Final regulations were issued August 15, 2014 relating to the retail inventory method of accounting. The regulations restate and clarify the computation of ending inventory values under the retail inventory method and provide special rules for certain taxpayers that receive margin protection payments or vendor allowances that are required to reduce cost of goods sold. This new information should have retailers working with their CPA to analyze and determine if an opportunity exists to reduce their taxable income by reducing the value of ending inventory.
Retail taxpayers can use the “retail method” of accounting for inventories prescribed under Regulation Section 1.471-8 to approximate cost or Lower of Cost or Market (LCM) values. Under the retail method, a taxpayer computes the value of ending inventory by multiplying a cost complement by the retail selling prices of goods on hand at the end of the tax year.
The cost complement is a ratio with the numerator being beginning inventory plus purchases during the tax year and the denominator being the retail selling price of beginning inventory plus the initial retail price of purchases for the year. Under the retail-cost method the denominator is adjusted for all permanent markups or markdowns. Taxpayers on the retail inventory method at “Lower of Cost or Market” generally may not make adjustments to the denominator for markdowns.
The final regulations clarify that a taxpayer using the retail inventory method may not reduce the numerator of the cost complement by the amount of an allowance, discount, or price rebate and under Regulation 1.471-3(e), must reduce only cost of goods sold.
A markdown allowance or margin protection payment is a payment provided by a vendor to a retailer in exchange for the retailer’s temporary or permanent reduction in the retail selling price of its inventory. For taxpayers using the retail inventory method, such allowance or payment is reflected as both a reduction of the numerator of the cost complement and in the final inventory retail price. The final regulations, however, clarify that a retail LCM method taxpayer may not reduce the numerator of the cost complement by markdown allowance or margin protection payments.
Addressing commentator concerns about recordkeeping burdens, the final regulations also allow two alternative methods for computing the cost complement:
- Retail – LCM taxpayers receiving margin protection payments may reduce the numerator for margin protection payments and must also quantify and reduce the denominator for the related markdowns.
- Taxpayers unable to track related markdowns but who can quantify their margin protection payments may reduce the numerator by the payments received but they must also adjust the denominator by an amount that would maintain an appropriate cost-complement percentage.
Since a retail inventory method is a method of accounting, a change to one of the required methods under the regulations (the general method or one of the two alternative methods) likely requires an Application for Change in Accounting Method (Form 3115) to be filed. The final regulations are applicable for tax years beginning after December 31, 2014. Revenue Procedure 2014-48 details procedures by which a taxpayer may obtain IRS automatic consent to make the change.
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