventory valuation method. Such an election is conditioned on the requirement that it will also be used for the valuation of inventory in financial statements (financial statement conformity). The LIFO method is preferred by taxpayers because it will, in most instances, generate the lowest inventory value by eliminating the increase in inventory due to price changes caused by inflation. Its disadvantages include additional computations plus the requirement to value inventory at cost, not LCM.
Retailers will use either the double-extension method or an index method for each pool. If the retailer can demonstrate that these methods, double-extension or an index method, are impractical, then the link-chain method may be approved. Any method of computing the LIFO value of a dollar-value pool must be used for the year of adoption of the LIFO methodology and for all subsequent years unless permission to change the method is requested and received. Many retailers also use the IPIC LIFO method under Treas. Regs. 1.472-8(e)(3). See IRM 184.108.40.206.7.7.
Dollar-value LIFO determines cost by using base-year data expressed in terms of total dollars as a unit of measure rather than the quantity and price of specific goods. Under this method, goods contained in inventory are grouped into a pool or pools.
Base-year cost as referenced in the preceding paragraph is the aggregate of the cost of all items in the pools as of the beginning of the taxable year in which LIFO was adopted. The year of adoption could be as early as 1948 when the LIFO regulations were amended to permit retailers to use the dollar-value LIFO method. The Form 970 and subsequent Forms 3115 will provide documentation of the retailer’s elections relative to its LIFO methodology.
Treas. Reg. 1.472-8(c) provides the principal rules for establishing pools. Items of inventory in the hands of wholesalers, retailers, jobbers, and distributors shall be placed into pools by major lines, types, or classes of goods. In determining such groupings, customary business classifications of the trade will be an important consideration. For example, the customary business classification in a department store is the department.
If a wholesaler or retailer is also engaged in the manufacturing or processing of goods, the pooling of the LIFO inventory for the manufacturing or processing operations is determined by the rules set forth in Treas. Reg. 1.472-8(b).
The computation of the retail LIFO inventory method involves the following steps and is made separately for each pool:
Determine year-end inventory in retail dollars at the permanent marked price, including the retail price of the in-transit merchandise.
Divide the amount determined in "a." above by the price index factor. The resulting amount equals retail in base-period prices. Compare the amount determined with the prior year’s total in base-period dollars. If the current year’s total is greater than the prior year’s total, the excess amount represents an increment or layer for the current year. The excess amount is multiplied by the same index factor to restate it in current period prices.
If the current year’s total is less than the prior year’s total, the difference represents a decrement. The decrement is used to reduce the most recent prior year layer, in terms of base-period prices. To the extent any decrement remains after reduction of the first layer, the second prior incremental layer is reduced. The reduction process continues until the entire decrement is exhausted.
The amount in each layer is converted back to current period prices based upon the index for each respective current period.
If there was an increment, all prior periods or layers would remain the same and the computation would only be necessary for the current layer.
If there was a decrement, only the last partially reduced layer would have to be recalculated since the intervening layers would have been eliminated by application of the decrement to the layer(s).
The cost complement for each LIFO pool is computed in the manner described in IRM 220.127.116.11.7.4 with two key differences:
The beginning inventory at cost and retail does not enter into the calculation. Only data pertaining to current year purchases are used to determine the cost complement.
Since LIFO inventory is based on cost, permanent markdowns taken during the year and applicable to merchandise purchased during the year, must be taken into account in computing the cost complement.
The examples shown on the subsequent pages demonstrate the differences in the cost complement calculations between non-LIFO retail valued at Cost, non-LIFO Retail valued at LCM and LIFO retail.
Computation of non-LIFO Retail Cost Complement Valued at Cost
Retail Value Cost Beginning inventory $39,000 $22,000 Purchases 60,000 35,000 Mark-ups (permanent) 1,500 Mark-ups Cancellations 500 Mark-downs (permanent) 2,400 Mark-downs cancellations 400 Sales 88,000 Retail value and cost Are determined as follows: Retail Value Cost Beginning inventory $39,000 $22,000 Purchases 60,000 35,000 Net Mark-ups: Mark-ups 1,500 Less mark-up cancellations 500 1,000 Mark-downs applicable 2,400 Mark-down cancellations 400 2,000 Total available $98,000 $57,000
The cost complement ratio equals 58.16 % ($57,000/$98,000)
Computation of non-LIFO Retail Cost Complement Valued at LCM
Retail Value Cost Beginning inventory $39,000 $22,000 Purchases 60,000 35,000 Mark-ups (permanent) 1,500 Mark-ups Cancellations 500 Mark-downs (permanent) 2,400 Mark-downs Cancellations 400 Sales 88,000 Retail value and cost Are determined as follows: Retail Value Cost Beginning inventory $39,000 $22,000 Purchases 60,000 35,000 Net Mark-ups: Mark-ups 1,500 Less mark-up cancellations 500 1,000 Mark-downs applicable Mark-down cancellations Total available $100,000 $57,000
The cost complement ratio equals 57.0% ($57,000/$100,000).
Computation of LIFO Retail Cost Complement
Retail Value Cost Beginning inventory $39,000 $22,000 Purchases 60,000 35,000 Mark-ups (permanent) 1,500 Mark-ups Cancellations 500 Mark-downs (permanent) 2,400 Mark-down Cancellations 400 Sales $88,000 Retail value and cost Are determined as follows: Retail Value Cost Beginning inventory N/A N/A Purchases $60,000 $35,000 Net Mark-ups: Mark-ups (permanent) 1,500 Less mark-up cancellations 500 1,000 Mark-downs applicable 2,400 Mark-downs cancellations 400 2,000 Total available $59,000 $35,000
The cost complement ratio equals 59.32 % ($35,000/$59,000)
The IRS and the Department of the Treasury prescribed the inventory price index computation (IPIC) method in Treas. Reg. 1.472-8(e)(3) to simplify the use of the dollar-value LIFO method, as more fully described below.
The IPIC method was designed to simplify the use of the dollar-value LIFO method, so that the LIFO method could be used by more taxpayers. Under the IPIC method, the taxpayer sorts its inventory by the United States Bureau of Labor Statistics (BLS) commodity codes and then applies BLS indexes to the items in its inventory. This simplifies the process of computing an index for a dollar-value pool because the taxpayer does not have to develop its own internal indexes.
Final regulations relative to the IPIC methodology were effective on December 31, 2001.
Treas. Reg. 1.472-8(c)(2) provides that a retailer that elects to use the IPIC method described in Treas. Reg. 1.472-8(e)(3) may elect to establish dollar-value pools for those items accounted for using the IPIC method based on either one of the following:
The general expenditure categories (i.e., major groups) in Table 3 (Consumer Price Index for all urban Consumers (CPI-U): U.S. city average, detailed expenditure categories) of the "CPI Detailed Report," or
The 2-digit commodity codes (i.e., major commodity groups) in Table 6 (Producer price indexes and percent changes for commodity groupings and individual items, not seasonally adjusted) of the "PPI Detailed Report."
The "CPI Detailed Report" and the "PPI Detailed Report" are published monthly by the BLS. These reports are available on the BLS website at http://www.BLS.gov .
A taxpayer electing to establish dollar-value pools under Treas. Reg. 1.472-8 (c)(2) may combine IPIC pools that comprise less than 5 percent of the total current-year cost of all dollar-value pools to form a single miscellaneous IPIC pool. In addition, a taxpayer electing to establish pools under Treas. Reg. 1.472-8(c)(2) may combine a miscellaneous IPIC pool that comprises less than 5 percent of the total current-year cost of all dollar-value pools with the largest IPIC pool. Each of these 5 percent rules is a method of accounting.
A taxpayer may not change to, or cease using, either 5-percent rule without obtaining the Commissioner's prior consent. Whether a specific IPIC pool or the miscellaneous IPIC pool satisfies the applicable 5-percent rule must be determined in the year of adoption or year of change (whichever is applicable) and redetermined every third taxable year counting the year of adoption or change as the first year. Any change in pooling required or permitted under a 5-percent rule is a change in method of accounting. A taxpayer must secure the consent of the Commissioner pursuant to Treas. Reg. 1.446-1(e) before combining or separating pools and must combine or separate its IPIC pools in accordance with Treas. Reg. 1.472-8(g)(2).
The adequacy of the number and the composition of the pools used by the taxpayer, as well as the computations incident to the use of such pools, will be determined in connection with the examination of the taxpayer’s income tax returns. Records must be maintained to support the base-year unit cost as well as the current-year unit cost for all items priced on the dollar-value LIFO inventory method.
Treas. Reg. 1.472-8(e)(3) describes the IPIC method by stating that it is an elective method of determining the LIFO value of a dollar-value pool using consumer or producer price indexes published by the BLS. A taxpayer using the IPIC method must compute a separate inventory price index (IPI) for each dollar-value pool. This IPI is used to convert the total current-year cost of the items in a dollar-value pool to base-year cost in order to determine whether there is an increment or liquidation (decrement) in terms of base-year cost and, if there is an increment, to determine the LIFO inventory value of the current year's increment (layer).
Using one IPI to compute the base-year cost of a dollar-value pool for the current taxable year and using a different IPI to compute the LIFO inventory value of the current taxable year's layer is not permitted under the IPIC method. The IPIC method will be accepted by the Commissioner as an appropriate method of computing an index, and the use of that index to compute the LIFO value of a dollar-value pool will be accepted as accurate and reliable. The appropriateness of a taxpayer's computation of an IPI, which includes all the steps described in Treas. Reg. 1.472-8 (e)(3)(iii), will be determined in connection with an examination of the taxpayer's federal income tax return. A taxpayer using the IPIC method may elect to establish dollar-value pools according to the special rules in paragraphs Treas. Reg. 1.472-8(b)(4) and (c)(2) or according to the general rules in Treas. Reg. 1.472-8 (b) and (c).
Any taxpayer electing to use the dollar-value LIFO method may elect to use the IPIC method. A taxpayer that elects to use the IPIC method for a specific trade or business must use that method to account for all items of dollar-value LIFO inventory. However, a taxpayer that uses the retail price indexes computed by the BLS and published in "Department Store Inventory Price Indexes" (available from the BLS by calling (202) 606-6325 and entering document code 2415) may elect to use the IPIC method for items that do not fall within any of the major groups listed in "Department Store Inventory Price Indexes."
The computation of an inventory price index (IPI) for a dollar-value pool requires the following four steps:
Selection of a BLS table and an appropriate month,
Assignment of items in a dollar-value pool to BLS categories (selected BLS categories),
Computation of category inflation indexes for selected BLS categories, and
Computation of the IPI. A taxpayer may compute the IPI for each dollar-value pool using either the double-extension method (double-extension IPIC method) or the link-chain method (link-chain IPIC method), without regard to whether the use of a double-extension method is impractical or unsuitable. The use of either the double-extension IPIC method or the link-chain IPIC method is a method of accounting, and the adopted method must be applied consistently to all dollar-value pools within a trade or business accounted for under the IPIC method. A taxpayer that wants to change from the double-extension IPIC method to the link-chain IPIC method, or vice versa, must secure the consent of the Commissioner under Treas. Reg. 1.446-1(e). This change must be made with a new base year as described in Treas. Reg. 1.472-8(e)(3)(iv)(B)(1).
Under the IPIC method, an IPI is computed using the consumer or producer price indexes for certain categories (BLS price indexes and BLS categories, respectively) listed in the selected BLS table of the "CPI Detailed Report" or the "PPI Detailed Report" for the appropriate month.
Retailers may select BLS price indexes from either of the following sources:
Table 3 (Consumer Price Index for all Urban Consumers (CPI-U): U.S. city average, detailed expenditure categories) of the "CPI Detailed Report," or
Table 6 (or another more appropriate table) of the "PPI Detailed Report."
In the case of a retailer using RIM, the appropriate month is the last month of the retailer's taxable year. A taxpayer not using RIM may annually select an appropriate month for each dollar-value pool or make an election on Form 970, "Application to Use LIFO Inventory Method," to use a representative appropriate month (representative month). An election to use a representative month is a method of accounting and the month elected must be used for the taxable year of the election and all subsequent taxable years, unless the taxpayer obtains the Commissioner's consent under Treas. Reg. 1.446-1(e) to change or revoke its election.
A taxpayer must assign each item in a dollar-value pool to the most-detailed BLS category of the selected BLS table that contains that item. For example, in Table 6 of the "PPI Detailed Report" for a given month, the commodity codes for the various BLS categories run from 2 to 8 digits, with the least-detailed BLS categories having a 2-digit code and the most-detailed BLS categories usually (but not always) having an 8-digit code.
Treas. Reg. 1.472-8(e)(3)(iii)(C)(2) provides for a 10 percent method to assign items to BLS categories using a three-step procedure in lieu of assigning each item in a dollar-value pool to the most detailed BLS categories. The 10 percent method is a method of accounting and a taxpayer that wants to change its method of selecting BLS categories (i.e., to or from the 10 percent method) must secure the Commissioner’s consent in accordance with Treas. Reg. 1.446-1(e). A taxpayer that voluntarily changes its method of selecting BLS categories or of selecting a BLS category for a specific item must establish a new base year in the year of change.
A category inflation index reflects the inflation that occurs in the BLS price indexes for a selected BLS category (or, if applicable, 10 percent BLS category) during the relevant measurement period.
The BLS price indexes are the cumulative indexes published in the selected BLS table for the appropriate month. A taxpayer may elect to use either preliminary or final BLS price indexes for the appropriate month, provided that the selected BLS price indexes are used consistently. However, a taxpayer that elects to use final BLS price indexes for the appropriate month must use preliminary BLS price indexes for any taxable year for which the taxpayer files its original federal income tax return before the BLS publishes final BLS price indexes for the appropriate month.
If a BLS price index for a most-detailed or 10 percent BLS category is not otherwise available for the appropriate or representative month (but not because the BLS categories in the BLS table have been revised), the taxpayer must use the BLS price index for the next most-detailed BLS category that includes the specific item(s) in the most-detailed or 10 percent BLS category. If a BLS price index is not otherwise available for the appropriate or representative month because the BLS categories in the BLS table have been revised, the rules of Treas. Reg. 1.472-(e)(3)(iii)(D)(4) apply.
If the taxpayer is using the double-extension IPIC method, the category inflation index for a BLS category is the quotient of the BLS price index for the appropriate or representative month of the current year divided by the BLS price index for the appropriate month of the taxable year preceding the base year (base month).
However, if the taxpayer did not have an opening inventory in the year that its election to use the dollar-value LIFO method and double-extension IPIC method became effective, the category inflation index for a BLS category is the quotient of the BLS price index for the appropriate or representative month of the current year divided by the BLS price index for the month immediately preceding the month of the taxpayer's first inventory production or purchase.
If the taxpayer is using the link-chain IPIC method, the category inflation index for a BLS category is the quotient of the BLS price index for the appropriate or representative month of the current year divided by the BLS price index for the appropriate month used for the immediately preceding taxable year.
However, if the taxpayer did not have an opening inventory in the year that its election to use the dollar-value LIFO method and link-chain IPIC method became effective, the category inflation index for a BLS category for the year of election is the quotient of the BLS price index for the appropriate or representative month of the current year divided by the BLS price index for the month immediately preceding the month of the taxpayer's first inventory production or purchase.
The following sections provide details regarding the computation of the IPI under the double-extension and link-chain IPIC method.
Under the double-extension IPIC method, the IPI for a dollar-value pool is the weighted harmonic mean of the category inflation indexes (or, if applicable, compound category inflation indexes) determined under Treas. Reg. 1.472-8(e)(3)(iii)(D) for each selected BLS category (or, if applicable 10 percent BLS category) represented in the taxpayer's dollar-value pool at the end of the taxable year.
The formula for computing the weighted harmonic mean of the category inflation indexes is: [Sum of Weights/Sum of (Weight/Category Inflation Index)].
The weights to be used when computing this weighted harmonic mean are the current-year costs (or, in the case of a retailer using RIM, the retail selling prices) in each selected BLS category represented in the dollar-value pool at the end of the taxable year.
Under the link-chain IPIC method, the IPI for a dollar-value pool is the product of the weighted harmonic mean of the category inflation indexes (or, if applicable, the compound category inflation indexes) determined under Treas. Reg. 1.472-8(e)(3)(iii)(D) for each selected BLS category (or, if applicable, 10 percent BLS category) represented in the taxpayer's dollar-value pool at the end of the taxable year multiplied by the IPI for the immediately preceding taxable year.
The formula for computing the weighted harmonic mean of the category inflation indexes is the following: [Sum of Weights/Sum of (Weight/Category Inflation Index)].
The weights to be used when computing this weighted harmonic mean are the current-year costs (or, in the case of a retailer using the retail inventory method, the retail selling prices) in each selected BLS category represented in the dollar-value pool at the end of the taxable year.
Examples that illustrate the IPIC rules as discussed in this section are contained in the IPIC Treasury Regulations which begin at Treas. Reg. 1.472-8(e)(3).
Treas. Reg. 1.471-1 provides that merchandise should be included in inventory only if title thereto is vested in the taxpayer.
The regulation further states "[a]ccordingly, the seller should include in his inventory goods under contract for sale but not yet segregated and applied to the contract and goods out upon consignment, but should exclude from inventory goods sold (including containers), title to which has passed to the purchaser. A purchaser should include in inventory merchandise purchased (including containers), title to which has passed to him, although such merchandise is in transit or for other reasons has not been reduced to physical possession, but should not include goods orders for future delivery, transfer of title to which has not yet been effected."
For COD cash (or collection) on delivery goods, title to such goods remains with the seller and such goods must be included in the seller’s inventory until the purchaser accepts the goods and pays for them.
Inventory shrinkage is a term used to describe the difference between the inventory records (i.e. book value) and the amount verified by a physical count. Inventory shrinkage is a common problem in the retail industry.
Causes of shrinkage include employee theft, shoplifting, damage, spoilage, administrative and paperwork errors, and vendor errors/issues.
Cycle counting is a widely accepted practice in the retail industry and is considered more accurate, less expensive, and less disruptive than conducting a year-end physical inventory. Cycle counting is a means of conducting physical inventories at each store, in rotation, throughout the year.
Large retailers typically rely on historical information to estimate the amount of shrinkage between the physical inventory date and the end of the tax year. In part due to their size, large retailers are able to compile statistical data to measure their rate of shrinkage as a percentage of sales.
Shrinkage arises with respect to perpetual inventories. Under a perpetual inventory system, inventory is updated with every purchase and sale. Since individual purchases and sales of goods are tracked through detailed accounting records, a retailer knows at all times the value of its inventory. Because of inventory shrinkage, a physical inventory is taken at intervals to verify the accuracy of the amounts shown in the inventory records. To the extent of inventory shrinkage, the inventory account is adjusted to bring it to actual.
Example. A retailer shows in its accounting records a value of $65,000 for certain inventory goods, which consists of multiple stock-keeping units (SKUs) totaling 5,600 units. The aggregate value of these goods is recorded on the company's books as a financial asset. At the annual physical inventory, where each item is physically counted and double-checked, the total items counted equal 5,200 with an aggregate cost value of $60,250. Inventory has "shrunk" by 400 units with a value of $4,750.
IRC 471 permits estimates for inventory shrinkage. Rev. Proc. 98-29 provides guidance on computing the amount of shrinkage and provides a safe harbor method that taxpayers may use to compute shrinkage.
A potential compliance risk involves retailers that perform their physical inventories at periods other than a tax year-end and do not elect the safe harbor method described in Rev. Proc. 98-29. For these taxpayers, an opportunity exists to adjust the year-end perpetual book inventory by an un-supportable shrinkage factor. Consequently, the determination of the accuracy of a retailer's method of estimating shrinkage is heavily dependent on the particular facts in each case.
The requirement that a LIFO taxpayer value its inventory at cost does not limit the allowance of a shrinkage reserve. A shrinkage reserve is based upon the quantity of goods on hand. It is not a reserve for the value of the goods on hand, which is not allowed for those taxpayers electing to use the LIFO method.
Rev. Proc. 86-46 applies to retail department stores that (1) have elected to use the LIFO inventory identification method in conjunction with the retail inventory method of valuing inventories, and (2) have elected to use the BLS department store price indexes published monthly by the IRS.
The acceptability of the department store index figures is based upon specific arrangements with the BLS to compute statistically sound index figures for retail department stores.
The use of the BLS department store method has been in decline since 2001. Many taxpayers that previously used this method are now using the IPIC method.
If a retailer has engaged in an asset acquisition, i.e., if the assets of a business have been purchased for a lump sum, or if the retailer has acquired the stock of another corporation and has made an election pursuant to IRC 338 with respect to the acquisition, an inventory step-up issue may exist on the tax return.
An inventory step-up generally occurs when the taxpayer makes a fair market value determination for inventory items acquired when it has purchased the assets of a business for a lump-sum or when a taxpayer-corporation acquires the stock of another corporation and makes an election pursuant to IRC 338.
The step-up is the increase to fair market value of the inventory acquired. Any step-up reflected on the tax return most likely would appear as a "favorable to the taxpayer" Schedule M item and would mean that book fair market value of inventory and tax fair market value of inventory differ.
According to FAS 141, "a business combination occurs when an entity acquires net assets that constitute a business or acquires equity interests of one or more other entities and obtains control over that entity or entities." Further, FAS 141 requires that all business combinations in the scope of the statement be accounted for by a single method—the purchase method. According to the pronouncement, the purchase method records the net assets acquired in a business combination at their fair values.
In allocating the cost of an acquired entity to assets acquired and liabilities assumed, FAS 141 states the following: "Following the process described in paragraphs 36-46 (commonly referred to as the purchase price allocation), an acquiring entity shall allocate the cost of an acquired entity to the assets acquired and liabilities assumed based on their estimated fair values at date of acquisition (refer to paragraph 48)…."
Paragraph 37 of FAS 141 provides general guidance for assigning amounts to assets acquired and liabilities assumed, except goodwill. The guidance for inventories as contained in paragraph 37 indicates the following.
Finished goods and merchandise at estimated selling prices less the sum of (a) costs of disposal and (b) a reasonable profit allowance for the selling effort of the acquiring entity.
Work in process at estimated selling prices of finished goods less the sum of (a) costs to complete, (b) costs of disposal, and (c) a reasonable profit allowance for the completing and selling effort of the acquiring entity based on profit for similar finished goods.
Raw materials at current replacement costs.
Based on the foregoing, the guidance for assigning fair value to inventory as contained in FAS 141 mirrors precisely one of the methods a taxpayer or the examiner may use to determine the fair market value of inventory items—the comparative sales method—as set forth in Rev. Proc. 2003-51.
Rev. Proc. 2003-51 describes three methods that a taxpayer or the examiner may use to determine the FMV of inventory items for purposes of a purchase price allocation when the assets of a business have been purchased for a lump sum or if a corporation has acquired the stock of another corporation and made an election pursuant to IRC 338 with respect to the stock acquisition. The methods described to allocate the purchase price (actual or deemed) of the assets acquired are the replacement cost method, the comparative sales method, and the income method. Allocation of the purchase price is required to determine the basis of each asset.
The revenue procedure acknowledges that in making an inventory valuation determination, it is necessary to allow for a division between the buyer and the seller of the profit on the inventory, taking into account that the quantity of inventory purchased may be greater than the quantity of inventory usually purchased. See Knapp King-Size Corp. v. U.S., 527 F.2d 1392 (Ct. Cl. 1975) and to Nestle Holdings Inc. v. Commissioner, T.C. Memo. 1995-441.
For the retail industry, a coordinated issue paper relative to the inventory step-up issue was issued on October 31, 1991 and has not been de-coordinated. According to the Coordinated Issue Paper, when valuing retailers' inventories, the cost of reproduction method which values inventories at replacement cost, i.e., what it would cost to assemble identical inventories under prevailing market conditions, is less susceptible to error and therefore more appropriate to use than the comparative sales method.
If, however, a taxpayer uses the "comparative sales" or "net realizable value" method, all expenses attributable to the disposition of the acquired inventory, not just direct disposition costs, must be included in the taxpayer's computation. Consideration must also be given to the time that would be required to dispose of the inventory, the part of the expected selling price that is attributable to going concern, and to a profit that is commensurate with the amount of investment and degree of risk.
In making the inventory value determination, the IRS will take into account a fair division of the inventory profit between the seller and buyer of the bulk inventory.
The replacement cost method as discussed in Rev. Proc. 2003-51 is another name for the cost of reproduction method contained in the Retail Industry Coordinated Issue Paper. Like the Coordinated Issue Paper, Rev. Proc. 2003-51 indicates that the replacement cost method generally provides a good indication of FMV if inventory is readily replaceable in a wholesale or retail business, but generally should not be used for a manufacturing concern.
A significant book/tax difference in valuing the FMV of an acquired inventory requires review. This difference should be found on the Schedule M-3. If the taxpayer has used the comparative sales method to value tax inventory, which is the method required by GAAP for book valuation, there should not be a significant book /tax valuation difference.
Correctly applied, the cost of reproduction method, the preferred method for retailers, and the comparative sales method should arrive at the same value. Therefore, there should not be a significant book /tax valuation difference under the cost of reproduction methodology.
A coordinated issue provides guidance to examiners on significant issues that are not being examined and resolved consistently. Coordinated issues establish uniform positions within industry or issue areas. Examiners cannot deviate from such positions without the concurrence of Industry/Issue Teams. The coordinated issues involving inventory are as listed below.
Dollar-Value LIFO: Bargain Purchase Inventory – 09-09-95 (UIL 472.15-01)
Whether goods purchased in bulk at discounted amounts (bargain purchase inventory) are separate items from goods purchased or produced subsequently for purposes of calculating the value of the taxpayer's inventory under the dollar-value LIFO method authorized by Treas. Reg. 1.472-8.
Whether the change in the definition of an inventory item is a change in a method of accounting within the meaning of IRC 446 and the regulations thereunder, subject to the provisions of IRC 481.
If the inventories purchased at discount constitute separate items, whether the taxpayer has the burden of proof to demonstrate with inventory records that such items were on hand at the end of the year.
Dollar-Value LIFO: Earliest Acquisition Method - 10-23-95 (UIL 472.08-10 )
Whether a taxpayer, electing the earliest acquisition method of determining the current year cost of items making up a dollar-value LIFO pool, can determine the index used to value an increment without double-extending the actual cost of the goods purchased or produced during the year in the order of acquisition.
Dollar-Value LIFO: Segment of Inventory Excluded for the Computation of the LIFO Index – 6-26-95 (UIL 472.08-09)
Whether a LIFO index developed by double-extending one segment of the inventory can be applied to another segment of the inventory that was not double-extended.
Has the taxpayer included all merchandise, including goods in-transit, in its ending inventory computations?
Is the taxpayer using a dual index method? Historically, most taxpayers maintain their inventory records using the cost of items most recently purchased. However, if LIFO is elected, the taxpayer oftentimes has elected to use the earliest acquisition method to determine the current year cost without changing the record keeping system, hence the use of a dual index method. One index (the deflator index) is used to convert current-year cost to base-year cost and a second index (the increment valuation index) is used to value the increment. The Form 970, used to elect LIFO, will indicate if the taxpayer has elected the earliest acquisition method to determine current year cost. See the coordinated issue section regarding Dollar-Value LIFO earliest acquisition method contained in IRM 18.104.22.168.7.11 as this issue has been designated a coordinated issue.
Has the taxpayer included temporary or promotional markdowns in determining the retail price of goods on hand? Temporary or promotional markdowns, which may be in effect as of year-end, should not be reflected in the retail price used in the computation of the cost complement.
The IRS's position is the following:
A taxpayer using the LIFO retail inventory method may not exclude the cost and estimated retail selling price of inventory in transit from the numerator and denominator of the cost complement ratio.
A taxpayer using the LIFO retail inventory method may not gross up the cost of inventory in transit by dividing it by the cost complements determined for merchandise previously recorded in the taxpayer's stock ledger.
Retailers are reducing the selling value of display merchandise (e.g., big screen TVs and computers) because the goods are removed from their boxes and placed on display. Generally, the reduced retail price of the display merchandise is not marked on the item until the last closed box is sold. Retailers have been accelerating deductions solely upon the placement of goods on display.
The IRS's position is the following:
Having elected to use the dollar-value LIFO method under Treas. Reg.1.472-8, a taxpayer must use the LIFO method to account for all items that fall within its dollar-value pools.
Bargain purchase. See the coordinated issue section regarding Dollar-Value LIFO: Bargain Purchase Inventory contained in IRM 22.214.171.124.7.11.
Treas. Reg. 1.471-2(f) identifies certain methods that are not acceptable for purposes of the IRC 471 inventory valuation:
Deducting from the inventory a reserve for price changes or an estimated depreciation in the value thereof
Taking work in process, or other parts of the inventory, at a nominal price or at less than its proper value
Omitting portions of the stock on hand
Using a constant price or nominal value for so-called normal quantity of materials or goods in stock
Including stock in transit, shipped either to or from the taxpayer, the title to which is not vested in the taxpayer
Segregating indirect production costs into fixed and variable production cost classifications and allocating only the variable costs to the cost of goods produced while treating fixed costs as period costs which are currently deductible. This method is commonly referred to as the "direct cost" method.
Treating all or substantially all indirect production costs (whether classified as fixed or variable) as period costs which are currently deducible. This method is generally referred to as the "prime cost" method.
If the examination of a retailer includes inventory or cost of goods sold, the examiner should obtain the following:
A copy of the Form 970 whereby the taxpayer first elected the LIFO Method if LIFO has been designated on the return as the methodology used to value inventory for tax purposes.
Copies of all Forms 3115, Change of Accounting Method Requests, involving inventory changes/computations, inclusive of consent agreements and all correspondence between the parties relative to the method change(s).
Copies of all appropriate internal procedures of the taxpayer regarding the physical movement of merchandise as well as a discussion of the associated paperwork and data entry to record transactions. Any clarification of the procedures should be discussed with the appropriate taxpayer personnel. An on-site tour of the various facilities where this paperwork and merchandise is physically processed is the most effective method of understanding the taxpayer’s merchandise system.
A copy of the schedule of the dates on which the merchandise at each location was counted during the year.
A copy of the physical inventory procedures and instructions in effect for the years under examination for both stores and distribution centers, if different. Any indications of an incomplete or inaccurate inventory should be discussed with the taxpayer.
A copy of the layer and/or historical LIFO lapse schedules. These schedules will provide the complete historical detail of the taxpayer’s LIFO computations. These schedules may provide indications of changes made to pools, business emphasis changes, the pattern of the cost complement factors, and the propriety of the price index figures used.
The detail of all computations supporting the quantification of ending inventory for book and for tax inclusive of all reconciliation computations between book and tax and the computations supporting the development of the index used.
Summary Stock Ledger information.
The information contained in the preceding sections is to provide agents a fundamental overview of the topics discussed. In addition, many technical discussions of inventory methodologies and issues can be accessed through both Lexis-Nexis and Westlaw research.
The Inventory Technical Advisors are available to advise and assist agents with respect to their examination of inventory issues.
This section provides general background information about the IRC 263A Uniform Capitalization Rules (UNICAP) and the application of these rules to inventories maintained by retailers.
This section also provides the general accounting practices reported by retailers in applying the UNICAP rules.
For retailers, inventories play a significant role in the computation of taxable income. Goods in inventory generally represent the most significant asset on a retailer’s balance sheet. Similarly, the cost of goods sold (COGS) generally represents the largest single item of expense (as an offset to sales revenue) on a retailer’s income statement.
Consequently, the application of the UNICAP rules to inventories will significantly impact a retailer’s tax liability.
Is the retailer required to capitalize in accordance with IRC 263A indirect costs associated with property acquired for resale? Small resellers of the following are excepted:
Personal property. See Treas. Reg. 1.263A-3(b).
De minimis production activities. See Treas. Reg. 1.263A-3(a)(2)(ii).
Property produced under contract. See Treas. Reg. 1.263A-3(a)(3).
If the retailer is subject to the UNICAP rules, did the retailer capitalize costs to property acquired for resale in accordance with IRC 263A and the regulations thereunder? Did the retailer properly characterize and capitalize the most common indirect costs it incurs, which include the following:
All purchasing costs
All capitalizable handling costs
All off-site storage costs
All capitalizable service costs including both capitalizable storage costs and the capitalizable portion of mixed service costs?
Does the retailer have production activities which are determined to be more than de minimis as defined in Treas. Reg. 1.263A-3(a)(2)(iii)?
Has the retailer made a proper determination as to whether it is a producer or reseller if it produces property or has property produced for it under contract? (i.e., contract manufacturing of other than private label goods)?
Is the retailer using a proper cost allocation method for determining additional IRC 263A costs properly allocable to the property acquired for resale and to property it produces? Proper cost allocation methods include the following:
Simplified resale method without historic absorption ratio election
Simplified resale method with historic absorption ratio election
Simplified production method without historic absorption ratio election
Simplified production method with historic absorption ratio election
A facts and circumstances allocation
Has the retailer properly classified and capitalized service costs and capitalizable mixed service costs?
Did the retailer use book purchases in lieu of tax purchases in computing its absorption ratios under the simplified resale method?
Has the retailer taken an inconsistent position relative to its production activities with respect to IRC 263A and IRC 199?
IRC 471 provides the general rules for inventory and authorizes the Secretary to determine when the use of inventories is necessary to clearly reflect income and to determine the valuation methods that are acceptable for tax purposes.
Treas. Reg. 1.471-1 provides that in order to reflect income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income producing factor.
IRC 263A, enacted under the Tax Reform Act of 1986, prescribes uniform capitalization rules for property produced or held for resale.
Under IRC 263A, resellers of personal property must capitalize the acquisition costs of property acquired for resale and all indirect costs properly allocable to property produced and property acquired for resale.
Additional IRC 263A costs generally are those costs, other than interest, that were not capitalized under the taxpayer’s method of accounting immediately prior to the effective date of IRC 263A, but that are required to be capitalized under IRC 263A.
IRC 263A costs are defined as the costs that a taxpayer must capitalize under IRC 263A. IRC 263A costs are the sum of a taxpayer’s IRC 471 costs, its additional IRC 263A costs, and interest capitalizable under IRC 263A(f).
Treas. Reg. 1.263A-1(f) sets forth various detailed or specific (facts and circumstances) cost allocation methods that taxpayers may use to allocate direct and indirect costs to property produced and property acquired for resale.
Treas. Reg. 1.263A-1(g) provides general rules for applying cost allocation methods to the various categories of costs.
Treas. Reg. 1.263A-2(b) and 1.263A-3(d) provide simplified methods to allocate additional 263A costs to eligible property produced or eligible property acquired for resale.
Treas. Reg. 1.263A-1(h) provides a simplified method for determining capitalizable mixed service costs incurred during the taxable year with respect to eligible property (i.e., the aggregate portion of mixed service costs that are properly allocable to the taxpayer’s production or resale activities).
The Tax Reform Act of 1986 enacted IRC 263A to provide a single comprehensive set of rules to govern the capitalization of the costs of producing, acquiring, and holding property, subject to appropriate exceptions.
Retailers’ and wholesalers’ inventories were not subject to any indirect costing rules and, as such, indirect costs incurred by retailers and wholesalers to acquire goods for resale were not capitalized prior to the enactment of IRC 263A.
IRC 263A established new rules for the capitalization of costs in inventories for tax purposes. Both producers and resellers of tangible personal and real property are required to capitalize costs under the provisions of IRC 263A. In addition, IRC 263A applies to the resale of intangible property. For retailers:
The rules require the capitalization of direct costs of acquiring the property and the property’s properly allocable share of indirect costs. IRC 263A(b)(2)(B) excepts personal property acquired for resale by a small reseller from the capitalization rules of IRC 263A.
Although retailers and wholesalers have always had to treat the net invoice price (invoice price less trade or other discounts, except discounts approximating a fair interest rate) as an inventory cost including transportation costs and other costs associated with acquiring possession of the goods that are added to the net invoice price, most of the indirect costs incurred to acquire the goods for resale were charged to expense for both financial and tax purposes prior to the law change.
Although a cost is subject to capitalization under IRC 263A, it may not be proper to capitalize such cost for financial reporting (GAAP) purposes.
The legislative history to IRC 263A indicates that Congress wanted the IRS to adopt a flexible approach in the accompanying regulations by providing simplified methods and assumptions when the costs and burdens of compliance outweigh the benefits especially since retailers did not have cost accounting procedures in place prior to the adoption of the uniform capitalization rules.
In enacting IRC 263A, Congress intended that full-absorption type rules apply to retailers that, prior to these rules, were required to include in inventory only invoice price plus freight less discounts. Now, large retailers, those with more than $10 million in gross receipts, have to include additional costs (e.g., purchasing, handling, off-site storage, and applicable general and administrative costs) in their inventory cost calculations.
The IRC 263A regulations respect the flexibility provided by traditional cost accounting principles by permitting taxpayers to allocate direct and indirect costs to property produced and property acquired for resale using a variety of cost allocation methods. See Treas. Reg. 1.263A-1(f)(1).
Like the full absorption method of IRC 471, additional IRC 263A costs are added to the retailer’s book cost of inventory. In addition to the cost allocation methods provided in Treas. Reg. 1.263A-1(f)(2) and (3), any other reasonable method may be used to properly allocate direct and indirect costs among units of property produced or acquired for resale. See Treas. Reg. 1.263A-1(f)(4).
The simplified resale method, the simplified production method, and the simplified service cost method are allocation methods intended to alleviate some of the administrative burden of complying with the IRC 263A capitalization rules.
A taxpayer can allocate mixed service costs required to be capitalized to eligible property using the simplified service cost method. See Treas. Reg. 1.263A-1(h). The simplified service cost method may be used in conjunction with either a facts and circumstances approach or a simplified method of allocating costs to eligible property produced or eligible property acquired for resale.
The following sections describe practices commonly followed in the retail sector.
Retailers employ buyers, assistant buyers, merchandise managers and analysts, general merchandise managers and other personnel engaged in purchasing merchandise or goods (merchandising employees). Merchandising employees in a retail context purchase the goods for resale (inventoriable goods). Merchandising employees are assigned to various product lines or categories of goods (e.g., women’s shoes, men’s shoes, home furnishings, house-wares, lingerie, infants, etc.).
Other personnel, such as administrative support, provide services adjunct to buyers and other employees who purchase goods for resale and/or maintain the inventory of goods for resale.
Purchasing activities of buyers and/or merchandising employees include (but are not limited to):
Selection of merchandise
Maintenance of stock assortment and volume
Placement of purchase orders
Establishment and maintenance of vendor contracts and
Comparison and testing of merchandise.
Buyers also manage inventory, negotiate costs, evaluate competition, establish replenishment strategies, execute the development and maintenance of purchase orders, manage markdown projection processes and the projection of vendor allowances, manage the negotiation and collection of vendor allowances, develop inventory exit strategies, execute stock ledger reviews and purchase journal reviews.
Buyers also establish and approve pricing strategies while evaluating the financial impact of price changes.
Buyers may plan and approve all advertising and marketing strategies.
Buyers may also be responsible for the development and training of the buying team, including assistant buyers and/or merchandising analysts.
Many large retailers have centralized purchasing departments that are located in the corporate headquarters. Decentralized buying procedures use buyers that are assigned to specific stores or geographic locations.
Some retailers design virtually all of their goods held for resale. Other retailers may design only a portion of their goods held for resale which are known as private label goods (e.g., a department store’s (store) label goods). In these circumstances, the retailer typically has an in-house design group that develops the private (store) label goods. Oftentimes, private label goods are produced by independent parties under contract. As a general rule, these independent parties are located in countries overseas.
The recent elimination of import quotas has created an opportunity for retailers to directly source production of private label goods with contractors located in low labor cost countries.
Since the retail industry is highly competitive, retailers must provide consumers with a wide variety of shopping options and/or merchandise selections. To survive in today's economy, retailers need to be distinguishable from the competition. Carrying exclusive merchandise provides retailers an opportunity to differentiate its merchandise assortment from its competition.
Some retailers enter into exclusive licensing and/or royalty agreements with major celebrities and/or designers to provide for differentiated merchandise assortments and to compete in the industry on a basis other than price.
Licensing and/or royalty costs include fees incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe or other similar right associated with property produced or property acquired for resale. These costs include the otherwise deductible portion (e.g., amortization) of the initial fees incurred to obtain the license and any minimum annual payments and royalties that are incurred by a licensee. Treas. Reg. 1.263A-1(e)(3)(ii)(U).
In addition to the initial fee, a celebrity and/or designer will also receive financial compensation in exchange for granting certain property rights to the retailer in the form of royalty payments. The royalty rate varies depending on the type of merchandise licensed and may be established as a percentage of retailer’s sales price or the purchase price of the licensed merchandise.
As a general rule, royalty rates vary between 3% and 7%.
Licensing and franchise costs are indirect costs required to be capitalized to the extent they are properly allocable to property produced or property acquired for resale. See Treas. Reg. 1.263A-1(e)(3)(ii)(U).
Frequently, a retailer reports royalties paid or incurred in connection with a licensing arrangement as an IRC 162 cost, contending the royalty payments are marketing, selling, and advertising expenses (or similar in nature to such expenses).
Statement of Financial Accounting Standards (SFAS) No.151, effective for inventory costs incurred during fiscal years beginning June 15, 2005, amended the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter 4, regarding costs included in inventory.
For GAAP purposes, absorption costing of inventory is required for external reporting. For producers/manufacturers, Treas. Reg. 1.471-11 requires the use of the full absorption method of inventory costing whereby both direct (materials and labor) and indirect production costs must be taken into account in the computations of inventoriable costs. Absorption costing for book purposes can and oftentimes does differ from the full absorption method as required for tax.
For retailers, the cost of merchandise is the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. To the net price, transportation and other necessary charges incurred in acquiring possession of the goods should be added. See Treas. Reg. 1.471-3(b).
IRC 263A is broader than both GAAP and the full absorption rules of Treas. Reg. 1.471-11 and, as a result, a retailer may not be required to capitalize for financial reporting purposes certain additional costs that are required to be capitalized for tax reporting purposes.
Whether capitalization is required for financial reporting purposes depends on factors such as the nature of the business operations and industry practice. The individual facts and circumstances will control the determination. See the Emerging Issues Task Force (EITF) Issue No. 86-46.
As a general rule, retailers do not capitalize additional IRC 263A costs to inventory for financial statement purposes.
This section covers potential tax issues and key terms and concepts involving IRC 263A.
The IRS has addressed the issue of whether the costs incurred by a retailer's merchandising department are mixed service costs as defined by Treas. Reg. 1.263A-1(e)(4)(ii)(C). The IRS's position is that, since the costs incurred in the merchandising department includes the costs of purchasing goods for resale, the merchandising department does not constitute a service department. Consequently, the IRS has concluded that the purchasing costs incurred in the merchandising department are properly capitalizable indirect costs in accordance with Treas. Reg. 1.263A-1(e)(3)(ii)(F).
A retailer may attempt to reclassify as capitalizable service costs or as indirect costs not subject to capitalization its indirect costs incurred to acquire property for resale. Reclassifications such as these attempt to eliminate from capitalization the indirect costs as described in Treas. Reg. 1.263A-1(e)(3) which are costs properly allocable to property acquired for resale. Included in such indirect costs requiring capitalization are purchasing, handling and storage costs which are the indirect costs most often incurred by retailers/resellers. Purchasing, handling, off-site storage costs and the allocable general and administrative costs pertaining to these costs are generally required by statute to be capitalized to inventory.
A retailer/ reseller with production activity and a small reseller with more than de minimis production activity:
Must capitalize all direct costs and certain indirect costs associated with the tangible personal property it produces.
Must use the simplified production method and may not use the simplified resale method for the capitalization of additional IRC 263A costs.
A retailer/reseller with de minimis production activities must capitalize the de minimis production activity costs but may use the simplified resale method.
A small retailer/reseller is not required to capitalize additional IRC 263A costs associated with any personal property that is produced incident to its resale activities, provided the production activities are de minimis in accordance with Treas. Reg. 1.263A-3(a)(2)(iii).
Property produced under contract is treated as property produced by the taxpayer.
A small retailer/reseller is not required to capitalize additional IRC 263A costs to property produced for it under contract with an unrelated person if the contract is entered into incident to the resale activities of the small reseller and the property is sold to its customers.
In general, a retailer/reseller engaged in both production and resale activities with respect to inventory property (e.g., stock in trade or other property properly includible in the inventory of the retailer) and non-inventory property held for sale to customers in the ordinary course of the retailers’ business may elect the simplified production method but may not elect the simplified resale method unless:
Its production activities with respect to its eligible property, under Treas. Reg. 1.263A-2(b)(2), are de minimis and incident to its resale of its stock in trade or other property of a kind which would properly be included in inventory or property held primarily for sale to customers in the ordinary course of business. See Treas. Reg. 1.263A-3(a)(2)(ii)
The personal property (e.g., private label goods) produced under a contract with an unrelated person and the contract is entered into incident to its resale activities and the property is sold to its customers. See Treas. Reg. 1.263A-3(a)(4)(iii).
Notice 2007-29 contains interim guidance relative to negative additional IRC 263A costs in conjunction with the use of a simplified method.
At issue is whether negative amounts may be included with additional IRC 263A costs and whether aggregate additional IRC 263A costs may be a negative number.
A negative amount may occur, for example, when a taxpayer includes book costs greater than those required for tax purposes in the IRC 471 cost of inventory (e.g., book depreciation greater than tax depreciation) and the taxpayer does not adjust its IRC 471 costs to remove this excess depreciation amount but instead makes a negative adjustment to its additional IRC 263A costs.
Significant distortions, including undercapitalization, may result when a retailer treats negative amounts as additional IRC 263A costs.
Pending issuance of additional published guidance subsequent to Notice 2007-29, the IRS will not challenge the inclusion of negative amounts in computing additional costs under IRC 263A which represent IRC 471 costs that were capitalized to inventory using a facts and circumstances method such as a burden rate or a standard cost rate.
The IRS will not, however, approve any change in method of accounting to change the costs capitalized under IRC 471 to begin capitalizing a cost under IRC 471 and to remove the same cost from ending inventory by treating it as a negative additional IRC 263A cost.
Any taxpayer previously granted consent to change its method of accounting for the inclusion of negative amounts in computing additional costs under IRC 263A will be required to conform its method of accounting to any future published guidance.
Refer to IRM 126.96.36.199.4.3, Marketing Exclusive Designer/Celebrity Brands, in this section which contains a discussion of this topic.
An income tax issue may exist if a retailer’s book purchases and tax purchases differ. This circumstance can occur if a retailer reduces its purchases by vendor allowances or some other reduction for tax purposes but does not reduce its purchases by the same amounts for book purposes.
If book purchases exceed tax purchases and the retailer uses book purchases to compute its storage and handling costs absorption ratio and its purchasing costs absorption ratio under the simplified resale method, both ratios will be understated as a result of which the combined absorption ratio will be understated, which in turn will under-capitalize additional IRC 263A costs to ending inventory.
Current year purchases are defined in both Treas. Reg. 1.263A-3(d)(3)(D)(2) and 1.263A-3(d)(E)(2) and generally mean the taxpayer’s IRC 471 costs incurred with respect to purchases of property acquired for resale during the current taxable year.
IRC 471 costs are costs, other than interest, that were capitalized under the taxpayer’s method of accounting immediately prior to the enactment of IRC 263A. See Treas. Reg. 1.263A-1(d)(2). For a reseller, IRC 471 costs would include the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may, or may not, be deducted at the option of the taxpayer, provided a consistent course is followed, plus transportation or other necessary costs incurred in acquiring possession of the goods. See Treas. Reg. 1.471-3(b).
Additional IRC 263A costs are defined as the costs, other than interest, that were not capitalized under the taxpayer’s method of accounting immediately prior to the effective date of IRC 263A, but that are required to be capitalized under IRC 263A. See Treas. Reg. 1.263A-1(d)(3).
IRC 263A costs are defined as the costs that a taxpayer must capitalize under IRC 263A. IRC 263A costs are the sum of a taxpayer’s IRC 471 costs, its additional IRC 263A costs, and interest capitalizable under IRC 263A(f). See Treas. Reg. 1.263A-1(d)(4).
Capitalize means, in the case of property that is inventory in the hands of a taxpayer, to include in inventory costs and, in the case of other property, to charge to a capital account or basis. See Treas. Reg. 1.263A-1(c)(3).
Small reseller is defined as a reseller that acquires personal property for resale during the taxable year whose (or its predecessors’) average annual gross receipts do not exceed for the three previous taxable years (test period) $10,000,000. See Treas. Reg. 1.263A-3(a)(1) and 1.263A-3(b)(1). However, taxpayers that acquire real property for resale are subject to IRC 263A with respect to real property regardless of their gross receipts. See IRC 263A(b)(2).
Service costs are defined as a type of indirect costs (e.g., general and administrative costs) that can be identified specifically with a service department or function or that directly benefit or are incurred by reason of a service department or function. See Treas. Reg. 1.263A-1(e)(4)(i)(A).
Capitalizable service costs are defined as service costs that directly benefit or are incurred by reason of the performance of the production or resale activities of the taxpayer. Therefore, these costs are required to be capitalized under IRC 263A. See Treas. Reg. 1.263A-1(e)(4)(ii)(A).
Deductible service costs are defined as service costs that do not directly benefit or are not incurred by reason of the performance of the production or resale activities of the taxpayer, and therefore, are not required to be capitalized under IRC 263A. Deductible service costs include costs incurred by reason of the marketing, selling, advertising, and distribution activities of the taxpayer. See Treas. Reg. 1.263A-1(e)(4)(ii)(B) and 1.263A-1(e)(4)(iv).
Mixed service costs are defined as service costs that are partially allocable to production or resale activities (capitalizable mixed service costs) and partially allocable to non-production or non-resale activities (deductible mixed service costs). See Treas. Reg. 1.263A-1(e)(4)(ii)(C).
Total mixed service costs are defined as the total costs incurred during the taxable year in all departments or functions of the taxpayer’s trade or business that perform mixed service activities. In determining the total mixed service costs of a trade or business, the taxpayer must include all costs incurred in its mixed service departments and cannot exclude any otherwise deductible service costs. For example, if the accounting department within a trade or business is a mixed service department, then in determining the total mixed service costs of the trade or business, the taxpayer cannot exclude the costs of personnel in the accounting department that perform services relating to non-resale activities. Instead, the entire cost of the accounting department must be included in the total mixed service costs. See Treas. Reg. 1.263A-1(h)(6).
Purchasing costs include the costs attributable to purchasing activities. See Treas. Reg. 1.263A-1(e)(3)(ii)(F) and 1.263A-3(c)(3)(i). Purchasing costs are costs associated with operating a purchasing department or office within a trade or business, including personnel costs (e.g., of buyers, assistant buyers, and clerical workers), relating to the following:
The selection of merchandise
The maintenance of stock assortment and volume
The placement of purchase orders
The establishment and maintenance of vendor contracts
The comparison and testing of merchandise.
Storage costs include the costs of carrying, storing, or warehousing property. Storage costs are capitalized under IRC 263A to the extent they are attributable to the operation of an off-site storage or warehousing facility (an off-site storage facility). See Treas. Reg. 1.263A-1(e)(3)(ii)(H). However, storage costs attributable to the operation of an on-site storage facility as defined in Treas. Reg. 1.263A-3(c)(5)(ii)(A) are not required to be capitalized under IRC 263A. Storage costs attributable to a dual-function storage facility as defined in Treas. Reg. 1.263A-3(c)(5)(ii)(G) must be capitalized to the extent that the facility’s costs are allocable to off-site storage. See Treas. Reg. 1.263A-3(c)(5)(i).
Handling costs include costs attributable to processing, assembling, repackaging, and transporting goods, and other similar activities with respect to property acquired for resale, provided the activities do not come within the meaning of the term produce as defined in Treas. Reg. 1.263A-2(a)(1). Handling costs are generally required to be capitalized under IRC 263A. However, handling costs incurred at a retail sales facility with respect to property sold to retail customers at the facility are not required to be capitalized. Thus, handling costs incurred at a retail sales facility to unload, unpack, mark, and tag goods sold to retail customers at the facility are not required to be capitalized. In addition, handling costs incurred at a dual-function storage facility with respect to property sold to customers from the facility are not required to be capitalized to the extent that the costs are incurred with respect to property sold in on-site sales. See Treas. Reg. 1.263A-1(e)(3)(ii)(G) and 1.263A-3(c)(4)(i).
The five steps to approaching an IRC 263A issue include the following:
Identify the taxpayer’s production or resale activities in the year(s) under examination. Some considerations include whether the retailer engages in any production activities, whether the personal property is private label property and whether the production activities were contracted out.
Determine if the application of any special rules or exemptions exist such as the small reseller exception; the 90/10 exception for mixed service costs (Treas. Reg. 1.263A-1(h)(8)); the 90/10 exception for storage costs (Treas. Reg. 1.263A-3(c)(5)(iii)(c)); or the 1/3 – 2/3 exception for buyers (Treas. Reg. 1.263A-3(c)(3) (ii)(A).
Identify the additional IRC 263A costs subject to capitalization. See Treas. Reg. 1.263-1(e)(3) and 1.263A-3(c).
Determine the costs the taxpayer identified as mixed service costs and how the taxpayer allocated the mixed service costs to production or resale activities. See Treas. Reg. 1.263A-1(h) and 1.263-1(g)(4).
Determine the method(s) of allocation used to allocate all the direct and indirect costs, including mixed service costs that directly benefited or were incurred by reason of production or resale activities to the property produced or acquired for resale, (i.e., ending inventory). See Treas. Reg. 1.263A-1(f), 1.263A-2(b) and 1.263A-3(d).
To examine an IRC 263A issue, the examiner should obtain the following documents:
All IRC 263A workpapers inclusive of all computations.
Internal control workpapers for cost accounting purposes. These workpapers are essential if the retailer engages exclusively in production activities.
Any Forms 3115 that requested a change in method of accounting with respect to additional IRC 263A costs and/or IRC 263A absorption ratio calculations and/or methods and/or IRC 471 costs.
This section provides guidance on how IRC 263A affects retailers that self-construct assets used in their trade or business. This section also provides guidance regarding situations in which retailers are required to capitalize interest under IRC 263A(f).
Self-constructed assets are assets produced by the taxpayer for use by the taxpayer in its trade or business.
In general, IRC 263A(f) limits the capitalization of interest to interest that is paid or incurred during the production period of certain property referred to as designated property.
Designated property includes all real property produced by the taxpayer and tangible personal property produced by the taxpayer which has:
a long useful life
an estimated production period exceeding two years, or
an estimated production period exceeding one year and a cost exceeding $1,000,000.
Interest capitalized under IRC 263A(f) is treated as a cost of the designated property and is recovered in accordance with Treas. Reg. 1.263A-1(c)(4) through depreciation, amortization, cost of goods sold, or by an adjustment to basis at the time the property is used, sold, placed in service or otherwise disposed of by the taxpayer.
Cost recoveries are determined by the applicable IRC sections and regulation provisions relating to the use, sale, or disposition of property.
The retailer fails to capitalize indirect costs altogether or omits certain costs that directly benefit or are incurred by reason of its production activity.
The retailer inappropriately treats certain self-constructed assets (e.g., stores) as property produced on a "routine and repetitive" basis. Stores are neither mass-produced nor do they have a high turnover. See Rev. Rul. 2005-53 and Treas. Reg. 1.263A-1 and Treas. Reg. 1.263A-2 for rules regarding self-constructed assets produced on a routine and repetitive basis.
The retailer does not capitalize any interest (or capitalizes an insufficient amount of interest) during the production period.
The retailer does not treat real property or applicable tangible property that is produced for it by a contractor under a contract with it or an intermediary as designated property. The retailer for whom property is being constructed under a contract is subject to the interest capitalization rules on payments made to the contractor, and the contractor is subject to the rules on any costs that it incurs in excess of payments received by it to date.
The retailer nets interest income with interest expense. Rev. Rul. 90-40 provides that interest expense required to be capitalized by IRC 263A(f) may not be reduced by interest income earned from temporarily investing unexpended debt proceeds.
The retailer improperly treats functionally interdependent property as separate units of property. See Treas. Reg. 1.263A-10(b)(1) and Treas. Reg. 1.263A-10(b)(2).
The retailer fails to use the avoided cost method of interest capitalization. See Treas. Reg. 1.263A-9.
The retailer incorrectly determines accumulated production expenditures. See Treas. Reg. 1.263A-11.
The retailer incorrectly determines the computation periods and/or the production period of a unit of designated property. See Treas. Reg. 1.263A-9(f)(1) and Treas. Reg. 1.263A-12.
The retailer fails to capitalize all other direct or indirect costs, such as insurance, taxes, and storage, that directly benefit or are incurred by reason of the production of property without regard to whether they are incurred during a period in which production activity occurs.
IRC 263A(g)(1) defines the term "produce" to include construct, build, install, manufacture, develop, or improve. See S. Rept. 99-313, at 140 (1986), 1986-3 C.B. (Vol. 3) 1, 140; Von-Lusk v. Commissioner, 104 T.C. 207, 214-216 (1995).
IRC 263A(g)(2) provides that a taxpayer shall be treated as producing any property produced for the taxpayer under a contract with the taxpayer. See Suzy’s Zoo v. Commissioner, 273 F.3d 875, 879 (9th Cir. 2001), affg. 114 T.C. 1 (2000).
Treas. Reg. 1.263A-1(a)(3)(ii) provides that taxpayers that produce real property and tangible personal property (producers) must capitalize all the direct costs of producing the property and the property’s properly allocable share of indirect costs as described in Treas. Reg. 1.263A-1(e)(2)(i)(A) and (B) and in Treas. Reg. 1.263A-1(e)(3)(i) and (ii) regardless of whether the property is sold or used in the taxpayer trade or business.
Treas. Reg. 1.263A-2 provides the rules relating to property produced by the taxpayer.
Treas. Reg. 1.263A-2(a)(3) provides that, except as specifically provided in IRC 263A(f) with respect to interest costs, producers must capitalize direct and indirect costs properly allocable to property produced under IRC 263A, without regard to whether those costs are incurred before, during, or after the production period (as defined in IRC 263A(f)(4)(B)).
Treas. Reg. 1.263A-8 through 1.263A-15 provide guidance with respect to the capitalization of interest under IRC 263A(f).
T.D. 8584 dated December 29, 1994 and effective January 1, 1995 provides the final regulations relating to the requirement to capitalize interest with respect to the production of property. The final regulations provide guidance necessary for taxpayers to comply with the requirement to capitalize interest with respect to certain produced property.
IRC 263A was enacted as part of the Tax Reform Act of 1986, Pub. L. 99- 514, Sec. 803(a), 100 Stat. 2350. In enacting IRC 263A, Congress intended that a single, comprehensive set of rules generally should govern the capitalization of costs of producing property in order to more accurately reflect income and make the tax system more neutral.
The purpose of the IRC 263A cost identification and cost capitalization, as well as the IRC 263A(f) interest capitalization, provisions is to maintain parity among taxpayers.
Interest capitalization results in deduction of the interest incurred to finance an asset’s production in the years in which income from the asset is realized.
Prior to the enactment of IRC 263A, neither the Code nor the regulations identified all of the indirect costs required to be capitalized in connection with self-constructed assets. Such costs were identified through published revenue rulings on specific costs and various court cases that addressed specific costs.
Simplified allocation methods are generally not available for the determination of capitalizable mixed service costs or to allocate costs to self-constructed assets. However, there are two exceptions. The exceptions are for self-constructed assets produced by a taxpayer that are substantially identical in nature to, and produced in the same manner as, inventory property or non-inventory property that is produced for sale that the taxpayer is also producing and self-constructed assets produced on a "routine and repetitive" basis.
All costs associated with self-constructed assets must be accumulated and capitalized. The capitalized costs are written off through depreciation and amortization according to the type of fixed asset. No depreciation is allowed for land. Buildings are depreciable over its real property lives. Furnishings and fixtures used in operations, known as retail trade assets, are depreciable over its personal property lives.
The self-constructed asset records may be substantiated by only one invoice. On the other hand, a complicated trail, which can include allocation studies, drawings, bid proposals, and planning documents to tie back to invoices, may exist. More complex trails tend to be the result of new construction or a major remodel of an existing store.
In general, any improvement to property described in Treas. Reg. 1.263(a)-1(b) constitutes a production of property. See Treas. Reg. 1.263A-8(d)(3)(i). Generally, any improvement to designated property constitutes the production of designated property. See Treas. Reg. 1.263A-8(d)(3)(i).
A retailer may make the avoided cost calculation on the basis of either a full taxable year or a shorter period. A retailer must use the same computation periods for all designated property produced during a single taxable year. The choice of a computation period is a method of accounting. Any change in the computation period is a change in method of accounting requiring the consent of the Commissioner under IRC 446(e) and Treas. Reg. 1.446-1(e). See Treas. Reg. 1.263A-9(f)(1).
Costs are generally taken into account in the computation of accumulated production expenditures at the time and to the extent they would otherwise be taken into account under the retailer's method of accounting (e.g., after applying the requirements of IRC 461, including the economic performance requirement of IRC 461(h)).
The remodeling of existing stores and new construction of stores are common occurrences in the retail industry.
Most retailers produce such projects either by paying outside contractors or by using their own employees to perform the construction.
It is important that a retailer involved in production activities use the same standards to measure the cost of a project as a retailer that purchases a completed asset outright.
Financial Accounting Standards Board (FASB) Statement No. 34 provides for book purposes the standards for capitalizing interest costs as part of the historical cost of certain assets.
For interest capitalization under GAAP, assets must require a period of time to be readied for their intended use.
FASB No. 34 lists assets that an enterprise constructs for its own use (such as facilities) and assets intended for sale or lease that are constructed as discrete projects (such as real estate projects) as types of assets to which interest capitalization would apply.
According to FASB No. 34, interest capitalization is required for those assets if the effect of capitalization, compared with the effect of expensing interest, is material. Otherwise, interest capitalization is not required.
FASB No. 34 indicates that interest is not capitalized for routinely manufactured inventories of large quantities produced on a repetitive basis.
Treas. Reg. 1.263A-9(g)(4) provides that the avoided cost method is applied for tax reporting purposes without regard to any financial or regulatory accounting principles for the capitalization of interest. Therefore, interest capitalization for tax purposes is determined without regard to FASB 34.
FASB No. 62 amended FASB No. 34 with respect to netting interest income and interest expense in determining the amount of interest to be capitalized in certain restricted tax-exempt borrowings. For tax purposes, retailers are not permitted to net interest income and interest expense in determining the amount of interest that must be capitalized with respect to restricted tax-exempt borrowings. See Treas. Reg. 1.263A-9(g)(4).
This section covers key terms and concepts involving self-constructed assets and interest capitalization under IRC 263A.
Self-constructed assets are assets produced by a taxpayer for use by the taxpayer in its trade or business. Self-constructed assets are subject to IRC 263A. See Treas. Reg. 1.263A-1(d)(1).
Capitalization of interest under the avoided cost method described in Treas. Reg. 1.263A-9 is required with respect to the production of designated property. See Treas. Reg. 1.263A-8(a)(1).
The term "produce" is defined in IRC 263A(g) and in Treas. Reg. 1.263A-2(a)(1)(i). For purposes of IRC 263A, produce includes the following: construct, build, install, manufacture, develop, improve, create, raise, or grow. See Treas. Reg. 1.263A-8(d)(1)and 1.263A-2(a)(1)(i).
In general, except as provided in paragraphs (b)(3) and (b)(4) of Treas. Reg. 1.263A-8(b), designated property means any property that is produced and that is:
Real property, or
Tangible personal property with a class life of 20 years or more (long-lived property), but only if the property is not property described in IRC 1221(1) in the hands of the taxpayer or a related person, or
Property with an estimated production period (as defined in Treas. Reg. 1.263A-12) exceeding two years (2-year property), or
Property with an estimated production period exceeding one year and an estimated cost of production exceeding $1,000,000 (1-year property). See Treas. Reg. 1.263A-8(b)(1).
Accumulated production expenditures (APEs) generally mean the cumulative amount of direct and indirect costs described in IRC 263A(a) that are required to be capitalized with respect to the unit of property, including interest capitalized in prior computation periods, plus the adjusted bases of any property used in reasonably proximate manner to produce a unit of designated property.
APEs may also include the basis of any property received by the taxpayer in a nontaxable transaction. See Treas. Reg. 1.263A-11(a).
The costs included in APEs are:
Costs of designated property (including an allocable share of common features).
Common features include any real property that benefits real property produced by, or for, the retailer or a related person, and that is not separately held for the production of income. Common features include streets, sidewalks, sewer lines, and cables that are not held for the production of income separately from the units of real property they benefit. See Treas. Reg. 1.263A-10(b)(3).
Adjusted bases (or portion thereof) of any equipment, facilities, or other similar assets, used in a reasonably proximate manner for the production of a unit of designated property during any measurement period in which the asset is so used. Examples of assets used in a reasonably proximate manner include machinery and equipment used directly or indirectly in the production process, such as assembly-line structures, cranes, bulldozers, and buildings.
Interest capitalized in prior computation periods
Costs incurred and capitalized with respect to a unit of property prior to the beginning of the production period are included in determining the amount of APEs beginning on the date on which the production period of the property begins. For example, the cost of raw land acquired for development and the capitalized costs of planning and design activities are taken into account as APEs beginning on the first day of the production period. See Treas. Reg. 1.263A-1(e)(1) and 1.263A-11(b).
The avoided cost method is used to calculate the amount of interest required to be capitalized under IRC 263A(f). Any interest the retailer theoretically would have avoided if the APEs had been used to repay or reduce the retailer’s outstanding debt must be capitalized under the avoided cost method. See Treas. Reg. 1.263A-9(a)(1).
For each unit of designated property, the avoided cost method requires the capitalization of the following:
Traced debt amount (See Treas. Reg. 1.263A-9(b)), and
Excess expenditure amount. (See Treas. Reg. 1.263A-9(c))
Under the avoided cost method, the retailer may (but is not required to) make the avoided cost calculation on the basis of a full taxable year. If the retailer uses the taxable year as the computation period, a single avoided cost calculation is made for each unit of designated property for the entire taxable year. See Treas. Reg. 1.263A-9(f)(1)(i).
If the retailer uses computation periods that are shorter than the taxable year, an avoided cost calculation is made for each unit of designated property for each shorter computation period within the taxable year. See Treas. Reg. 1.263A-9(f)(1)(i).
The choice of a computation period is a method of accounting. Any change in the computation period is a change in method of account requiring the consent of the Commissioner under IRC 446(e) and Treas. Reg. 1.446-1(e). See Treas. Reg. 1.263A-9(f)(1)(ii).
If a retailer uses the taxable year as the computation period, measurement dates must occur at quarterly or more frequent regular intervals. See Treas. Reg. 1.263A-9(f)(2).
The interest capitalized with respect to a unit of designated property must be equal to the total interest incurred on the traced debt during each measurement period as defined in Treas. Reg. 1.263A-9(f)(2)(ii) that ends on a measurement date described in Treas. Reg. 1.263A-9(f)(2)(iii). See Treas. Reg. 1.263A-9(b)(1).
Traced debt with respect to a unit of designated property is the outstanding eligible debt as defined in Treas. Reg. 1.263A-9(a)(4) that is allocated, on that date, to the APEs with respect to the unit of designated property under the rules of Treas. Reg. 1.163-8T. Traced debt also includes unpaid interest that has been capitalized with respect to such unit under Treas. Reg. 1.263A-9(b)(1) and that is included in accumulated production expenditures on the measurement date. See Treas. Reg. 1.263A-9(b)(2).
An excess expenditure amount occurs if there are APEs in excess of traced debt with respect to a unit of designated property on any measurement date described in Treas. Reg. 1.263A-9(f)(2). The retailer must, for the computation period that includes the measurement date, capitalize with respect to the unit the excess expenditure amount calculated under Treas. Reg. 1.263A-9(c)(1).
See Treas. Reg. 1.263A-9(a)(4) for information on eligible debt.
Non-traced debt means all eligible debt on a measurement date other than any debt that is treated as traced debt with respect to any unit of designated property on that measurement date. See Treas. Reg. 1.263A-9(c)(5)(i)(A).
Retailers may elect not to trace debt. If such an election is made, the average excess expenditures and weighted average interest rate under Treas. Reg. 1.263A-9(c)(5) are determined by treating all eligible debt as non-traced debt. See Treas. Reg. 1.263A-9(d).
The election not to trace debt is a method of accounting that applies to the determination of capitalized interest for all designated property of the taxpayer. The making or revocation of the election is a change in method of accounting requiring the consent of the Commissioner under IRC 446(e) and Treas. Reg. 1.446-1(e).
During the preliminary review of the tax return and at the beginning of the examination, the examiner must identify the production activities of the retailer.
Did the retailer produce (including under contract) any self-constructed assets or designated property?
If production occurred, was the retailer subject to any special rules or exemptions?
If production occurred, what costs were incurred subject to capitalization?
If production occurred, did the retailer allocate all the direct and indirect costs that directly benefited or were incurred by reason of the production activities to the property produced?
If production of designated property occurred, did the retailer capitalize interest in accordance with IRC 263A(f) and the regulations thereunder?
An information document request (IDR) request should contain the following:
A listing of all the production activities in progress during the examination cycle, including the project numbers and other identifying information relative to each project.
Identification of the accounts to which construction costs were charged for book and for tax purposes.
Copies of the appropriation requests including all amendments and supplements to the request for each project.
Copies of all contracts and related agreements with outside contractors relative to the construction of assets.
A schedule of all loan proceeds received, including the date of each loan, the amount of each loan, how the proceeds of each loan were received, the interest rate charged on each loan, and the repayment terms and conditions of each loan.
Copies of all the loan agreements inclusive of amendments and supplements.
Schedules detailing the computation of capitalized interest under the avoided cost method sufficient to identify each unit of property produced, the criteria used to determine the unit of property, the estimated production periods by units, the actual production periods by unit, the accumulated production expenditures by unit, traced debt by unit, measurement dates used, computation period(s) used, accumulated production expenditures by unit, and excess expenditure amounts by unit.
Any and all Forms 3115 relative to the capitalization of costs of self-constructed assets and the capitalization of interest.
The date each project was placed in service.
If, under the UNICAP rules, certain cost centers were either not included by the retailer or appear to have been under-allocated, examiners should consider interviewing some of the employees in these cost centers to identify additional IRC 263A costs.
The information contained in the preceding sections is to provide agents a fundamental overview of the topics discussed. In addition, many technical discussions of self-constructed assets and interest capitalization can be accessed through both Lexis-Nexis and Westlaw research.
The IRC 263A Technical Advisors are available to both advise and assist agents with their examination both of self-constructed assets and interest capitalization issues.
An IRC 263A reference guide, IRC 263A Uniform Capitalization, Document 10822, Catalogue No. 25981E is available on IRS.gov.
This section provides general background information about vendor allowances reported by retailers and the general accounting practices for such allowances.
Trade programs are fundamental to many industries. Vendors use trade programs to promote and sell their goods. Vendors provide various types of allowances, credits and rebates to retailers through a variety of programs and arrangements to support the merchandise purchased for resale. These allowances often represent a significant percentage of a vendor’s total marketing budget and make an important contribution to a retailer’s profit margin.
Historically, the accounting treatment for vendor allowances among retailers has been inconsistent. As a general rule, the proper treatment for Federal income tax reporting is similar to financial reporting. In certain circumstances, however, an allowance may need to be reported as current income for tax purposes. Accounting for vendor allowances should follow the economic substance of the underlying transaction, which should be evidenced by an agreement with the vendor.
Is the vendor allowance an item of gross income, a trade or other discount, or a loan/deposit? (Characterization issue)
When is the vendor allowance includible in gross income? (Timing issue)
How is the vendor allowance allocated to ending inventory? (Allocation issue)
Treas. Reg. 1.61-3(a) defines gross income, in a merchandising business, as total sales less the cost of goods sold.
Treas. Reg. 1.471-1(c) provides that cost is the primary basis of accounting for inventory.
Treas. Reg. 1.471-3(b) defines the cost of merchandise, for inventory purposes, as the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate.
Treas. Reg. 1.471-3(b) provides that cash discounts approximating a fair interest rate may or may not be deducted from the invoice price at the option of the taxpayer, provided a consistent method is followed.
Treas. Reg. 1.471-3(b) provides that transportation and other necessary charges incurred in acquiring merchandise for resale are added to the net invoice price.
Not all allowances, discounts, and rebates received by a purchaser of goods constitute purchase price adjustments.
Treas. Reg. 1.451-1(a) states that the right to receive income is fixed at the earliest of required performance, the date the payment becomes due, or the date payment is received.
What did the parties intend and for what purpose or consideration was the vendor allowance provided to the retailer? Is the allowance intended to reduce a specified gross purchase price of goods to an agreed net price or to reimburse the retailer for a consideration separate from the purchase price of goods?
Where the purpose and intent of the parties is solely to reach an agreed upon net selling price, the allowance is properly viewed as an adjustment to the purchase price that reduces gross sales.
Where the allowance is contingent upon the performance of services by the retailer, the allowance is properly viewed as gross income.
When did the retailer recognize the vendor allowance in gross income?
Although it may appear that determining when an allowance is earned is simple, complications can result from the use of estimates, judgments, and differences between agreements and companies.
The determination of timing recognition can be difficult due to perceived intent, arrangement complexity, lack of adequate documentation, and issues regarding vendor viability.
Vendor allowances may be earned at the time the related goods are purchased, but received in the subsequent taxable year. The retailer should reduce the cost of inventory when purchased and not as a later year adjustment to cost of goods sold.
How did the retailer report the vendor allowance on its tax return?
A retailer can obtain a more favorable tax result by treating a vendor allowance as a reduction to inventory cost rather than an item of gross income.
What method did the retailer use to value ending inventory?
Treating a vendor allowance as a reduction in the purchase price is beneficial for retailers using the First-In, First-Out (FIFO) or Last-In, First-Out (LIFO) method.
For retailers using FIFO, the tax effect is relatively straightforward because the amount calculated is a direct reduction of ending inventory. Vendor allowances will affect the cost complement for various inventory pools for retailers using the retail inventory method (RIM).
For retailers using Retail-LIFO, allowances received for current purchases should flow through the income statement unless there is a current year increment. For vendor allowances included in a current year increment, a retailer obtains the benefit of indefinite deferral until a LIFO decrement occurs.
What evidence documents the terms and conditions of the arrangement?
Vendor allowance documentation varies by vendor, by retailer, and may depend upon factors such as the customer, the product, geography, and/or purchasing volume.
A retailer’s customary business practice may be formal (e.g. written agreements) or informal (e.g. verbal agreements). The Emerging Issues Task Force (EITF) 02-16 suggests formal contractual arrangements are the norm.
How did the retailer allocate vendor allowances, properly treated as trade or other discounts, to ending inventory?
Did the vendor or the retailer initiate the arrangement?
Whether an allowance represents a trade or other discount is a question of fact.
Neither the Internal Revenue Code nor the regulations define the term trade discount or other discounts. Rev. Proc. 2008-52 defines a "qualifying volume-related trade discount" (for purposes of a safe harbor accounting method change provision) as:
An allowance received or earned based solely upon the volume of the merchandise to which the allowance relates
An allowance that does not obligate nor expect the recipient to perform or provide services in exchange for the allowance
An allowance that does not reimburse expenses
Essentially, a trade discount is a purchase price adjustment or price rebate that a retailer receives with respect to goods that it has purchased for resale without regard to the time of payment for such goods. Implicit in the definition of trade discount, including volume or quantity reductions, is the concept requiring a nexus between the trade discount and the merchandise giving rise to the trade discount.
A volume discount is an allowance a retailer earns when the quantity, in terms of items or dollars of purchases relating either to specific products or all products, exceeds certain levels. For example, a retailer may earn an allowance equal to one percent of total purchases when the total purchase reaches 103 percent of last year's total. Vendors generally establish volume discounts based on projected or prior year sales rather than execution or profitability.
Retailers often receive cash payments or credits applied to future purchases from vendors for trade programs. In some situations, retailers may charge back vendors on open invoices through the accounts payable process. Allowances that are recognized in the income statement, but not yet received, may be reported as a vendor receivable.
Many retailers receive allowances in the form of a fixed percentage discount for purchases. Retailers usually account for fixed discount arrangements as a reduction of inventoriable product cost rather than a reduction of cost of sales or gross income.
Retailers typically have arrangements with more than one vendor and more than one arrangement with the same vendor. Many trade programs provide allowances for current and annual purchases of goods and performance or merchandising activities. Arrangements are typically negotiated between the vendor’s direct sale force/brokers and the retailer’s merchandising department (i.e. buyers).
Department store chains commonly receive salary credits for staffing certain departments and display allowances for providing space to promote a vendor’s image and goods. Apparel, cosmetic, and jewelry vendors frequently use display allowances to have their merchandise displayed in a unique format apart from their competitor’s merchandise.
Up-front payments in exchange for multi-year agreements to make future purchases of goods and slotting allowances are common in the operation of retail grocery, drug, discount, and auto parts stores.
Large retailers are in a position to negotiate favorable prices from suppliers.
The apparel industry is subject to the moods and whims of customers. Markdown allowances, sell-throughs, and charge-backs are common, particularly in the moderate priced market.
Most apparel does not sell at full price. Markdown money is a standard part of the apparel industry. In its most benign form, markdown money offers a way for vendors and retailers to share the inherent risks in doing business.
The trend toward trade promotion may be attributed to scanner technology that emerged in the 1980s. The technology provided data that clearly tracked the impact of price reductions. Consequently, trade promotion spending has increased significantly as a percentage of marketing budgets while advertising, which is hard to link to sales, has decreased.
EITF 02-16 provides guidelines standardizing the reporting of vendor allowances and improving transparency.
Guidelines presume cash considerations are an adjustment to the purchase price of inventory and included in cost of sales when recognized in the retailer’s income statement. Cash considerations include credits against trade amounts owed to the vendor.
Guidelines provide two possible exceptions to the presumption:
Allowances that reimburse a retailer for specific, incremental and identifiable costs incurred to sell a vendor’s product(s)
Allowances that reimburse a retailer for assets or services
The allowance is for assets or services
Up-front cash payments are typically reported as a deferred liability and recognized as income as a reduction of cost of goods sold usually over the longer of the contract term or expected customer relationship period.
A vendor allowance is an inducement or incentive made to a reseller (i.e. wholesaler, broker, or retailer) with the primary objective of creating an immediate sale.
Traditionally, vendor allowances have been divided into two groups: buying allowances and merchandising allowances:
Buying allowances are considered a reduction of the cost of products purchased, thus may be allowed as reductions of inventory cost.
Merchandising allowances, on the other hand, are characterized as part of the product’s selling price and reportable as gross income.
The two major categories of buying allowances are cash discounts and trade discounts.
A cash discount is a reduction in the invoice or purchase price for paying within a specified time period. For example, 2/10, net 30 means a 2% discount is granted to the retailer if payment is made within 10 days, otherwise the full invoice price is due within 30 days. Consequently, a cash discount is intended to speed payment and provide liquidity to the vendor.
One of two methods is used to account for cash discounts.
Under the gross method, the purchase price of merchandise is recorded at the full invoice price when the inventory is received and a corresponding accounting entry is made for accounts payable, again at the full invoice price. When payment is made in time to take advantage of the discount, accounts payable are debited for the full invoice price, cash is credited for the amount actually paid, and income is reported for the cash discount earned.
Under the net method, the purchase price of merchandise is reduced at the time of purchase for the amount of the potential cash discount. The reduction is made regardless of whether the discount offered is actually taken. Any cash discounts not taken advantage of are recorded as expense items.
A retailer may allocate cash discounts to ending inventory on a pro-rata basis or an average basis. Allocating cash discounts to ending inventory on a pro-rata basis will not provide for a clear reflection of income because the cash discounts will be allocated to items in inventory for which cash discounts either were not offered or were offered at a different rate. For example, if all the cash discounts taken are attributable to item A and ending inventory included only item B, then ending inventory should not be reduced by cash discounts because the cash discounts were not taken on any of the items remaining in ending inventory. Rev. Rul. 69-619 and Rev. Rul. 73-65 require the allocation of cash discounts to individual items on an invoice-by-invoice basis.
A trade discount is generally for volume or quantity purchases.
A quantity discount is a price reduction given for large purchases. The rationale for quantity discounts is to obtain economies of scale and pass some (or all) of the savings on to the retailer. A quantity discount typically takes one of two forms:
A cumulative quantity discount is based on the quantity purchased over a set period of time (e.g. calendar year).
A non-cumulative quantity discount is based on the quantity of a single order (e.g. full truckload). This price reduction is intended to encourage large orders and reduce the vendor’s administrative costs (e.g. billing, shipping).
The contractual terms establish the basis for the amount of the allowance. The allowance is generally stated as a percentage of goods purchased by the retailer. In some situations, this allowance is provided as a lump-sum cash payment to the retailer in advance of its purchases. Alternatively, the allowance may be based on the retailer’s sell-through of goods to its customers or the allowance may be based on the goods on hand in the retailer’s stores or distribution centers as of a certain date.
The IRS requires retailers to use the actual amounts rather than estimates or average amounts for discounts earned. The IRS’s position is contrary to a fairly prevalent practice for retailers that use the net method of accounting for cash discounts. Under the net method, a retailer does not adjust the purchase cost of goods for the amount of cash discount offered at the time the purchase is recorded in the inventory ledger. Instead, the purchase is recorded at the gross purchase price and the cash discount is simply accumulated in a separate cash discounts account. At the end of the year, a retailer compares the aggregate level of cash discounts offered to goods purchased throughout the year and reduces ending inventory by this same percentage.
A merchandise display allowance is an incentive offered to a retailer to provide space and assets to display a vendor’s products. Display space is designed to be unique and project a particular image of the vendor and the vendor’s products. The design, layout and signage in this area are generally based on the vendor’s specifications. Display fixtures are defined to include, but are not limited to, shelving, racks, display cases, free-standing display units, decorative items such as track lighting, and upgraded ceilings, walls and floors.
Retailers typically pay the full cost of the fixtures or build-outs up front and then provide the vendor with documentation in order to receive reimbursement. As an alternative, some vendors provide fixtures to retailers rather than reimbursing retailers for these costs. The incentive usually offsets all or a portion of the costs incurred by retailers to provided upgraded space improvements and fixtures to display the vendor’s products. Retailers generally own the assets, pay personal property taxes on the assets, and insure the assets.
Retailers usually record cash allowances for merchandise displays as a reduction to the bases of the acquired assets for both book and tax reporting purposes. Under this method, such allowances are recognized as gross income as a reduction to depreciation expense over the lives of the assets.
Historically, the primary issue for display allowances is when such allowances are includible in gross income. Whereas retailers generally take the position that these allowances reduce the bases of the acquired assets, the IRS takes the position that these allowances represent gross income.
The examiner should consider the following audit steps to identify display allowances:
Review vendor payables for debit entries and vendor receivables for credit entries
Review asset and depreciation records for assets with negative bases or credits reducing the bases of specific assets
Review cost segregation studies, particularly the indirect cost section, for allowances associated with a new store opening or a major remodel
If an allowance does not possess a sufficient nexus to the purchase of goods, it may be a payment for some unrelated purpose such as the purchase of services or reimbursement of expenses. Under this circumstance, the character of the allowance depends upon the nature of the payment.
A trade or other discount is distinguished from a performance allowance that must be treated independently in that the purpose of a trade or other discount is to reduce the purchase price of the goods whereas a performance allowance is intended to cover a separate consideration. Like trade or other discounts, performance allowances are typically computed as a percentage of goods purchased by a retailer. The increasingly complex nature of trade programs in the retail industry often makes the determination more difficult to distinguish one from the other.
Common examples of performance based allowances in the retail industry are cooperative advertising and salary (payroll) credits.
Cooperative advertising is an arrangement by which advertising costs are shared by two parties. In this type of an arrangement, a product or service is advertised using the names of both a vendor and a retailer.
Many retailers participate in cooperative advertising programs with multiple vendors to obtain reimbursement for a portion of the advertising costs incurred to promote their goods sold in their stores. For retailers, cooperative advertising allowances subsidize qualifying advertising and similar promotional expenditures related to a vendor’s product that they normally would not undertake without vendor support.
Agreements generally stipulate:
Advertising media to be used
Conditions relative to the advertising of the specific product
Vendor’s name and logo usage
When the advertising is to be performed
Size or length of advertisement
Amounts to be paid or credited to the retailer
Agreements may be negotiated by the retailer’s buyers or its advertising department personnel.
Vendors usually require a retailer to file a claim for reimbursement. The purpose of the claim is to ensure proof of the retailer’s performance. Documentation to substantiate that the vendor’s advertising criteria were met generally consists of the advertiser’s invoice to the retailer and actual copies of the ads (ad tear sheets). Large retailers, however, may not be required to submit claims for reimbursement.
A vendor’s reimbursement for cooperative advertising costs may be a fixed amount, or a percentage of purchases or advertising costs. Fixed reimbursement rates are commonly around 50 percent, but can be higher. Under an accrual program, credits accumulate as products are purchased or are volume-based. A typical accrual percentage is around 5 percent of net purchases. Allowances will sometimes fluctuate according to the volume of purchases. The rules and policies generally vary by advertising arrangement and by vendor. The reimbursement process may take weeks or months.
A retailer typically pays the full amount of the advertising up front, and then provides the vendor with documentation in order to receive reimbursement. In lieu of cash reimbursement, a vendor may issue credit for future purchases or reduce a retailer’s outstanding receivable.
The primary audit consideration for cooperative advertising is whether such allowances were reported as gross income or as a reduction to the purchase price of merchandise. For example, a retailer receives cooperative advertising funds from a vendor to place a certain product in its weekly circular. Under EITF 02-16, although the advertising cost can be specifically identified, the allowance is not considered to be incremental because the retailer would have sent the weekly circular regardless of whether the vendor’s advertisement was included. Accordingly, for book purposes, this amount would be treated as a reduction of inventoriable product cost.
A secondary audit consideration is when the allowances were included in gross income. An accrual method retailer’s right to a cooperative advertising allowance is generally fixed when the advertising is performed and not at the time documentation is provided to the vendor or when payment is received.
A salary or payroll allowance is an incentive offered to a retailer to provide more space and sales staff dedicated to promoting the vendor’s product. The allowance is intended to cover a portion of the cost of in-store representatives. Certain marketing considerations, such as counter space, product placement, staffing and pay incentives must be met to qualify for the credit. Contracts are generally written, multi-year agreements. This type of allowance is common in the department store industry in general and in the cosmetic and jewelry departments in particular.
The allowance is usually based on a percentage of actual or projected sales of the vendor’s products rather than a percentage of products purchased. Alternatively, the allowance may be based on a percentage of certain employees’ salaries.
The primary audit consideration is whether such allowances were reported as gross income or as a reduction to the purchase price of merchandise. The IRS takes a position that these allowances are provided to a retailer for the provision of services. Specifically, extra marketing costs to promote and sell a vendor’s products. Thus, these allowances represent gross income under IRC 61.
Some retailers receive up-front cash payments from vendors in exchange for a commitment to purchase a targeted volume over a period of time or to remain a customer for a specified period of time. These arrangements may grant the vendor the status of exclusive or primary supplier. In addition to the future purchase of goods, the arrangement may require the retailer to provide certain marketing services. Certain categories of goods, such as spices, greeting cards and batteries are typically associated with these multi-year agreements. While the agreement may provide the retailer with the unrestricted use of the cash payment, the agreement usually provides that the retailer must return pro rata amounts if it does not fulfill its purchase obligation.
Retailers usually record up-front cash payments on their books as a liability when received. Retailers recording the up-front cash payment as a liability recognize income on the books as purchases are made to satisfy the volume commitment. Retailers generally record the earned portion as a reduction to cost of goods sold.
Historically, the primary issue associated with this type of allowance is when the cash payment is includible in gross income. Retailers generally characterize the cash payments as advance trade discounts and offset inventory costs under Treas. Reg. 1.471-3(b). Retailers may also take the position that the up-front payments are in the nature of loans or deposits from the vendors that must be repaid if the terms of the agreement are not met and, thus, do not constitute gross income upon receipt. Conversely, the IRS has taken the position that the cash payments represent gross income as payment for the exclusive right to supply the retailer with goods of a specific type. The IRS also has taken the position that since the retailer alone controls whether or not the prerequisite purchases are made, the payments are an accession to wealth, clearly realized, and over which the taxpayer has complete dominion and control.
Rev. Proc. 2007-53 provides a safe harbor that allows the deferral of qualified advance trade discounts. To the extent a retailer meets the five conditions in the revenue procedure, the character of the up-front cash payments should not be in dispute. The five conditions are:
The payment is a commitment to purchase a minimum amount of merchandise.
The purchase period is 5 years or less.
The payment is intended to discount the purchase price of the merchandise.
The retailer is obligated to repay all or an allocable portion of the payment if the purchase commitment is not met.
The retailer does not treat the payment as a payment for services in its financial statement.
The examiner should consider the extent to which the agreement obligates the retailer to perform or provide cooperative advertising services. Rev. Proc. 2007-53 excludes up-front cash payments designated for this purpose. The examiner should also consider whether the terms of the agreement exceeds 5 years. If so, the retailer is not protected by this administrative relief.
The primary purpose of slotting allowances is to enhance a product’s visibility at the retail level. Vendors pay slotting allowances for the right to secure, expand, and retain a position on retail store shelves and, in some cases, limit shelf space available to competing products. In its most basic form, a slotting allowance is an incentive, generally in the form of a one-time, up-front payment, to a retailer to introduce a new product and to obtain space for such product in a retailer’s stores and warehouse. Several permutations of the basic form exist, including:
Eye-level shelving, end caps, special displays (premium product placement fees)
Expanded shelf space (facing allowances)
Retaining shelf space (pay-to-stay allowances)
Retailer costs to remove and dispose of discontinued product from shelf space (failure or exit fees)
A slotting allowance for a new product is generally made on a per-item, per-store, and per-metropolitan area. The actual amount of a slotting allowance varies by product category and company. Several factors such as a vendor’s track record, a retailer’s size, market size and location, and shelf size and location contribute to the actual amount of a slotting allowance.
Many retailers record slotting fees as a reduction to cost of goods sold. Some immediately record the allowance in whole, some amortize the allowance into income over a period of time and some apply the allowance directly to reduce the cost of specific items (e.g. SKU, UPC), product categories, or departments.
The primary audit consideration is when such allowances were reported as gross income. A retailer should include a slotting allowance as income, assuming a fixed right to receive income exists, at the earliest of when it is received, due, or earned, whichever occurs first. A vendor can deduct the entire payment in the year made under IRC 162.
Traditional retailers must carry an inventory of merchandise in order to meet uncertain demand. Uncertain demand, in certain situations, contributes to retailers holding either too little or too much inventory for certain merchandise. When demand falls short of expectations, retailers hold an inventory of unwanted merchandise at full retail sales price. A retailer must mark down the full retail sales price in order to dispose of the merchandise.
Vendor trade programs may offer some form of guarantee to address the possibility that certain merchandise may not sell as well as expected. A margin protection or markdown participation allowance is one form of guarantee to address this potential situation. A margin protection allowance is an incentive offered to a retailer to reimburse the retailer for shortfalls in the sales price received by the retailer for the vendor’s product. This allowance provides a retailer with gross margin protection during times of heavy promotion and markdowns to move slow-moving or outdated merchandise, or to increase sales of a particular product. In all of these situations, the allowance affects the price for which the inventory is actually sold and essentially shifts much of the risk from the retailer to the vendor.
Markdown allowances are generally negotiated at the time the product is purchased. These allowances, however, may be negotiated after the initial purchase. Such an allowance may be demanded as a concession by large retailers, and if this is the case, the terms may appear on their purchase orders.
Margin protection allowances do not present a tax issue under the LIFO method since inventory is valued at cost. Cost should be reduced by the amount of allowance under the invoice cost method to reconcile with the lower of cost or market adjustment. The allocation should be made on an item-by-item basis, not a vendor-by-vendor basis.
The examiner should consider margin protection allowances when the retailer uses the RIM-FIFO-LCM method. Under this method, the acquisition cost, not the retail selling price of merchandise, is reduced by the allowance. The net tax effect is that the inventory value is reported below cost and market value.
Unsaleable goods will always exist in the retail industry due to defect or damage. Defective or damaged merchandise is merchandise that does not conform to a retailer’s sales-floor ready requirements. Situations may involve poor fit or quality, shipment of the wrong size or color, imperfections or shortages. Other goods are unsaleable and taken off the retail shelf due to expiration or discontinuation.
Retailers accepting defective or damaged merchandise usually demand some kind of compensation from their vendors. A conflict may arise between a retailer and vendor over the retailer’s compensation for unsaleable goods.
A common vendor approach to compensation for defective merchandise emphasizes a credit, usually stated as a percentage of purchases, to cover the cost of defective merchandise and the related handling costs. Retailers deduct the percentage allowance off each invoice. Under the terms of this arrangement, a retailer is prohibited from filing additional claims for defective merchandise. The retailer either destroys the defective merchandise or disposes of it through alternative distribution channels.
This type of allowance generally relates to the original purchase transaction so as to constitute a trade or other discount.
Retailers usually deduct the percentage allowance off each vendor invoice, reducing the cost of all items in inventory by the amount of the defective merchandise allowance.
For large retailers, this type of an allowance is negotiated at the time the goods are purchased. Proper tax treatment for this permutation is under consideration.
In a typical sales-based arrangement, a vendor agrees to reimburse a retailer for offering a temporary reduced selling price on certain product during a short-term promotional period. The retailer receives an amount based on the specific units of product sold during that period. In theory, the consumer directly benefits from this type of allowance by way of a reduced price for the product. The unique feature of this type of an allowance is that it is based on the sell-through of the goods by a retailer to its customers rather than its purchase of goods from the vendor.
The emergence of scanner technology in the 1980s contributed to the trend toward promotional discounts. This technology provided retailers and vendors with data that clearly tracked the impact of price reductions by comparing stores that offered promotions against stores that did not.
A sales-based arrangement provides a vendor with certain advantages over traditional purchased-based allowances, including a reduced incentive to forward buy (i.e. retailers are only paid for items sold within the specified period) and a simpler accounting model because the retailer does not earn promotional dollars on products remaining in inventory at the end of the period.
The proper tax treatment of sales-based allowances is uncertain due to the lack of published guidance. Applying advice provided in several revenue rulings on tax rebates for previously paid federal excise taxes with respect to floor stocks of tires, a position can be made that sales based allowances constitute gross income because they relate to product that has already been sold. If the examiner encounters this issue, he/she should determine if published guidance has been issued since the publication of this Internal Revenue Manual section.
The examiner should establish what evidence exists to document the arrangement between the retailer and its vendors. Formal written documentation may consist of a retailer’s master agreement (if initiated by retailer), purchase orders, side letters, electronic communication, or a vendor’s master agreement (if initiated by vendor). The source and type of documentation will affect its persuasiveness.
The examiner should consider the following techniques to identify, develop, and resolve any issues.
Review public information, including the following:
Review tax return information, including the following:
Other Current Liabilities for Deferred Income
Schedule M for book/tax reporting differences
Request and review from the taxpayer certain documents, including:
A list of vendors that provided allowances
A description of the particular types of allowances received and the coding used in the taxpayer’s records to identify the type of allowance
Identification of the general ledger accounts and standard journal entries used to record allowances
Identification of the time allowances are recorded – when earned or when paid
Retailer's written policies and practices
Internal Audit Reports
Written agreements substantiating the terms and conditions of sampled arrangements. Examples of such agreements include: (1) Retailer's or Vendor's Master Agreement; (2) Memorandum of Understanding; (3) Offering or Deal Sheets; (4) Purchase Orders; and (5) Electronic Communication.
Review account detail
Credits to vendor payables and inventory accounts
Credits to asset basis records
Interview buyers or other appropriate personnel who have first hand knowledge of vendor allowances.
Observe for any unique presentation of merchandise for certain vendors
Observe the placement and prominence of certain goods on shelves and other display fixtures. Such observances can provide certain insights. For example:
If an individual greeting card vendor has over 90% of the shelf space, it is more likely than not the retailer received an allowance.
If a single vendor occupies a significant space displaying fixtures promoting its image, it is more likely than not the retailer received an allowance
Consider a statistical sample.
Use a statistical sample of reductions in the purchases account to identify vendor allowances treated as trade discounts.
Small and medium-sized closely held businesses may report little or no vendor allowances.
Consider the possibility of unreported allowances for small and medium retailers or where internal controls are lacking.
Consider making third-party vendor contacts if circumstances warrant.
This section provides additional information on vendor allowances
Retailers employ many buyers, assistant buyers, and other employees (i.e. merchandising employees) that are involved with the purchase of merchandise. Merchandising employees are generally organized into merchandising divisions with responsibility for one or two departments at a store.
A primary responsibility of merchandising employees is the negotiation of terms for items selected for purchase. Merchandising employees are responsible for assuring that the merchandise to be acquired can be sold at a retail price that will generate the targeted profit percentage. Buying and merchandising decisions are influenced by vendor allowances. In most transactions, vendor allowances, discounts, and rebates are offered or demanded as part of the overall negotiated price.
Buyers are also responsible for determining and recording the reason for each cost concession. The details of the negotiated agreement will be entered into the product data records or maintained by the buyer. It is in the retailer’s best interest to monitor its progress in earning incentive allowances and rebates to ensure that all potential recoveries are earned.
Globalization of the world economies in general, and more specifically, the impact of China, India, and other developing economies, will require buyers to gain knowledge of the rules and regulations of various different governments in the countries in which they do business or have supply partners.
A change in the treatment of vendor allowances is considered to be a change in method of tax accounting which generally can be made only with prior IRS consent. For example, changing from including vendor allowances in gross income to deferring its recognition through a corresponding reduction to inventory cost represents a change in accounting method. An adjustment under IRC 481(a) should be reported reflecting the cumulative effect of the method change.
Rev. Proc. 2008-52, Appendix § 21.04 provides an automatic consent procedure for certain volume-related trade discounts. Request for permission must be filed by the due date of the tax return. Certain requirements must be met in order to qualify for this procedure, including the following.
The reseller must receive the monies solely upon the purchase of a particular volume of the merchandise.
The reseller must be neither obligated nor expected to perform or provide any services in exchange for the monies.
The monies must not be a reimbursement of an expenditure incurred or to be incurred by the reseller.
In an over-billing arrangement, a retailer requests that a vendor issue an invoice for more than the purchase amount. The vendor invoice typically bills the retailer for goods in an amount that exceeds the actual price of the goods by an agreed upon percentage. The over-billed amount is charged to purchases.
The retailer may use the over-billed amount in two ways. The retailer can request a check as repayment for the over-billed amount or the retailer can use the over-billed amount by taking a deduction off a subsequent invoice (i.e. the retailer initiates a credit memo that accompanies a payment to the vendor).
Vendors record the over-billed amount by debiting accounts receivable and crediting both sales (for the correct purchase price) and the over-billed liability account.
A retailer that debits the full invoice amount as a purchase and does not account for the over-billed amount until it initiates a memo to the vendor overstates purchase and is not reporting taxable income correctly. To the extent the over-billed amount is not used until a subsequent taxable year, the result is an overstatement of purchases in the year paid.
Retailers have a system to track over-billing. The initial over-billing policy/procedures letter, generally prepared by the retailers finance department, is provided to the vendor by the purchasing department.
An information document request can be issued to request a description of the over-billing tracking procedures and the policy/procedures letter provided to the vendor. An interview of purchasing and finance department personnel will also assist in obtaining information relating to over-billing procedures.
Vendors are often willing to provide incentives to secure shelf space in retail stores. While incentives are typically reserved for the retailer itself in the form of slotting allowances, the practice of guaranteeing shelf space through gifts or direct payments to a buyer is possible.
Meals and entertainment are normal business interactions, but when the financial benefit becomes extravagant, like a vacation to Hawaii, it overcomes the rational business decision. The buyer is making decisions based on the magnitude of his/her financial gain and not the merits of the product.
Globalization is likely to lead to an increase in these situations since kickbacks are common in some countries. While a payment in the United States is illegal, the payment may not be illegal in other parts of the world.
This section provides general background information about tangible assets and depreciation items reported by retailers and the general accounting practices for such items.
Tangible assets have physical substance and are easily identified. Tangible assets include land, land improvements, buildings, leasehold improvements, inventory, and equipment.
Retailers generally have significant investments in property and store-related assets. Consequently, for retailers, the depreciation deduction for tangible property plays a significant role in the computation of taxable income.
Is the expenditure an ordinary and necessary business expense or a capital expenditure?
If the expenditure is a capital expenditure, is the recovery period assigned to the expenditure proper?
If the recovery period assigned to the expenditure is proper, is the computation of the depreciation deduction proper?
IRC 162 allows a deduction for ordinary and necessary expenses paid or incurred in carrying on a trade or business.
IRC 263(a) disallows a deduction for any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property.
IRC 263A and its regulations provide guidance regarding the required capitalization of certain costs. Self-constructed assets are assets produced by a taxpayer for use by the taxpayer in its trade or business and are subject to IRC 263A. Costs that are capitalized under IRC 263A are recovered through depreciation, amortization, cost of goods sold, or by an adjustment to basis at the time the property is used, sold, placed in service, or otherwise disposed by the taxpayer.
IRC 165(a) allows a deduction for any loss sustained during the taxable year. Under Treas. Reg. 1.165-1(b) an IRC 165(a) loss must be evidenced by a closed and completed transaction and fixed by identifiable events.
IRC 167 explicitly allows, as a current expense, a depreciation deduction that represents a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) of property used in a trade or business. See Treas. Reg. 1.167(a)-1
IRC 168 specifies the rules for the depreciation deduction allowed by IRC 167(a) for most tangible property. The Modified Accelerated Cost Recovery System (MACRS) applies to most tangible property placed in service after 1986. Under MACRS, the depreciation deduction is computed using a prescribed depreciation method, recovery period, and convention.
IRC 1221 defines a capital asset as any property held by a taxpayer, whether or not held in connection with a trade or business. One of the exceptions to this definition is depreciable and real property used in a taxpayer’s trade or business.
IRC 1245 property generally is personal property, or other tangible property (except a building and its structural components) used as an integral part of manufacturing, production, extraction, or the furnishing of transportation, communications, electrical energy, gas, water, or sewage disposal services. Gain on the disposition of IRC 1245 property is ordinary income to the extent of depreciation recapture on the property.
IRC 1250 property is any real property (other than IRC 1245 property) that is or has been property subject to a depreciation allowance. For property held by the taxpayer for less than one year, gain on the disposition of IRC 1250 property is ordinary income to the extent of depreciation recapture on the property. For property held by the taxpayer for at least one year, gain on the disposition of IRC 1250 property is ordinary income in an amount equal to the difference between the depreciation allowance for the property and the depreciation allowance that the taxpayer would have taken if the taxpayer had used the straight-line method.
Capitalization, depreciation and clear reflection of income are inextricably intertwined with the ultimate question being the success of the taxpayer’s method of accounting in clearly reflecting income.
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.
A large amount of case law addresses whether some expenditures are currently deductible under IRC 162 or must be capitalized under IRC 263(a). It is not uncommon to encounter situations with very similar fact patterns that arrive at very different conclusions. Consequently, the particular facts involved in each case receive significant attention.
IRC 168(c) and Rev. Proc. 87-56 provide recovery periods for fixed assets. Many nonrealty assets used in the retail industry fall under Class 57.0 Distributed Trades and Services of Rev. Proc. 87-56.
Asset classification is a facts and circumstances assessment. Tests developed under prior law for investment tax credit purposes can be used to distinguish IRC 1245 property from IRC 1250 property for depreciation purposes under MACRS. Allocations must be based on a logical and objective measure of the portion of equipment that constitutes IRC 1245 property.
Tax depreciation recovery periods and methods have important implications for the cost of capital and for capital expenditures in particular types of capital assets.
Capital expenditures for tangible property are recovered through depreciation allowances. The current-law cost recovery allowances assume that assets wear out at a specified rate over time. This rate is independent of the actual or expected economic conditions facing each taxpayer.
MACRS bases cost recovery allowances on specified time periods. It does not take intensity of use into account for purposes of determining the depreciation amount. Consequently, many assets may actually depreciate faster or slower than the MACRS-specified time periods, depending on how intensively they are used.
Current law contemplates that sufficient records be kept on an asset-by-asset basis in order to determine the amount of gain or loss to be recognized if an asset is disposed of prior to the end of its recovery period. Different lives and methods are commonly used for financial and tax reporting purposes. In addition, different lives and methods may be used for regular tax and AMT purposes. Consequently, most of the administrative burden associated with the current law relates to record keeping requirements.
Site selection is critical in making a retail store profitable. A good location draws traffic, which is essential to generating sales.
Once a retailer has chosen its sites, it may either lease its stores or purchase (own) them. The decision to buy or lease is made based on the cash flows that each choice confers.
Large retailers generally build their own stores from the ground up. They usually lease the land to preserve capital for future expansion. Large retailers may receive landlord incentives to open an anchor store (See IRM 188.8.131.52 for more information on leases and Landlord Incentives).
Retailers typically make significant investments in the form of leasehold improvements when leasing space in a shopping center. The improvements are needed to build out the space to their own specifications. In many situations, the landlord will pay for all or part of the build-out costs.
Retailers renovate and update their stores (owned and leased) to meet the changing tastes of consumers and to comply with state and local building, health, and safety codes. Most retailers remodel and update their stores every five to ten years.
Statements of Financial Accounting Standards (SFAS) # 6 defines tangible assets as:
Having an estimated useful life of 2 or more years,
Not intended for sale in the ordinary course of business, and
Intended to be used or available for use by the company.
Tangible assets are:
Stated at cost, including items funded with landlord construction allowances,
Depreciated primarily using the straight-line method over the estimated useful lives of the assets. Buildings are estimated to have useful lives of 40 years. Furniture, Fixtures, & Equipment are estimated at 5 years. Computer Equipment and Software are estimated at 3 to 5 years.
Depreciation expense is included within Selling, General and Administrative (SG & A) expenses.
Leasehold improvements are:
Recorded at their gross cost, including items funded with landlord construction allowances
Depreciated on the straight-line method over the shorter of their useful lives or related lease terms
Landlord incentives used to build out leased space are:
Recorded as a deferred liability
Amortized as a reduction of rent expense over the initial lease term
Financial Accounting Standards Board (FASB) #144, Accounting for the Impairment or Disposal of Long-Lived Assets.
Assets are written down to fair value
This section covers various tangible asset and depreciation issues.
Tangible Personal Property Treas. Reg. 1.48-1(c) provides that tangible personal property includes all property (other than structural components) which is contained in or attached to a building. The following property constitutes tangible personal property for purposes of the credit:
Transportation and office equipment
Display racks and shelves
Neon or other signs, which is contained in or attached to a building
Definition of Building Treas. Reg. 1.48-1(e)(1) provides the term building generally means any structure or edifice enclosing a space within its walls, and usually covered by a roof. The purpose of the building is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. The term includes, for example, structures such as:
Factory and office buildings
Railway or bus stations
Definition of Structural Components Treas. Reg. 1.48-1(e)(2) provides that the term structural components includes such parts of a building as:
Walls, partitions, floors and ceilings, as well as any permanent coverings therefore such as paneling or tiling; windows and doors
All components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts
Plumbing and plumbing fixtures, such as sinks and bathtubs
Electrical wiring and lighting fixtures
Escalators, and elevators, including all components thereof
Other components relating to the operation and maintenance of a building
Classification criteria under MACRS depend on an asset's class life and whether the asset is IRC 1245 property or IRC 1250 property.
In computing the depreciation deduction, this distinction is important in determining whether certain real property is considered to have a class life. It is particularly important in the area of building depreciation.
Buildings and their structural components have an assigned recovery period. Residential rental property (as defined in IRC 168(e)(2)(A)) is depreciated over 27.5 years using the straight-line method and nonresidential real property (as defined in IRC 168(e)(2)(B)) is depreciated over 39 years using the straight-line method.
IRC 1245 property, if assigned a 5-year recovery period, for example, is depreciated using the 200-percent declining balance method.
If the timing of an asset’s cost recovery is accelerated, the present value of the depreciation deductions for the asset will change. A taxpayer obtains a tax benefit if tax deductions can be accelerated. Consequently, some taxpayers conduct cost segregation studies, which itemize the hundreds or thousands of individual elements used in constructing a building and distinguish which elements may be classified as IRC 1245 property and which elements are IRC 1250 property.
Local law definitions generally are not controlling in cost segregation studies. For example, a certain building fixture may be considered real property under local law, but unless this fixture is considered a structural component under Treas. Reg. 1.48-(e)(2), it constitutes IRC 1245 property for federal income tax reporting purposes.
Rev. Proc. 87-56 sets forth the class lives of property that are necessary to compute the depreciation allowances under IRC 168. The revenue procedure establishes two broad categories of depreciable assets:
Asset classes 00.11 through 00.4 consist of specific assets used in all business activities.
Asset classes 01.1 through 80.0 consist of assets used in specific business activities.
The same item of depreciable property can be described in both an asset category (that is, asset classes 00.11 through 00.4) and an activity category (that is, asset classes 01.1 through 80.0). In such a case, the item is classified under the asset category.
Asset class 57.0 of Rev. Proc. 87-56 includes IRC 1245 assets used in wholesale and retail trade, personal and professional services, and IRC 1245 assets used in marketing petroleum and petroleum products. Assets in class 57.0 have a recovery period of 5 years for purposes of IRC 168(a).
For equipment, the recovery period depends either on the type of asset or the specific industry. Certain assets, such as computers, office furniture, fixtures, and equipment, and cars and trucks are assigned the same recovery period in all industries. To a large extent, however, the current depreciation system is industry-based rather than asset-based. Most investments in equipment are assigned a recovery period that depends on the specific industry.
All costs related to fixed assets must be accumulated, capitalized, and written down through depreciation/amortization deductions according to the type of fixed asset.
No depreciation is allowed for land. Office buildings are depreciable over 39 years. Furniture, fixtures, and equipment (i.e. retail trade assets), used in retail stores and not described in asset classes 00.11 through 00.4 of Rev. Proc. 87-56 are depreciable over personal property lives.
Virtually all retailers use a computerized fixed asset record system to track an asset from the date it is placed in service until its disposal date.
Fixed asset records may be substantiated by only an invoice or a complicated trail may exist with allocation studies, drawings, bid proposals, and planning documents to tie back to invoices. More complex trails tend to be the result of new construction or a major remodel of an existing store.
Both hard copy and computer records should be available for each asset placed in service. Detailed asset records should be obtained in a computer format which can be converted into a database or spreadsheet form. The examiner will gain efficiency and the flexibility to sort and perform a segmental analysis by asset description, asset class, location and other categories. Computerized records also facilitate statistical sampling techniques.
Typical types of tangible assets are described below.
Land is the primary component of real property. The examiner should consider the environmental liabilities for a site including leaking underground storage tanks, conservation easements, and pollution cleanup requirements. This is especially true with former gasoline station sites and former warehouse/industrial facilities which have been converted to retailing.
Land improvements (other than buildings) include utilities, site lighting, parking lots, roadways, walkways, walls, fences, and landscaping if they are depreciable. Depreciable improvements may constitute IRC 1245 property or IRC 1250 property.
Building values are probably the easiest to review and verify.
Leasehold Improvements are made to leased property and typically include structural components such as walls, wallpaper, floors, suspended ceilings, and lighting and usually revert to the landlord at the end of the lease. See IRM 184.108.40.206.
Equipment constitutes most of the tangible personal property and includes store furniture and fixtures such as display racks and shelves. An examiner should consider using a judgment or statistical sample when reviewing equipment because of the large number of items in a retail store. This may be accomplished by examining select locations or particular categories of asset types. Typical asset types for general retailing include shelving, show cases, gondolas, counters, display cases, racks, tables, mirrors, checkouts, computers, and POS equipment. At distribution centers, asset types include dock equipment/levelers, racks, conveyors, forklifts/lift trucks, battery chargers, and computers.
A retailer's assets are assigned class lives and depreciation is computed using MACRS.
Generally, a retailer’s tangible personal property is either: 1) 5-year property under MACRS asset classes 57.0, Distributive Trades and Services, 00.12, Information Systems, 00.13, Data Handling, or 00.241/00.242, Trucks; or 2) 7-year property under MACRS asset class 00.11, Office Furniture, Fixtures and Equipment.
A common issue is whether an asset identified as tangible personal property and is described in both Class 57.0 (an activity category) and Class 00.11 (an asset category) is 5-year property under Class 57.0 or is 7-year property under Class 00.11. The decision is based entirely on the asset’s inherent nature. For example, if a table is used on the retail floor for display or for cutting material and can also be used in the store manager’s office, then it is 7-year property under Class 00.11. However, if a table can only be used on the retail floor for display or cutting material, then it is 5-year property under Class 57.0.
A retailer's land improvements are either: 1) 15-year property under MACRS asset class 00.3 -- Land Improvements; or 2) 39-year property which is specifically assigned to nonresidential real property (IRC 168(e)(2)(B)), including elevators and escalators.
For leasehold improvements, lessees are treated as any other owner for the purpose of determining MACRS deductions for a lessee's improvements subject to MACRS rules. Thus, a lessee's deductions for the property are determined without regard to the lease term, (IRC 168(i)(8)). This means that the lessee depreciates property over its MACRS recovery period even if the lease term is shorter or longer.
If the lease terminates before the end of the MACRS recovery period for the lessee’s improvement, and the lessee does not retain the improvement, the lessee has a gain or loss for the remaining unrecovered basis of the property on the lessee’s tax records. The remaining basis of the unamortized leasehold improvements that are left behind is a deductible loss. A gain would arise if, for example, the tenant is paid to terminate the lease and the payment exceeds the basis of the leasehold improvements, including lease acquisition costs, if any.
Bonus depreciation may be applicable in certain tax years.
The Economic Stimulus Act of 2008 provides a 50-percent additional first-year depreciation deduction for most new depreciable personal property acquired and placed in service in 2008.
Examiners should verify eligibility (e.g., placed-in-service dates.)
Temporary provision for accelerated depreciation for business property on Indian reservations.
IRC 168(j) provides special recovery periods.
May be extended in periodic "extenders" bills.
Land is not a depreciable asset. Rather, the cost to acquire land is capitalized. The cost basis is recovered upon its sale.
Although land is not depreciated, certain improvements made to land can be depreciated.
When there is a close connection between the grading and clearing of land and other depreciable assets, the costs of grading and clearing have been held to be depreciable.
The allocation of costs between depreciable land improvement costs from other expenditures that are not depreciable can be a difficult issue.
Selections for store sites are critical for retailers who rely on customer traffic.
After the location is determined, size, design, layout, and ownership are among the decisions to be made.
Retailers continuously analyze customer information to determine who the customers are and what merchandise they want to purchase. Profiles include:
Age, sex, family composition
Personal and family income
Frequency and average total dollar purchase
Distance from residence or work to retail outlet
Whether the trip to the store was a destination stop or an impulse visit
When the retailer decides to expand, the customer profile will be an important tool used in identifying future locations. Whether in the same city or in a different geographic area, a retailer will attempt to locate sites which have the most potential customers and which will best suit the customers' needs. Generally, the primary needs of a customer relating to location are accessibility and convenience.
Various sources of information are available to identify future sites, including:
Larger retailers may have a department involved in store expansion.
Consultants may be hired to select areas and identify available sites.
Publications containing details of demographics of specific geographical areas and existing retail activity in those areas may be reviewed.
Existing and potential development restrictions, street and other access information will be secured from local governmental units.
After a site is selected, a purchase or an option to purchase is made.
A number of tests on the land and a study of traffic flow will be performed.
If the site proves to be unsatisfactory or a better site is procured, the land may be sold or the option to buy will be allowed to expire.
If the retailer has purchased more land than is needed, the excess, sometimes called "outlots" will be sold.
Land site development costs should be capitalized including:
Studies done for a particular site including soil tests for construction suitability
Environmental studies to identify potential site cleanup costs
Asbestos studies to assess liabilities from existing properties
Salaries and other costs of the internal staff (e.g., legal, engineering and planning) who work with these studies
Identification of the studies can be found by a review of accounts payable, particularly in legal and professional accounts
Larger retailers are approached by developers who want the retailers to commit to new shopping areas being planned. Anchor store incentives may be offered for a retailer’s agreement to be part of the development. Incentives can include:
Land for free or for a reduced price
Monies provided by the developer to construct all or a portion of the store
Construction of the store by developer and lease to the taxpayer for a below market rate
The selection process for a warehouse or distribution center site differs from store sites. The important aspects are:
Convenience of the location for possible rail shipments and incoming truck deliveries, and
Proximity of outgoing distribution to all of the retail outlets serviced by that facility.
After the retailer conducts site studies and purchases the land, the design and construction phase will commence.
A significant amount of time and money is invested in each project before construction actually begins.
Permits and approvals must be secured from the community or governmental agencies.
The building shell and interior layout will be designed and redesigned.
A facade appropriate for the immediate area will be developed.
Permanent financing must be arranged.
The project will be let out for bids and contractors will be selected.
Fixtures and furnishings must be selected and ordered for an appropriate delivery date.
Grand opening dates must be targeted.
During the construction period, progress is closely monitored for quality and timeliness and stock in trade must be selected and ordered.
Large retailers who continuously expand enjoy certain economies which save both time and money. For example:
The retailer may have a number of prototype construction design plans from which to choose.
Differences among the designs could include square footage or one-story vs. two-story structures.
Contractors familiar with the retailer's building plans may be used on several projects.
Suppliers may submit a price, guaranteed for a specified period of time, for certain material used in the construction of all stores.
The timetable for construction as well as the ordering of the related retail fixtures and furnishings and inventory is documented and known.
Grand opening marketing plans which have proven successful in the past may need only minor modifications in a new area.
Whenever a major new construction project is undertaken, it is necessary to allocate the project costs between the various asset classes. First, assets must be classified as either tangible personal property or a land improvement (including building/structural components). Then, these two categories can be further broken down into MACRS asset classes.
Retailers may overstate the amount allocated to personal property. It is necessary to thoroughly review the taxpayer's allocation studies by correlating all items to the drawings, bid/specification packages, and invoices. Since a retailer may open dozens of locations in a given year, studies may only be done on representative stores and the percentage allocations that result from the studies may be applied to all similar projects. To properly examine the allocations, the examiner must determine that projects have been grouped according to similar features such as construction type (one-story, two-story, mall, freestanding), construction quality (block, brick, poured cement, wood), size (based on square footage), and utility (apparel, shoes, department, grocery, other specialty, distribution center).
After the grouping of projects has been reviewed, it is necessary to analyze a select number of allocations in detail. IRS engineers may perform this task. Sometimes the allocation analysis must be done without a retailer's detailed allocation study. For example, the retailer may have used a relative percentage allocation based on allocation studies done in prior years. Generally, it is more efficient to do a detailed analysis on projects which the retailer also has analyzed.
To analyze the projects in detail, first collect all pertinent documents (drawings, bid/specification packages, contractor payment invoices, vendor invoices, etc.). Then compare the documents to the costs in the retailer's allocation study. It may be necessary at some point to tour and photograph the location being analyzed.
Tours should be carefully planned. Retail personnel at a store may not be knowledgeable about the allocation study or how to identify assets listed in the study. Therefore, ensure that persons knowledgeable about the allocation study are included on the facility tour. It is also important that the retail personnel locate the assets listed in the allocation study during the facility tour.
If a tour cannot be arranged, a detailed analysis can be accomplished through a series of meetings with the retailer to work through the study and drawings. The retailer may be able to provide photographs as an aid.
Many position papers exist for most of the common assets at issue in construction remodeling projects including ceiling tile, rest room components, fire prevention, emergency systems, communication systems, security systems, electrical systems, and mechanical systems (Heating, Ventilation, Air Conditioning: HVAC). Please contact the Retail Technical Advisors for further information.
Real estate taxes incurred during the production period should be capitalized for self-constructed assets. The taxpayer may be capitalizing its estimate of property taxes for the project and not adjusting the estimate to the actual amount on the property tax statements.
Interest costs incurred during the construction period must be capitalized. An examiner should consider IRC 263A(f) interest capitalization. See IRM 220.127.116.11.
Retailers may purchase existing facilities for expansion through:
Other retailer’s closed stores
Mergers and acquisitions
Generally, the most difficult factor for a potential purchaser to overcome is location.
If the structure is deemed to have potential for conversion, a preliminary estimate of upgrading and conversion costs will be made.
IRC 1060 describes special allocation rules for asset acquisitions:
Form 8594 is used.
There are seven classes of assets.
Potential issues include fair market value determinations, identification of all assets acquired, allocation of purchase price, and subsequent abandonment losses.
Merchandise presentation involves strategies for displaying the items for sale, including store layout and décor.
Periodically, a retailer will remodel its stores for various reasons including:
A more modern appearance
To maintain customer interest
To compete with newer stores
Consistent floor plans
Remodeling expenditures are made for items such as:
Flooring, wall covering, ceiling, lighting, shelving or rack displays
Technological improvements, such as electronic scanning, checkout registers and security equipment
A new facade, parking lot, dock, or mechanical equipment
Retailers may remodel stores on a rotational basis, improving a specified number of stores each year.
The assets which make up a new store or remodeling project must be categorized for depreciation by type of property and then depreciated over a designated recovery period. Remodeling costs may be partially expense or capital depending on the facts of the case.
Most retailers believe the current classification system does not reflect the economic realities for store remodeling costs. Retailers claim its buildings do not last 39 years because of the need for frequent remodeling improvements.
Similarly, an older warehouse or distribution center may be totally renovated or upgraded into a modern automated computerized merchandise handling operation which can accommodate a larger volume of inventory flow in a more efficient manner.
The retailer usually will maintain a file for each remodeling project containing all data pertinent to the project, including:
Payments for store fixtures.
After completion of the project, the payments and invoices from the file are used to establish capital assets on the fixed asset record system.
IRC 168(e)(3)(E)(ix) is a temporary provision that provides a 15-year recovery period for qualified retail improvement property. The property must be placed in service after 2008 and before 2010.
Qualified retail improvement property, as defined by IRC 168(e)(8), means any improvement to an interior portion of a building which is nonresidential property if:
Such portion is open to the general public and is used in the trade or business of selling tangible personal property or services to the general public, and
Such improvement is placed in service more than 3 years after the date the building was first placed in service.
Qualified retail improvement property does not include any improvement for which the expenditure is attributable to:
The enlargement of the building
Any elevator or escalator
Any structural component benefitting a common area, or
The internal structural framework of the building
In addition to qualified retail improvement property, leased stores may have qualified leasehold improvement property:
Defined in IRC 168(e)(6), IRC 168(k)(3) and Treas. Reg. 1.168(h)-1(c).
Entitled to straight-line depreciation over a 15-year recovery period .
Must be placed in service before 2010
The provision may be extended in periodic extender bills
Under current law, repair and maintenance expenditures are deducted when incurred, i.e., they are expensed. However, substantial improvements that enhance the value of property must be capitalized and depreciated.
The distinction between a repair expenditure and an improvement that must be capitalized, however, is a difficult determination, and significant controversy exists in this area. The legal distinction between the two is often one of degree and intention. An engineer can assist with the identification of the nature of the expenditure and the unit of property to which the expenditure applies.
In determining whether an expenditure is capital or is chargeable against operating income, it is necessary to consider the purpose for which the expenditure was made. To repair is to restore to a sound state or to mend, while a replacement connotes a substitution.
A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor does it appreciably prolong its life. It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired.
Repair expenditures are distinguishable from those replacements, alterations, improvements or additions which prolong the life of the property, increase its value or make it adaptable to a different use. A repair is a maintenance charge, while the others are additions to capital investment that should not be applied against current earnings.
Repairs that neither materially add to the value of the property nor appreciably prolong its life are referred to as incidental repairs, and may be expensed. A costly disbursement undertaken to keep an asset operational may be an incidental repair depending on the nature of the work in relation to the taxpayer's operations.
Capital expenditures generally materially extend a property's life or increase its value. While all repair or maintenance spending prolongs a property's life to some extent, capitalization is required if the expenditure extends the life of the property compared to its life prior to the condition necessitating the expenditure.
Capital expenditures include expenditures for permanent improvements or betterments made to increase a property's value, to restore the property, or to make good the exhaustion thereof.
Expenditures that adapt property to new or different uses are capital expenditures, as are costs to put property in operating condition.
Expenditures that arrest deterioration and appreciably prolong the life of the property must be capitalized.
Capitalization also is required for replacements of major components or elements of an asset, and for the reconditioning of property or the improvement of property as part of an overall plan of rehabilitation.
In order to expand an existing facility or build a new one, a taxpayer may need to demolish existing property. In retailing, demolition may be the removal of walls to change traffic patterns or to tie into a new addition during a remodel. Demolition costs should be capitalized if they are part of a capital improvement. When a retailer purchases land and demolishes existing buildings to prepare the site for new construction, the costs of demolition should be capitalized as part of the land.
Examiners should review the retailer's capitalization policies. Often a retailer will expense all costs under a certain dollar criteria. These expenses may have a material impact when they are capitalized, particularly if the costs pertain to several locations.
Examiners may find retailers filing a change in accounting method for changes in capitalization policies.
The examiner may encounter a repair study by the retailer which reclassifies previously capitalized repairs to current expenses. These involve a change in accounting method and should be scrutinized closely by the examiner. Normally, assistance from an engineer should be obtained.
On March 7, 2008 the IRS published Proposed Treas. Reg. 1.263(a)-3 regarding the treatment of amounts paid to acquire, produce, or improve tangible property.
The previously proposed regulations released in 2006 were withdrawn.
The effective date is for tax years beginning on or after the date final regulations are published.
No retroactive treatment is allowed. The regulations cannot be relied upon in the proposed form.
Examiners need to consider the many new rules and clarifications when the final regulations are published.
Various laws require retailers to remove or contain asbestos in their buildings.
Retailers incur various costs to remove or contain asbestos to comply with these laws.
The costs incurred to treat asbestos in a retailer’s building introduce the question whether such costs are ordinary and necessary repair expenses or capital improvements.
Contact the Environmental Technical Advisors.
In general, the primary or predominant use of an asset determines its classification to an activity class. In some situations, the application of this provision can be controversial.
For example, gas stations and convenience stores (C-stores) belong to asset class 57.1, which has a class life of 20 years whereas a retailer’s building is depreciated over 39 years. Like many other retailers, motor fuel outlet stores sell goods other than petroleum products, including food, drinks and other convenience items.
To remedy this controversy, Congress provided a 15-year depreciation schedule for gas stations and C-stores that qualify as retail motor fuel outlets.
IRC 1250 property placed in service on or after August 20, 1996, will qualify as retail motor fuel outlets (whether or not food or other convenience items are sold at the outlets) if any of the following tests are met:
50 percent or more of the gross revenues generated from the property are derived from petroleum sales, or
50 percent or more of the floor space in the property is devoted to petroleum marketing sales (not including floor space devoted to related services, such as oil changes, and floor space devoted to nonpetroleum products, such as tires and oil filters), or
The property is 1400 square feet or less.
Gross revenue is defined as the revenue generated by the sale of the product to the consumer. For purposes of determining whether a C-store building qualifies as a retail motor fuels outlet, gross revenue includes all excise and sales taxes. The gross revenue attributable to petroleum sales (gasoline and oil sales) (not including gross revenue from related services, such as the labor cost of oil changes, and gross revenue from the sale of non-petroleum products, such as tires and oil filters) should be compared to gross revenue from all other sources (e.g., food items, beverages, lottery, video rentals, etc.). The gross revenue should be analyzed for a full tax period. Temporary fluctuations, such as a special 6-month promotion, should not be included in the gross revenue test.
When a retailer closes an establishment that is no longer economically viable, but does not dispose of the property before year-end, it may attempt to prematurely deduct the loss prior to sale. The mere closing of the structure is not an event that qualifies as an actual disposition for tax purposes. No loss is allowed until an actual disposition occurs, per Treas. Reg. 1.167(a)-8.
The term "disposition" means the permanent withdrawal of property from use in the taxpayer's trade or business or use for the production of income. The withdrawal may be made in several ways, including sale, exchange, retirement, abandonment, or destruction. Further, a disposition does not include the retirement of a structural component of a building, except as provided by IRC 168(i)(8)(B). Moreover, the manner of disposition (e.g., normal retirement, abnormal retirement) is not a consideration.
If an asset is disposed of by sale or exchange, gain or loss is recognized as provided under the applicable provisions of the Code, except as provided in Treas. Reg. 1.168(i)-1 (relating to general asset accounts).
If an asset is disposed of by physical abandonment, loss is recognized in the amount of the adjusted basis of the asset at the time of the abandonment, except as provided in Treas. Reg. 1.168(i)-1 (relating to general asset accounts). To qualify for the recognition of loss from physical abandonment, the taxpayer must intend to discard the asset irrevocably so that the taxpayer will neither use the asset again, nor retrieve the asset for sale, exchange, or other disposition.
If an asset is disposed of other than by sale or exchange or physical abandonment (as, for example, where the asset is transferred to a supplies or scrap account), gain is not recognized. Loss is recognized in the amount of the excess of the adjusted basis of the asset over its fair market value at the time of the disposition, except as provided in Treas. Reg. 1.168(i)-1 (relating to general asset accounts). No loss is recognized upon the conversion of property to personal use.
For financial reporting purposes, a retailer is required to recognize a loss under FASB 144 when a long-lived asset's income stream ceases.
The assets must be reviewed annually for impairment.
The closed stores are reported at lower of carrying amount or fair value less selling costs.
The assets are no longer depreciated for financial accounting.
See IRM Exhibit 4.43.1-1 Store Closing.
A cost segregation study allocates the total cost or value of property into appropriate classes of property in order to compute depreciation. These studies make detailed inventories of individual assets, in order to distinguish items of IRC 1245 property from items of IRC 1250 property.
A cost segregation study may be conducted on new construction, on a property acquisition, or on property already owned using a change in accounting method, which is also known as a look-back study.
Some retailers have hired firms to conduct cost segregation studies. Retailers use cost segregation studies to shorten depreciable lives of improvements to property, whether leased or owned. The principal focus has been on reclassifying assets from buildings (IRC 1250 property) to personal property (IRC 1245 property). For tax purposes, a building includes all of its structural components. The cost of these components is not recovered separately from the building. Rather, these costs are recovered using the life and depreciation method appropriate for the building as a whole. Upon a reclassification, such costs are no longer treated as structural components of a building, but as property belonging to the retailer’s general activity class.
The number of individual items in a cost segregation study can be substantial. As noted earlier, the distinction between IRC 1245 property and IRC 1250 property is not always clear, which can result in significant differences of opinion. Despite these challenges, cost segregation studies should be closely scrutinized by examiners.
In assessing audit risk for a cost segregation study, an examiner should make the following audit considerations:
Is the study based on contemporaneous records, reconstructed records, or estimates and assumptions that have no supporting records?
Did the study use actual costs or estimated costs?
Did the study use modeling or statistical sampling? Modeling separates properties by common store footprints. For example, free-standing stores are separated from mall stores; leased stores are separated from owned stores. Under modeling, the study takes a sampling of stores within each group and applies the sample results to the population.
An IRS Cost Segregation Audit Techniques Guide was developed in 2004 and should be reviewed by the examiner. It can be found on the IRS web site. It is an excellent resource guide and topics include:
Cost segregation methodologies
Principal elements of a quality cost segregation study
Review and examination of a cost segregation study
Change in accounting method
Relevant court cases
Information document requests
Industry specific guidance including the LMSB RFPH Retail Industry Director Directive (IDD).
The IDD was issued in 2004 concentrating on 54 property classifications. It is not an official pronouncement of the law or position of the IRS. The IDD effectively utilizes resources in the classification and examination of a retailer.
General Audit Techniques include the following:
Reconcile amount per return to working trial balance
Scrutinize the basis of assets to ensure proper recordation
Determine the retailer’s policy with respect to capitalization threshold
Review the retailer’s retirement policy of assets and dispositions
Review annual report to identify store openings, expansions and major remodels
Analyze Schedule M adjustments for depreciation differences
Review Asset & Depreciation Ledger for assets with basis reduction or negative tax basis
Determine if any inducement was made for a new store or to encourage the retailer to remain at the location
Determine, from the developer’s perspective, whether its intent was to compensate the retailer for certain assets or expenses
Analyze remodel expenditures for proper asset classification or expense
Determine if a remodel included an expansion
Determine the purpose of any remodel. Is there a betterment of the property?
Make an engineering referral or consult an engineer for assistance
Review Treas. Reg. 1.263(a)-4
Cost Segregation Auditing Techniques include the following:
Read and evaluate cost segregation documents
Verify cost basis and reconcile depreciation records
Conduct a risk analysis to evaluate audit potential
Interview the preparer
Inspect the property
Review and verify the classes of property
Perform a cost analysis
Consider sampling techniques
Review any Forms 3115 related to depreciation or repair expense
Apply law, regulations, and other appropriate guidance to facts
This section provides general background information about intangible assets and amortization items reported by retailers and the general accounting practices for such items.
Intangible assets are generally characterized by a lack of physical existence and a high degree of uncertainty concerning future benefits.
Usually, these assets result from the operation of legal or contractual rights and include trademarks, patents, non-compete agreements, employment contracts, and goodwill. They may be self-created or they may be purchased. The cost of an intangible asset is generally recovered through amortization.
Is the valuation of acquired intangibles in an asset acquisition proper?
Is the retailer properly classifying intangible assets?
Is the intangible asset self-created or purchased?
Is the amortization period and method computed properly?
Did the retailer take a partial loss deduction for intangible assets?
IRC 167 allows as a deduction for depreciation a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property, both tangible and intangible, used in a trade or business.
Under Treas. Reg. 1.167(a)-3, two requirements must be met in order to depreciate an intangible asset:
The asset must have a limited useful life
The life can be estimated with reasonable accuracy.
IRC 197 allows an amortization deduction with respect to the capitalized costs of certain intangible property that is acquired by a taxpayer and that is held by the taxpayer in connection with the conduct of a trade or business. The deduction is allowed on a straight-line basis over a 15-year period. If IRC 197 applies, the taxpayer may not use IRC 167 to depreciate the intangible property.
IRC 197 does not apply to intangible property that is created by the taxpayer if the intangible property is not created in connection with a transaction (or series of related transactions) that involves the acquisition of a trade or business or a substantial portion of a trade or business.
IRS Publication 535 provides an overview of IRC 197 intangibles.
Treas. Reg. 1.263(a)-4 generally requires a taxpayer to capitalize an amount paid to create or acquire an intangible or to create or enhance a separate and distinct intangible asset.
On January 5, 2004, the Department of the Treasury and the IRS issued final regulations on the capitalization of intangibles.
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.
Treas. Reg. 1.263(a)-5 requires a taxpayer to capitalize an amount paid to facilitate the following transactions (without regard to whether the transaction is comprised of a single step or a series of steps carried out as part of a single plan and without regard to whether gain or loss is recognized in the transaction):
an acquisition of assets that constitute a trade or business (the taxpayer can be the acquirer or the target);
an acquisition by the taxpayer of an ownership interest in a business entity if, immediately after the transaction, the taxpayer and the business entity are related within the meaning of IRC 267(b) or IRC 707(b);
an acquisition of an ownership interest in the taxpayer (other than an acquisition by the taxpayer of an ownership interest in the taxpayer, whether by redemption or otherwise);
a restructuring, recapitalization, or reorganization of the capital structure of a business entity (including reorganizations described in IRC 368 and distributions of stock by the taxpayer as described in IRC 355;
a transfer described in IRC 351 or IRC 721 (whether the taxpayer is the transferor or transferee);
a formation or organization of a disregarded entity;
an acquisition of capital;
a stock issuance;
a borrowing; and
writing an option.
The purpose of an allowance for depreciation or amortization is to protect the integrity of periodic income measurement by allocating costs to the period in which they arose.
Tax law relies on the concept of fair market value to allocate the purchase price of a business to the various assets in an asset acquisition. As a practical matter, the fair market value of an asset is never an absolute amount. Rather, there is likely to be a range of possible values. An examiner should consider whether the taxpayer has reported an amount or amounts outside the range of reasonableness.
Goodwill is defined in Treas. Reg. 1.197-2(b)(1).
Amortization is the commonly accepted way of referring to depreciation of intangible property. The Internal Revenue Code and the regulations, however, use the term depreciation, except in the context of IRC 197.
The term "section 197 intangible" is a term of art with a specified but limited meaning.
Retailers frequently incur expenditures for intangible assets in the normal course of their business operations.
Intangible assets originate for most retailers from the acquisition of other retailers’ businesses. The fair market value of intangible assets acquired in an acquisition is usually supported by an appraisal made by an independent valuation company. The most common intangible assets acquired in an acquisition include:
Trademarks and trade names
Private label design and development
Favorable portion of operating leases
Customer and/or credit card lists
Financial Accounting Standards Board (FASB) 142 breaks intangibles into two broad classes:
Intangible assets with finite lives subject to amortization usually on a straight-line method based on useful life.
Intangible assets with indefinite lives not subject to amortization, but subject to an impairment test.
Costs of internally developing, maintaining, or restoring intangible assets that are not specifically identifiable, that have indeterminate lives, or that are inherent in a continuing business are expensed.
Following are several retail industry applications for intangibles.
IRC 197 intangibles include:
Going concern value
Workforce in place
Business books and records, operating systems, or any other information base
Any patent, copyright, formula, process, design, pattern, know-how, format, or other similar item
License, permit, or other right granted by a governmental unit or agency
Covenant not to compete entered into in connection with the acquisition of all or a substantial interest in a trade or business
Franchise, trademark, or trade name, including renewals of such interests
Goodwill is the value of a trade or business based on the expected continued patronage due to its name, reputation, or any other factor.
When a retailer acquires an existing business, the retailer must allocate the purchase price to each asset acquired in an amount equal to the asset's fair market value to determine the basis of the acquired assets.
When an existing business is sold, the selling price usually exceeds the total fair market value of the tangible assets owned by the business. The purchase price not allocated to tangible assets is assigned to intangible assets, such as goodwill.
Goodwill has been defined as "the expectancy of continued patronage..." , and "the expectancy that the old customers will resort to the old place." Goodwill is acquired by a purchaser of a going concern where the transfer enables the purchaser to step into the shoes of the seller. Prior to enactment of IRC 197, goodwill was nondepreciable as a rule of law because of the difficulties inherent in the computation of both its life and its value.
Under IRC 197, going concern value is the additional element of value of a trade or business that attaches to property by reason of its existence as an integral part of an ongoing business activity.
Going concern value includes value based on the ability of a business to continue to function and generate income even if there is a change in ownership (but does not include any other IRC intangible).
Going concern value also includes the value based on the immediate use or availability of an acquired trade or business, such as the use of earnings during any period in which the business would not otherwise be available or operational.
Workforce in place includes the composition of a workforce (for example, its experience, education, or training), the terms and conditions of employment, whether contractual or otherwise, and any other value placed on employees or any of their attributes.
The amount paid or incurred for workforce in place includes, for example, any portion of the purchase price of an acquired trade or business attributable to the existence of a highly-skilled workforce, an existing employment contract (or contracts), or a relationship with employees or consultants (including, but not limited to, any key employee contract or relationship).
Workforce in place does not include any covenant not to compete or other similar arrangement.
IRC 197 intangibles include any information base, including a customer-related information base.
An information base includes business books and records, operating systems, and any other information base (regardless of the method of recording the information).
A customer-related information base is any information base that includes lists or other information with respect to current or prospective customers.
The amount paid or incurred for information base includes, for example, any portion of the purchase price of an acquired trade or business attributable to the intangible value of technical manuals, training manuals or programs, data files, and accounting or inventory control systems.
Other examples include the cost of acquiring customer lists, subscription lists, insurance expirations, patient or client files, or lists of newspaper, magazine, radio, or television advertisers.
Know-how for purposes of IRC 197 intangibles includes any patent, copyright, formula, process, design, pattern, know-how, format, package design, computer software (as defined at Treas. Reg. 1.197-2 (c)(4)(iv)), or interest in a film, sound recording, video tape, book, or other similar property.
A customer-based intangible is any composition of market, market share, or other value resulting from the future provision of goods or services pursuant to contractual or other relationships in the ordinary course of business with customers.
Customer-based intangibles include any portion of the purchase price of an acquired trade or business attributable to the existence of:
A customer base
A circulation base
An undeveloped market or market growth
Insurance in force
The existence of a qualification to supply goods or services to a particular customer
A mortgage servicing contract (as described at Treas. Reg. 1.197-2(c)(11)
An investment management contract
Any other relationship with customers involving the future provision of goods or services
A supplier-based intangible is the value resulting from the future acquisition, pursuant to contractual or other relationships with suppliers in the ordinary course of business, of goods or services that will be sold or used by the retailer
Supplier-based intangibles include, for example, any portion of the purchase price of an acquired trade or business attributable to
The existence of a favorable relationship with persons providing distribution services (such as favorable shelf or display space at a retail outlet)
The existence of a favorable credit rating
The existence of favorable supply contracts
The amount paid or incurred for supplier-based intangibles does not include any amount required to be paid for the goods or services themselves pursuant to the terms of the agreement or other relationship.
IRC 197 intangibles include any license, permit, or other right granted by a governmental unit (including, for purposes of IRC 197, an agency or instrumentality thereof) even if the right is granted for an indefinite period or is reasonably expected to be renewed for an indefinite period.
These rights include, for example, a liquor license, a taxicab medallion (or license), an airport landing or take-off right (sometimes referred to as a slot), a regulated airline route, or a television or radio broadcasting license.
The issuance or renewal of a license, permit, or other right granted by a governmental unit is considered an acquisition of the license, permit, or other right.
IRC 197 intangibles include any covenant not to compete, or agreement having substantially the same effect, entered into in connection with the direct or indirect acquisition of an interest in a trade or business or a substantial portion thereof.
An agreement requiring the performance of services for the acquiring retailer or the provision of property or its use to the acquiring retailer does not have substantially the same effect as a covenant not to compete to the extent that the amount paid under the agreement represents reasonable compensation for the services actually rendered or for the property or use of the property actually provided.
A covenant not to compete (or other arrangement to the extent such arrangement has substantially the same effect as a covenant not to compete) is not to be considered to have been disposed of or to have become worthless until the disposition or worthlessness of all interests in the trade or business or substantial portion thereof that was directly or indirectly acquired in connection with such covenant (or other arrangement).
Trademarks and trade names represent the inherent value of the acquired retailer's name and/or its store (house) brands.
IRC 197 intangibles include any franchise, trademark or trade name.
The term franchise has the meaning given in IRC 1253(b)(1) and includes any agreement that provides one of the parties to the agreement with the right to distribute, sell, or provide goods, services, or facilities, within a specified area.
The term trademark includes any word, name, symbol, or device, or any combination thereof, adopted and used to identify goods or services and distinguish them from those provided by others.
The term trade name includes any name used to identify or designate a particular trade or business or the name or title used by a person or organization engaged in a trade or business.
A license, permit, or other right granted by a governmental unit is a franchise if it otherwise meets the definition of a franchise.
A trademark or trade name includes any trademark or trade name arising under statute or applicable common law and any similar right granted by contract.
The renewal of a franchise, trademark, or trade name is treated as an acquisition of the franchise, trademark, or trade name.
For financial reporting, franchise, trademark or trade name costs must be amortized over a period not to exceed 40 years.
IRC 197 intangibles do not include the following assets, rights or costs:
Any interest in a corporation, partnership, trust, or estate
Any interest under an existing futures contract, foreign currency contract, notional principal contract, interest rate swap, or similar financial contract
Any interest in land
Computer software that is readily available to the general public, is subject to a nonexclusive license, and has not been substantially modified.
Any fees for professional services and any transaction costs incurred by parties to a transaction in which all or any portion of the gain or loss is not recognized under part III of subchapter C of the IRC.
IRC 197 intangibles do not include any of the following assets not acquired in connection with the acquisition of a trade or business or a substantial part of a trade or business:
An interest in a film, sound recording, video tape, book, or similar property
A right to receive tangible property or services under a contract or from a governmental agency
An interest in a patent, patent application, or copyright
Certain rights that have a fixed duration or amount as provided in the regulations
Any right to service indebtedness secured by residential real property
An interest in computer software
IRC 197 intangibles do not include an interest under either of the following:
An existing lease or sublease of tangible property
A debt that was in existence when the interest was acquired
The term "amortizable section 197 intangible" generally means any section 197 intangible acquired after August 10, 1993 (or after July 25, 1991, if a valid retroactive election under Treas. Reg. 1.197-1T has been made), and held in connection with the conduct of a trade or business or an for-profit activity. A self-created intangible is not an amortizable IRC 197 intangible.
An amortizable IRC 197 intangible is treated as depreciable property used in the retailer’s trade or business.
If an amortizable IRC 197 intangible is held for more than one year and used in the retailer’s trade or business, any gain on disposition, up to the amount of allowable amortization, is ordinary income (IRC 1245 gain). Any remaining gain, or any loss, is an IRC 1231 gain or loss.
If an amortizableIRC 197 intangible is held one year or less, any gain or loss on disposition is an ordinary gain or loss.
A retailer cannot deduct any loss on the disposition or worthlessness of an IRC 197 intangible that was acquired in the same transaction (or series of related transactions) as other IRC 197 intangibles that are still owned by the retailer.
Instead, the retailer must increase the adjusted basis of each remaining amortizable IRC 197 intangible by a proportionate share of the nondeductible loss.
The increase in adjusted basis for each retained intangible is determined by multiplying the nondeductible loss on the disposition of the intangible by the following fraction:
The numerator is the adjusted basis of the retained intangible on the date of the disposition.
The denominator is the total adjusted bases of all the retained intangibles on the date of the disposition.
Acquired intangible assets and benefits as defined in Treas. Reg. 1.263(a)-4 require capitalization if acquired from another party in a purchase or similar transaction and include:
An ownership interest in a corporation, partnership, trust, estate, limited liability company, or other entity
Financial instruments (e.g., debt instruments, notional principal contracts, options, etc.)
Prepaid expenses: amounts prepaid for services or benefits to be received in the future
Amounts paid to obtain certain memberships and privileges, such as lifetime staff privileges at a hospital. However, amounts paid for product certification (such as ISO 9000 costs) are not required to be capitalized.
Amounts paid to obtain or renew certain rights from a governmental agency, such as a trademark, copyright, license, franchise, permit, etc.
Amounts paid to another party to induce that party to enter into, renew, or renegotiate an agreement that produces certain rights
Amounts paid to terminate certain contracts that allow the retailer to reacquire a valuable right that it did not possess just prior to the termination
Amounts paid to acquire, produce, or improve real property owned by another, where the retailer expects to thereby receive significant future benefits
Amounts paid to defend or perfect title to intangible property
Created intangibles require capitalization. The determination of whether an amount is paid to create an intangible is based on facts and circumstances. Distinctions between labels used to describe the intangible and the labels used by the taxpayer and other parties to the transaction are disregarded.
Transaction costs require capitalization. Transaction costs facilitate the acquisition, creation, and enhancement of intangible assets, subject to the de minimis rule and the simplifying rule for employee compensation and overhead. Also, costs that facilitate the retailer's restructuring or reorganization of a business entity or that facilitate a transaction involving the acquisition of capital, including a stock issuance, borrowing, or recapitalization, require capitalization.
The costs discussed in the preceding paragraphs of this sub-section apply to amounts paid or incurred on or after December 31, 2003.
In an acquisition, the determination of the fair market values of the intangibles may be problematic.
The retailer will want to value land and 39-year property as low as possible and allocate some of the purchase price to goodwill or going concern, if beneficial, or perhaps even to inventory. See IRM 18.104.22.168.6.9 regarding the inventory step-up issue.
Purchased intangibles will appear on the balance sheet and the amortization schedule.
Form 8594, Asset Acquisition Statement, should be attached to the tax return to report the purchase/sale of a group of assets if goodwill or going concern could attach to such assets and if the purchaser’s basis in the assets is determined only by the amount paid for the assets.
The package design costs coordinated issue paper was de-coordinated on September 28, 2007 as a result of Treas. Reg. 1.263(a)-4.
Package design means the specific graphic arrangement or design of shapes, colors, words, pictures, lettering, and other elements on a given product package, or the design of a container with respect to its shape or function. Activity related to sales promotions, ingredient listings, trademarks and trade names is not package design in nature.
Because it is often on the basis of the package alone that a buying decision is made, large amounts of time and money are expended to develop effective packaging. Historically, manufacturers incurred most package design costs. The incidence of retailers incurring package design costs has increased, however, with the growing popularity of private label brands or house brands (products manufactured by others but sold exclusively by a particular retailer under its own label).
Although a retailer's primary private brand may carry the name of the company, the same retailer may also carry other private brands which are not as obvious because they carry no identifying information to link them to the retailer. Examiners should be alert to identifying all private brands when determining packaging costs.
Package design costs are related to the development of an initial concept, artistic representations, photography, preparation of prototypes, market testing, and final revisions. Costs related to designs which were suggested but rejected may be applied to subsequent designs and become part of their costs. For some products, such as aspirin, standard containers provided by the manufacturer are used and retailers incur only label design costs. In the past, all costs associated with creating a package design were deducted by retailers as current expenses.
Recognizing that most packaging has a useful life in excess of one year, the IRS had taken the position that package design costs should be capitalized with an indefinite, non-amortizable life. Elections were available, however, allowing amortization over a specified period. See Rev. Proc. 97-35 and Rev. Proc. 98-39.
The final regulations regarding capitalization of intangibles (Treas. Reg. 1.263(a)-4) provide that an amount paid to create a package design, computer software, or an income stream from the performance of services under a contract, is not treated as an amount that creates a separate and distinct intangible asset.
Retailers will often expend significant amounts to develop, acquire, and defend a private label. From the retailer's perspective, the private label represents an important economic benefit by identifying goods specific to the retailer. Many retailers develop private label (store/house) brands to reduce competitive pricing pressure, build customer loyalty, and generate higher margins. The value of this intangible asset is typically determined by the cost to replace the design and production elements of the private label brand.
If the retailer has a large number of items which will carry the private label, a brandmark, or master label look, may be developed. This would include a specific color scheme, name logo, and background graphics. All private product labels then would be a variation of this brandmark. For example, a can of private label corn and a can of private label peas would have the same master label, varying only by the picture of the product on the front of the can. The retailer might contract with an outside consultant to develop the brandmark, but use in-house personnel to apply that look to each individual product.
For financial purposes, the amortization period is similar to the amortization period for trademarks and trade names.
The valuation of a lease acquired in an acquisition may produce a favorable lease or an unfavorable lease.
A favorable lease represents the value of an operating lease where the rent is below the market rate as of the acquisition date. The basis of this intangible asset is usually determined by taking the difference between the present value of the market rate and the lease agreement rate. The basis determination will include renewal periods if renewal is probable.
An unfavorable lease represents the value of an operating lease where the rent is above the market rate as of the acquisition date. An unfavorable lease will result in a deferred credit that is amortized over the life of the lease.
Generally, any website costs that are not software are classified as website content. This includes literary content, graphics, sound, and video.
Advertising content is deducted currently. All other content is capitalized if it has a useful life extending beyond the current year.
Domain names are generally regarded as intangible personal property. The nominal annual domain name registration fees are generally deductible.
However, if a retailer acquires a domain name, then capitalization should be considered under Treas. Reg. 1.263(a)-4(b). The retailer is paying for a property interest that meets the definition of a purchased intangible.
Some retailers may acquire multiple domain names at premiums to protect the reputation of their business which may be considered for capitalization.
Although computer software has tangible and intangible characteristics, it generally constitutes intangible property for Federal income tax purposes.
For purposes of IRC 197, computer software is defined as any program that is designed to cause a computer to perform a desired function. Software includes computer programs of all classes such as operating systems, compilers, translators, assembly routines, utility programs, and application programs. Software may be developed, purchased, or leased.
Computer software generally is treated as an IRC 197 intangible; however, certain off-the-shelf and certain separately acquired software are not considered to be an IRC 197 intangible. Off-the-shelf software:
Is readily available for purchase by the general public
Is subject to a non-exclusive license
Is not substantially modified
IRC 167(f) provides rules for computing the depreciation deduction for property specifically excluded from IRC 197. Under this provision, excluded purchased computer software is depreciated on a straight-line basis over a 36-month useful life.
Risk is what differentiates purchased software from internally-developed software.
Under IRC 197, computer software acquired in an acquisition is amortizable over 15 years.
For leased software, rental payments are deductible as a business expense over the lease term in the same manner as any other rental payments under Treas. Reg. 1.162-11.
Are the computer software costs included, without being separately stated, in the cost of computer hardware (bundled software)? When computer software is bundled with computer hardware, without being separately stated, the cost of the bundled software is capitalized and depreciated as part of the computer hardware.
Is computer software internally developed or purchased? This distinction is important in analyzing the federal tax consequences of computer software costs. In some situations, software costs closely resemble research and experimental expenditures and, consequently, may be expensed in the same manner as research and experimental expenditures.
Audit Techniques can include the following:
Reconcile amounts per return to working trial balance
Reconcile differences between book and tax amortization to Schedule M
Analyze change in G/L account balances
Review current year dispositions
Secure analysis of items amortized; verify basis and lives
Determine if the intangible is acquired or self created
Determine if the intangible qualifies for amortization
Verify that a determinable useful life for the intangibles exists
Verify amortization computations
Determine if retailer expensed intangibles for book purposes
Determine if any abandonment losses for intangibles are present
Consult an engineer for fair market value issues
This section provides general background information about lease transactions reported by retailers and the general accounting practices for such leases.
The retail industry is an asset-intensive business often financed by operating leases. More frequently than other industries that make use of operating leases, retailers make leasehold improvements on top of the leased property. Retailers commonly obtain concessions from landlords to defray all or part of their leasehold improvement costs.
Retailers are typically the tenant in lease arrangements, but may also be the landlord. For example, a retailer may sublease a former store or certain departments within a current store. As a result, leases, while not unique to the retail industry, can be a significant area impacting business operations and income.
Whether the deduction for rent expense is improperly accelerated or insufficient rental income is reported.
Whether income recognition of tenant construction allowances is improperly deferred by recognition through basis reduction.
Whether a sale-leaseback transaction represents a genuine sale or a financing transaction.
IRC 162(a)(3) provides a current deduction for rentals or other payments required to be made as a condition to the continued use or possession of property used in a trade or business to which the taxpayer has not taken title.
Rent is generally reported by both landlord and tenant and allocated to the periods of time specified in the lease.
Unless the rental agreement is a section 467 rental agreement (see IRM 22.214.171.124.6.2), rent is deducted when paid for cash basis taxpayers or for accrual basis taxpayers when the all-events test is met and economic performance occurs for the rental liability.
Unless the rental agreement is a section 467 rental agreement (see IRM 126.96.36.199.6.2), advance rentals are required to be capitalized and deducted over the lease term.
Unless the rental agreement is a section 467 rental agreement (see IRM 188.8.131.52.6.2), income received is generally taxable in the year in which it is received for cash basis taxpayers and when payable for accrual taxpayers.
The taxpayer with a depreciable interest in leasehold improvements must generally depreciate the improvements, if nonresidential real property, over 39 years.
Gain or loss from the sale of property is recognized
The timing of rent payments may not coincide exactly with accounting periods. A liability account is required to reflect the amount of unpaid rent at the end of the accounting period.
Proper accounting for leases depends on whether substantially all of the risks and benefits of ownership of property have been transferred from the lessor to the lessee.
The determining factor in the tax treatment of construction allowances and improvements is the tax ownership of the leasehold improvements.
The benefits and burdens of ownership test establishes tax ownership by evaluating several factors.
The benefits and burdens of ownership test establishes tax ownership by evaluating several factors. Whether a lease is a true lease is based on all the facts and circumstances. The factors considered include:
Whether legal title passes
How the parties treat the transaction
Whether an equity interest was acquired in the property
Whether the contract creates present obligations on the seller to execute and deliver a deed and on the buyer to make payments
Whether the right of possession is vested
Who pays property taxes
Who bears the risk of loss or damage to the property
Who receives the profits from the operation and sale of the property
Who carries insurance with respect to the property
Who is responsible for replacing the property
Who has the benefits of any remainder interests in the property
Many retailers lease substantially all of their stores and warehouses.
Operating leases are commonly used in the retail industry.
Lease agreements typically include the following terms and conditions:
Initial lease term of 10 to 20 years and renewal options,
Rent escalation (step rent) clauses, or
Percentage (contingent) rent obligation.
Anchor or major retailers often receive incentives to open a store in a new development.
Retailers commonly receive tenant (construction) allowances to defray the cost of improvements made to leased stores.
Construction allowances rarely exceed the retailer’s cost of construction.
Historically, grocery chains prefer to own real estate in centers in which they are the major tenant or anchor.
Annual rent expense is an average of rent over the lease term taking into account:
Rent abatement (rent holidays), and
Fixed or known rent increases (rent escalation clauses).
Rent expense is generally recognized on a straight-line basis, over the lease term, beginning on the date the retailer takes possession of the leased property and including any option periods considered in the determination of that lease term.
The difference between the amounts charged to rent expense and rent paid is recorded as a deferred liability.
Leasehold improvements are:
Recorded at their gross cost, including items funded with landlord construction allowances.
Depreciated on the straight-line method over the shorter of their useful lives or related lease terms.
Landlord incentives used to build out leased space are:
Recorded as a deferred liability.
Amortized as a reduction of rent expense over the initial lease term.
Percentage rent is generally based upon store sales exceeding a stipulated amount and is recognized as incurred.
For additional information about leases refer to:
Statements of Financial Accounting Standards (SFAS) No. 13, Accounting for Leases
The Financial Accounting Standards Board (FASB) Staff Position No. 13-1, Accounting for Rental Costs Incurred during a construction period (Statement of Financial Position 13-1).
A lease transfers the right to use and occupy real estate in exchange for the payment of rent. The classification of lease transactions as well as the recognition of income and deductions associated with lease transactions is often different for tax and financial reporting purposes.
Fixed rent for long-term leases is rare because landlords typically require the base rent to keep pace with the rate of inflation. Thus, lease terms exceeding several years usually contain a rent escalation clause. The base rent can be adjusted by a dollar amount, a fixed percentage, or a fixed index such as the Consumer Price Index (CPI). The CPI is commonly used to escalate rent for leases of retail space.
IRC 467 and the Income Tax Regulations under § 467 provide rules for rental agreements involving the use of tangible personal property that provide increasing or deferred rent or, for agreements entered into after May 18, 1999, decreasing or prepaid rent, and that require payments of $250,000 or more (§ 467 rental agreements). The accounting methods required by § 467 have three primary purposes:
to provide consistent reporting of rent by landlords and tenants,
to adjust rents in appropriate circumstances to take into account the time value of money, and
to prevent tax avoidance.
To achieve these objectives, the regulations under § 467 provide for one of three different accounting methods, depending on the circumstances:
allocation of rent in accordance with the rental agreement (most common method),
the proportional rental method, which adjusts rents for the time value of money, and
the constant rental method (rent leveling), which prevents tax avoidance. The constant rental method (rent leveling) applies only if an agreement is a disqualified leaseback or long-term agreement. If the term of a rental agreement is in excess of 75 percent of the statutory recovery period of the leased property (19 years for land), the rental agreement qualifies as a long-term agreement. A rental agreement is a leaseback if the lessee (or a related person) had any interest in the property (other than a de minimis interest) at any time during the two-year period ending on the date the agreement was entered into. A long-term agreement or leaseback is disqualified only if the Commissioner determines that a principal purpose for providing increasing or decreasing rent is the avoidance of Federal income tax.
For most leases of retail space, the landlord and tenant will not be subject to constant rental accrual (rent leveling) because either there is no tax avoidance purpose for the increasing or decreasing rents or the agreement meets one of the exceptions in the regulations under § 467. Exceptions to the constant rental accrual method (rent leveling) include the following:
The uneven rent test – The uneven rent test is met if the rent allocated to each calendar year does not vary from the average rent allocated to all calendar years by more than 10 percent (15 percent for real property); and
The increase or decrease in rent is wholly attributable to one of the contingent rent provisions set forth in the regulations under § 467 (for example, price indexes, percentage of sales, or a requirement to pay third-party costs) and/or one of rent holiday provisions in the regulations. To meet the constant rental accrual (rent leveling) exception, the rent holiday must be a consecutive period that is either three months or less and at the beginning of the lease term, or it must be of reasonable duration based on commercial practice in the locality where use of the property occurs and not exceed the lesser of 24 months or 10 percent of the lease term. A rent holiday is a period where no rent or reduced rent is charged. The period is usually short term in nature and granted for the period of store construction. Typically, a free rent period allows the tenant to use money that would otherwise be used to pay rent for payment of construction costs. Generally, rent free periods of 12 months or less, dependent upon local customary practices, are reasonable. A longer rent-free period is acceptable in certain circumstances.
Under FASB 13, a taxpayer is required to level rent expenses by amortizing the total of all rental payments over the life of the lease
Example 1: Application of FASB 13 Retailer enters into a 15-year lease, which requires base rent of $10 per square foot during the first five years, $12 per square foot for the second five years, and $14 per square foot during the third five years. Under FASB 13, $12 per square foot (the leveled amount) is deducted throughout the life of the lease.
Example 2: Differences of Reporting for Tax and Financial Retailer enters into a 10-year lease and landlord provides a first year rent holiday. The rent payment schedule calls for annual rent of $125,000 for the second through fifth year of the lease and $200,000 for remaining five years of the lease.
Year Financial Tax Difference 1 $150 $0 $150 2 $150 $125 $25 3 $150 $125 $25 4 $150 $125 $25 5 $150 $125 $25 6 $150 $200 $(50) 7 $150 $200 $(50) 8 $150 $200 $(50) 9 $150 $200 $(50) 10 $150 $200 $(50) $1500 $1500 $0
The primary audit consideration is whether the taxpayer overstated its current deduction for rent expense by including accrued (step) rents associated with future tax years.
The examiner should consider the following audit techniques to address the issue of step rents:
Review liabilities for accrued rents or rents payable accounts.
Review Schedule M for adjustment to remove stepped up rent from the tax return.
Test selected leases to determine if the excess (amortized) rents were excluded from the tax return deduction.
Percentage rent provisions are common in shopping center leases because of the speculative nature of retail sales. For the landlord, this provision provides an opportunity to share in the future economic success of the retailer’s business, often in exchange for a lower base fixed minimum rent. For the retailer, this provision provides an opportunity to establish an overall cost and budget for operating its business at the location. In particular, it allows a retailer to align the payment of rent with actual cash flow.
Percentage rent provisions in retail leases usually provide that the percentage rent is in addition to the fixed base minimum rent. Percentage rent is calculated as a percentage of the tenant's annual sales in excess of a fixed dollar amount made in or from the premises. The fixed dollar amount is often referred to as the breakpoint. Defining what constitutes a sale for purposes of calculating percentage rent, and determining what may be excluded or deducted, often is the subject of negotiation between landlord and tenant.
The primary audit consideration is whether the taxpayer estimates sales volume and accrues a liability for percentage rent throughout the taxable year.
The examiner should consider the following audit techniques to address the issue of estimating percentage rents:
Ask how percentage rent is recorded.
Analyze lease abstracts and/or accrued percentage rent payables accounts.
Examine leases to determine when the liability for percentage rent becomes fixed, if estimates are recorded.
Use the percentage rent agreement to determine if all sales are reported.
Obtain copies of reports sent to the landlord and reconcile those sales figures with sales reported as income.
Obtain copies of any landlord audits and reconcile those sales figures with sales reported as income.
Some of these techniques may be impractical with a large retailer, but useful in the audit of a small retailer with only a few stores.
A shopping center needs one or more major or anchor retail tenants to acquire sufficient patronage to make the entire shopping center a success.
Anchor stores often command significant inducements as a condition to locating in a shopping center. A developer’s inducement may be in the form of cash, transfer of ownership of the building, and/or transfer of ownership of the land on which the store is built. Anchor stores usually agree to operate a store for a period of 15 years in exchange for receipt of an inducement.
A developer’s payment of cash is typically less than the cost of IRC 1250 improvements incurred by a retailer.
IRC 118 provides a means for any anchor tenant to exclude intangible inducements from gross income.
The primary audit consideration is whether the taxpayer properly reduced the bases of the assets acquired with the proceeds under IRC 362(c)(2).
The examiner should consider the following audit techniques to address the basis reduction issue:
Review annual report for new store openings and major remodels.
Review asset & depreciation ledger for assets with basis reduction or negative tax basis.
Review Schedule M adjustments for depreciation differences.
Apply the Industry Director’s Directive to facts and circumstances.
Determine if the inducement was made for a new store or to encourage the retailer to remain at the location.
Determine, from the developer’s perspective, whether its intent was to compensate the retailer for certain assets or expenses.
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 allowance 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.
The primary audit consideration is whether the taxpayer receives an accession to wealth from the receipt of a construction allowance.
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.
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 applies the rules of Treas. Reg. § 1.263(a)-4(d)(6) to account for the allowance paid.
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.
The benefits and burdens of ownership test establishes tax ownership by evaluating several factors first adopted in Grodt & McKay Realty v. Commissioner, 77 T.C. 1221 (1981). See IRM 184.108.40.206.3(5)
For short-term retail leases, IRC 110 provides a safe harbor for retail tenants receiving qualified lessee construction allowances. A retailer tenant’s gross income does not include allowances used to construct improvements of qualified long-term real property. Qualified long-term real property is:
Nonresidential real property that is part of, or otherwise present at, the retail space for which the short-term lease applies. A short-term lease is a lease (or other agreement for occupancy or use) of retail space for 15 years or less (as determined pursuant to IRC 168(i)(3)). Retail space is nonresidential real property that is leased, occupied, or otherwise used by the lessee in its trade or business of selling tangible personal property or services to the general public. The term retail space includes not only the space where the retail sales are made, but also space where activities supporting the retail activity are performed (such as an administrative office, a storage area, and employee lounge). A taxpayer is selling to the general public if the products or services for sale are made available to the general public, even if the product or service is targeted to certain customers or clients.
Nonresidential real property as the retail space reverts to the lessor at the termination of the lease
The examiner should consider the following audit techniques to address the issue of gross income from the receipt of construction allowances:
Review annual report for new store openings and major remodels.
Review asset & depreciation ledger for assets with basis reduction or negative tax basis.
Review Schedule M adjustments for depreciation differences.
Determine that the lease agreement for the retail space expressly provides that the construction allowance is for the purpose of constructing or improving qualified long-term real property for use in the lessee's trade or business at the retail space. An ancillary agreement between the lessor and the lessee providing for a construction allowance, executed contemporaneously with the lease or during the term of the lease, is considered a provision of the lease agreement for this purpose provided the agreement is executed before payment of the construction allowance.
Examine contracts to determine ownership of leasehold improvements.
Apply the benefits and burdens test to determine tax ownership of the leasehold improvements.
Allowances only apply to realty improvements. If the retailer conducted a cost segregation study, which reallocated costs from IRC 1250 to IRC 1245 property, determine if the study considered the receipt of construction allowances in the computation of any IRC 481(a) adjustment.
A sale and leaseback describes a transaction in which the owner of property sells it to another party and immediately leases that property back from the buyer. Thus, the seller of the property becomes the seller-lessee, and the buyer of the property becomes the buyer-lessor. A sale-leaseback may include all or part of the property sold and may be for all or part of the property’s remaining useful life.
In the context of the retail industry, the retailer, which owned the property, becomes the tenant and continues to control and use the property, paying rent. A retailer may consider this arrangement when it wants a new store, distribution center, headquarters, or other building built to its own unique specifications and does not want to tie up capital in real property.
A typical lease under a sale-leaseback arrangement is long-term, usually 15 to 20 years with renewal options. The lease is usually a triple net lease, i.e., the lessee is responsible for all real estate taxes, building insurance, and maintenance on the property, in addition to rent.
FASB 98 describes the conditions needed for the transaction to be considered a true sale and leaseback under GAAP.
The primary audit consideration is whether the transaction represents a true sale or a financing. A secondary audit consideration is whether the transaction, if determined to be a sale, reflects the fair market value of the property.
The examiner should consider the following audit techniques to address the issue of sale and leasebacks:
Review the sale and purchase agreement and determine if the lessor retains significant and genuine attributes of a traditional owner, including benefits and burdens of ownership. The examiner also should consider whether the landlord/purchaser is either a related party or a tax indifferent party.
The incidence of taxation depends upon the substance of a transaction. The transaction must be viewed as a whole, and each step, from commencement to consummation, is relevant.
If the examiner determines that the transaction lacks economic substance, s/he should determine whether the transaction should be reclassified as one of the following:
A like-kind exchange (real property for a leasehold interest of 30 years or more)
A financing arrangement
A sham transaction to shift income and deductions
If the examiner determines that a true sale occurred, the examiner should:
Review the independent professional appraisal to determine if the sale price reflects the fair market value of the property. A loss may result from an unreasonable selling price. A loss may represent, in part, a real economic loss and a deferred loss such as a prepayment of rent.
Determine the character (capital or ordinary) of the gain or loss.
Review the lease agreement to determine if the rate of rent is reasonable under the facts and circumstances. Rental payments on the leaseback may be set higher than the prevailing market to compensate the seller-lessee for a selling price that is set below fair market value. The examiner should consider the character of the gain or loss if a true sale occurred.
The examiner should consider whether, before the sale, the retailer capitalized all construction period costs, (e.g., costs subject to IRC 263A).
In addition to base rent, most leases provide for the recovery of a landlord’s operating expenses through one or more recovery mechanisms. Shopping center owners recover their operating expenses through a mechanism called the common area maintenance charge or CAM. Examples of common CAM charges include mall security, parking lot and hallway maintenance. CAM charges are usually allocated on a pro rata basis among the shopping center tenants.
Common CAM clauses in retail leases:
Require retailers to pay estimated CAM charges each month in advance.
Require landlords to provide a written statement itemizing actual CAM costs at the end of the year.
Afford retailers the right to audit the landlord’s books and records to verify the expenses were incurred and the amounts are accurate.
When examining this area, the examiner should establish what evidence exists to document the arrangement between the retailer and its landlord or tenant.
The examiner should consider reviewing the following general audit techniques to identify potential issues and obtaining the following documentation to substantiate the propriety of the retailer’s lease transactions.
Review public information, including the following:
The retailer's website for new store openings and major remodels
Review tax return information, including the following:
Other current liabilities for accrued rents, deferred rent credits, and rents payable accounts
Schedule M to identify book/tax differences, such as step rents to remove stepped up rent from the tax return, depreciation differences
Review books and records, including asset and depreciation ledger for assets with basis reduction or negative tax basis.
Obtain and review written documentation, including the following:
Letter of intent to lease
Rent payment schedule
Construction, operation, and reciprocal easement agreement
Supplement agreements, which are also known as side agreements, allocable share agreements and separate agreements
Certificate of occupancy
The examiner should refer to the specific retail topics and issues for additional audit techniques.
A real estate lease is an agreement that gives a lessee the right to use and occupy real estate owned by the lessor in exchange for the payment of rent. A lease is usually for a stated period of time and includes a specific periodic cost. The lease of retail space generally consists of base rent and percentage rent.
Base (Standard) Rent
The base rent is the amount a tenant contracts to pay for the use and occupancy of the property.
The monthly rental rate is usually quoted in terms of actual dollars and in dollars per square foot.
Percentage (Contingent) Rent
The percentage rent is an amount in addition to the base rent.
Percentage rent is future rent payments based on factors that do not exist or cannot be measured at the inception of the lease.
Retail leases often include a clause calling for percentage rent.
Percentage rent is generally measured on annual sales in excess of a stipulated amount (specified minimum level).
Certain categories of sales may be excluded, such as sales to employees, sales taxes collected, and delivery charges.
Retailers usually pay a fixed amount each month plus an additional amount based on a percentage of sales.
Percentage rent is not a fixed liability until the end of the measurement period.
High-priced low-volume retailers normally pay relatively higher percentages than low profit high volume businesses.
Example: On September 1, 2008, a retailer opens a new store. The percentage rent agreement calls for 5 percent of annual sales in excess of $1M. The retailer files its tax return on a fiscal year ending in January, but the lease year runs from September 1, 2008 to August 31, 2009. The taxpayer estimates that annual sales for this store will be $2.5M. The estimated percentage rent would be $75,000. Actual sales from September 1, 2008 through January total $1.8M. If percentage rent is accrued evenly over time, the retailer would claim a deduction of $31,250 ($75,000 x 5 months/12months). If percentage rent is accrued based on sales, the retailer would claim a deduction of $54,000 ($75,000 x $1.8M/$2.5M).
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.
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.
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.
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.
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.
FASB 13 requires some leases to be treated as capital assets.
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.
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:
Taxable income will increase by the amount of book depreciation and interest expense.
Taxable income will decrease by the amount of lease payments treated as rent expense.
It is usually more advantageous to treat the lease as an operating lease for tax purposes.
This section provides general background information about accrued liabilities reported by retailers and the general accounting practices for such liabilities reported.
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.
Retailers regularly set up reserves to cover contingent liabilities. These liabilities normally arise in the ordinary course of business.
Is the reported liability associated with a deductible or nondeductible expense?
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?
If nondeductible or not currently deductible, is the amount reported properly on Schedule M?
If the related expense is deductible and recognized in the proper tax year, is the amount of liability reasonably accurate?
If a nondeductible capital expenditure, does the statute provide for a systematic cost recovery of the expenditure?
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.
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.
Taxpayers using the accrual method of accounting are entitled to deduct expenses in the year incurred, regardless of when paid.
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.
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.
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:
The all events test (but for economic performance) is met,
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,
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
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.
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.
Whether a taxpayer has satisfied the all events test is a question of law.
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.
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.
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.
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.
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 220.127.116.11.
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.
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.
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).
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.
The Supreme Court has held that a liability incurred by operation of law is fixed for tax accrual purposes.
Accruals or reserves for sales returns and allowances are common in the retail industry. Retailers recognize that some sales are eventually returned for refund.
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.
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.
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.
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).
A valued principle in financial accounting is that expenditures should be recognized in the same period as the income to which they relate.
Costs and expenses directly identifiable with specific revenues are recognized in the period in which the revenues are recognized.
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.
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.
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.
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.
Obligations associated with the retirement of long-lived tangible assets are recognized when incurred based on law, contract, or another identifiable event.
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.
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.
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.
Tax accrual accounting generally results in an earlier reporting of income items and a later reporting of expense items than financial accrual accounting.
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.
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).
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.
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.
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.
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.
There are many variations used to post accruals, but some common variations are:
Adjusting journal entries debiting returns/allowances and crediting receivables directly without the use of a reserve account, or
When reserves are credited, the corresponding debits are to either expense accounts or cost of sales.
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.
The examiner should consider the following audit techniques to address the issue of sales returns and allowances:
Review Schedule M to identify book/tax differences reported for timing adjustments.
Review Schedule L and general ledger accounts for returns and allowances and compare to Schedule M detail.
Scan the general ledger account(s) for unusual entries or multiple entries made near the end of the fiscal year.
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.
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.
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.
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.
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.
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:
Relatively long periods in which a particular rebate or refund may be claimed.
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.
The absence of a large volume of relatively homogeneous transactions.
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.
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.
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.
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.
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.
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.
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.
The examiner should consider the following audit techniques to address the issue of cash rebates:
Review Schedule M to identify book/tax differences reported for timing adjustments.
Review Schedule L and general ledger accounts for returns and allowances and compare to Schedule M detail.
Scan the general ledger account(s) for unusual entries or multiple entries made near the end of the fiscal year.
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.
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.
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.
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.
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.
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.
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.
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.
Treas. Reg. 1.451-4(d) and (e) provides for consistency between financial reporting and information to be furnished with a return.
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:
Does the sales incentive program meet the criteria for a deduction under Treas. Reg. 1.451-4?
Is the computation of estimated future redemption correct?
Is the computation of cost correct?
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.
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.
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.
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.
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.
The following issues may arise from a retailer’s accounting for its loyalty or reward program:
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?
How is the estimated future redemption rate determined?
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?
What is the cost of a point?
Whether the retailer’s customers have a conditional or unconditional right to redemption.
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.
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.
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.
Retailers establish a reserve for bad debts for all probable losses from accounts receivable. The reserve is normally based upon a percent of sales.
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.
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.
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.
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.
The store closing reserve includes an estimate of the following costs:
The operating losses of the store through the anticipated closing date
The loss on the sale or abandonment of the leasehold improvements, fixtures, and equipments
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
The lease termination costs
The severance or relocation benefits of the employees at the store
A write-off of the inventory at the store
Third party liquidator costs
Other costs incidental to store closings
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.
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.
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.
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.
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.
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 18.104.22.168.6.13.
The examiner should consider the following items in examining this issue:
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.
With respect to other estimates, the examiner should adjust any estimates to actual costs incurred before the deduction is allowed.
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.
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.
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.
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.
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.
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.
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.
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.
Retailers purchase self-insurance policies for many types of coverage, including auto, general liability, product liability, worker’s compensation, business interruption and other coverage.
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:
Premiums are based on the experience of the insured during the policy period.
The self-insured part of the premium is not due until claims are filed or until the insurance company pays the claims.
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.
An excess loss premium representing the insurance company's charge for covering any losses that exceed a stated limit.
The self-insured part of the premium will be changed if loss experiences are different than expected.
The policy generally covers a period of one year.
Payments or refunds relating to a policy may be made years after the end of the policy year.
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.
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.
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.
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.
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.
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.
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.
The examiner should consider the following audit techniques when indications of self-insurance is present:
Review insurance policies to obtain policy and funding schedules.
Verify coverage for each type of insurance to determine deductibility and areas of self-insurance.
Trace source and payment of deductibles. Also trace payment for policies beyond the broker.
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.
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.
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.
Review Schedule M adjustments for offsets to the prepaid liability insurance account. The reserve is deductible for financial purposes but not for tax purposes.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
The primary audit consideration is whether the taxpayer receives an accession to wealth from the receipt of a construction allowance.
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.
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.
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.
Once a retailer receives an income item, it must decide whether to give it tax effect at that time.
Prepaid income items are amounts received before the retailer provides the corresponding consideration (e.g. goods or services).
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.
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.
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.
IRM 22.214.171.124 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.
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.
Procedures to test liability accounts are normally tests of the entire balance, not samples.
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.
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.
Identify general ledger accounts which report:
Credit balances associated with the receipt of payments for future services. The payments may have been improperly deferred for tax reporting purposes.
Long overdue balances. The liability may have ceased to exist for various reasons.
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.
Debit balances. The liability may represent deferred income.
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.
Unusual entries (e.g. entries that are contrary to normal entries for that account)
Trends or changes in account activity that appears contrary to reasonable expectation.
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.
Consider the possibility that reserves may be recorded in multiple accounts. A reserve recorded to several different accounts is more difficult to identify.
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.
Compare two or more accounts that are related in some essential or significant way.
Additional considerations are included in this section.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
The primary audit consideration is whether the retailer has claimed a current deduction for a contested liability.
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.
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.
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.
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.
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.
This section provides general background information about business expenses reported by taxpayers in the retail industry and the general accounting practices for such expenses.
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.
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.
Is the reported business expense deductible or nondeductible?
If the expense is deductible, is the liability fixed and determinable? In other words, did the retailer deduct the expense prematurely?
If the expense is nondeductible, is the amount reported properly on Schedule M (e.g. penalty)?
If the expense is a nondeductible capital expenditure, does the statute provide for a systematic cost recovery of the expenditure?
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.
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.
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.
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.
Treas. Reg. 1.446-1(a)(4)(ii) requires taxpayers to properly categorize items between capital and expense.
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.
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.
Deductions are viewed as a matter of legislative grace and taxpayers bear the burden of proving their entitlement to any deduction claimed.
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.
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.
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.
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.
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.
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.
To qualify as necessary, an expense must be helpful and appropriate in promoting and maintaining the taxpayer’s business.
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.
Finally, an expense must be directly connected to (or proximately result from) the taxpayer’s trade or business, not that of another.
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.
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.
The determination of whether an item is deductible currently or must be capitalized turns on the unique facts and circumstances of the item.
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.
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.
A valued principle in financial accounting is that expenditures should be recognized in the same period as the income to which they relate.
Costs and expenses directly identifiable with specific revenues are recognized in the period in which the revenues are recognized.
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.
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.
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.
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.
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.
Retailers generally attempt to deduct costs rather than capitalize them.
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:
Where to find a product.
How much the product costs.
Why they should buy the product now (e.g. a sale or special event).
Retailers use a wide variety of traditional media and non-media advertising types to attract and retain customers including, but not limited to:
Newspaper & magazine ads
Direct mail free-standing inserts (FSI), flyers, circulars
Radio and TV spots (FCC licensed stations and cable)
Promotional items (e.g. caps, T-shirts)
In-store signage, displays, demonstrations and announcements
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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:
Use the property consistent with the donee’s exempt purposes solely for the care of the ill, the needy, or infants,
Not transfer the property in exchange for money other property, or services, and
Provide the taxpayer a written statement that the donee’s use of the property will be consistent with such requirements.
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.
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.
The enhanced computation is equal to the lesser of:
Basis plus one-half of the item’s appreciation (i.e. basis plus one-half of fair market value in excess of basis), or
Two times basis.
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:
$1,000 plus 1/2 x ($5,000 - $1000) = $3,000
$1,000 x 2 = $2,000
Charitable contribution deduction = $2,000
Cost of Goods Sold reduction = $1,000
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.
Potential Compliance Risks
Fair market value of the donated property is overstated.
Cost of goods sold is not reduced by the basis of the donated property.
Charitable contribution deduction exceeded two times cost.
Charitable contribution deduction exceeded 10 percent limitation.
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).
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.
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.
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.
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.
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.
See the Food Industry Coordinated Issue Paper for specific details in this area.
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.
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.
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.
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.
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.
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.
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.
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.
Retailers incur a variety of pre-opening expenses in connection with new stores. Pre-opening expenses may include:
Payroll and related costs for hiring and training new employees and managers to operate a new store
Costs for maintenance, service and supplies
Utility (e.g. electricity, gas, telephone, water) and occupancy (e.g. rent) costs preceding the opening of a store
Office, non-selling, and janitorial supplies normally consumed within a few months
Expenses for selling supplies such as paper and plastic bags
Maintenance and incidental repairs incurred prior to opening a store
Other normal and recurring store operating costs, including advertising, freight and postage, security, travel, employee relocation.
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.
For financial reporting purposes, retailers generally expense the costs incurred prior to opening a new store.
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).
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.
Whether the retailer uses a new subsidiary for a new store or a new chain of stores.
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.
Potential Compliance Risks
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.
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.
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.
When the amounts of professional fees and services are significant, their deductibility (or non-deductibility) can become an important tax consideration.
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:
A deductible expense
A personal expense
A nondeductible capital expenditure, which may be subject to depreciation or amortization
A deductible loss
A combination of the above
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.
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).
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.
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).
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.
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.
Potential Compliance Risks
Capital structure alterations (restructuring, recapitalization, reorganization)
Borrowing, including the issuance of debt
Mergers & Acquisitions
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.
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.
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.
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.
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.
Mergers and Acquisitions
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.
Amounts that are inherently facilitative must be capitalized, regardless of when the activity for which the payment is made is performed.
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.
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.
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.
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.
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.
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.
A settlement payment may represent a penalty that is not deductible for tax reporting purposes.
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.
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.
The taxpayer bears the burden of proving that it is entitled to a full or partial deduction of any settlement amount paid.
Potential Compliance Risks
Whether any portion of a settlement payment represents a nondeductible fine or penalty under IRC 162(f).
Additionally, the same issues that arise with respect to legal and other professional fees generally arise for settlement payments.
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.
If materials and supplies do not constitute inventory, tax treatment is governed by Treas. Reg. 1.162-3.
Treas. Reg. 1.162-3 allows the expensing of materials or supplies in the year of purchase if:
They are incidental,
No record of consumption is kept, and
No physical inventories are taken.
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.
Retailers strive for the best return on investment. Consequently, retailers spend significant sums of money every year to build and renovate stores.
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.
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.
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.
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.
Conversely, substantial improvements that enhance the value of property must be capitalized and depreciated. The factors indicating capitalization are:
Increase value of property
Substantially prolong life of property
Adapt property to a new or different use
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.
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?
Defining a unit of property is often a challenge in addressing a repair versus capital expenditure issue.
The particular facts involved in each case receive a great deal of attention by the courts.
Many of the criteria to distinguish deductible and capitalized costs are relatively subjective in nature (e.g. "incidental," "significant future benefit" ).
The examiner may find cases that have relatively similar facts but come to entirely different conclusions.
Potential compliance risks include store remodeling costs and asbestos removal costs.
Store Remodeling Costs
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?
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?
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.
Asbestos Removal Costs
Three methods are generally accepted for asbestos abatement: (1) encapsulation (2) removal and (3) enclosure.
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.
Generally speaking, removal costs do not require capitalization when the removed asset is replaced. See Rev. Rul. 2000-7.
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).
The IRS takes the position that Rev. Rul. 2000-7 does not apply to asbestos removal costs.
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.
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.
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).
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.
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.
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.
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.
An uncollectible amount raises a question of when the retailer may claim a bad debt deduction for such amount.
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.
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.
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.
The year of worthlessness is fixed by identifiable events that form the basis of reasonable grounds for abandoning any hope of recovery.
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)
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.
Potential Compliance Risks
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.
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.
The burden of proving that debt is worthless and the year in which the debt became worthless is on the taxpayer.
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.
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.
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.
The issue of when a deduction can be claimed for prepaid expenses arises in many industries, including retail.
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).
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.
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:
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.
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.
Retailers may incur fines and penalties for a variety of reasons. Retailers commonly incur fines and penalties associated with
Environmental matters (e.g. storm water run-off, leaky refrigeration systems/ozone leakage)
Safety matters (e.g. federal law prohibits anyone under 18 from operating certain machinery such as forklifts and paper balers)
Employment matters (e.g. hiring illegal aliens)
Sales-related matters (e.g. pricing inaccuracies/scanner overcharges; state departments of weight and measures infractions; cigarettes sold to underage customers).
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.
For financial reporting purposes, fines and penalties are expensed as incurred.
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).
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.
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).
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.
Potential Compliance Risk – Whether the retailer deducted any fines or penalties for tax reporting purposes.
Retailers work for legislation favorable to them and their industry (e.g. national sales tax).
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.
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.
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.
For financial reporting purposes, trade association dues and lobbying expenses are expensed as incurred.
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:
Influencing legislation (i.e. direct lobbying of the legislature)
Participating in a political campaign of a candidate for public office
Attempting to influence the public regarding elections, legislative matters, or referendums (i.e. grassroots lobbying)
Communicating with "covered executive branch officials."
Trade associations notify their membership under IRC 6033(e)(1)(A)(ii) of the amount of dues allocable to political expenditures.
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.
Audit Techniques should include the following below.
The examiner should review Schedule M for permanent book-tax differences.
The examiner should obtain detailed schedules for Schedule M adjustments (i.e. political contributions and lobbying expenditures).
The examiner should ask if the retailer maintains a government liaison department and, if so, ask how the costs of the department are reported.
The examiner should request copies of trade association IRC 6033(e) notifications confirming the nondeductible percentage for association dues.
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.
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.
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.
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.
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.
In assessing audit risk, the examiner should scan the expenses per the return and consider those which are large, unusual or questionable.
The examiner should scan the Schedule M for book-tax differences.
The examiner should obtain detailed schedules of nondeductible items and compare to items found during the analysis of general ledger accounts.
The examiner should trace the selected expenses back through the books to the original source documents.
The examiner should verify the timing of the expense.
The examiner should verify the amount of the expense.
The examiner should be aware of possible technical issues discussed in this section.
The examiner should consider the appropriate use of sampling techniques to enhance and improve the examination process for selected expenses.
Payment of another’s expense and personal expenses should also be considered.
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.
In the review of reported business expenses consider the possibility that the retailer may have deducted the business expenses of another person.
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:
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.
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.
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.
The examiner should consider the following audit techniques to address the issue of deductibility when a taxpayer pays another’s expenses:
Identify the motive or purpose that caused the taxpayer to pay the obligations of the other person.
Determine whether the motive supports an ordinary and necessary expense of the taxpayer’s trade or business.
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.
In order to gain new business or to retain and increase the existing customer base, numerous vendors offer incentives to retailers. Awards or prizes received by retailers are not merchandise intended to be offered for sale, they are enticements offered to owners or to other authorized decision makers with the intention of obtaining or increasing sales to that retailer. In some cases the retailer will pay a higher price and forfeit allowances or rebates in order to qualify for trips or other personal incentives.
Examples of incentives and possible scenarios include:
Purchase plateau awards which are received by the retailer as a result of an offering to all applicable retailers. Vendor A, Inc. awards a $ 500 color television to non-corporate Retailer X, who properly reports the $ 500 value in income. Vendor B, Inc. awards a $ 2000 trip to non-corporate Retailer Y, but does not issue the required Form 1099, Retailer Y does not report the fair market value as income, since no Form 1099 was issued.
Bribes or kickbacks are given to owners or employees as a result of the vendor's attempt to get the product purchased. Vendor A's salesperson pays one-third of his/her commission to the corporate buyer in exchange for the buyer discontinuing the purchase of a competitor's product.
The retailer may purchase personal, non-merchandise items from the vendor which are billed to the retailer as part of a normal product invoice. The retailer pays the invoice and deducts the full amount as a cost of goods sold. For example, a wholesaler offers several different trips which a retailer can purchase at a favorable rate. The reduced rate is possible as a result of the wholesaler negotiating with travel agents for a large number of these trips, also the wholesaler requests and receives monies from several large product manufacturers to offset a portion of the costs. The retailer selects a trip with a cost of $ 4000. For the next 5 months the wholesaler will include on its monthly invoice a line item for $ 800. Since the monthly purchases average between $ 50,000 and $ 100,000, the extra amount does not distort the payment.
Audit procedures can include the following:
Secure and review internal audit reports and policies regarding purchasing practices.
Request information pertaining to key employees who have been dismissed and interview them about retailer treatment of vendor incentives.
Ask questions regarding the receipt and disposition of non-inventory vendor awards.
Determine if the owners, family, or key employees took any vacations or received any property provided by vendors.
Personal expenses of the owners of a retail business may find their way into a tax return and be deducted as part of cost of goods sold or some type of expense.
These expenditures can cover a broad range of services or merchandise. In many cases the taxpayer purchases personal goods or services from vendors with whom they also conduct normal business. In other cases vendors foreign to the operation of the business are involved.
Retailers usually have vendor access to many products or services which the average household consumes or uses during the year. The owners of a closely held business are not likely to purchase products for their own use at retail from a competing business when the product is available at their own store for cost.
Audit procedures can include the following:
Secure and review the taxpayer's policy and practice regarding merchandise withdrawn for personal use and determine the reasonableness and accuracy of the records maintained.
Review the accounts payable records for unusual vendors.
This section provides general background information about common business tax credits within the Retail industry.
Tax credits are generally appealing to businesses because they give a business a more favorable dollar-for-dollar reduction in tax, rather than a deduction from taxable income.
Temporary credits are sometimes available to taxpayers due to disasters occurring from hurricanes (e.g., Hurricane Katrina in 2005), severe storms, tornadoes, earthquakes and floods. These credits, when codified, are generally of limited duration and within specified time periods.
Is the retailer entitled to claim the amount reported as a tax credit?
Is the amount reported as a tax credit proper? A tax credit is generally limited by amount, percentage, or a combination of both.
Did the retailer reduce, if required to do so, any related tax deductions (e.g., salaries and wages expense) by the amount of related tax credit?
IRC 38 governs business tax credits.
Research and Experimental (R&E) - IRC 41
Investment Credit – IRC 46
Work Opportunity Tax Credit (WOTC) – IRC 51
Welfare-to-Work Credit (W-t-W) – IRC 51A
New Markets Tax Credit – IRC 45D
Empowerment Zone Credit – IRC 1396
Indian Employment Credit – IRC 45A
Did the retailer use a consultant in the computation of its tax credit(s) claimed on its original tax return or amended tax return?
Did the retailer pay an outside vendor to compute its tax credits on a contingency fee basis or as a percentage of credits earned?
Has the retailer filed any claims (either formal or informal) for additional credits?
Retailers frequently use outside consultants such as payroll companies to compute certain credits.
Retailers routinely experience rapid labor turnover and oftentimes hire persons from targeted groups of hard-to-employ individuals under several statutory provisions that provide a tax credit.
Federal income tax credits generally have no impact on the retailer’s books for financial purposes.
Many credits require a proportional decrease in the related expense resulting in a Schedule M adjustment.
Some tax credits an examiner may see on a retailer’s tax return include:
Research and Experimental (R&E) - IRC 41
Investment Credit – IRC 46
Work Opportunity Tax Credit (WOTC) – IRC 51
Welfare-to Work Credit (W-t-W) – IRC 51A
New Markets Tax Credit – IRC 45D
Empowerment Zone Credit – IRC 1396
Indian Employment Credit – IRC 45A
Retailers generally do not deal in basic research, development, or experimentation of new products. Some retailers, however, have claimed research credit related to computer software development and other research activities.
The credit is computed on Form 6765.
Should the examiner encounter this credit on the examination, contact the Research Credit Technical Advisor for assistance.
The investment credit comprises the following:
Examiners may need to take a closer look at these credits if deemed material.
The most common type of investment credit on a retail examination is the energy credit.
Many retailers look for energy efficiencies when remodeling or building new stores.
The temporary WOTC, (formerly known as the "Targeted Jobs Credit" ), which was authorized by the Small Business Job Protection Act of 1996, is meant to induce employers to hire members of families receiving benefits under the Temporary Assistance to Needy Families (TANF) program and other groups thought to experience employment problems regardless of general economic conditions (e.g., food stamp recipients and ex-felons) as defined by IRC 51 (d).
In 2007, the Tax Relief and Health Care Act of 2006 (P.L. 110-28) extended the WOTC provision through August 31, 2011. P.L. 110-28 merged the W-t-W Credit into the WOTC effective for job start dates beginning January 1, 2007. It added "rural renewal county" to the places of residence for designated community residents. The legislation also:
Adopted H.R. 976's definition of disabled veterans
Raised the age limit to less than 40-year olds for designated community residents
Clarified the definition of vocational rehabilitation referrals
Allowed the WOTC and tip credit against the AMT.
WOTC is available on an elective basis. WOTC allows employers a credit against their federal tax liability for hiring individuals from one or more of eleven targeted groups. The targeted groups are:
Qualified TANF recipients
Qualified Designated Community Residents (DCR), formerly the High Risk Group
Qualified Vocational Rehabilitation Referrals
Qualified Summer Youth
Qualified Food Stamps recipients
Qualified SSI recipients
Qualified Long-term Family Assistance recipients, formerly Welfare-to-Work individuals
Unemployed veterans (2009-2010 only)
Disconnected youth (2009-2010 only)
The amount of the credit available is determined by the amount of qualified wages paid by the employer. For purposes of the credit, generally wages are defined by reference to the Federal Unemployment Tax Act (FUTA) definition of wages contained in IRC 3306(b). Qualified wages consist of wages attributable to service rendered by a member of a targeted group during the one-year period beginning with the day the individual begins work for the employee.
The WOTC is a two-tiered tax credit providing a 25 percent credit of an employee’s first year wages up to $6,000 for employees that work between 120 and 399 hours and 40 percent of the employee’s first year wages up to $6,000 for employees that work at least 400 hours. The maximum credit is $2,400. With respect to qualified summer youth employees, the maximum credit is $1,200 (40 percent of the first $3,000 of qualified first year wages).
Certification. An individual is not treated as a member of a targeted group unless, on or before the day on which the individual begins work, the employer receives or requests in writing certification from the designated local agency that the individual is a member of the targeted group. The agency is designated by the Department of Labor who administers the WOTC. The examiner should review such receipts or requests by comparing postmarks (or received dates) with dates the individual actually begins work.
Minimum Employment Period. No credit is allowed for qualified wages paid to employees who work less than 120 hours in the first year of employment.
Non-qualified Individuals. No credit is allowed for wages paid to a relative or dependent of the employer. No credit is allowed for wages paid to an individual who is more than a 50 percent owner of the entity. Similarly, wages paid to replacement workers during a strike or lockout are not eligible for WOTC. Wages paid to any employee during any period for which the employer received on-the-job training program payments with respect to that employee are not eligible for WOTC. WOTC generally is not allowed for wages paid to individuals who had previously been employed by the employer (i.e. "rehires" ).
Independent Employment Firms. Retailers who routinely employ members of targeted groups often rely on independent employment firms who pre-screen the individuals to ensure that all the qualification and certification requirements are met for the retailer. An additional review of these qualifications by a designated local agency should satisfy any concerns the examiner may have as to proper designation of an individual to a specific targeted group.
Some tax compliance concerns involving WOTC and W-t-W credits emerged shortly after the issuance of Rev. Rul. 2003-112 in November 2003.
Some taxpayers contended they were improperly denied certification for certain new hires prior to the revenue ruling.
In May 2004, the IRS became aware of taxpayers filing refund claims to preserve entitlement to WOTC or W-t-W tax credits for past years.
Some taxpayers contended that their entitlement to WOTC and W-t-W tax credits does not necessarily require state certification.
Claims cite the Targeted Jobs Tax Credit (TJTC) litigation to support the position that state certification is not required.
Case law allowed the TJTC without certification where the state agencies were no longer operating due to lack of funding. Announcement 2000-58 provided an administrative resolution for TJTC, allowing a credit for 50 percent of taxpayer claims.
TJTC and WOTC are different thus the taxpayer’s position has no merit.
It is the IRS’s position that no credit will be allowed for any WOTC and W-t-W claims without proper certification by a designated local agency in accordance with the statute; see IRS Announcement 2006-49.
If the retailer employs a large number of targeted individuals, the examiner should consider a statistical sample to ensure that all IRC 51 requirements have been met.
Does the retailer have certification from a designated local agency for each of the employees for which the WOTC is claimed?
Did the retailer claim a credit for any individuals who are not qualified for WOTC?
Does the amount reported as qualified wages include any amount paid or incurred that the retailer used to claim for other employment-related tax credits? A business cannot count wages for both the WOTC and W-t-W credits and other employment-related tax credits.
Did the retailer reduce the amount deducted on its tax return for salaries and wages by the amount of the WOTC? The deduction must be reduced by the amount of the credit.
Did the retailer consider the employee’s employment period in computing the credit percentage? A business cannot claim the WOTC and W-t-W credits if the employee worked less than 120 hours. If an employee works between 120 and 400 hours, the business can claim a credit of 25% for hours worked after 10/1/1997.
Did the amount reported include amounts paid or incurred for employees that do not qualify for the credit?
The Taxpayer Relief Act of 1997 added W-t-W to the Internal Revenue Code.
The W-t-W tax credit was inserted as a separate provision in the Internal Revenue Code to help the federal effort to move welfare recipients onto payrolls. It is meant to encourage employers to hire particularly disadvantaged members of the TANF group, namely, long-term family assistance recipients.
Like WOTC, W-t-W is available on an elective basis. Generally, qualified wages consist of wages attributable to service rendered by a long-term family assistance recipient during the two-year period beginning with the day the individual begins work for the employer.
The W-t-W program provides employers with credits up to $3,500 for a qualified worker’s first year of employment and $5,000 for the second year.
The credit is equal to 35 percent of the first $10,000 in qualified wages for new hires who work 400 or more hours (or 180 days) the first year.
The credit increases to 50 percent of the first $10,000 in qualified wages the second year.
The Tax Relief and Health Care Act of 2006 (P.L. 110-28) made many changes to the W-t-W credit including incorporating the separate provision for long-term assistance recipients into the WOTC. For long-term family assistance recipients hired after January 1, 2007:
The credit is equal to 25 percent of the first $10,000 in qualified wages for new hires who work between 120 and 399 hours the first year of employment.
The credit is equal to 40 percent of the first $10,000 earned during the first year of employment if individuals work at least 400 hours.
The credit is equal to 50 percent of the first $10,000 earned for the second year of employment.
Qualified wages are cash.
The examiner should consider the WOTC audit considerations when examining the W-t-W credits.
The New Markets Tax Credit, IRC 45D as added by the Community Renewal Act of 2000, is a new tax credit created to spur investment in low-income or economically disadvantaged areas.
As part of the general business credit, the New Markets Tax Credit is five percent of a qualified equity investment in a qualified community development entity (CDE) as of the original issue date. The five-percent rate is for the first three allowance dates and increases to six-percent for each of the four remaining allowance dates. The allowance dates are the initial offering date and the first six anniversary dates of the initial offering date. The total credit is 39 percent and is claimed over seven annual allowance periods. Credit limitations for each calendar year are applicable.
As part of the general business credit, the New Markets Tax Credit is subject to the limitations of IRC 38 and the carryover rules of IRC 39. However, the credit may not be carried back to tax years before January 1, 2001.
A qualified equity investment is the cost of any stock in a corporation or any capital interest in a partnership that is a qualified CDE, as certified by the Secretary of the Treasury, if:
The investment is acquired on the original issue date solely in exchange for cash,
Substantially all of the cash is used to make qualified low-income community investments, and
The investment is designated by the qualified CDE for new markets credit purposes.
If during the seven years from the original issue date of the qualified equity investment, a recapture event occurs with respect to the investment, then the New Markets Tax Credit must be recaptured. The recapture penalty is severe. Although only the credits claimed (i.e., those credits for which the taxpayer received a tax benefit) are recaptured, the underpayment interest begins to accrue from the due date of the return without extensions for each year the credits were claimed. Additionally, the interest may not be deducted as a reasonable and necessary business deduction. Finally, the recapture amount is treated as an increase in the tax after the regular tax liability and the alternative minimum tax liability are determined.
The Secretary of the Treasury shall prescribe regulations for this section that:
Limit the amount of credit for investments which are directly or indirectly subsidized by other federal benefits,
Prevent abuses of this section,
Provide guidance to determine if the investment requirements are met Impose appropriate reporting requirements, and
Apply this provision to newly formed entities.
The Empowerment Zone (EZ) and Enterprise Community (EC) Initiative is focused on the creation of self-sustaining long-term development in distressed urban and rural areas throughout the country.
The Federal government has established approximately 80 Empowerment Zones and Renewal Communities in many areas across the U.S. The federal tax benefits available in EZs and ECs are designed to encourage businesses to invest in these areas.
The Empowerment Zone Employment Credit (EZEC) provides businesses with an incentive to hire individuals who both live and work in an empowerment zone.
A qualified zone employee is any full-time or part-time employee who:
Performs substantially all employment services for an employer located within an empowerment zone,
Resides within the same empowerment zone where that individual is employed (anywhere in the District of Columbia for the DC zone), and
Is employed by the employer for at least 90 days while performing those services.
Qualified zone wages are any wages the business pays or incurs for services performed by an employee while the employee is a qualified employee. Qualified zone wages include training and education expenses.
The total amount of qualified wages (including training and education expenses) cannot be more than $15,000 for each employee each tax year.
The credit is 20% of the current year qualified wages.
Form 8844 is used to claim this credit. The credit is a component of the general business credit.
The regulations do not impose specific record-keeping requirements. However, an employer is expected to have and maintain records sufficient to identify each employee with respect to whom the employer claims the EZEC, and to maintain records sufficient to establish where each employee actually worked and lived during the relevant period.
The EZEC website is a great tool for examiners to determine if a particular area is considered an EZ or EC area. The current website is http://www.ezec.gov.
An address locator is available on the internet to assist the examiner in determining whether a business or residence is located within a Renewal Community (RC), EZ or EC. This online tool can help verify if a particular location is eligible for the tax incentives offered in RC/EZ/EC areas. The website is administered by the U.S. Department of Housing and Urban Development. The current website for the "RC/EZ/EC Address Locator" is http://egis.hud.gov.
Did the retailer claim the EZEC with respect to wages paid or incurred during the calendar year to employees providing services at a store located within an enterprise community or zone? A retailer is not entitled to claim the EZEC with respect to wages paid or incurred during the calendar year to employees providing services at a store located outside an enterprise community or zone.
Does the amount shown as qualified wages include any amount paid or incurred that the retailer used to claim the WOTC? A business cannot count wages for both the WOTC and W-t-W credits and the EZEC.
Does the retailer reduce the amount deducted on its tax return for salaries and wages by the amount of the EZEC? The deduction must be reduced by the amount of the credit.
Does the amount reported include amounts paid or incurred for employees that do not qualify for the credit? A business cannot count wages paid to an employee that is:
Related to the employer
A five-percent owner
An individual employed for fewer than 90 days
An employee of golf courses, massage parlors, hot tub or suntan facilities, gambling facilities and liquor stores
An employee of farming businesses with owned or leased assets having a fair market value or basis exceeding $500,000.
The Indian Employment Credit provides businesses with an incentive to hire individuals who live on or near an Indian reservation. A business can claim the credit if it pays or incurs qualified wages to a qualified employee.
A qualified employee is:
An enrolled member of an Indian tribe or the spouse of an enrolled member of an Indian tribe, or
An employee who performs substantially all of his or her services for the business within an Indian reservation,
While performing those services, the employee has his or her main home on or near that reservation.
Qualified wages are any wages the business pays or incurs for services performed by an employee while the employee is a qualified employee. Wages are generally defined as those wages subject to the FUTA without regard to the FUTA dollar limit.
Health insurance costs a business pays on behalf of a qualified employee are treated as qualified wages. However, amounts paid or incurred for health insurance under a salary reduction arrangement are not treated as qualified wages.
The total amount of qualified wages (including qualified employee health insurance costs) cannot be more than $20,000 for each employee each tax year.
In most cases, the credit is 20% of the excess of the current year qualified wages and qualified employee health insurance costs over the sum of the corresponding amounts paid or incurred during calendar year 1993.
Form 8845 is used to claim this credit.
Audit Considerations include the following:
Did the amount reported as qualified wages include any amount paid or incurred that the retailer used to claim the WOTC? A business cannot count wages for both the WOTC and W-t-W credits and the Indian Employment Credit.
Did the retailer reduce the amount deducted on its tax return for salaries and wages by the amount of the Indian Employment Credit? The deduction must be reduced by the amount of the credit.
Does the amount reported include amounts paid or incurred for employees that do not qualify for the credit? A business cannot count wages paid to an employee that is: (1 An employee to whom the retailer paid or incurred wages at a rate that would cause the retailer to pay the employee more than $30,000 if the rate applied for the entire year, (2) Related to the employer, (3) A certain dependent, (4) Any five-percent owner, (5) An individual who performs services involving certain gaming activities, and (6) An individual who performs services in a building which houses certain gaming activities.
About two-thirds of the state of Oklahoma is classified as former Indian reservations that qualify for the Indian employment tax credit.
Review the following Forms:
Form 3468, Investment Credit (one of the components of the general business credit)
Form 3800, General Business Credit
Form 5884, Work Opportunity Tax Credit
Form 8844, Empowerment Zone and Renewal Community Employment Credit
Form 8845, Indian Employment Credit
Form 1120, Schedule J, Line 6d to assess audit risk
Prepare a comparative analysis for multiple tax years to identify any unusual fluctuations from year to year
Review Form 8886 for disclosure of contingency fees related to credits
Review the workpapers used to calculate the dollar amounts of the credit.
Verify the amount of the carryover to the current year under exam
Review all supporting documentation
Review claims for credit not claimed on the original filed tax return
Certain credits require a reduction in the amount of the otherwise allowable expense deduction. Verify a Schedule M adjustment was made to reduce the related expense deduction.
Specialists should be contacted when appropriate
[Reserved] This section has been reserved for electronic commerce. Refer to http://www.irs.gov/businesses/small/article/0,,id=108188,00.html.
This section provides a brief description of the specialty areas that may affect the retailer. The examiner will want to refer to a specialist in the local area to address an issue in the area of international, financial products, and employment tax. The examiner will also want to refer to a specialist if they require the assistance of an economist, engineer, or a computer audit specialist. This section will briefly provide an explanation of how these specialists will be able to assist the examiner in the audit of a retailer.
Each of the specialty areas is described in detail in other parts of the IRM. A reference to the applicable IRM sections is provided in each of the discussions below.
This section briefly describes how international issues can affect the retailer. For further information on the International program, please refer to IRM 4.60 and 4.61. Referral criteria and procedures are found specifically in IRM 4.60.6.
A large portion of a retailer’s overseas purchases of apparel comes from relatively low-wage countries, particularly in Asia.
Imported merchandise from these countries is usually made to the specifications of the importing American wholesalers and retailers. Also, fabric is often produced in a country other than that where the cutting and sewing of the apparel takes place.
United States (U.S.) purchasers often use buying agents or trading companies as intermediaries when dealing with overseas factories. Although these may be independent firms, they are often subsidiaries ("CFC" or Controlled Foreign Corporation) of the domestic purchaser.
The foreign intermediary (whether related or unrelated) may perform a number of functions. These may include:
Inspecting the goods for quality both during production and at completion
Assisting in the selection of factories and the procurement and refinement of initial samples
Arranging and coordinating the supply of fabric
Supervising shipping logistics
Keeping the U.S. buyer informed about market conditions in the supplying country or region
Potential transfer pricing issues can arise under IRC 482 when the CFC performs these functions. In determining the potential transfer pricing issue, the examiner should assess the real economic risk borne by the CFC.
When a CFC handles goods which are manufactured or consumed outside of its country of incorporation, there are also potential issues involving foreign base company income under Subpart F.
Transfer pricing and IRC 482 issues can arise anytime there are transactions between related parties. The examiner should be aware of this issue particularly when one of the parties is a foreign entity that does not file a U.S. tax return. These entities could be a foreign corporation controlled by U.S. shareholders (a CFC), a U.S. corporation owned or controlled by non-U.S. shareholders (an "FCC", or Foreign Controlled Corporation), or other entities where common control exists between a U.S. taxpayer and a non-U.S. entity.
IRC 482 cases involve determining whether prices charged in controlled transactions meet the arm's length standard. The purpose is to place a controlled taxpayer on par with an uncontrolled taxpayer, as if the taxpayer were dealing at arm's length with an uncontrolled taxpayer.
Treas. Reg. 1.482-1(c) establishes a best method rule for selecting the proper method for determining the arms length price. The charge for a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm's length result. Treas. Reg. 1.482-3 and Treas. Reg 1.482-4 list specified methods for determining an arm's length charge for a controlled transfer of tangible property and intangible property, respectively. For more information on examining IRC 482 issues, please see IRM 4.61.3.
When examining a company in the apparel industry, the examiner should be aware of commission charges between the US parent and the CFC. Buying agents or trading companies purchase inventory from foreign sources and then sell them to the domestic company. An issue may arise about the appropriate compensation for the CFC.
In evaluating the arm's-length nature of the commission arrangement between the domestic parent and the CFC under IRC 482, steps to be taken typically would include efforts:
To identify and develop comparables in the same geographic market
To distinguish or make appropriate adjustments to the taxpayer's comparables or other comparables that are identified
To adjust the CFC's results based on the results of comparable uncontrolled transactions, to the extent those can be found.
To start, a functional analysis must be made of the managerial, financial, and other links between the domestic parent and its CFC. This would involve an analysis of the functions performed within both companies.
The following checklist has been prepared as an aid in the identification and collection of basic economic and financial data needed for the development of IRC 482 issues.
Name and geographic location of all related entities: How the entities are related, and where they are incorporated
Principal business activity of each affiliate: Products involved, levels of market served, and principal customers
Copies of most detailed financial statements available including supporting schedules for each affiliate for each year in question
Information for controlled sales between affiliates regarding type of property involved, functions performed, and value contributed by each of the parties
Copies of all contracts and/or agreements for controlled sales regarding: provision of quota for exports, provision of financing to support manufacturing and shipping processes, provision with respect to initial samples and suggesting modifications to samples, provision of test orders, provision of administrative freight service, assumption of risks for defects or delivery, and taking title to finished goods .
Detailed information relative to any uncontrolled sales of taxpayer in which the physical property and circumstances were similar to those of the controlled sales
Discussions with corporate officers, members of the tax department, department heads or tax professionals employed by the company. Information should be obtained directly from individuals involved in the actual day-to-day operations and not through the tax department personnel.
The principal and background documents described in the regulations under Treas. Reg. 1.6662-6. The failure to maintain or timely produce such documentation may be grounds for imposition of the transfer pricing penalty under IRC 6662. See also Rev. Proc. 94-33.
Not all of the above functions may be performed on every examination, but they do provide a starting point for the examiner. Examiners must be resourceful and use techniques that may be required under each particular set of facts and circumstances in each case.
It is important to have the economist and local counsel involved as early as possible. They can assist the examiner in selecting and seeking cooperation from potential third party witnesses and in selecting the correct method for determining the arm's-length price.
IRC 482 issues involve very substantial resources for the taxpayer and the IRS. Many IRC 482 issues have been successfully resolved before the filing of the taxpayer's return or before the IRS elevates the issue in an examination through the use of Advanced Pricing Agreements (APAs).
An APA is an agreement between the IRS and the taxpayer on a transfer pricing method. This methodology may be applied to any apportionment or allocation of income, deductions, credits, or allowances between or among two or more entities owned or controlled, directly or indirectly, by the same interests.
The APA process is designed to be a flexible problem-solving process, based on cooperative and principled negotiations between taxpayers and the IRS. Taxpayers formally initiate the process for APAs. APAs require discussions among the taxpayer, one or more associated enterprises, and one or more tax administrations, including the IRS.
APAs exist under our various tax treaties and are consummated through each country's Competent Authority office's referral procedures. A more extensive description of APAs can be found in the Tax Treaty Related Matters of IRM 4.60.3.
IRC 954(a)(2) and (d) define foreign base company sales income as income derived in connection with the purchase/sale of personal property from/to (or on behalf of) a related person. In this case, the property is manufactured, produced, grown, or extracted outside the country where the CFC is created or organized. In addition, the property is purchased or sold for use, consumption, or disposition outside such foreign country.
Buying agents or trading companies purchase inventory from foreign sources and then sell it to the domestic company. Most domestic companies establish their own buying agents in foreign countries.
New sources for apparel production are sprouting up in the Philippines, Indonesia, Singapore, Sri Lanka, South Korea and the People's Republic of China. However, U.S. companies are still using their Hong Kong buying agents to procure goods manufactured in other countries.
Nearly all merchandise that is bought from these low wage countries is made to the specifications of the importing U.S. producers and retailers. This means that U.S. purchasers provide samples of the styles and the designs they want produced and often supply the fabrics, which they may have purchased in another country. All of this is coordinated through the buying agent, who may then treat the sale of the merchandise to the U.S. Company as a sale of its merchandise.
For more information on Foreign Base Company Sales Income, refer to IRM 4.61.7.
Suggested audit guidelines are:
Analyze gross income figures to ensure that proper costs are deducted from gross receipt figures
Ascertain that the taxpayer is limited to the cost figures according to the U.S. tax accounting concepts so that the CFC includes or excludes costs that should or should not be in the cost of goods sold computation
Determine if, in arriving at the cost of goods sold for Subpart F income sales, the taxpayer was consistent in its method of computation for purposes of applying the de minimis rule (the lesser of 5 percent of gross income or $ 1,000,000) or the full inclusion rule (70 percent of gross income) under IRC 954(b)(3).
Be aware that purchases or sales may be made on behalf of a related person with a commission paid to the CFC which would, if identifiable, be Subpart F income. Examiners should be alert to this possibility as the commission would come from the unrelated third party and would not stand out as income arising in a transaction between related parties.
There are numerous other international issues that may affect the retailer. These include: permanent establishment rules, certain branch income, foreign tax credit, extraterritorial income, foreign sales corporations, IRC 199 issues, Captive Offshore Insurance, and joint operations with foreign entities.
These issues are further detailed in IRM 4.61. International examiners have special training on the various international issues. Consideration should be given to making a referral to an International specialist. Referral criteria and procedures are specifically found in IRM 4.60.6.
This section briefly describes the computer audit specialist’s (CAS) role in the examination of a retailer. For more information in the CAS program, please refer to IRM 4.47.
A retailer’s large volume of business transactions results in a large volume of computerized data. The CAS will facilitate the examination of a retailer with computerized records.
A CAS can be an integral part of the exam team. As a team member, the CAS can:
Provide an overview of accounting systems
Generate reports from data not available in hardcopy format
Plan examination areas, develop issues, lay groundwork for future issues
Examine issues that were previously considered beyond reach due to the large amount of data that needed to be screened in order to uncover meaningful details
A CAS can assist the exam team by providing numerous reports that may assist the examiner. The following is not an all-inclusive list:
Comparatives from year to year
Stratification of accounts
Selection of detailed invoices
Defragmenting of invoices
Analysis of double-sided journal entries
Retailer enters into a large volume of business transactions every day, including transactions for sales to customers and purchases from vendors. The examination of a retailer should include special consideration of the accounting systems and records used to account for these voluminous transactions.
Cost of Goods Sold (COGS) is the largest expense for a retailer. Ending inventory, which is indirectly related to COGS, should be examined to determine if goods in-transit have been included. Failure to account for inventory in-transit will overstate the COGS deduction.
To compute in-transit inventory, a taxpayer may accumulate purchase invoices received after year-end for a period of time and examine them for dates from the prior year. If the period of time selected by the taxpayer to accumulate purchase invoices is too short to capture all invoices attributable to purchases made prior to year-end, the purchase journal for the following year should be examined to determine the proper amount of in-transit merchandise.
A CAS can access the computerized Purchases Journal to determine the proper amount of inventory in-transit through the following steps:
Determine the date that will serve as the cut off for receipt of prior year invoices
Request all or part of the subsequent year Purchases Journal that includes transactions posted through the cut off date
Isolate the transactions dated through the end of the prior year
Separate the invoices by LIFO pool for the requisite LIFO calculations.
An analysis of the fixed asset files of a taxpayer can determine the proper allocation between IRC 1245 and IRC 1250 property.
A retailer will use a construction in process (CIP) account to accumulate all costs associated with a project. A predetermined ratio may be applied against the account to determine the amount of IRC 1245 and IRC 1250 property. The detailed Accounts Payable and General Ledger records will contain a data field for the project codes. By collecting all records associated with a project, computer analysis can determine whether all construction costs are included in the CIP account. Another analysis can be used to compare the costs in a CIP account to the value of the assets depreciated that relate to the project.
The detailed Accounts Payable and General Ledger records will contain a data field for the project codes. By collecting all records associated with a project, computer analysis can determine whether all construction costs are included in the CIP account. Another analysis can be used to compare the costs in a CIP account to the value of the assets depreciated that relate to the project.
The CAS can also search accounts payable detail records for the names and/or numbers of vendors known to provide construction related products or services. Include the following in the search for capital items:
Analyze costs of environmental clean up, bond issuance and professional fees
Review supply and repair accounts to obtain vendor information and to defragmentize invoices
Analyze security accounts to obtain costs associated with devices to reduce shoplifting
Many retailers have their own in-store credit cards. Some retailers will even have a different credit card for each operating division. As expected, some customers will default on their credit card charges.
The Tax Reform Act of 1986 eliminated the reserve method of accounting for bad debts. After 1986, an account must actually be worthless before it can be written off.
The examiner should review the retailer’s policies to determine worthlessness and if the retailer is complying with such policies. The examiner should also evaluate the aggressiveness of the retailer's write-off policy.
If the retailer's policy is too aggressive or if the retailer fails to comply with written policy, analyze the accounts written off. Only worthless accounts can be written off.
Since a large retailer may have millions of credit card accounts, the analysis performed by the CAS should consider these steps:
Reconcile the Accounts Receivable credit card file to the tax return. If possible, reconcile the write-offs for one or two months to a schedule that ties to the return. This will save time by eliminating the need to analyze the entire file.
Transfer a sample of the data to a spreadsheet or database for analysis. The information can then be manipulated to determine if the retailer is too aggressive or to formulate a write-off policy that identifies only worthless accounts.
The Accounts Receivable file analyzed must contain sufficient information to test for premature write-offs and to test any new write-off policy. The file should contain, among other items:
Account Type -- Indicates if the account is a revolving charge or if full payment is due monthly
Write-Off Type -- Includes the write-off code. Accounts written off due to bankruptcy may contain a different code for the chapter of bankruptcy filed. If the account holder files for bankruptcy the retailer may attempt to write-off the account even if it is not yet delinquent.
Write-Off Amount -- This may be the balance at the start or end of the month. Verify that payments received in the write-off month receive proper treatment.
Write-Off Date -- Specifies the date that the account is written off. Be aware that accounts written off in prior years may still be in the file, although inactive.
Waiver Code -- Indicates if special treatment was granted. Credit managers can delay write-off by entering a code in this field.
A CAS can assist in the review of the retailer’s reserve accounts.
The Description and Payee fields in the General Ledger or Accounts Payable files can be searched for words such as Reserve or Estimate. The titles found in the Chart of Accounts can also be inspected for similar terms.
Reserves may also be identified by searching general liability accounts for even amounts or amounts that are evenly divisible by an even number. The amount field can also be inspected for values ending in three or more zeroes.
The CAS can help measure the retailer's participation in certain compliance programs. This will require coordination with the employment tax specialist. The employment tax program is further detailed in IRM 4.23.
An analysis of the Accounts Payable will determine if all required recipients of non-employee compensation received a Form 1099. Some accounts with high potential for containing non-employee compensation are:
The Payee field of the records found in these accounts may be examined to locate non-corporate recipients. The records can be printed or transferred to a spreadsheet for data manipulation. The employment tax examiner can eliminate all records that indicate a corporate payee (e.g. terms such as corp. or Inc.). Any remaining records can be tested to determine Form 1099 filing requirements.
This type of analysis can be successful when examining a retailer operating many smaller stores. Those small operations allow more discretion by the individual store manager in contracting for landscaping, maintenance and snow removal.
This type of analysis should be coordinated with the employment tax examiner. Examination of the Form 1099 files can lead to issues regarding backup withholding and areas of inadequate compliance such as missing taxpayer identification numbers.
Current law requires withholding at a rate of 30 percent on amounts paid for services rendered by non-resident aliens.
An accounts payable vendor analysis similar to the one used for Forms 1099 can be conducted to check Form 1042 reporting and withholding compliance. The accounts payable record should be inspected for indications of a foreign address. The statutory withholding on remittances of dividends, interest and royalties is 30% unless exempt or reduced by tax treaty.
The CAS can perform a vendor analysis based upon store departments or cost centers. For example, suppliers of fishing equipment who may be liable for excise taxes can be identified by examining purchases charged to the sporting goods department. A similar analysis of electronics departments can identify manufacturers using ozone depleting chemicals.
This section discusses the role an engineering specialist may have in an examination of a retailer. Below are some of the areas for retailers where the engineers are a primary resource.
The Engineer Program consists of engineers, appraisers and business valuation specialists ("engineers" ) with the expertise, industry experience, and specialized training in technical or industry-specific issues. Further detail regarding the engineering program can be found in the IRM 4.48.
Although not discussed here, other areas where an engineer may assist include: Tangible Assets, Inventory Valuation, Bargain Purchase with LIFO, Gain on Purchase Receivables, Assets, Inventory and 263A issues as discussed in previous IRM sections.
It is important to involve the engineer early in the planning stages of the examination to allow the engineer to coordinate with other members of the team. This will afford the accurate identification and factual development of issues including an efficient and effective resolution. The Engineering Program also has a key role in the Outside Expert Program.
The engineer can assist in the identification of issues involving depreciation and amortization of assets. This can include the determination and computation of IRC 1245 and 1250 property including:
Placed in service issues
Asset basis issues (e.g. cost segregation studies)
Sale, exchange and disposal of assets issues
The Engineering Program is the principal source of technical expertise for examining cost segregation and repair studies. These asset studies may be performed as a result of new construction, major renovation or acquisition.
The engineer can assist the examiner with depreciation issues by applying the basic depreciation rules for MACRS, identifying the recovery period for an asset under MACRS, and calculating the proper bonus depreciation (if applicable).
The engineer can assist in differentiating between a capital expenditure and a deductible expenditure. Typical expenses include improvements and repairs to real property, demolition and other land site development costs. The engineer can provide guidance on whether the expenditure adds to the value of the property, substantially prolongs the useful life of the property, or adapts the property to a new or different use.
The engineer can assist in developing issues regarding the capitalization of land acquisition costs, and the allocation between personal property and land improvements.
The engineer can participate in the examination of gains and losses from sales and exchanges of assets used in a taxpayer’s trade or business, involuntary conversions, other than casualties and thefts, and income due to the recapture provisions under IRC 1245, IRC 1250, IRC 1252, IRC 1254 and IRC 1255.
In an IRC 1060 Applicable Asset Acquisition, the engineer identifies and analyzes the assets acquired and liabilities assumed including all costs and consideration to determine the total purchase price, verifies the fair market value (FMV) of the assets and the allocation of the purchase price into the various asset classes.
In an IRC 338 Qualified Stock Purchase, the engineer can perform the following:
Apply the statutory definition of a "Qualified Stock Purchase" to determine if a transaction has met the criteria under IRC 338
Calculate the Aggregate Deemed Sales Price for the old target resulting from an IRC 338 election
Calculate the Adjusted Grossed-Up Basis for the new target resulting from an IRC 338 election
Distinguish the resulting tax consequences between an IRC 338 election and an IRC 338(h)(10) election
The engineer can assist with the valuation of inventory in an IRC 338(g) or 338(h)(10) election which allows a step-up in the basis of inventory resulting in a faster write-off of the purchase price. The engineer will consider Rev. Proc. 2003-51.
The engineer can assist with the analysis of leases and leasehold interests for fair rental value determination and value.
The engineer can assist in the identification of intangible assets that are IRC 197 assets and thus subject to 15-year amortization.
The engineer can assist with issues related to research and experimentation expenditures under IRC 174, qualified research expenditures (QRE) under IRC 41, and other pertinent issues (base period & gross receipt analysis) involved in the research credit calculation under IRC 41.
The Engineering Program can assist in the review of qualified appraisal reports in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP) and IRS standards.
Engineers/appraisers can assist with the review of donations of partial interests, future interests, and interests with restricted use.
The engineer can assist with the deduction amount for the contribution of inventory to a qualified charitable organization. Under IRC 170(e)(3), a deduction is allowed up to the lesser of a) cost plus 50% of appreciation, and b) twice the basis. The FMV is based on the condition of the product and the market.
IRC 199 is the centerpiece of the American Jobs Creation Act of 2004 (AJCA), and provides for domestic manufacturers to receive a deduction for the net income resulting from the domestic production of products.
The engineer can assist in the examination of the domestic production deduction (DPD). The engineer can assist with the following.
The determination of the location where manufacturing took place
The removal of income from embedded services
The determination of the extent of "assembly" and its qualification as "manufacturing"
The determination of whether an item was substantially produced by analyzing the changes from the taxpayer’s raw materials to the final product
The AJCA added IRC 409A to the Internal Revenue Code. IRC 409A provides that all amounts deferred under a nonqualified deferred compensation (NQDC) plan for all taxable years are currently includible in gross income unless excepted. The final regulations under IRC 409A (published on April 17, 2007) address both the FMV of stock related to stock options and Stock Appreciation Rights (SAR).
Generally, if a NQDC plan fails to meet the requirements of IRC 409A, all amounts deferred under the plan are includible in gross income for the taxable year. Certain rules and exceptions apply.
) If a deferred amount is required to be included in income under IRC 409A, the amount also is subject to an additional 20% income tax and an additional tax equivalent to interest on taxes deferred in prior years.
The engineer can provide assistance with the following.
The determination of appropriate stock valuations as related to SARs and stock options per the requirements of IRC 409A
The valuation of associated hypothetical options where such are utilized to make allocations of total estimated equity value across stock classes
International Examiners are involved in a complex and sophisticated area of tax administration which may involve assistance from other specialists (economists and engineers). Typically, the engineers’ expertise is helpful in numerous international issues, including:
Subpart F "assembly versus manufacturing"
Shared services (manufacturing, assembly, testing distribution, sales and marketing) and the proper allocation of such expenses
Advanced Pricing Agreements (APA) relative to transferred goods and services
Acquisitions of tangible and intangible assets
Cost sharing of R&E and other issues relative to IRC 482
Worthless stock deduction
The engineer can also assist with functional analysis, services contract evaluation, taxpayer site visits and interviews, and tangible and intangible asset identification and valuation.
The Financial Products Program seeks to identify, develop and resolve financial products and transactional issues which are national in scope, significant in dollars, important to tax administration and uniformly and consistently treated. The Program performs timely, effectively planned and managed examinations of financial products issues providing for quality results and minimization of burden to the IRS and the taxpayers.
The Financial Products Specialist can help the examiner with a number of issues, including the following:
Original Issue Discount (OID) treatment for credit card fees: Many card issuing banks and merchant banks are treating Interchange and Merchant Discount fees as interest and OID. This issue is discussed in IRM 126.96.36.199.6.6.
Factoring of accounts receivable: This practice is common in the retail industry and involves the sale of accounts receivable to a factoring company. This issue is discussed in IRM 188.8.131.52.6.7.
Securitization of accounts receivable: This practice consists of the sale of a pool of receivables to a special purpose vehicle that finances the purchase by issuing securities on the market. Repayment of principal and payment of interest for these securities are made with the cash flow generated by the assigned receivables.
Mark-to-Market Issues: IRC 475(a) generally provides that a "dealer in securities" must recognize gain or loss on any security that is held at the close of the taxable year as if the security were sold by the dealer for its fair market value on the last business day of its taxable year. Whether a taxpayer is a dealer in securities is a question of fact. A taxpayer that is a dealer in commodities or a trader in securities or commodities can elect to use the mark-to-market method of accounting if it so elects in a timely fashion. The definition of a "security" (e.g. notes) is broad and can be found in IRC 475(c)(2).
Requesting a Financial Products Specialist referral is mandatory for: (a) Coordinated Industry Cases, (b) cases with activity codes 221, 223, 226-230 and 290, and (c) cases with activity code 483 that have gross receipts/deductions of $1,000,000 and above at the beginning of the examination. Request both mandatory and voluntary referrals through the Specialist Referral System (SRS).
Please refer to the financial products IRM 4.37.1 for more information.
The Employment Tax Handbook in IRM 4.23 discusses the issues that are identified in an employment tax examination. IRM 184.108.40.206.2.2.1 explains the analysis of Forms 1099 for potential backup withholding and reporting compliance issues. Employment tax examinations also include executive compensation issues such as stock options, nonqualified deferred compensation and golden parachute payments described in IRM 220.127.116.11.3.
Additional issues include fringe benefits, employee vs. independent contractor status, and penalties related to filing information returns, withholding taxes, and timely depositing taxes.
The examiner should confirm the validity of the resource listed before relying on it. Additionally, this is not an all-inclusive list.
ACRS & ITC - Suspended Acoustical Ceilings [10/31/1991] [UIL 48.01-18]
Does the suspended acoustical ceiling installed in the selling area of the new store facilities qualify as either three-year or five-year ACRS property? Would this property also qualify for the investment tax credit?
Heating, Ventilating, and Air Conditioning (HVAC) Systems ACRS & ITC [10/31/1991] [UIL 48.01-19]
Do HVAC units installed in retail grocery stores qualify for the investment tax credit and for the three-year or five-year recovery periods provided by ACRS?
Tenant's Rent Leveling IRC 467 Lease Agreements [11/6/1995] [UIL 467.03-03]
Is Company R, for all leases described, allowed to accrue as an annual deduction the annual amount due under a lease agreement or a constant rental amount as defined by IRC 467(e)?
Valuation of an Acquired Retailer's Inventory [10/31/1991] [UIL 471.08-05]
Is the cost of reproduction method more appropriate than the comparative sales method in determining the fair market value of a retailer's inventory?
When the comparative sales method is used as a basis for valuing a retailer's inventory, what costs should be considered as inventory disposition costs?
IRC 401(k) Accelerated Deduction [9/5/1995] [UIL 404.11-03]
Are contributions to a qualified cash or deferred arrangement within the meaning of IRC 401(k) or to a defined contribution plan as matching contributions within IRC 401(m) deductible by the employer for a specific taxable year, if those contributions are attributable to compensation which was earned by plan participants after the end of such tax year?
State and Local Location Tax Incentives (SALT) [5/23/2008] [UIL 118.01-02]
Does a state or local location tax incentive, whether in the form of an abatement, credit, deduction, rate reduction, or exemption (hereinafter referred to as a "location tax incentive" ), give rise to gross income under IRC 61?
Is the amount of such a location tax incentive deductible as a tax paid or accrued during the taxable year under IRC 164?
Assuming for the sake of argument that the location tax incentive is an item of gross income, is it excludible as a non-shareholder contribution to capital under IRC 118(a)?
Industry Director Directive on the Planning and Examination of Gift Card/Certificate Issues in the Retail, Food, & Beverage Industries #2 [10/03/08] [UIL 451.13-04]
This Directive updates Industry Director Directive #1 for Gift Cards/Certificates.
Industry Director Directive on the Planning and Examination of Gift Card/Certificate Issues in the Retail, Food, & Beverage Industries [5/23/2007] [UIL 451.13-04]
This Directive provides direction to effectively utilize resources in the classification and examination of a taxpayer who is receiving gift card/certificate income.
Industry Director Directive #2 on Mixed Service Costs [5/1/2007] [UIL 263A-07-00 and 263A.06-01]
This Directive provides field assistance on the Tier I Mixed Service Costs Issue by offering direction on how to distinguish between resellers’ merchandising departments and producers’ purchasing departments.
Field Directive on the Planning and Examination of Cost Segregation Issues in the Retail Industry [12/16/2004] [UIL 168.20-00]
This Directive provides direction to effectively utilize resources in the classification and examination of a taxpayer who is recovering costs through depreciation of tangible property used in the operation of a retail business.
Planning and Examination of Construction "Tenant" Allowances for Leases Greater Than 15 Years [3/24/2003] [UIL 118.01-02]
This Directive provides guidelines for the efficient use of audit time and resources devoted to the examination of payments, commonly called "tenant allowances," made by developers to retail lessees with respect to long- term leases. This Directive only applies to those taxpayers with leases that do not meet the short-term lease definition of IRC 110(c)(2) and IRC 168(i)(3), and the related regulations.
Planning and Examination of Developer Inducements [10/16/2002] [UIL 118.01-03]
This Directive provides guidelines for the efficient use of audit time and resources devoted to the examination of amounts paid to retailers as inducements to "construct, open and operate," or to "continue to operate" a retail store. Such payments are frequently encountered in the retail industry and are often referred to as "developer inducements." The Directive only applies to payments made to a retailer who either has or will have legal title to the building, and either has or will have legal title to the real property on which the building stands, or has or will have a ground lease of such duration that the retailer effectively owns the realty.
The examiner should confirm the validity of the resource listed before relying on it. Additionally, this list is not all-inclusive.
National Retail Federation (NRF) - http://www.nrf.com
The NRF is the world's largest retail trade association, with membership comprising all retail formats and channels of distribution including department, specialty, discount, catalog, internet, independent stores, chain restaurants, drug stores and grocery stores as well as the industry's key trading partners of retail goods and services. NRF represents an industry with more than 1.6 million U.S. retail establishments, more than 24 million employees - about one in five American workers - and 2006 sales of $4.7 trillion. As the industry umbrella group, NRF also represents more than 100 state, national and international retail associations.
Retail Industry Leaders Association (RILA) (formerly known as International Mass Retail Association (IMRA)) - http://www.rila.org
RILA is the world’s leading alliance of retailers and their product and service suppliers. RILA members represent more than $1.5 trillion in sales annually and operate more than 100,000 stores, manufacturing facilities and distribution centers nationwide. Its member retailers and suppliers have facilities in all 50 states, as well as internationally, and employ millions of Americans.
Food Marketing Institute (FMI) - http://www.fmi.org
FMI is a nonprofit association which conducts programs in research, education, industry relations and public affairs on behalf of its 1,500 member companies – food retailers and wholesalers – in the United States and around the world. FMI’s retail membership is composed of large, multi-store chains, regional firms and independent supermarkets. Its international membership includes 200 companies from 50 countries.
National Association of Chain Drug Stores (NACDS) - http://www.nacds.org
NACDS is the country's largest pharmacy organization. NACDS, formed in 1933, serves as the voice of chain pharmacies representing the concerns of community pharmacies in Washington, D.C., state capitals, and cities across the nation. Membership is open to companies operating four or more retail pharmacies open to the public. NACDS membership consists of more than 200 chain community pharmacy companies. NACDS membership includes more than 1,000 suppliers of goods and services to chain community pharmacies. NACDS international membership has grown to include 100 members from 30 countries.
National Association of Convenience Stores (NACS) - http://www.nacsonline.com
NACS is the international trade association representing all types of convenience store and petroleum marketing companies from independent stores to large chains. NACS members include companies that manufacture or distribute products and/or services to the convenience store and petroleum marketing industry.
National Grocers Association (NGA) - http://www.nationalgrocers.org
NGA is the national trade association representing retail and wholesale grocers that comprise the independent sector of the food distribution industry. An independent retailer is a privately owned or controlled food retail company operating in a variety of formats. Most independent operators are serviced by wholesale distributors, while others may be partially or fully self-distributing. NGA members include retail and wholesale grocers and their state associations, as well as manufacturers and service suppliers.
The examiner should confirm the validity of the resource listed before relying on it. Additionally, this list is not all-inclusive.
Randy L. Allen, Bottom Line Issues in Retailing, The Touche Ross Guide to Retail Management (Chilton Book Company, Radnor, PA).
Rona Ostrow & Sweetman R. Smith, The Dictionary of Retailing (Fairchild Publications, Attn: Book Division, 7 East 12th Street, New York, NY 10003, (212) 741-4280).
Ron L. Fowel, Sr., Barry G. High & Howard K. Kingsbury, Guide to Retail Shops, Volumes 1 and 2 (Practitioners Publishing Company, Attn: Subscription Dept., P.O. Box 966, Fort Worth, TX 76101-9940, (800) 323-8724).
Paul A. Wilson, Kenneth E. Christensen, & Ernst and Whinney, LIFO for Retailers, A Business, Financial, and Tax Guide (Ronald Press Publications, Attn: Continuation Department, John Wiley & Sons, Inc., 1 Wiley Drive, Somerset, NJ 08873).
Financial Executive Division, National Retail Merchants Association, NRMA Retail Accounting Manual (Revised Ed. Financial Executive Division, National Retail Merchants Association, 100 West 31st Street, New York, NY 10001, (212) 244-8780).
Financial Executive Division, NRMA Retail Accounting Manual, (Book Two) (Financial Executive Division, National Retail Merchants Association, 100 West 31st Street, New York, NY 10001, (212) 244-8780).
Louis C. Moscarello, Retail Accounting and Financial Control (John Wiley & Sons, Inc., 1 Wiley Drive, Somerset, NJ 08873).
Leslie J. Schneider, Federal Income Taxation of Inventories (Matthew Bender and Company Inc. 1997).
Gordon Smith & Russell Parr, Valuation of Intellectual Property and Intangible Assets (3rd Ed. John Wiley & Sons, Inc. 2000).
Gordon Smith, Corporate Valuation: A Business and Professional Guide (John Wiley & Sons, Inc. 1998).
International Council of Shopping Centers, The SCORE: ICSC's Handbook on Shopping Center Operations, Revenues, and Expenses (2004 Ed. International Council of Shopping Centers) (1992).
First National Bank of Chicago, Retailing Companies Division, The Retailing Industry: A Statistical Review for Fiscal 1990, 1989, and 1988. (First National Bank of Chicago, Retailing Companies Division 1990).
Mary A. Hines, Shopping Center Development and Investment,(2nd Ed.John Wiley and Sons, Inc. 1998).
: The examiner should confirm the validity of the resource listed before relying on it. Additionally, this list not all-inclusive
The following are examples of the numerous industry related publications which might be useful to the examiner in gaining insight into various aspects of a retailer's operation. Larger taxpayers may have their own in-house library containing a number of these industry periodicals.
Apparel Import Digest American Apparel & Footware Association (AAFA)
1601 Kent St., Suite 1200 Arlington, VA 22209
(703) 524-1864 (800) 520-2262
Annual report providing statistical information on apparel imports of the previous year, including data by fabric, country and garment line
Chain Store Age
425 Park Avenue New York, NY 10022-3506
Information on non-merchandising topics including finance, security, information systems, store planning, real estate and construction
North American Publishing Co.
1500 Spring Garden Street,
Philadelphia, PA 19130
Addresses new products, technologies and issues of interest to buyers of consumer electronics, major appliances and consumer computing products
Distribution Center Management
Alexander Communications Group, Inc.
712 Main Street,
Boonton, NJ 07005
Telephone: (973) 265-2300,
Industry news and strategies to assist distribution center and warehouse professionals improve efficiency
Drug Store News
425 Park Avenue
New York, NY 10022-3506
Directed to those responsible for planning, merchandising and operating drug stores and pharmacies, including industry news and reports
425 Park Avenue
New York, NY 10022-3506
Directed to those responsible for planning, merchandising and operating discount stores, including industry news and reports
Grocery Headquarters Magazine
Macfadden Communications Group
333 Seventh Ave.
New York, N.Y. 10001
News and feature articles pertaining to chain and independent grocers as well as brokers and wholesalers
Home Channel News
425 Park Avenue
New York, NY 10022-3506
Directed to those responsible for planning, merchandising and operating home centers, including industry news and reports
Journal Of Marketing
American Marketing Association
311 S. Wacker Dr.
Chicago, IL 60606
Directed to marketing executives and teachers, it includes articles related to marketing trends, ideas, techniques and discoveries
American Marketing Association
311 S. Wacker Dr.,
Chicago, IL 60606
Current articles on marketing and this association's activities
MMR Mass Market Retailers
Racher Press, Inc. 2
20 Fifth Ave
New York, NY 10001
Fax (212) 725-4594
Events and trends relating to growth and development of the supermarket, drug and discount chain industry
Minnesota Grocers Association
533 Saint Clair Ave.
St Paul, MN 55102-2800
This is an example of what would possibly be available for each state. Trade journal for retailers and wholesalers in the grocery industry
Nation's Restaurant News
425 Park Avenue
New York, NY 10022-3506
Directed to those responsible for planning, merchandising and operating restaurants, including industry news and reports
Bill Communications, Inc.
New York, NY 10003
Provides information regarding food distribution as well as research and topics pertaining to grocery management
Red Coat Publishing
900 Cummings Center,
Beverly, MA 01915
Serves the information needs of the retail industry
Shopping Center Digest
Jomurpa Publishing Co.
20 N Broadway,
Nyack, NY 10960
Provides information on new and expanding centers as well as space availability and specifics of the expansion plans of larger retailers
Shopping Centers Today
International Council of Shopping Centers
1221 Avenue of the Americas
New York, NY 10020-1099
Data pertaining to the industry as well as the activities of the council
National Retail Federation
325 7th Street, NW, Suite 1100
Washington, DC 20004
Emphasizes issues and concerns in operations, credit, human resources, merchandising, store design, marketing and other areas of interest to senior level management in stores, buying offices and shopping centers
Penton Media, Inc.
249 W. 17th Street
New York, NY 10011
A weekly publication for retailers, brokers and wholesalers
Value Retail News