IRS releases final regulations on the retail inventory method
TAX ALERT |
On Aug. 14, 2014, the IRS released the final regulations on the retail inventory method (RIM) under Treas. Reg. section 1.471-8. The regulations contain rules specific to retailers, allowing them to approximate the value of goods in ending inventory at cost, or at the lower of cost or market (LCM), by using RIM. Under RIM, taxpayers value ending inventory by multiplying the retail selling prices of the goods on hand at the end of the taxable year by a cost complement. The regulations have an effective date of Aug. 15, 2014, and apply to taxable years beginning after Dec. 31, 2014.
RIM can be an effective method for determining the cost of inventory for many companies, such as those that must inventory groups of small goods that are homogeneous and difficult to price using traditional perpetual inventory systems. In the event a company uses RIM to value a portion of its inventory, it should be noted that the regulatory requirements for the computations are very specific and challenging.
The release of these latest regulations provides the IRS with the ammunition to challenge improper computations under RIM. However, the IRS also released Rev. Proc. 2014-48, which provides the procedures for adopting the regulations and a limited window of opportunity to fix improper accounting methods. In addition, the favorable last-in, first-out (LIFO) guidance in the revenue procedure allows a company to effectively lock prior benefits into its LIFO layers.
Determining inventory value
When using RIM, the cost complement is calculated as follows:
For retailers using RIM to value inventory at cost (retail cost method), the denominator is adjusted for all permanent markups and markdowns. However, retailers using RIM to value inventories at LCM (retail LCM method) may only use markdowns to cancel or correct markups.
The regulations prohibit reducing the numerator of the cost complement for sales-based vendor allowances allocable only to cost of goods sold under Treas. Reg. section 1.471‑3(e). In addition, taxpayers using the retail LCM method may not reduce the numerator of the cost complement by the amount of an allowance, discount or price rebate that is related to or intended to compensate for a permanent reduction in the taxpayer’s selling price of inventory (a margin protection payment).
For taxpayers on the retail LCM method that may have difficulty removing a margin protection payment from the numerator of the cost complement, the regulations provide for two alternative methods.
The alternative methods come with a price. Once the taxpayer uses an alternative method, the taxpayer must use that method for all cost complements.
Alternative method #1
A taxpayer using the retail LCM method may reduce the numerator of the cost complement by the amount of all margin protection payments if the taxpayer also reduces the denominator of the cost complement by the amount of the permanent reduction in the retail selling price to which the margin protection payments relate (the related markdowns).
Alternative method #2
A taxpayer using the retail LCM method that is able to determine the amount of all margin protection payments but cannot determine the amount of the related markdowns may reduce the numerator of the cost complement by the amount of all margin protection payments if the taxpayer also reduces the denominator. The denominator must be reduced by the amount that, in conjunction with the reduction of the numerator for the margin protection payments, maintains what would have been the cost complement percentage before taking into account the margin protection payments and the related markdowns. A taxpayer that can determine the amount of related markdowns but not the associated margin protection payments may not use this method to compute an adjustment to the numerator.
A taxpayer using the retail LCM method may use statistical sampling in conjunction with any method of computing the cost complement to determine the amount of margin protection payments and related markdowns. A taxpayer using statistical sampling must use it for all margin protection payments and related markdowns associated with the inventory items valued by a particular cost complement, but is not required to use it for every cost complement. A change to using statistical sampling or to discontinue the use of statistical sampling is not a method of accounting.
LIFO taxpayers using RIM
A taxpayer using the LIFO inventory method with RIM must use the retail cost method. Additional adjustments are required as outlined in Reg. section 1.462-1(k).
Adopting the new regulations
Rev. Proc. 2014-48 provides the exclusive procedures for adopting the final regulations. The revenue procedure also contains procedures to ameliorate certain impermissible reductions in the denominator of the cost complement. The six specific changes that use the automatic consent procedures are:
- 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 Treas. Reg. section 1.471‑3(e) to reduce only cost of goods sold
- From adjusting to not adjusting the denominator of the cost complement for temporary markups and markdowns
- In the case of the retail LCM method, from adjusting to not adjusting the numerator of the cost complement by the amount of a margin protection payment
- In the case of the retail LCM method, from adjusting to not adjusting the denominator of the cost complement for permanent markdowns
- In the case of the retail LCM method, from using one method for computing the cost complement described in Treas. Reg. section 1.471‑8(b)(3) to using a different method described in Treas. Reg. section 1.471‑8(b)(3)
- In the case of the retail cost method, from not adjusting to adjusting the denominator of the cost complement for permanent markups and markdowns
Rev. Proc. 2014-48 allows taxpayers to implement the final regulations (1) using a section 481(a) adjustment, or (2) on a cut-off basis for the taxpayer’s first or second taxable year beginning after Dec. 31, 2014. If a cut-off basis is used, the change applies only to the computation of ending inventories after the beginning of the year of change. For taxpayers not using LIFO, any adjustments would be recognized in the current year on a cut-off basis.
To the extent a LIFO taxpayer using RIM has reduced its numerator and not its denominator for sales-based vendor allowances or margin protection payments captured in LIFO layers, the option to use a cut-off section 481(a) adjustment would provide audit protection and allow the taxpayer to leave its LIFO layers undisturbed. Taxpayers not using LIFO that have an unfavorable adjustment should consider whether it makes sense to use a section 481(a) adjustment to take advantage of the four-year spread.
The final regulations around RIM and the related revenue procedure may provide retailers the opportunity to correct the impermissible use of markdowns, obtain a four-year spread for unfavorable adjustments, and achieve audit protection for prior years. For LIFO taxpayers, the opportunity exists to leave existing LIFO layers undisturbed while providing audit protection for prior years. Retailers should discuss with their tax advisors how to take advantage of this opportunity.