Changing Method of Accounting to Comply With New Retail-Inventory Method Regulations

Editor: Michael Dell, CPA

Tax Accounting

In Rev. Proc. 2014-48, the IRS provides the exclusive procedures taxpayers must use to obtain consent under Sec. 446(e) to change a method of accounting to comply with the recently issued final regulations (T.D. 9688) on the retail-inventory method of accounting. The final regulations detail the proper calculation of ending inventory values under the retail-inventory method, and provide alternative calculation methods for taxpayers using the retail-lower-of-cost-or-market (retail-LCM) method of accounting to account for margin protection payments.

Taxpayers using the retail-inventory method may have to file for an accounting method change. They should examine how they currently account for margin-protection payments and sales-based vendor chargebacks to decide whether they must make an accounting method change.

Background

The IRS issued final regulations (T.D. 9688) on how to compute ending inventory values under the retail-inventory method. The final regulations are generally consistent with the proposed regulations, with a few clarifications and modifications, and could have a significant adverse effect on retail taxpayers that use the retail-inventory method FIFO lower-of-cost-or-market (LCM) method.

Rev. Proc. 2014-48

The procedure in Rev. Proc. 2014-48 applies to a taxpayer using the retail-inventory method that wants to make one of the following changes: (1) from adjusting to not adjusting the numerator of the cost complement by the amount of an allowance, discount, or price rebate that is required under Regs. Sec. 1.471-3(e) to reduce only cost of goods sold; or (2) from adjusting to not adjusting the denominator of the cost complement for temporary markups and markdowns.

For a retail-LCM taxpayer, the procedure applies when changing (1) from adjusting to not adjusting the numerator of the cost complement by the amount of a margin-protection payment; (2) from adjusting to not adjusting the denominator of the cost complement for permanent markdowns; or (3) from using one method for computing the cost complement described in Regs. Sec. 1.471-8(b)(3) to using a different method described in Regs. Sec. 1.471-8(b)(3).

For a retail-cost taxpayer, the procedure applies when changing from not adjusting to adjusting the denominator of the cost complement for permanent markups and markdowns.

The scope limitations in Sections 4.02(1)-(4) and (7) of Rev. Proc. 2011-14 do not apply for a taxpayer’s first or second tax years beginning after Dec. 31, 2014.

A taxpayer making a change for its first or second tax year beginning after Dec. 31, 2014, may either use a Sec. 481(a) adjustment or implement the change on a cutoff basis. If using a cutoff basis, the change applies only to the computation of ending inventories after the beginning of the year of change. A Sec. 481(a) adjustment is neither permitted nor required if a change is made on a cutoff basis.

Implications

Taxpayers should analyze the accounting method changes that may be required or desired under the new regulations, as well as the different procedures that are available for making those changes.

When the cutoff method is used, the new method would be used for the tax year of change. Any difference between the new method and the previous method would be included in taxable income in the year of change. Alternatively, with a Sec. 481(a) adjustment, the difference between the new method and the previous method would be computed as of the first day of the year of change. That difference, if unfavorable (i.e., it causes an increase in taxable income), would be included in taxable income over four years instead of all in the current year.

As noted, the transition guidance permits a taxpayer making a change for its first or second tax year beginning after Dec. 31, 2014, either to use a Sec. 481(a) adjustment or to implement the change on a cutoff basis. Although many taxpayers may initially think that using a cutoff method may be easier, that benefit should be weighed against the loss of a four-year spread on the pickup of taxable income related to an unfavorable accounting method change. Alternatively, a taxpayer using the last-in, first-out (LIFO) method may wish to make the change on a cutoff basis to prevent an increase to prior-year LIFO layers.

Summary

The final regulations clarify the computation of ending inventory values under the retail-inventory method and provide specific rules regarding the treatment of temporary markdowns, sales-based vendor chargebacks, and margin-protection payments under the retail-inventory method. Many retailers currently using the retail-inventory method will have to file an automatic accounting method change using the procedures provided in Rev. Proc. 2014-48.

Other accounting method changes could also reduce taxable income, such as adoption of the retail-inventory method for additional inventory, a change in the level at which cost complements are computed, a change to incorporate all appropriate adjustments to cost in the numerator of the cost complements, a change to include the initial retail selling price of goods in the denominator of the cost complements (i.e., no permanent markdowns for beginning inventory or current-year purchases for LCM taxpayers), and a change to incorporate all appropriate permanent reductions in the retail selling price of goods on hand at the end of the tax year.

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in Washington.

For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.