By Ellen McElroy, Esq. and Anthony J. Balden, Esq.
Pepper Hamilton LLP, Washington, DC
On October 6, 2011, the Treasury Department released Prop. Regs. §1.471-8 (the Proposed Regulations (REG-125949-10)) with new rules on the Retail Inventory Method (RIM) of accounting for inventories.
RIM is used to convert the retail sales price of ending inventory to a value that approximates either the value of inventory at cost under Regs. §1.471-3 or the Lower of Cost or Market method (LCM) under Regs. §1.471-4. Under RIM, ending inventory is determined by multiplying a cost complement by the cost of inventory on hand at year-end valued using retail sales prices. The cost complement equals the value of beginning inventory plus goods purchased during the year divided by the retail selling prices of beginning inventory and goods purchased during the year. This amount is reduced by permanent markups and markdowns.
Proposed regulations were issued to restate and clarify in "plain language"1 how to compute ending inventory values under RIM. More importantly, the rules were issued to incorporate a special rule for certain taxpayers that receive margin protection payments and similar vendor allowances. The Proposed Regulations will apply to taxable years beginning after publication as final regulations in the Federal Register. Further, the IRS is requesting comments regarding the Proposed Regulations by January 5, 2012.
In general, §471 and its related Treasury Regulations require that a taxpayer's inventory accounting methods clearly reflect income and "conform as nearly as may be to the best accounting practice in the trade or business."2 As businesses have a broad range of products and conventions, the Treasury Regulations under §471 provide a number of different methods and special rules that apply to different types of industries, including retail merchants, securities dealers, farmers, manufacturers, and others. The Proposed Regulations deal specifically with retail merchants and provide simplifying conventions for calculating the value of retail inventories.
Current Regs. §1.471-8 allows retail merchants to use RIM to approximate inventory valuation. As noted, under RIM, the total of the retail selling prices for goods on hand in each department or class is reduced by an amount that bears the same ratio to the total as (i) the total retail selling prices of goods in opening inventory plus the retail selling prices of goods purchased (with proper adjustments for mark-ups and mark-downs) less (ii) the cost of goods included in opening inventory plus the cost of goods purchased during the year, bears to the amount in (i).
This language is somewhat difficult to follow, and an example may better illustrate these calculations.
A) Total retail selling prices at the end of the year: $250
B) Total retail selling prices in opening inventory: $200
C) Retail selling prices of goods purchased during the year: $500
D) Mark-down: $25
E) Cost of goods in opening inventory: $150
F) Cost of goods purchased during the year: $300
B + C - D - (E + F)
B + C - D
Reduction = $83.33; Retail Inventory Value = $166.67
Regs. §1.471-8 provides that the result of this calculation "should represent as accurately as may be the amounts added to the cost price of the goods to cover selling and other expenses of doing business and for the margin of profit." Therefore, in this example applying RIM, the inventory is valued at $166.67 and $83.33 is the approximation of additional expenses and profit. Though these current Treasury Regulations allow for the computations to be made, these rules are not easily applied. In addition, more recent guidance regarding sales-based vendor allowances necessitated additional clarification. According to the Preamble, the Proposed Regulations were released to simplify RIM computations and address outstanding items.
Proposed Regulations - Computations
Under the Proposed Regulations, RIM is calculated in a simplified manner, using a so-called "cost complement" to adjust the retail sales price of ending inventory. The numerator of the cost complement is the value of beginning inventory plus the cost of purchases during the year. The denominator of the cost complement is the retail selling price of beginning inventories plus the initial retail selling price of purchases. This cost complement is multiplied by the retail selling price of ending inventory, and the result is the ending inventory value. Using the same variables listed above:
Cost complement =
E + F
B + C - D
Cost complement x A = Ending Inventory Value
Ending Inventory Value = $166.67; Reduction = $83.33
Proposed Regulations - Other Special Rules
As with the current regulations, Prop. Regs. §1.471-8(d) requires a taxpayer with multiple departments or classes of goods to compute its cost complements separately for each department or class. Various goods have different selling expenses and profit margins, so a separate cost complement reflects separate valuations.
Cost allowances also must be taken into account for inventory valuation purposes under Regs. §1.471-3, including mark-ups, mark-downs, and other allowances, but the Proposed Regulations clarify that sales-based vendor allowances reduce the cost of goods sold and do not reduce inventory cost or value for these calculations. Prop. Regs. §1.471-3(e) requires that allowances or rebates earned from selling specific merchandise be treated merely as a reduction in cost. The Proposed Regulations specify that this new rule applies to RIM calculations.
For all calculations, taxpayers must include permanent mark-ups and mark-downs in determining the retail selling prices of inventory on hand at year-end under Regs. §1.471-8(b)(3). Any permanent change in the selling price may be taken into account. However, a taxpayer may not include a mark-down if it is not an actual reduction of the sales price.
For taxpayers approximating LCM under Regs. §1.471-4, other special rules in Prop. Regs. §1.471-8(b)(2)(iii) require that a margin protection payment or mark-down allowance to compensate for a permanent reduction in retail selling prices cannot be used to reduce the numerator of the cost complement, and mark-downs cannot be used to reduce the denominator of the cost complement.
Example 1 in Prop. Regs. §1.471-8(e) illustrates these rules. In the example, a retailer is unable to sell tables for $100, and it reduces the price to $90. The retailer's supplier provides a $6 margin protection payment given the price decrease. The cost complement numerator cannot be reduced by the margin protection payment, and the cost complement denominator cannot be reduced by the mark-down. Despite the changes made by the retailer, the cost complement in this example remains the same. The retail selling price, however, is reduced to reflect the mark-down, and this reduction lowers the ending inventory valuation.
Finally, last-in, first-out (LIFO) taxpayers are subject to additional adjustments under Regs. §1.472-1(k).Though beyond the scope of this article, these adjustments require eliminating certain price changes occurring after the closing of the taxpayer's preceding taxable year. LIFO taxpayers must use RIM to approximate the cost method, and they cannot use RIM to approximate LCM.
Request for Comments
The Preamble to the Proposed Regulations discusses Prop. Regs. §1.471-8(b)(2)(iii) and its relevance to the approximation of inventory valuations. Without the special rules in Prop. Regs. §1.471-8(b)(2)(iii), a retailer earning an allowance or other rebate that is not a sales-based vendor allowance could decrease the cost complement numerator. In addition, if this allowance or rebate is related to a permanent mark-down, the total retail sales price at the end of the year would be reduced. In other words, a smaller cost complement would be applied to a lower year-end retail sales price, resulting in a significantly lower value for inventory. The Preamble sets forth the government view that such rules would lead to inconsistent results and would not clearly reflect income.
With Prop. Regs. §1.471-8(b)(2)(iii), the cost complement numerator is not reduced, ensuring that a double reduction is not claimed, but the Service requests comments on another approach. This approach would allow the numerator to be reduced for non-sales based allowances, but it would also require a reduction in the denominator for all permanent mark-downs. Taxpayers should consider whether Prop. Regs. §1.471-8(b)(2)(iii) or this alternative approach would lead to significantly different results and whether comments may be necessary to address particular circumstances.
The IRS will consider written comments submitted, and, in addition to the specific request for comments above, the Service requests comments on the clarity of the Proposed Regulations generally and how they can be made easier to understand. Comments should be submitted by January 5, 2012.
The Proposed Regulations provide a simplified way of approximating year-end inventory. While taxpayers and practitioners should welcome the IRS's attempt to simplify and clarify inventory valuations, both should consider how the rules apply and whether further clarification or different approaches are required. It is important to note that the Service previously issued a directive to field agents on the treatment of sales-based vendor allowances (see the IRS's Field Directive on Treatment of Sales-Based Vendor Allowances (SBVA) and Margin Protection Payments (MPP) under §471, LMSB-04-0910-02 (9/24/10), available at http://www.irs.gov/businesses/article/0,,id=228133,00.html) and indicated that future regulations would clarify RIM. In particular, under the current regulations, certain taxpayers reduced the numerator of the cost complement ratio without making a corresponding adjustment to the denominator for allowances, discounts, and price rebates. Acknowledging that the regulations could be interpreted to allow the practice, the directive indicated that agents were not to expend resources challenging such treatment. Consequently, if these regulations are finalized consistent with the Proposed Regulations, it is likely that this examination position will be reinvigorated.
© 2011 Pepper Hamilton LLP
For more information, in the Tax Management Portfolios, see Tovig and Herndon, 578 T.M., Inventories: General Principles; LIFO Method, and in Tax Practice Series, see ¶3590, Inventories.
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