Discounting: Consumer demand vs. accounting complexity
Understand the tax implications that arise with discounting goods
INSIGHT ARTICLE |
Consumer expectations of discounted merchandise are the catch-22 of the retail world, especially as it relates to seasonal goods. On one hand, discounts bring more customers through the door or to online marketplaces which increase opportunities for additional customer purchases and a higher volume sales. On the other hand, discounts can skew brand value perception, deplete margin, and frequently, make for complicated financial management, affecting the retailer’s tax obligations as well as top line revenue.
The shift to earlier discounting, during the holiday season in particular, can cause retailers and suppliers to alter their purchasing and inventory management processes, changing everything from promotional programs to supply-chain management. If the practice of early discounting continues to be the norm, retailers should be mindful of the variety of business complexities, especially as it relates to results and margin. Likewise, it is prudent to consider how discounting may impact corporate taxes of the business. From sales tax implications on gift cards, to changes in inventory levels at year-end, there are key tax considerations worth reviewing.
Let's look at how tax considerations related to discounting and purchase incentives may impact your cash flow.
Discounted inventory and accounting methods
If your business is considering discounting goods, thought should be given to your current tax accounting methods, how to change those methods, and if you desire to do so, the effect of using the new method(s) going forward, as well as the impact on the tax side of the varied choices that are available.
For example, retailers that apply heavy discounts to their goods during sale season may reduce the cost of their inventory that is recorded on their books by making a market adjustment. For financial statement purposes, this market adjustment, or discount, may take on many faces. In some cases, retailers may pick certain lots of inventory that will be marked down to what the retailer expects will be the ultimate sale price. In other cases, businesses may mark down all of their inventory, or a portion of it, by simply taking a percentage of the inventory as a reduction. And still in other cases, a retailer may get more specific and mark down each item of inventory to the anticipated sell price.
Lower of cost or market
The inventory rules for federal tax generally do not permit retailers to reduce their inventory value for a general allowance for expected sales during the holiday season, yet there is some ability to recognize a reduction in inventory valuation. For tax purposes, there are many rules that must be followed when taking market adjustments, also known as lower of cost or market (LCM). In the case of LCM, in order to take a write-down and reduce the carrying value of inventory for tax purposes, retailers must value the inventory at the current bid price for the goods at the time of the inventory count. By definition, the bid price is the replacement cost. This concept is very different than discounting the inventory for the sales price or the price a retailer expects to sell the goods for.
For consumer products companies and retailers, many times the cost to replace the goods is very close in cost to the original carrying value of the inventory so there would generally not be a significant, if any, market adjustment on the tax value of the inventory. However, exceptions to the valuation of the inventory at replacement cost include write-downs for abnormal goods or goods that are unique and unusual design (i.e., custom-produced items). In such instances, the business must provide proof of sales or purchases of such items within the timeframe around the inventory valuation date. If it can be shown that the sales price or purchase price of like items is lower than cost, then a retailer may be able to justify an inventory write-down for federal income tax purposes.
The rules for subnormal goods provide another option for taxpayers to discount inventory for federal income tax purposes. Subnormal goods are goods that a business has an inability to sell or use because the goods are damaged, have imperfections, have shop wear, have had changes of style, odd or broken lots or other similar causes.
Goods that meet this definition may be valued at net realizable value (NRV), which is generally equivalent to the selling price, less costs, to dispose of the goods. When discounting to sell goods faster, provide a deal or because too many were ordered, the subnormal goods rules generally do not apply. The most likely application of the subnormal goods rule is for retailers to show that a change of style occurred for the item, for example, when clothing or shoes are no longer in style and therefore warrant a reduction in the inventory value for tax purposes. In order to value the goods at NRV, retailers must also offer the goods for sale within 30 days of the year-end inventory date.
Uniform capitalization (UNICAP)
UNICAP rules can also impact federal income tax related to discounted inventory. Under the UNICAP rules, businesses are required to look at the costs involved in manufacturing or distributing inventory, and capitalize certain expenses into ending inventory at year-end resulting in increased taxable income, as well as a corresponding negative impact to cash flow.
If a discount is taken for financial statement purposes but cannot be taken for tax purposes to the same extent, the absorption (capitalization) of costs under UNICAP will be determined based on the higher tax valuation of the inventory. To the extent not already considered, this could lead to an unexpected adjustment if tax and cash flow planning is based on the lower financial statement value of the inventory. Additionally, reducing inventory levels at year-end will help to reduce the UNICAP adjustment that would otherwise increase taxable income.
Purchase incentives and sales tax
As consumers seek to make the most of their spending during the holidays or throughout the year, gift cards, coupons or customer loyalty points will see heavy usage to help defray out-of-pocket costs. Retailers must pay close attention to the patchwork of state and local sales tax guidance on the treatment of various incentives in each state.
At a high level, sales tax calculations related to the consumer spending trends associated with discounts can be addressed through four main categories: coupons or direct discounts, gift cards, loyalty programs and deal-of-the-day incentives.
Coupons and discounts
Store coupons or in-store discounts effectively lower the amount the retailer receives for the item being purchased, therefore the sales tax generally is calculated on the customer's lower final price after the discount.
Manufacturing coupons lower the amount being charged to the customer, but do not change the total sales price from the seller perspective as the seller will be reimbursed by a third party (the manufacturer). In most cases, the sales tax is calculated on the sales price before application of manufacturing coupon discounts.
Gift cards typically are considered a cash equivalent and therefore no sales tax is charged at the time the gift card is purchased. Sales tax is applied at the time a gift card is used to purchase merchandise, with few exceptions.
Loyalty or reward programs
States are continuing to develop guidance in the area of loyalty and reward programs. Some states treat loyalty point redemptions as consideration paid by the customer whereas others treat the points as a true reduction in sales price. Sales tax implications vary greatly by state; a full review of the state tax requirements is recommended for those retailers using loyalty or reward based programs.
So-called deal-of-the-day incentives typically offer discounted pricing for products and services via prepaid vouchers. The deal promotion company, such as Groupon, and the seller each receive a share of the voucher fee. Streamlined Sales Tax member states generally calculate sales tax based on the price paid for the voucher while nonmember states may take other approaches, such as charging sales tax on the full, non-discounted price of the service provided.
Review procedures regularly
While trends in consumer spending play out at the cash register, these shifts can also make a real difference in your back office, affecting your tax planning efforts and bottom line results. Retailers and suppliers need to recognize how the nickels and dimes customers seek through discounts should be treated for tax purposes. Errors applied to a single transaction may seem inconsequential, but when multiplied across many year-end purchases and multiple states, the potential for miscalculation and missed tax planning opportunities is significant. Your sales tax processes and inventory accounting methods should be reviewed annually, at minimum, to make sure they align with current guidance across all jurisdictions.