Proposed Regs. Relating to the Retail-Inventory Method

Editor: Greg A. Fairbanks, J.D., LL.M.

Tax Accounting

The IRS issued proposed regulations (REG-125949-10) relating to the retail- inventory method of accounting. The proposed regulations restate and clarify the computation of ending inventory values under the retail-inventory method and provide special rules for taxpayers that receive margin protection payments and similar vendor allowances.

Background

In general, the retail-inventory method regulations of Regs. Sec. 1.471-8 allow retailers to approximate (1) cost (retail-cost method) or (2) cost or market, whichever is lower (retail-LCM method), by multiplying the retail selling price of ending inventory by the cost-to-retail ratio. The cost-to-retail ratio compares (1) the cost of beginning inventory plus the cost of purchases to (2) the retail selling price of beginning inventory plus the initial retail selling price of purchases, with certain adjustments for markups and markdowns. A LIFO taxpayer that elects to use the retail-inventory method must approximate costs.

Regs. Sec. 1.471-3 currently provides that the invoice price less trade or other discounts is considered in determining the cost of inventory purchased during the year. Prop. Regs. Sec. 1.471-3(e), however, provides that an allowance, discount, or price rebate a taxpayer earns by selling specific merchandise is a reduction in the cost of goods sold and does not reduce the inventory cost or value of inventory at the end of the year.

The Proposed Regs.

In addition to restating and restructuring the regulations under Regs. Sec. 1.471-8, the proposed regulations add rules addressing the treatment of sales-based vendor allowances, vendor markdown allowances, and margin protection payments.

Sales-based vendor allowances: The proposed regulations clarify the interaction of Prop. Regs. Sec. 1.471-3(e) with the retail-inventory method. The proposed regulations exclude sales-based vendor allowances from the numerator (the cost of beginning inventory and the cost of purchases) of the cost-to-retail ratio.

Cost-to-retail ratio under the retail-LCM method: The preamble to the proposed regulations explains that, under the retail-LCM method, a reduction in retail selling price reduces the value of ending inventory in the same ratio as the cost-to-retail ratio. If a taxpayer earns an allowance, discount, or price rebate, the inventory costs in the numerator (the cost of beginning inventory and the cost of purchases) of the cost-to-retail ratio declines, resulting in a reduction of the value of ending inventory. If the allowance, discount, or price rebate is permanent, ending inventory is further reduced as a result of the decrease in ending retail selling price. The IRS concludes that these reductions in the ending inventory valuation (1) generally result in lower ending inventory value for a retail-LCM method taxpayer than for a similarly situated FIFO taxpayer that values inventory at LCM and (2) do not clearly reflect income.

The IRS refers to this as a distortion that is addressed in the proposed regulations by providing that a retail-LCM method taxpayer may not reduce the numerator of the cost-to-retail ratio for an allowance, discount, or price rebate that is related to, or intended to compensate for, a permanent markdown of selling price. Thus, in the case of markdown allowances and margin protection payments, the value of ending inventory computed under the retail-LCM method would be reduced solely as a result of the reduction in retail selling price. The IRS concluded that this would avoid an unwarranted additional reduction in inventory value for a single markdown allowance and would more reasonably approximate LCM.

As an alternative, the IRS stated that the retail-inventory method could achieve the same result by permitting taxpayers to reduce the numerator (the cost of beginning inventory and the cost of purchases) of the cost-to-retail ratio for all non–sales-based allowances, discounts, or price rebates, including markdown allowances, but requiring a reduction of the denominator (the retail selling price of beginning inventory plus the retail selling price of purchases) of the cost-to-retail ratio for all permanent markdowns related to markdown allowances. In the proposed regulations, the IRS specifically requests comments on whether the final regulations should provide this or other alternative retail-LCM methods.

Temporary price adjustments: The proposed regulations clarify that the denominator (the retail selling price of beginning inventory plus the retail selling price of purchases) of the cost-to-retail ratio and the ending retail inventory selling prices are not reduced for temporary markdowns and markups.

Effective date: The proposed regulations will apply for tax years beginning after the date the regulations are published as final.

EditorNotes

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.

For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.