Examining Process Chapter 43.
Retail Industry Section 1.
The tax law references are general and brief in nature.
The examiner should not rely upon these references for a complete understanding of the law.
If this Handbook conflicts with the basic IRM text, the latter will prevail.
Procedural statements in this Handbook are for emphasis and clarity and are not to be taken as authority for administrative action.
The examiner should study, consider, and apply the Handbook material where it is appropriate, to ensure an efficient and effective examination.
Consequently, the fourth quarter historically contributes a significant portion of profitability for many retailers.
Any factors negatively affecting fourth quarter sales may have a material adverse effect on profitability for the entire year.
All economic activity is categorized into twenty industry sectors, one of which is retail.
Retail trade is included in sectors 44 and 45.
General merchandise is the umbrella term comprising both lines.
Various government agencies are empowered to see that retail businesses follow such laws.
Retailers must comply with numerous provisions regulating the importation, promotion, and sale of merchandise, consumer and employee protection, and the operation of retail stores and warehouse facilities.
The law allows the consumer to have information about the warranty from the manufacturer as well as the seller.
The new law provides that debtors have a maximum of 210 days after filing to keep or relinquish leases, down substantially from prior law.
The exclusivity period afforded debtors is not limited to 18 months after filing and suppliers can now reclaim their goods from the debtor within 45 days of bankruptcy as opposed to the previous 10-day limit.
The pace of technological advance is rapid and as the cost of technology declines, its use will become even more widespread.
Technological advances have made it feasible to manage and operate efficiently in larger sizes than previously, often on a global basis.
The intuitive ability to correctly anticipate consumer interests will always be a key, and a distinctly human skill needed in the industry.
Retailers are using this information to focus on relationship marketing as a way to gain market share.
Store retailers and catalog retailers are using the internet to become multi-channel retailers.
The extent to which these issues are controlled and the operation of the rules of engagement will depend largely on the importance or impact of the issue.
An annual accounting period can be a calendar or fiscal year.
For example, the last Friday in January instead of January 31.
This results in some tax years being 52 weeks long and some being 53 weeks long.
A 53-week tax year will occur about once every seven years.
While a regular year-end comparison is often misleading because some months have more weekends than others, a 52-53 week tax year uses four-week blocks, which are easily compared with one another.
Using a year-end tied to a specific date can also eliminate many accruals which might otherwise be needed, such as weekly wages.
The flexibility of acceptable choices inherent in financial reporting is unenforceable in a tax system designed to ensure as far as possible that similarly situated taxpayers pay the same tax.
To achieve this goal, the tax system uses "rules" rather than broad "standards.
They are subject to interpretation by various governing bodies, including the Financial Accounting Standards Board FASB and the Securities and Exchange Commission SECwhich create and interpret accounting standards.
Similarly certain accounting methods used by retailers involve estimates or assumptions; the nature of which are material due to the levels of subjectivity and judgment necessary to account for uncertain matters or susceptibility of such matters to change.
In some situations, retailers may exercise judgment in selecting acceptable principles and methods for specific circumstances of diverse and complex economic activities.
The essential element of a material item is that it involves the proper time for the inclusion of the item in income or the taking of a deduction.
If the practice does not permanently affect the taxpayer's lifetime taxable income, but does or could change the taxable year in which taxable income is reported, it involves timing and is therefore considered a method of accounting.
Some methods, including Retail LIFO, computing inventory shrinkage, and reporting income from advertising allowances and coupons are primarily retail in nature.
These revenue procedures and any subsequent revenue procedures dealing with changes in method should be consulted in all cases which have a change in method of accounting issue.
Except during certain window periods, a taxpayer under examination may not file a Form 3115 without the approval of the authorized IRS official.
Also, a retailer under examination may not request to change an impermissible method of accounting if the year in which the taxpayer adopted the method is a year under examination; or if the year under examination is a year in which a taxpayer made an unauthorized change in method.
The examiner may need to revise both the year of the change and the IRC 481 a adjustment.
The examiner should request information pertinent to the issue during the audit if the requested method appears questionable.
When considering a Form 3115, the National Office generally relies on information submitted by the retailer which may be lacking in detail.
The examiner should determine whether the various books, records and other information available would provide a more complete and objective perspective to the National Office.
Access to all applicable information regarding a Form 3115 may result in the National Office making a different determination than would occur if only the retailer-provided information was reviewed, and future problems resulting from inappropriate approval may be circumvented.
Withdrawn, denied, and pending Forms 3115 should be considered to determine if the retailer made unauthorized changes prior to a decision by the National Office.
Schedule M provides a resource to assist the examiner in determining whether any unauthorized changes exist.
In the event of an unauthorized change, the examiner may disallow the unauthorized change and place the retailer back on its prior method.
If they do, the examiner must determine the appropriate year of change and the IRC 481 a adjustment and spread.
Financial accounting and tax accounting, however, are distinct systems of reporting information.
In the final analysis, a tax accounting method must conform to principles of tax accounting, not GAAP, in order to clearly reflect income.
The result of these different objectives is a disparity between book and taxable income.
Schedule M is a critical schedule for identifying potential tax issues resulting from both temporary and permanent differences between financial and tax accounting.
Consequently, the documentation supporting Schedule M adjustments is important in determining compliance with tax law.
Pertinent documentation includes books of original entry, audited financial statements, schedules and source documents such as invoices, contracts, and agreements.
Ask the taxpayer to explain the accounting treatment of such items for financial and tax purposes if the expected items are not listed on Schedule M.
The failure to identify items that were not reported for tax, or items that were deducted only for tax purposes, could result in overlooking potential adjustments to taxable income.
In some situations e.
Reserves for these various sales deductions are often computed as a percentage of sales based on historical return percentages.
Common prepaid income items in retailing include gift card sales, layaway sales, club memberships, and extended service plans.
Prepaid income items are typically credited to a current liability account at the time of cash receipt.
Income is recognized at some later date, which may be a different tax year.
Most memberships are for 12 months.
For tax purposes prepaid items are generally included in income upon receipt, unless a deferral provision applies.
Inventories represent a capitalized cost that is "deducted" through cost of goods sold in the year of sale.
Similarly, cost of sales generally represents the largest single item of expense on the income statement.
At the same time, inventory is arguably the asset with the highest probability of being incorrectly valued because of the judgments and estimates required in determining the appropriate valuation at taxable year-end.
Inventory accounting methods are cost flow assumptions and, with some exceptions, will have no direct relation to the underlying management of physical inventory.
Most retailers prefer to use RIM rather than the cost method in determining the value of inventory.
Acquisition cost includes all of the costs associated with taking possession of merchandise.
Acquisition costs include invoice price, inbound freight costs, import fees and duties, commissions and other similar acquisition costs.
Acquisition cost should be reduced for trade discounts received.
Cash discounts for early payment of invoice may be deducted or not deducted at the taxpayer's option as long as the method is consistent.
Because of the recordkeeping requirements involved, most retailers have elected the retail inventory method which does not require such tracing.
Due to advances in technology, including bar codes and POS terminals, retailers now have the capability to use the cost method with little or no increased recordkeeping costs.
Under LCM, "market" generally refers to replacement cost for the same goods in the same quantities that the taxpayer would normally acquire.
For retailers, the market will often be the retail sales price after markdowns and discounts because retail goods tend to have a high obsolescence or change of style factor.
An illustration of a fixed price contract in retail can be found in Treasury Regulation 1.
In the slotting allowances are used to quizlet of purchased goods, market means the bid price prevailing at the date of the inventory for the particular merchandise in the volume in which usually purchased by the taxpayer.
The taxpayer will usually have a separate report computing the LCM deduction which lists each item, the number on hand plus the cost and market value.
The LCM deduction is usually recorded in a separate reserve or contra-asset account rather than directly to inventory.
The taxpayer must actually offer those goods for sale at that price in order to call it market.
For retailers, this usually means the price of the goods on the shelf.
If the offer is not a bona fide offer, or if only a small portion of the goods are offered for sale, such a price should not be accepted as market.
As a general rule, the regulations require that the actual cost of goods remaining in inventory is the inventoriable cost.
This would normally require matching the goods in inventory to their specific invoices.
This method is usually practiced only for high dollar-value goods like appliances, furniture, televisions, etc.
Consequently, the first goods purchased are the first ones deemed sold and the costs for the goods in inventory at the end of the year are the amounts paid for those goods most recently purchased.
A condition placed upon such an election is that it must also be used for the valuation of inventory in financial statements.
The primary advantage of the LIFO method is that, in most cases, it generates the lowest inventory value, by eliminating the increase in inventory due to price changes caused by inflation or other factors.
The primary disadvantage of the LIFO method is the additional computations and the fact that inventories must be valued at cost.
LCM is not permitted under LIFO.
Under the dollar-value method of LIFO valuation, changes in inventory are measured in dollars and not units.
Under this method, the goods contained in the inventory are grouped into a pool or pools as explained below.
Where the retailer can demonstrate that these methods are impractical, the link-chain method may be approved.
Any method of computing the LIFO value of a dollar-value pool must be used for the year of adoption and for all subsequent years, unless permission to change is received.
Subsequent to the initial year, each inventory period will result in an increment "layer" or decrement to the prior cumulative inventory measured in terms of base-year costs.
At any year-end, the cumulative inventory value of all layers will reflect the true growth in inventory rather than increased dollars relating to the same inventory size caused by price increases.
The separation of goods into pools is fundamental to dollar-value LIFO.
Within each pool are different items.
Items of inventory in the hands of wholesalers, retailers, jobbers, and distributors must be placed into pools by major lines, types or classes of goods unless the retailer elects to use IPIC-method pools.
In determining such groupings, customary business classifications of the trade will be an important consideration.
The regulations providing for the natural business unit method of pooling may be employed only with the permission of the Commissioner of the IRS.
The appropriateness of the number and composition of the pools used, as well as all computations incidental to such pools, are to be determined by the examination of the taxpayer's return.
The pools selected slotting allowances are used to quizlet be used consistently for all subsequent years unless permission to change is granted by the Commissioner.
The quantity of each item in the pool at the close of the year is extended at both base-year unit cost and current-year unit cost.
The two costs are then each totaled.
Specific rules are to be used in determining those costs.
Example 1 in Treas.
For each pool, the index indicates the level of price change that occurs from the beginning of the first taxable year under the LIFO method.
An appropriate index must be used for each pool.
Under this method, the total retail value of its ending inventory is reduced to approximate cost through the application of cost complements.
The method takes into account permanent mark-ups and permanent mark-downs and in general facilities the calculation of the inventories of retailers.
RIM can be used with FIFO or LIFO.
The retail inventory method can be used to determine cost or lower of cost or market.
Specifically, the valuation of inventory at cost and the resulting gross margins are computed by applying a calculated cost-to-retail ratio to the retail value of ending inventories.
The failure to take appropriate markdowns currently can result in an overstatement of inventory under the lower of cost or market principle.
The year-end inventory value of those goods on hand at cost or market is determined by Treas.
LCM normally generates an inventory value that is lower than that determined by using the cost method; therefore, it is more likely to be used.
This method, which normally generates a higher inventory valuation, is less likely to be used.
When it is used, all permanent markup and permanent markdown adjustments are made in determining the retail value.
This basis is required because profit margins may be materially different for departments or classes of goods.
Consequently, the departments or classes of goods will often correspond to the pools for LIFO purposes.
These allowances can be grouped into the following broad categories: buying allowances and promotional allowances.
The allowances are generally recognized as a reduction in cost of goods sold at the time the related inventory is sold.
For example, a retailer may record the receipt of a cooperative advertising allowance for a qualifying advertising or similar promotional expense as a credit to advertising expense.
For most retailers, stores are owned outright, leased, or operated under arrangements where the retailer owns the building and leases the land.
Intangible property identified as "amortizable IRC 197 intangibles" are amortized over 15 years.
Other acquired intangible assets are amortized under IRC 167 on a straight-line basis over the periods during which the particular asset may reasonably be expected to be useful to the taxpayer in its business.
More frequently than other industries, retailers make leasehold improvements on top of leased property.
This practice is not as common in other industries.
This expected term is used in the determination of whether a store lease is a capital or operating lease and in the calculation of straight-line rent expense.
Consequently, rent expense is recognized for financial reporting purposes at the earlier of the first rent payment or the date of possession of the leased property.
The difference between the amounts charged to rent expense and the rent paid is recorded as deferred lease incentive and amortized over the lease term.
A construction allowance is used to defray the cost of constructing a store the retailer intends to operate.
Historically, for financial accounting purposes, retailers recorded construction allowances as a reduction to the cost of the leasehold improvements and depreciated the credits over the useful life of the leasehold improvements.
Due to SEC guidance issued in 2005, retailers now record construction allowances as a deferred liability and amortize the allowances on a straight-line basis over the life of the lease as a reduction to rent expense.
If significant expenditures are made for leasehold improvements late in the expected term of a lease, judgment is applied to determine if the leasehold improvements have a useful life that extends beyond the original expected lease term or if the leasehold improvements have a useful life that is bound by the end of the original expected lease term.
These estimates may be based on the results of an independent study and may consider historical claim frequency and severity as well as changes in factors such as its business environment, benefit levels, medical costs, and the regulatory environment.
Advertising costs consist primarily of print costs, point of sale advertising and marketing promotions.
This period is typically less than one year.
However, a taxpayer may elect to deduct start-up expenditures incurred after October 22, 2004, in the year in which the active trade or business to which the expenditures relates begins.
Any start-up expenditures that are not deductible may be deducted by the taxpayer ratably over the 180-month period beginning with the month in which the active trade or business begins.
Therefore, a taxpayer is no longer required to attach a statement to the return or specifically identify the deducted amount as start-up expenditures for the IRC 195 election to be effective.
A taxpayer may choose to forego the deemed election by clearly electing to capitalize its start-up expenditures on a timely filed Federal income tax return including extensions for the taxable year in which the active trade or business begins.
In addition, there are a number of different record systems maintained by retailers which deal exclusively with the acquisition, level, and disposition of inventory.
Larger retailers should also have records detailing their compliance with the uniform capitalization requirements.
The examiner may request tax accrual workpapers and other audit workpapers in certain limited situations.
For technical questions for TAW, contact the Slotting allowances are used to quizlet technical advisor team.
A number of these records are briefly described below.
The content of this record will usually include the prior year's balance and sometimes the budgeted balance.
A limited description of the entry may also be included.
The monthly totals should be scanned for accounts which contain entries which are abnormal in size or source.
Unusual contra-entries or year-end entries can quickly be identified.
Others show only net debits and credits for each month, with the specifics recorded elsewhere.
Review of the ledger can provide a quick overview of the activity of the account during the year.
Not all of these entries will necessarily flow through to the tax return.
There will generally be a brief explanation of the entry shown in the journal.
Most of the ledger entries reflect either the establishment of a payable for a future payment or the elimination of the payable when the subsequent payment is made.
These records could be reviewed using a number of different techniques.
The examiner may identify certain vendors whose transactions with the taxpayer have significant audit potential.
These transactions can be isolated by vendor.
Larger dollar expenditures may therefore have a higher probability of being improperly classified.
The amounts reflected in the receivable could be monies due from third party credit cards; from banks on installment contract paper which was sold; from customers whose checks were not accepted by the bank; or from vendors as a result of overpayments, rebates, or renegotiated items.
Depending on the number, nature, and amount, a barometer of the reasonableness of the taxpayer's current write-offs may be the collection history of previously written off accounts.
Gross excellent what are the best real money poker sites can is generally the largest line item in the tax return.
Gross income includes merchandise sales, leased department income and other income such as shipping and handling fees.
Prepaid income transactions typically occur in the ordinary course of business rather than a result of a structured tax strategy.
IRC 61 a 3 expressly includes gains derived from dealings in property.
Even if a taxpayer follows GAAP for financial reporting purposes, the IRS may require different treatment for tax purposes.
The term "sale" is given its ordinary meaning for Federal income tax purposes and is generally defined as a transfer of property for money or a promise to pay money.
If the general rule is followed, and the advance payments are included in income in the year accrued either for tax or financial statement purposes, proper matching of revenue and costs will insure that the cost of goods sold has been taken into account.
If the inventoriable goods rule is applicable, Treas.
The Supreme Court has given a liberal construction to the term in recognition of the intent of Congress to tax all gains except those specifically exempted.
Consequently, any statutory exclusion from income must be narrowly construed.
Specifically, when is income received in advance of selling goods or performing services includible in gross income?
Deferring items of income provides an economic benefit to retailers from the time value of money.
The longer the period between the date an item is received and the date the item is included in gross income, the greater the economic benefit.
The fact that the retailer cannot presently compel payment of the money is not controlling.
In applying the all events test, the various courts have distinguished between conditions precedent, which must occur before the right to income arises, and conditions subsequent, the occurrence of which will terminate an existing right to income, but the presence of which does not preclude the accrual of income.
Consequently, a retailer that receives payment for goods or services must accrue the amount unless the receipt is subject to substantial limitations or restrictions, or is a deposit or a loan.
Several factors are considered, but no single factor is controlling.
Otherwise, an accrual method taxpayer could shift at will the reporting of income from one year to another.
Shipping and handling revenue is also included in gross income.
In some situations e.
Common prepaid income items in retailing include gift card sales, layaway sales, club memberships, and extended service plans.
Prepaid income items are typically credited to a current liability account at the time of cash receipt.
Income is recognized at some later date, which may be a different tax year.
Reserves for these various sales deductions are often computed as a percentage of sales based on historical percentages.
Alternatively, sales taxes collected from customers may not be considered income and included in accounts payable or accrued liabilities until remitted to the taxing authorities.
Store credits for returned merchandise may be offered in the form of gift cards.
Gift cards, extended service plans, and club memberships are just a few examples of items for which payment usually precedes performance.
Consequently, the IRS generally takes the position that prepaid income is includible in gross income in the year of receipt while retailers take the position that prepaid income is includible in a subsequent year or years when performance takes place.
In the 1990s, many retailers replaced their gift certificates with gift cards.
For retailers, gift cards offer flexibility in promoting customer loyalty because they make it easier to track purchases and thus offer opportunities to enhance future sales.
Gift cards are generally non-refundable unless required by state law.
Proceeds from the sale of gift cards are recorded at the time of sale as a liability.
Gross income is reported and the liability is relieved when the holder redeems the gift card for merchandise.
In some situations, gift card sales are recognized when the likelihood of redemption by the customer is remote i.
If revenue recognition differs between book and tax, ask the retailer to address how such differences are reconciled and reported on the Schedule M.
Inquire about the following: 1 whether the gift cards are issued in lieu of cash refunds; 2 whether the gift cards are reloadable and if so, how reloads are tracked; and 3 whether the retailer uses a separate legal entity to manage its gift card program and if so to provide details of the arrangement.
The detail requested should include the name and the type e.
Ask if the retailer imposes any restrictions not otherwise listed on the gift card.
In this situation, the method used for tax reporting is the same method used for financial reporting i.
The absence of a Schedule M adjustment reconciling reporting differences indicates the retailer may be using an improper method of accounting for tax reporting purposes.
Gift card income is recognized when all events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.
The regulations do not permit deferral if the income has already been earned.
If gift cards expire before the end of the second year following the year of receipt, the income may have to be recognized sooner slotting allowances are used to quizlet the all events test.
Consequently, a deduction is allowed only when the merchandise is identified i.
Sales discounts on gift cards should be expensed in direct relationship to the recognition of income from the gift cards.
A retailer which expenses discounts while deferring income from the related gift card sales is improperly accelerating a deduction.
As a general rule, retailers that offer layaway sales do not require customers to enter into an installment note or other fixed payment arrangement when the down payment is received.
Retailers retain the merchandise, set it aside in inventory and release the merchandise to the customer when the customer has paid the full purchase price.
The advance payments from customers are recorded as a liability at the time they are received even if the payments are subject to forfeiture.
Gross income is reported and the liability is relieved when the customer pays the full purchase price and the merchandise is delivered to the customer.
Because IRC 453 b 2 B revoked the installment sales method for dealers in personal property, layaway sales now are under the same general rules as gift cards.
The deferral method is explained in IRM 4.
A substantial advance payment is therefore not deemed to have occurred until the last day of the taxable year in which layaway payments received equal or exceed the reasonable costs of the goods sold.
The two-year deferral period provided by Treas.
This deduction or estimate of cost of goods sold must be claimed at this time even if no goods are on hand when the income is recognized.
The deduction for the cost of goods sold is lost if it is not claimed at this time.
Any variance between the actual costs and the deduction claimed is corrected at the completion of the installment obligation.
Some retailers sell extended warranties or service contracts, such as electronics, which are in addition to the warranty provided by the manufacturer.
The coverage provided is usually for a number of years and the consumer usually pays the entire cost of the coverage up-front.
Some retailers may perform the covered-service work themselves while others may have a third party perform the work.
Some retailers are principals of the plan, retaining the contingent liabilities which arise from the coverage, or possibly paying a third party to assume total or partial responsibility.
Other retailers are acting as the agents of a third party, which is the principal of the plan.
As an agent, the retailer's involvement could be limited to selling the service contract to its customers, for which it would receive a commission.
The third party, who is paid to assume the risk, increasingly involves a contract written with an off-shore insurance company.
Consequently, any income received from the sale of extended warranties or service contracts is normally recognized in the year the contract is sold.
Any expenses related to providing services under the warranties or service contracts are allowed only in the year in which incurred.
This method is known as the service warranty income method "SWIM " and provides for a better matching of income and expenses.
If this method is not elected, then the income is recognized when received and the costs of the insurance must be amortized over the life of the policy.
The examiner is unlikely to encounter a reporting issue when the retailer is merely an agent which retains or receives commissions generated by the sale of extended product warranties or service agreements.
Any potential issue would relate to the normal year-end timing issues.
In situations where the retailer is the principal of the agreement sold to the customer, a number of potential issues may exist.
The retailer may be improperly deferring income received for the sale of the agreement.
The sale price may be reflected on the books as a prepaid liability recognized as income ratably over the life of the agreement.
The possibility also exists that the retailer may defer income recognition, or even the inclusion as a prepaid, in situations involving multiple payments.
The examiner should also secure the procedural guide stating how the taxpayer accounts for these monies.
A typical arrangement requires customers to prepay the entire membership fee.
Customers have a unilateral right to cancel their membership at any time during the term and receive a partial refund of the fee paid.
The advance payments from customers are recorded as a liability at the time they are received.
Gross income is reported and the liability is relieved over the term of the membership.
Most terms are for a period of 12 months and income is recognized ratably over this period.
This revenue procedure allows retailers an opportunity to defer annual membership fees to the next succeeding taxable year to the extent the prepaid income is not recognized in revenue in the taxable year of receipt.
These retailers generally receive commissions based on a percentage of sales.
The commissions are recognized as income at the time merchandise is sold to customers.
The SEC does not object to retailers presenting sales of leased or licensed departments in the amount reported as total revenue because of industry practice.
As such, a retailer should recognize the fee or commission as revenue is earned.
Some retailers operate a private label or an in-house credit card program to facilitate sales in their stores and generate additional revenue from fees related to extending credit.
Retailers typically establish a federally chartered bank as a wholly-owned subsidiary to hold and service the card accounts.
These captive banks act as the merchant bank and issuing bank with respect to the card transactions.
Such store cards bear the insignia of the issuing chain.
A 1997 tax law change added subsection iii slotting allowances are used to quizlet IRC 1272 a 6 C.
The application of this change in law to those credit card fees that are properly treated as giving rise to original issue discount OID results in the recognition of the income attributable to the fees in accordance with the constant yield method described in IRC 1272 a 6 for pools of loans.
In addition to merchant discount, in-house card programs treat fees earned for late payment and insufficient funds as OID.
Merchant discount fees are a charge for services, which must be recognized in income currently.
Alternative issues include the application of the matching rule for intercompany transactions and the methodology used to compute the amount of deferred income properly accounted for as OID.
The deferral calculation must be examined as well.
A factor is a financial intermediary who purchases the accounts receivable.
Retailers generate accounts receivable by selling goods and services to their customers on credit and then sell or assign their accounts receivable to a factor in exchange for a cash advance.
Some of the basic types vary the treatment of credit risk assumption and customer or debtor notification.
In many arrangements, factoring agreements provide for accounts to be purchased on both a recourse and non-recourse basis depending on the credit worthiness of the customers or the debtors.
The discount represents an ordinary loss.
The factor is capitalized through a contribution by the parent.
The determination of when a sale takes place depends on the totality of circumstances including when title passes and when possession is transferred.
The objective is to determine when the seller acquired an unconditional right to receive payment under the contract.
If the sales contract contains a condition precedent, the sale is not complete or the purchase price accruable until the condition is satisfied.
The customer acceptance provision should be substantive and bargained for.
The fact that customers rarely exercise this right is of no consequence.
It is the existence of the right which controls.
A barter transaction typically occurs directly between a retailer and the other party to the transaction.
In some situations, however, a third party, such as a barter company may facilitate the barter transaction.
Barter credits may have a contractual expiration date at which time they become worthless.
Traditional retailers may also enter into advertising barter transactions e.
However, the recognition of income and expense may occur in different tax years.
For example, a supermarket barters inventory for media credits.
The retailer redeems the media credits in a year subsequent to the year the inventory is provided to the media company.
Consider the description of the entries and titles of the accounts.
In many cases the cash register is a computer terminal from which data is directly entered into the computer.
This automated retail system is known as a Point of Sale POS inventory system.
They identify the type of transaction, the method of payment including credit card types and numbersauthorization codes and employee codes.
Sales detail by product, department, store, date, and time is immediately available to management personnel using these sophisticated systems.
When the product code is scanned, an immediate interaction with the product data base occurs, generating both the full retail price net of prior permanent markups and markdowns and the promotional markdown.
The customer is charged the net reduced price.
These price changes can be entered into the system in advance of the effective date.
For example, the database can be programmed to reflect that product X, which carries a normal retail price of 99 cents, will be on sale for 79 cents for a specified seven-day period.
The recording of the complete sales transaction is more time consuming and generally contains less detailed information.
In addition, if a certain type of sale is being improperly deferred these records could be searched for data by transaction code.
Before commencing a review of sales, the examiner should request and become familiar with the retailer's internal standard procedures for recording sales, including definitions of input codes.
The rationale is that most items are refundable.
An advance payment and deposit are similar in that both protect the seller e.
An advance payment and deposit are dissimilar in that an advance payment assures the seller that so long as it fulfills its contractual obligation, it can keep the money.
The customer or supplier who makes an advance payment retains no right to insist upon the return of such funds.
An advance payment essentially protects a seller i.
If a taxpayer's claim to income is being contested, click the following article the controversy is unsettled at the close of the taxable year, the item of income is not includible in that year, since the taxpayer's right to receive the income is not fixed.
Even when the other party to the transaction stands ready to pay the amount claimed it will not be income to the taxpayer if the funds are impounded or otherwise tied up so that they are not available to the taxpayer until the contest is settled.
The receipt of payment is one of the three basic events that may fix the taxpayer's right to receive, even if a contest is continuing.
If the matter is litigated, the year of settlement is the year in which a court makes a decision that becomes final.
A trial court's decision must become final, either through affirmation on appeal or through expiration of the right to appeal.
Many taxpayers' claims for income under government contracts are contested administratively without any litigation, and these cases follow the general rule of income in the year of settlement.
The all events test is not satisfied until the dispute is resolved.
Resolution of the dispute occurs when either the liability is acknowledged by the obligor, or the liability is finally determined by the court or other ''forum of last resort'' and is not subject to further appeal or contest.
The IRS has adopted the rule of law first established in H.
The ruling discusses three different situations.
The taxpayer over billed a customer due to a clerical error.
The customer discovered the error in the following year and disputed its liability for the over billed amount.
The taxpayer should recognize income in the year of sale for the correct amount.
The taxpayer shipped the wrong goods to the customer and during the year of sale the customer disputed its liability.
In this fact pattern, the taxpayer does not recognize any income in the year of sale because the taxpayer did not have a fixed right to receive payment for the incorrect goods.
The taxpayer shipped excess quantities of goods to the customer, but the customer agreed to pay for the excess quantities.
The taxpayer must recognize all the income in the year of sale.
There was never a dispute with the customer, so the taxpayer had a fixed right to receive the entire amount of income.
The rationale is that the dispute is a new event.
When the right to receive an amount becomes fixed, the right accrues.
The right to receive rather than the earning of the income is important.
The right to receive may often occur prior to the actual earning of the income, depending on the relevant agreement between the parties as well as other attendant circumstances.
It is not necessary in all circumstances that the right to receive be legally enforceable.
Enforceability of the right often pertains more to whether a debt may be collected than to whether the right to receive exists.
A retailer had the right to reimbursement of a portion of its advertising costs by vendors of advertised goods.
The IRS ruled that the taxpayer should accrue the reimbursement when it placed the advertising, and not at a later date when it filed a claim.
The purchase of obligations, such as accounts receivable, at a discount from face value has been held not to result in the receipt of income.
None of the three basic events fixing the right to receive occurs at the time of purchase merely because assets have been purchased for less than face value, and income is thus considered realized at the time of collection.
See Rhodes-Jennings Furniture Co.
The IRS stated that the all events test is not satisfied when the payment received is in the nature of a deposit.
The taxpayer received a payment from its customer at the end of Year 1 in exchange for the taxpayer's agreement to provide drivers for the customer's trucking operations for the first three months of Year 2.
The memo stated that the payment received would be treated as a deposit and not taxable if the customer had the right to back out of the purchase and could get a refund of the payment.
In this particular case, the service contract with the customer did not provide for the possibility of a refund, so the advance receipt had to be recognized as income in Year 1.
If a taxpayer does not have a duty to perform until the condition has been fulfilled, no right to receive occurs until the condition has been satisfied and, as a result, no accrual of income is required.
For goods shipped COD, title does not pass and a sale is not made until the goods are delivered, accepted, and payment simultaneously rendered.
The condition arises after the fixing of the absolute duty to perform.
The right to receive income arises even though that right may be reduced or eliminated by some subsequent event.
Such contingencies are considered in the same light as anticipated losses, or estimated or contingent liabilities.
None of these items result in current deductions, the approach under the tax law being to "wait and see" until the event occurs, and if it does, to give it some tax effect at that time.
The possibility of refunds is a condition subsequent not affecting the accrual of income.
The Supreme Court has ruled that unearned commissions are subject to refund if the related premiums are not paid because the possibility of a refund is a condition subsequent not affecting the accrual of income.
The cases and rulings have uniformly held that the taxability of the sales price is not affected by the possibility of a subsequent price adjustment.
Delivery is not listed as one of the three events giving rise to a right to receive.
For example in Pacific Grape Products Co.
However the seller billed for the unshipped goods and the buyer paid for such goods by year-end.
The court held that it was proper to accrue income at year-end.
On the other hand, in the case of Hallmark Cards, Inc.
The terms of the sale, however, were see more title to the goods and risk of loss did not pass to the buyer until January 1.
Although the customers were in physical possession of the merchandise at December 31, they did not own it, were not required to include it in year-end inventory, or pay personal property taxes on it.
The court held that the all events test was not satisfied until January 1, and, therefore, the taxpayer could accrue income from these sales at that time.
To reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.
The transportation or other necessary charges incurred in acquiring possession of the goods should be added to this net invoice price.
If a taxpayer does not have adequate records, but the record suggests that they are incurred as an offset to gross receipts, courts may estimate the offset based on the evidence.
Key record- keeping documents will also be identified.
Assistant buyers, administrative support, accounts payable clerks and inventory control personnel aid the head buyer in the purchasing process.
Management and secretarial staff also are involved peripherally in the buying function.
Vendor criteria include reliability and quality control.
Merchandise selection addresses consumer demand, quality, color, size, quantity, and delivery date.
Buyers negotiate there are no slot on disk cost including the various discounts e.
Buyers also negotiate marketing allowances for performance by the retailer, including cooperative advertising and shelving allowances.
Merchandising tasks include involvement in markups and markdowns, the display of the goods planograms and advertising.
An employee in receiving pulls a copy of the PO or a check-in document.
A confirmation is sent to the invoice processing department or entered into the computer system.
The unfilled order file is one of the records a buyer will use to determine an "open to buy" limit which is the budgeted amount a buyer is permitted to order for a specific period of time.
This journal is a subsidiary of the accounts payable system.
All documents entering the payables system are coded to reflect the nature of the transaction such as a regular merchandise transaction, a chargeback issued to a vendor, or a payment of an unearned discount.
Merchandise physically returned to a vendor is another type of transaction reflected in the purchase journal.
Markups increase the retail selling price of an item from the price at which it was initially marked.
Markup cancellations reduce the selling price of an item that was previously marked up to a point not lower than the original retail price established for the item.
Markdowns are the most common adjustments to the retail selling price of an item.
A markdown reduces the original retail price established for the item on the purchase order or product database.
These markdowns are taken at the sales register or Point of Sale POS terminal.
Usually the marked price of the item is not changed.
These markdowns initiated by the buyer are scheduled at the time of purchase of the goods to insure the items purchased will be off the shelves by an established date.
These markdowns are tracked separately since the buyer may have an agreement with the vendor for a partial or complete reimbursement of the markdown.
After an item has been marked down or reduced from its original marked price, this web page markdown cancellation restores the item to a higher price.
Only the increase back to the original more info price is considered a markdown cancellation.
To the extent the price increase results in a new price which exceeds the original retail price, the excess portion which exceeds the original retail price is a markup.
This can be called a variety of names, depending on the retailer.
The stock ledger in a perpetual inventory system contains a roll-up of summary data from the purchases journal or accounts payable system, the price change records, and the sales journal.
It also contains the original entry information reflecting the adjustment of the book inventory to the actual physical inventory.
It can also reflect the entry, either manual or automatic, to accumulate an estimate of the shrinkage to date.
It will usually show a roll-up of merchandise items which have been received but not yet charged to the stock ledger.
Summary information from the stock ledger is printed periodically.
The write-downs, however, cannot be reversed even if the inventory subsequently rises in value.
Market means replacement cost.
Market, however, should not exceed "net realizable value" defined as the estimated selling price minus the direct costs of disposing of the inventory.
Market should not be less than the net realizable value reduced by an allowance for a normal profit margin.
For tax purposes, however, only actual sales prices are considered.
If LIFO is used for tax purposes, LIFO must also be used for GAAP.
Under ARB 43, the primary basis of accounting for inventory is cost.
Commissioner439 US 522 1979 noted the Commissioner is vested in accordance with IRC 446 and IRC 471 with "wide discretion" in determining whether a particular method of inventory accounting should be disallowed as not clearly reflecting income.
The retail inventory method uses the relationship of cost to retail price to determine the cost of merchandise in inventory.
This method is an averaging method and its use has historically been more convenient to compute for most types of merchandise, especially as volume increases.
Acquisition cost includes all of the costs associated with taking possession of merchandise.
The cost should be reduced for trade discounts received.
Because of the recordkeeping involved, some retailers use the retail inventory method which does not require such tracing.
However, with computers, bar codes and POS terminals, many retailers now have the capability to use the cost method with little or no increased recordkeeping costs.
This method is generally practiced for high value goods.
Currently, this method is allowed only for the parts inventory of automobile dealers and heavy equipment dealers.
If the taxpayer elects the LIFO method, additional computations are necessary.
Additional information on the LIFO method is included below.
One method is for normal goods and is found in Treas.
The other method is for subnormal goods and is found in Treas.
If the taxpayer uses the retail inventory method described below, the computation of inventory value will result in the valuation of inventory at cost or market, whichever is lower.
Subnormal goods may be valued at their bona fide selling price less direct cost of disposition.
Bona fide selling price means actual offering of goods during a period ending not later than 30 days after inventory date.
The burden of proof will rest upon the taxpayer to show that such exceptional goods as are valued come within the classifications indicated and the taxpayer will maintain such records of the disposition of the goods as will enable a verification of the inventory to be made.
The retailer will usually have a separate report computing the LCM reduction which lists each item, the number on hand plus the cost and market value.
The LCM reduction is usually recorded in a separate reserve or contra-asset account rather than directly to inventory.
The goods must be actually offered for sale at that price in order to call the value market.
For retailers, this means the price of the goods on the shelf.
RIM uses the relationship of cost to retail price to determine the cost of merchandise in inventory.
This method is an averaging method and historically has been more convenient to use for most types of goods, especially as volume increases.
If a perpetual inventory is maintained in conjunction with the use of RIM, a retailer can determine profits without taking frequent physical inventories.
The year-end retail price of the goods on hand or its market value is determined by Treas.
Since the LCM method can generate an inventory value lower than cost, it is more frequently used.
The retail value of each item must be adjusted to reflect the retail price, as marked up from cost plus additional permanent markups less markup cancellations.
The percentage, the ratio of cost to retail, is also known as the cost complement.
Markdowns are a reduction to the selling price below the original sale price.
Markdown cancellations increase a previously marked down sales price no higher than the original retail price with any excess being considered a markup.
Net markdowns are markdowns less markdown cancellations.
The result is the LCM value of the ending inventory.
Valuing the inventory at cost rather than LCM will generally result in a higher inventory value.
When cost is used, all permanent markup and markdown adjustments are made in determining the retail value.
The requirement as set forth in Treas.
These departments or classes of goods often correspond to pools for LIFO purposes.
Such an election is conditioned on the requirement that it will also be used for the valuation of inventory in financial statements financial statement conformity.
The LIFO method is preferred by taxpayers because it will, in most instances, generate the lowest inventory value by eliminating the increase in inventory due to price changes caused by inflation.
Its disadvantages include additional computations plus the requirement to value inventory at cost, not LCM.
If the retailer can demonstrate that these methods, double-extension or an index method, are impractical, then the link-chain method may be approved.
Any method of computing the LIFO value of a dollar-value pool must be used for the year of adoption of the LIFO methodology and for all subsequent years unless permission to change the method is requested and received.
Many retailers also use the IPIC LIFO method under Treas.
Under this method, goods contained in inventory are grouped into a pool or pools.
The year of adoption could be as early as 1948 when the LIFO regulations were amended to permit retailers to use the dollar-value LIFO method.
Items of inventory in the hands of wholesalers, retailers, jobbers, and distributors shall be placed into pools by major lines, types, or classes of goods.
In determining such groupings, customary business classifications of the trade will be an important consideration.
For example, the customary business classification in a department store is the department.
The resulting amount equals retail in base-period prices.
The excess amount is multiplied by the same index factor to restate it in current period prices.
The decrement is used to reduce the most recent prior year layer, in terms of base-period prices.
To the extent any decrement remains after reduction of the first layer, the second prior incremental layer is reduced.
The reduction process continues until the entire decrement is exhausted.
Only data pertaining to current year purchases are used to determine the cost complement.
Under the IPIC method, the taxpayer sorts its inventory by the United States Bureau of Labor Statistics BLS commodity codes and then applies BLS indexes to the items in its inventory.
This simplifies the process of computing an index for a dollar-value pool because the taxpayer does not have to develop its own internal indexes.
These reports are available on the BLS website at.
In addition, a taxpayer electing to establish pools under Treas.
Each of these 5 percent rules is a method of accounting.
Whether a specific IPIC pool or the miscellaneous IPIC pool satisfies the applicable 5-percent rule must be determined in the year of adoption or year of change whichever is applicable and redetermined every third taxable year counting the year of adoption or change as the first year.
Any change in pooling required or permitted under a 5-percent rule is a change in method of accounting.
A taxpayer must secure the consent of the Commissioner pursuant to Treas.
Records must be maintained to support the base-year unit cost as well as the current-year unit cost for all items priced on the dollar-value LIFO inventory method.
A taxpayer using the IPIC method must compute a separate inventory price index IPI for each dollar-value pool.
This IPI is used to convert the total current-year cost of the items in a dollar-value pool to base-year cost in order to determine whether there is an increment or liquidation decrement in terms of base-year cost and, if there is an increment, to determine the LIFO inventory value of the current year's increment layer.
The IPIC method will be accepted by the Commissioner as an appropriate method of computing an index, and the use of that index to compute the LIFO value of a dollar-value pool will be accepted as accurate and reliable.
The appropriateness of a taxpayer's computation of an IPI, which includes all the steps described in Treas.
A taxpayer using the IPIC method may elect to establish dollar-value pools according to the special rules in paragraphs Treas.
A taxpayer that elects to use the IPIC method for a specific trade or business must use that method to account for all items of dollar-value LIFO inventory.
However, a taxpayer that uses the retail price indexes computed by the BLS and published in "Department Store Inventory Price Indexes" available from the BLS by calling 202 606-6325 and entering document code 2415 may elect to use the IPIC method for items that do not fall within any of the major groups listed in "Department Store Inventory Price Indexes.
A taxpayer may compute the IPI for each dollar-value pool using either the double-extension method double-extension IPIC method or the link-chain method link-chain IPIC methodwithout regard to whether the use of a double-extension method is impractical or unsuitable.
The use of either the double-extension IPIC method or the link-chain IPIC method is a method of accounting, and the adopted method must be applied consistently to all dollar-value pools within a trade or business accounted for under the IPIC method.
A taxpayer that wants to change from the double-extension IPIC method to the link-chain IPIC method, or vice versa, must secure the consent of the Commissioner under Treas.
This change must be made with a new base year as described in Treas.
A taxpayer not using RIM may annually select an appropriate month for each dollar-value pool or make an election on Form 970, "Application to Use LIFO Inventory Method," to use a representative appropriate month representative month.
An election to use a representative month is a method of accounting and the month elected must be used for the taxable year of the election and all subsequent taxable years, unless the taxpayer obtains the Commissioner's consent under Treas.
For example, in Table 6 of the "PPI Detailed Report" for a given month, the commodity codes for the various BLS categories run from 2 to 8 digits, with the least-detailed BLS categories having a 2-digit code and the most-detailed BLS categories usually but not always having an 8-digit code.
The 10 percent method is a method of accounting and a taxpayer that wants to change its method of selecting BLS categories i.
A taxpayer that voluntarily changes its method of selecting BLS categories or of selecting a BLS category for a specific item must establish a new base year in the year of change.
A taxpayer may elect to use either preliminary or final BLS price indexes for the appropriate month, provided that the selected BLS price indexes are used consistently.
However, a taxpayer that elects to use final BLS price indexes for the appropriate month must use preliminary BLS price indexes for any taxable year for which the taxpayer files its original federal income tax return before the BLS publishes final BLS price indexes for the appropriate month.
If a BLS price index is not otherwise available for the appropriate or representative month because the BLS categories in the BLS table have been revised, the rules of Treas.
A purchaser should include in inventory merchandise purchased including containerstitle to which has passed to him, although such merchandise is in transit or for other reasons has not been reduced to physical possession, but should not include goods orders for future delivery, transfer of title to which has not yet been effected.
Inventory shrinkage is a common problem in the retail industry.
Cycle counting is a means of conducting physical inventories at each store, in rotation, throughout the year.
In part due to their size, large retailers are able to compile statistical data to measure their rate of shrinkage as a percentage of sales.
Under a perpetual inventory system, inventory is updated with every purchase and sale.
Since individual purchases and sales of goods are tracked through detailed accounting records, a retailer knows at all times the value of its inventory.
Because of inventory shrinkage, a physical inventory is taken at intervals to verify the accuracy of the amounts shown in the inventory records.
To the extent of inventory shrinkage, the inventory account is adjusted to bring it to actual.
The aggregate value of these goods is recorded on the company's books as a financial asset.
For these taxpayers, an opportunity exists to adjust the year-end perpetual book inventory by an un-supportable shrinkage factor.
Consequently, the determination of the accuracy of a retailer's method of estimating shrinkage is heavily dependent on the particular facts in each case.
A shrinkage reserve is based upon the quantity of goods on hand.
It is not a reserve for the value of the goods on hand, which is not allowed for those taxpayers electing to use the LIFO method.
Many taxpayers that previously used this method are now using the IPIC method.
Any step-up reflected on the tax return most likely would appear as a "favorable to the taxpayer" Schedule M item and would mean that book fair market value of inventory and tax fair market value of inventory differ.
According to the pronouncement, the purchase method records the net assets acquired in a business combination at their fair values.
The guidance for inventories as contained in paragraph 37 indicates the following.
The methods described to allocate the purchase price actual or deemed of the assets acquired are the replacement cost method, the comparative sales method, and the income method.
Allocation of the purchase price is required to determine the basis of each asset.
See Knapp King-Size Corp.
According to the Coordinated Issue Paper, when valuing retailers' inventories, the cost of reproduction method which values inventories at replacement cost, i.
Consideration must also be given to the time that would be required to dispose of the inventory, the part of the expected selling price that is attributable to going concern, and to a profit that is commensurate with the amount of investment and degree of risk.
Like the Coordinated Issue Paper, Rev.
This difference should be found on the Schedule M-3.
Coordinated issues establish uniform positions within industry or issue areas.
The coordinated issues involving inventory are as what are pci express x4 slots used for below.
Historically, most taxpayers maintain their inventory records using the cost of items most recently purchased.
However, if LIFO is elected, the taxpayer oftentimes has elected to use the earliest acquisition method to determine the current year cost without changing the record keeping system, hence the use of a dual index method.
One index the deflator index is used to convert current-year cost to base-year cost and a second index the increment valuation index is used to value the increment.
The Form slotting allowances are used to quizlet, used to elect LIFO, will indicate if the taxpayer has elected the earliest acquisition method to determine current year cost.
See the coordinated issue section regarding Dollar-Value LIFO earliest acquisition method contained in IRM 4.
Temporary or promotional markdowns, which may be in effect as of year-end, should not be reflected in the retail price used in the computation of the cost complement.
Generally, the reduced retail price of the display merchandise is not marked on the item until the last closed box is sold.
Retailers have been accelerating deductions solely upon the placement of goods on display.
See the coordinated issue section regarding Dollar-Value LIFO: Bargain Purchase Inventory contained in IRM 4.
This method is commonly referred to as the "direct cost" method.
This method is generally referred to as the "prime cost" method.
Any clarification of the procedures should be discussed with the appropriate taxpayer personnel.
Any indications of an incomplete or inaccurate inventory should be discussed with the taxpayer.
These schedules may provide indications of changes made to pools, business emphasis changes, the pattern of the cost complement factors, and the propriety of the price index figures used.
In addition, many technical discussions of inventory methodologies and issues can be accessed through both Lexis-Nexis and Westlaw research.
Both producers and resellers of tangible personal and real property are required to capitalize costs under the provisions of IRC 263A.
In addition, IRC 263A applies to the resale of intangible property.
IRC 263A b 2 B excepts personal property acquired for resale by a small reseller from the capitalization rules of IRC 263A.
In addition to the cost allocation methods provided in Treas.
The simplified service cost method may be used in conjunction with either a facts and circumstances approach or a simplified method of allocating costs to eligible property produced or eligible property acquired for resale.
Merchandising employees in a retail context purchase the goods for resale inventoriable goods.
Merchandising employees are assigned to various product lines or categories of goods e.
Decentralized buying procedures use buyers that are assigned to specific stores or geographic locations.
Other retailers may design only a portion of their goods held for resale which are known as private label goods e.
In these circumstances, the retailer typically has an in-house design group that develops the private store label goods.
Oftentimes, private label goods are produced by independent parties under contract.
As a general rule, these independent parties are located in countries overseas.
To survive in today's economy, retailers need to be distinguishable from the competition.
Carrying exclusive merchandise provides retailers an opportunity to differentiate its merchandise assortment from its competition.
These costs include the otherwise deductible portion e.
Absorption costing for book purposes can and oftentimes does differ from the full absorption method as required for tax.
To the net price, transportation and other necessary charges incurred in acquiring possession of the goods should be added.
The individual facts and circumstances will control the determination.
See the Emerging Issues Task Force EITF Issue No.
The IRS's position is that, since the costs incurred in the merchandising department includes the costs of purchasing goods for resale, the merchandising department does not constitute a service department.
Consequently, the IRS has concluded that the purchasing costs incurred in the merchandising department are properly capitalizable indirect costs in accordance with Treas.
Reclassifications such as these attempt to eliminate from capitalization the indirect costs as described in Treas.
Purchasing, handling, off-site storage costs and the allocable general and administrative costs pertaining to these costs are generally required by statute to be capitalized to inventory.
This circumstance can occur if a retailer reduces its purchases by vendor allowances or some other reduction for tax purposes but does not reduce its purchases by the same amounts for book purposes.
For a reseller, IRC 471 costs would include the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may, or may not, be deducted at the option of the taxpayer, provided a consistent course is followed, plus transportation or other necessary costs incurred in acquiring possession of the goods.
However, taxpayers that acquire real property for resale are subject to IRC 263A with respect to real property regardless of their gross receipts.
See IRC 263A b 2.
Therefore, these costs are required to be capitalized under IRC 263A.
Deductible service costs include costs incurred by reason of the marketing, selling, advertising, and distribution activities of the taxpayer.
In determining the total mixed service costs of a trade or business, the taxpayer must include all costs incurred in its mixed service departments and cannot exclude any otherwise deductible service costs.
For example, if the accounting department within a trade or business is a mixed service department, then in determining the total mixed service costs of the trade or business, the taxpayer cannot exclude the costs of personnel in the accounting department that perform services relating to non-resale activities.
Instead, the entire cost of the accounting department must be included in the total mixed service costs.
Purchasing costs are costs associated with operating a purchasing department or office within a trade or business, including personnel costs continue reading />Storage costs are capitalized under IRC 263A to the extent they are attributable to the operation of an off-site storage or warehousing facility an off-site storage facility.
However, storage costs attributable to the operation of an on-site storage facility as defined in Treas.
Storage costs attributable to a dual-function storage facility as defined in Treas.
Handling costs are generally required to be capitalized under IRC 263A.
However, handling costs incurred at a retail sales facility with respect to property sold to retail customers at the facility are not required to be capitalized.
Thus, handling costs incurred at a retail sales facility to unload, unpack, mark, and tag goods sold to retail customers at the facility are not required to be capitalized.
In addition, handling costs incurred at a dual-function storage facility with respect to property sold to customers from the facility are not required to be capitalized to the extent that the costs are incurred with respect to property sold in on-site sales.
Some considerations include whether the retailer engages in any production activities, whether the personal property is private label property and whether the production activities were contracted out.
These workpapers are essential if the retailer engages exclusively in production activities.
This section also provides guidance regarding situations in which retailers are required to capitalize interest under IRC 263A f.
Stores are neither mass-produced nor do they have a high turnover.
The retailer for whom property is being constructed under a contract is subject to the interest capitalization rules on payments made to the contractor, and the contractor is subject to the rules on any costs that it incurs in excess of payments received by it to date.
The final regulations provide guidance necessary for taxpayers to comply with the requirement to capitalize interest with respect to certain produced property.
In enacting IRC 263A, Congress intended that a single, comprehensive set of rules generally should govern the capitalization of costs of producing property in order to more accurately reflect income and make the tax system more neutral.
Such costs were identified through published revenue rulings on specific costs and various court cases that addressed specific costs.
However, there are two exceptions.
The exceptions are for self-constructed assets produced by a taxpayer that are substantially identical in nature to, and produced in the same manner as, inventory property or non-inventory property that is produced for sale that the taxpayer is also producing and self-constructed assets produced on a "routine and repetitive" basis.
The capitalized costs are written off through depreciation and amortization according to the type of fixed asset.
No depreciation is allowed for land.
Buildings are depreciable over its real property lives.
Furnishings and fixtures used in operations, known as retail trade assets, are depreciable over its personal property lives.
On the other hand, a complicated trail, which can include allocation studies, drawings, bid proposals, and planning documents to tie back to invoices, may exist.
More complex trails tend to be the result of new construction or a major remodel of an existing store.
Generally, any improvement to designated property constitutes the production of designated property.
A retailer must use the same computation periods for all designated property produced during a single taxable year.
The choice of a computation period is a method of accounting.
Any change in the computation period is a change in method of accounting requiring the consent of the Commissioner under IRC 446 e and Treas.
Otherwise, interest capitalization is not required.
Therefore, interest capitalization for tax purposes is determined without regard to FASB 34.
For tax purposes, retailers are not permitted to net interest income and interest expense in determining the amount of interest that must be capitalized with respect to restricted tax-exempt borrowings.
Self-constructed assets are subject to IRC 263A.
For purposes of IRC 263A, produce includes the following: construct, build, install, manufacture, develop, improve, create, raise, or grow.
Common features include streets, sidewalks, sewer lines, and cables that are not held for the production of income separately from the units of real property they benefit.
Examples of assets used in a reasonably proximate manner include machinery and equipment used directly or indirectly in the production process, such as assembly-line structures, cranes, bulldozers, and buildings.
For example, the cost of raw land acquired for development and the capitalized costs of planning and design activities are taken into account as APEs beginning on the first day of the production period.
If the retailer uses the taxable year as the computation period, a single avoided cost calculation is made for each unit of designated property for the entire taxable year.
Any change in the computation period is a change in method of account requiring the consent of the Commissioner under IRC 446 e and Treas.
Traced debt also includes unpaid interest that has been capitalized with respect to such unit under Treas.
The retailer must, for the computation period that includes the measurement date, capitalize with respect to the unit the excess expenditure amount calculated under Treas.
If such an election is made, the average excess expenditures and weighted average interest rate under Treas.
The making or revocation of the election is a change in method of accounting requiring the consent of the Commissioner under IRC 446 e and Treas.
In addition, many technical discussions of self-constructed assets and interest capitalization can be accessed through both Lexis-Nexis and Westlaw research.
Vendors use trade programs to promote and sell their goods.
Vendors provide various types of allowances, credits and rebates to retailers through a variety of programs and arrangements to support the merchandise purchased for resale.
As a general rule, the proper treatment for Federal income tax reporting is similar to financial reporting.
In certain circumstances, however, an allowance may need to be reported as current income for tax purposes.
Accounting for vendor allowances should follow the economic substance of the underlying transaction, which should be evidenced by an agreement with the vendor.
Is the allowance intended to reduce a specified gross purchase price of goods to an agreed net price or to reimburse the retailer for a consideration separate from the purchase price of goods?
The retailer should reduce the cost of inventory when purchased and not as a later year adjustment to cost of goods sold.
Vendor allowances will affect the cost complement for various inventory pools for retailers using the retail inventory method RIM.
For vendor allowances included in a current year increment, a retailer obtains the benefit of indefinite deferral until a LIFO decrement occurs.
The Emerging Issues Task Force EITF 02-16 suggests formal contractual arrangements are the norm.
Implicit in the definition of trade discount, including volume or quantity reductions, is the concept requiring a nexus between the trade discount and the merchandise giving rise to the trade discount.
For example, a retailer may earn an allowance equal to one percent of total purchases when the total purchase reaches 103 percent of last year's total.
Vendors generally establish volume discounts based on projected or prior year sales rather than execution or profitability.
In some situations, retailers may charge back vendors on open invoices through the accounts payable process.
Allowances that are recognized in the income statement, but not yet received, may be reported as a vendor receivable.
Retailers usually account for fixed discount arrangements as a reduction of inventoriable product cost rather than a reduction of cost of sales or gross income.
Many trade programs provide allowances for current and annual purchases of goods and performance or merchandising activities.
Markdown allowances, sell-throughs, and charge-backs are common, particularly in the moderate priced market.
Markdown money is a standard part of the apparel industry.
In its most benign form, markdown money offers a way for vendors and retailers to share the inherent risks in doing business.
The technology provided data that clearly tracked the impact of price reductions.
Consequently, trade promotion spending has increased significantly as a percentage of marketing budgets while advertising, which is hard to link to sales, has decreased.
Cash considerations include credits against trade amounts owed to the vendor.
Consequently, a cash discount is intended to speed payment and provide liquidity to the vendor.
When payment is made in time to take advantage of the discount, accounts payable are debited for the full invoice price, cash is credited for the amount actually paid, and income is reported for the cash discount earned.
The reduction is made regardless of whether the discount offered is actually taken.
Any cash discounts not taken advantage of are recorded as expense items.
Allocating cash discounts to ending inventory on a pro-rata basis will not provide for a clear reflection of income because the cash discounts will be allocated to items in inventory for which cash discounts either were not offered or were offered at a different rate.
For example, if all the cash discounts taken are attributable to item A and ending inventory included only item B, then ending inventory should not be reduced by cash discounts because the cash discounts were not taken on any of the items remaining in ending inventory.
The rationale for quantity discounts is to obtain economies of scale and pass some or all of the savings on to the retailer.
The allowance is generally stated as a percentage of goods purchased by the retailer.
In some situations, this allowance is provided as a lump-sum cash payment to the retailer in advance of its purchases.
Under the net method, a retailer does not adjust the purchase cost of goods for the amount of cash discount offered at the time the purchase is recorded in the inventory ledger.
Instead, the purchase is recorded at the gross purchase price and the cash discount is simply accumulated in a separate cash discounts account.
At the end of the year, a retailer compares the aggregate level of cash discounts offered to goods purchased throughout the year and reduces ending inventory by this same percentage.
Display fixtures are defined to include, but are not limited to, shelving, racks, display cases, free-standing display units, decorative items such as track lighting, and upgraded ceilings, walls and floors.
As an alternative, some vendors provide fixtures to retailers rather than reimbursing retailers for these costs.
Retailers generally own the assets, pay personal property taxes on the assets, and insure the assets.
Under this method, such allowances are recognized as gross income as a reduction to depreciation expense over the lives of the assets.
Whereas retailers generally take the position that these allowances reduce the bases of the acquired assets, the IRS takes the position that these allowances represent gross income.
Under this circumstance, the character of the allowance depends upon the nature of the payment.
Like trade or other discounts, performance allowances are typically computed as a percentage of goods purchased by a retailer.
The increasingly complex nature of trade programs in the retail industry often makes the determination more difficult to distinguish one from the other.
In this type of an arrangement, a product or service is advertised using the names of both a vendor and a retailer.
Large retailers, however, may not be required to submit claims for reimbursement.
Fixed reimbursement rates are commonly around 50 percent, but can be higher.
Under an accrual program, credits accumulate as products are purchased or are volume-based.
A typical accrual percentage is around 5 percent of net purchases.
Allowances will sometimes fluctuate according to the volume of purchases.
The rules and policies generally vary by advertising arrangement and by vendor.
The reimbursement process may take weeks or months.
For example, a retailer receives cooperative advertising funds from a vendor to place a certain product in its weekly circular.
Accordingly, for book purposes, this amount would be treated as a reduction of inventoriable product cost.
The allowance is intended to cover a portion of the cost of in-store representatives.
Certain marketing considerations, such as counter space, product placement, staffing and pay incentives must be met to qualify for the credit.
Contracts are generally written, multi-year agreements.
This type of allowance is common in the department store industry in general and in the cosmetic and jewelry departments in particular.
The IRS takes a position that these allowances are provided to a retailer for the provision of services.
Thus, these allowances represent gross income under IRC 61.
These arrangements may grant the vendor the status of exclusive or primary supplier.
In addition to the future purchase of goods, the arrangement may require the retailer to provide certain marketing services.
Certain categories of goods, such as spices, greeting cards and batteries are typically associated with these multi-year agreements.
While the agreement may provide the retailer with the unrestricted use of the cash payment, the agreement usually provides that the retailer must return pro rata amounts if it does not fulfill its purchase obligation.
Retailers recording the up-front cash payment as a liability recognize income on the books as purchases are made to satisfy the volume commitment.
Retailers generally record the earned portion as a reduction to cost of goods sold.
Retailers generally characterize the cash payments as advance trade discounts and offset inventory costs under Treas.
Retailers may also take the position that the up-front payments are in the nature of loans or deposits from the vendors that must be repaid if the terms of the agreement are not met and, thus, do not constitute gross income upon receipt.
Conversely, the IRS has taken the position that the cash payments represent gross income as payment for the exclusive right to supply the retailer with goods of a specific type.
The IRS also has taken the position that since the retailer alone controls whether or not the prerequisite purchases are made, the payments are an accession to wealth, clearly realized, and over which the taxpayer has complete dominion and control.
To the extent a retailer meets the five conditions in the revenue procedure, the character of the up-front cash payments should not be in dispute.
The examiner should also consider whether the terms of the agreement exceeds 5 years.
If so, the retailer is not protected by this administrative relief.
Vendors pay slotting allowances for the right to secure, expand, and retain a position on retail store shelves and, in some cases, limit shelf space available to competing products.
The actual amount of a slotting allowance varies by product category and company.
Some immediately record the allowance in whole, some amortize the allowance into income over a period of time and some apply the allowance directly to reduce the cost of specific items e.
SKU, UPCproduct categories, or departments.
A retailer should include a slotting allowance as income, assuming a fixed right to receive income exists, at the earliest of when it is received, due, or earned, whichever occurs first.
A vendor can deduct the entire payment in the year made under IRC 162.
market best are money what accounts the demand, in certain situations, contributes to retailers holding either too little or too much inventory for certain merchandise.
When demand falls short of expectations, retailers hold an inventory of unwanted merchandise at full retail sales price.
A retailer must mark down the full retail sales price in order to dispose of the merchandise.
A margin protection or markdown participation allowance is one form of guarantee to address this potential situation.
This allowance provides a retailer with gross margin protection during times of heavy promotion and markdowns to move slow-moving or outdated merchandise, or to increase sales of a particular product.
In all of these situations, the allowance affects the price for which the inventory is actually sold and essentially shifts much of the risk from the retailer to the vendor.
These allowances, however, may be negotiated after the initial purchase.
Such an allowance may be demanded as a concession by large retailers, and if this is the case, the terms may appear on their purchase orders.
Cost should be reduced by the amount of allowance under the invoice cost method to reconcile with the lower of cost or market adjustment.
The allocation should be made on an item-by-item basis, not a vendor-by-vendor basis.
Under this method, the acquisition cost, not the retail selling price of merchandise, is reduced by the allowance.
The net tax effect is that the inventory value is reported below cost and market value.
Situations may involve poor fit or quality, shipment of the wrong size or color, imperfections or shortages.
Other goods are unsaleable and taken off the retail shelf due to expiration or discontinuation.
Retailers deduct the percentage allowance off each invoice.
Under the terms of this arrangement, a retailer is prohibited from filing additional claims for defective merchandise.
The retailer either destroys the defective merchandise or disposes of it through alternative distribution channels.
Proper tax treatment for this permutation is under consideration.
The retailer receives an amount based on the specific units of product sold during that period.
In theory, the consumer directly benefits from this type of allowance by way of a reduced price for the product.
The unique feature of this type of an allowance is that it is based on the sell-through of the goods by a retailer to its customers rather than its purchase of goods from the vendor.
This technology provided retailers and vendors with data that clearly tracked the impact of price reductions by comparing stores that offered promotions against stores that did not.
Applying advice provided in several revenue rulings on tax rebates for previously paid federal excise link with respect to floor stocks of tires, a position can be made that sales based allowances constitute gross income because they relate to product that has already been sold.
The source and type of documentation will affect its persuasiveness.
Examples of such agreements include: 1 Retailer's or Vendor's Master Agreement; 2 Memorandum of Understanding; 3 Offering or Deal Sheets; 4 Purchase Orders; and 5 Electronic Communication.
Such observances can provide certain insights.
Merchandising employees are generally organized into merchandising divisions with responsibility for one or two departments at a store.
Merchandising employees are responsible for assuring that the merchandise to be acquired can be sold at a retail price that will generate the targeted profit percentage.
Buying and merchandising decisions are influenced by vendor allowances.
In most transactions, vendor allowances, discounts, and rebates are offered or demanded as part of the overall negotiated price.
The details of the negotiated agreement will be entered into the product data records or maintained by the buyer.
For example, changing from including vendor allowances in gross income to deferring its recognition through a corresponding reduction to inventory cost represents a change in accounting method.
An adjustment under IRC 481 a should be reported reflecting the cumulative effect of the method change.
Request for permission must be filed by the due date of the tax return.
Certain requirements must be met in order to qualify for this procedure, including the following.
The vendor invoice typically bills the retailer for goods in an amount that exceeds the actual price of the goods by an agreed upon percentage.
The over-billed amount is charged to purchases.
The retailer can request a check as repayment for the over-billed amount or the retailer can use the over-billed amount by taking a deduction off a subsequent invoice i.
To the extent the over-billed amount is not used until a subsequent taxable year, the result is an overstatement of purchases in the year paid.
An interview of purchasing and finance department personnel will also assist in obtaining information relating to over-billing procedures.
While incentives are typically reserved for the retailer itself in the form of slotting allowances, the practice of guaranteeing shelf space through gifts or direct payments to a buyer is possible.
While a payment in the United States is illegal, the payment may not be illegal in other parts of the world.
Tangible assets include land, land improvements, buildings, leasehold improvements, inventory, and equipment.
Consequently, for retailers, the depreciation deduction for tangible property plays a significant role in the computation of taxable income.
Self-constructed assets are assets produced by a taxpayer for use by the taxpayer in its trade or business and are subject to IRC 263A.
Costs that are capitalized under IRC 263A are recovered through depreciation, amortization, cost of goods sold, or by an adjustment to basis at the time the property is used, sold, placed in service, or otherwise disposed by the taxpayer.
The Modified Accelerated Cost Recovery System MACRS applies to most tangible property placed in service after 1986.
Under MACRS, the depreciation deduction is computed using a prescribed depreciation method, recovery period, and convention.
Gain on the disposition of IRC 1245 property is ordinary income to the extent of depreciation recapture on the property.
For property held by the taxpayer for less than one year, gain on the disposition of IRC 1250 property is ordinary income to the extent of depreciation recapture on the property.
For property held by the taxpayer for at least one year, gain on the disposition of IRC 1250 property is ordinary income in an amount equal to the difference between the depreciation allowance for the property and the depreciation allowance that the taxpayer would have taken if the taxpayer had used the straight-line method.
It is not uncommon to encounter situations with very similar fact patterns that arrive at very different conclusions.
Consequently, the particular facts involved in each case receive significant attention.
Many nonrealty assets used in the retail industry fall under Class 57.
Tests developed under prior law for investment tax credit purposes can be used to distinguish IRC 1245 property from IRC 1250 property for depreciation purposes under MACRS.
Allocations must be based on a logical and objective measure of the portion of equipment that constitutes IRC 1245 property.
The current-law cost recovery allowances assume that assets wear out at a specified rate over time.
This rate is independent of the actual or expected economic conditions facing each taxpayer.
It does not take intensity of use into account for purposes of determining the depreciation amount.
Consequently, many assets may actually depreciate faster or slower than click here MACRS-specified time periods, depending on how intensively they are used.
Different lives and methods are commonly used for financial and tax reporting purposes.
In addition, different lives and methods may be used for regular tax and AMT purposes.
Consequently, most of the administrative burden associated with the current law relates to record keeping requirements.
A good location draws traffic, which is essential to generating sales.
The decision to buy or lease is made based on the cash flows that each choice confers.
They usually lease the land to preserve capital for future expansion.
Large retailers may receive landlord incentives to open an anchor store See IRM 4.
The improvements are needed to build out the space to their own specifications.
In many situations, the landlord will pay for all or part of the build-out costs.
Most retailers remodel and update their stores every five to ten years.
Buildings are estimated to have useful lives of 40 years.
Computer Equipment and Software are estimated at 3 to 5 years.
The purpose of the building is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space.
It is particularly important in the area of building depreciation.
Residential rental property as defined in IRC 168 e 2 A is depreciated over 27.
A taxpayer obtains a tax benefit if tax deductions can be accelerated.
Consequently, some taxpayers conduct cost segregation studies, which itemize the hundreds or thousands of individual elements used in constructing a building and distinguish which elements may be classified as IRC 1245 property and which elements are IRC 1250 property.
For example, a certain building fixture may be considered real property under local law, but unless this fixture is considered a structural component under Treas.
In such a case, the item is classified under the asset category.
Assets in class 57.
Certain assets, such as computers, office furniture, fixtures, and equipment, and cars and trucks are assigned the same recovery period in all industries.
To a large extent, however, the current depreciation system is industry-based rather than asset-based.
Most investments in equipment are assigned a recovery period that depends on the specific industry.
Office buildings are depreciable over 39 years.
Furniture, fixtures, and equipment i.
More complex trails tend to be the result of new construction or a major remodel of an existing store.
Detailed asset records should be obtained in a computer format which can be converted into a database or spreadsheet form.
The examiner will gain efficiency and the flexibility to sort and perform a segmental analysis by asset description, asset class, location and other categories.
Computerized records also facilitate statistical sampling techniques.
The examiner should consider the environmental liabilities for a site including leaking underground storage tanks, conservation easements, and pollution cleanup requirements.
Depreciable improvements may constitute IRC 1245 property or IRC 1250 property.
An examiner should consider using a judgment or statistical sample when reviewing equipment because of the large number of items in a retail store.
This may be accomplished by examining select locations or particular categories of asset types.
Typical asset types for general retailing include shelving, show cases, gondolas, counters, display cases, racks, tables, mirrors, checkouts, computers, and POS equipment.
However, if a table can only be used on the retail floor for display or cutting material, then it is 5-year property under Class 57.
Thus, a lessee's deductions for the property are determined without regard to the lease term, IRC 168 i 8.
This means that the lessee depreciates property over its MACRS recovery period even if the lease term is shorter or longer.
The remaining basis of the unamortized leasehold improvements that are left behind is a deductible loss.
A gain would arise if, for example, the tenant is paid to terminate the lease and the payment exceeds the basis of the leasehold improvements, including lease acquisition costs, if any.
Rather, the cost to acquire land is capitalized.
The cost basis is recovered upon its sale.
Whether in the same city or in a different geographic area, a retailer will attempt to locate sites which have the most potential customers and which will best suit the customers' needs.
Generally, the primary needs of a customer relating to location are accessibility and convenience.
Then, these two categories can be further broken down into MACRS asset classes.
Since a retailer may open dozens of locations in a given year, studies may only be done on representative stores and the percentage allocations that result from the studies may be applied to all similar projects.
To properly examine the allocations, the examiner must determine that projects have been grouped according to similar features such as construction type one-story, two-story, mall, freestandingconstruction quality block, brick, poured cement, woodsize based on square footageand utility apparel, shoes, department, grocery, other specialty, distribution center.
IRS engineers may perform this task.
Sometimes the allocation analysis must be done without a retailer's detailed allocation study.
For example, the retailer may have used a relative percentage allocation based on allocation studies done in prior years.
Generally, it is more efficient to do a detailed analysis on projects which the retailer also has analyzed.
Then compare the documents to the costs in the retailer's allocation study.
It may be necessary at some point to tour and photograph the location being analyzed.
Retail personnel at a store may not be knowledgeable about the allocation study or how to identify assets listed in the study.
Therefore, ensure that persons knowledgeable about the allocation study are included on the facility tour.
It is also important that the retail personnel locate the assets listed in the allocation study during the facility tour.
The retailer may be able to provide photographs as an aid.
Please contact the Retail Technical Advisors for further information.
The taxpayer may be capitalizing its estimate of property taxes for the project and not adjusting the estimate to the actual amount on the property tax statements.
An examiner should consider IRC 263A f interest capitalization.
Remodeling costs may be partially expense or capital depending on the facts of the case.
Retailers claim its buildings do not last 39 years because of the need for frequent remodeling improvements.
The property must be placed in service after 2008 and before 2010.
However, substantial improvements that enhance the value of property must be capitalized and depreciated.
The legal distinction between the two is often one of degree and intention.
An engineer can assist with the identification of the nature of the expenditure and the unit of property to which the expenditure applies.
To repair is to restore to a sound state or to mend, while a replacement connotes a substitution.
It does not add to the value of the property, nor does it appreciably prolong its life.
It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired.
A repair is a maintenance charge, while the others are additions to capital investment that should not be applied against current earnings.
A read more disbursement undertaken to keep an asset operational may be an incidental repair depending on the nature of the work in relation to the taxpayer's operations.
While all repair or maintenance spending prolongs a property's life to some extent, capitalization is required if the expenditure extends the life of the property compared to its life prior to the condition necessitating the expenditure.
In retailing, demolition may be the removal of walls to change traffic patterns or to tie into a new addition during a remodel.
Demolition costs should be capitalized if they are part of a capital improvement.
When a retailer purchases land and demolishes existing buildings to prepare the site for new construction, the costs of demolition should be capitalized as part of the land.
Often a retailer will expense all costs under a certain dollar criteria.
These expenses may have a material impact when they are capitalized, particularly if the costs pertain to several locations.
These involve a change in accounting method and should be scrutinized closely by the examiner.
Normally, assistance from an engineer should be obtained.
The regulations cannot be relied upon in the proposed form.
In some situations, the application of this provision can be controversial.
Like many other retailers, motor fuel outlet stores sell goods other than petroleum products, including food, drinks and other convenience items.
For purposes of determining whether a C-store building qualifies as a retail motor fuels outlet, gross revenue includes all excise and sales taxes.
The gross revenue attributable to petroleum sales gasoline and oil sales not including gross revenue from related services, such as the labor cost of oil changes, and gross revenue from the sale of non-petroleum products, such as tires and oil filters should be compared to gross revenue from all other sources e.
The gross revenue should be analyzed for a full tax period.
Temporary fluctuations, such as a special 6-month promotion, should not be included in the gross revenue test.
The mere closing of the structure is not an event that qualifies as an actual disposition for tax purposes.
No loss is allowed until an actual disposition occurs, per Treas.
The withdrawal may be made in several ways, including sale, exchange, retirement, abandonment, or destruction.
Further, a disposition does not include the retirement of a structural component of a building, except as provided learn more here IRC 168 i 8 B.
Moreover, the manner of disposition e.
To qualify for the recognition of loss from physical abandonment, the taxpayer must intend to discard the asset irrevocably so that the taxpayer will neither use the asset again, nor retrieve the asset for sale, exchange, or other disposition.
Loss is recognized in the amount of the excess of the adjusted basis of the asset over its fair market value at the time of the disposition, except as provided in Treas.
No loss is recognized upon the conversion of property to personal use.
These studies make detailed inventories of individual assets, in order to distinguish items of IRC 1245 property from items of IRC 1250 property.
Retailers use cost segregation studies to shorten depreciable lives of improvements to property, whether leased or owned.
The principal focus has been on reclassifying assets from buildings IRC 1250 property to personal property IRC 1245 property.
For tax purposes, a building includes all of its structural components.
The cost of these components is not recovered separately from the building.
Rather, these costs are recovered using the life and depreciation method appropriate for the building as a whole.
As noted earlier, the distinction between IRC 1245 property and IRC 1250 property is not always clear, which can result in significant differences of opinion.
Despite these challenges, cost segregation studies should be closely scrutinized by examiners.
Modeling separates properties by common store footprints.
For example, free-standing stores are separated from mall stores; leased stores are separated from owned stores.
Under modeling, the study takes a sampling of stores within each group and applies the sample results to the population.
It can be found on the IRS web site.
It is not an official pronouncement of the law or position of the IRS.
The IDD effectively utilizes resources in the classification and examination of a retailer.
Is there a betterment of the property?
They may be self-created or they may be purchased.
The cost of an intangible asset is generally recovered through amortization.
The deduction is allowed on a straight-line basis over a 15-year period.
If IRC 197 applies, the taxpayer may not use IRC 167 to ready what are the most popular slot machines in las vegas you the intangible property.
As a practical matter, the fair market value of an asset is never an absolute amount.
Rather, there is likely to be a range of possible values.
An examiner should consider whether the taxpayer has reported an amount or amounts outside the range of reasonableness.
The Internal Revenue Code and the regulations, however, use the term depreciation, except in the context of IRC 197.
The fair market value of intangible assets acquired in an acquisition is usually supported by slotting allowances are used to quizlet appraisal made by an independent valuation company.
The purchase price not allocated to tangible assets is assigned to intangible assets, such as goodwill.
Prior to enactment of IRC 197, goodwill was nondepreciable as a rule of law because of the difficulties inherent in the computation of both its life and its value.
A self-created intangible is not an amortizable IRC 197 intangible.
Any remaining gain, or any loss, is an IRC 1231 gain or loss.
However, amounts paid for product certification such as ISO 9000 costs are not required to be capitalized.
The determination of whether an amount is paid to create an intangible is based on facts and circumstances.
Distinctions between labels used to describe the intangible and the labels used by the taxpayer and other parties to the transaction are disregarded.
Transaction costs facilitate the acquisition, creation, and enhancement of intangible assets, subject to the de minimis rule and the simplifying rule for employee compensation and overhead.
Also, costs that facilitate the retailer's restructuring or reorganization of a business entity or that facilitate a transaction involving the acquisition of capital, including a stock issuance, borrowing, or recapitalization, require capitalization.
Activity related to sales promotions, ingredient listings, trademarks and trade names is not package design in nature.
Historically, manufacturers incurred most package design costs.
The incidence of retailers incurring package design costs has increased, however, with the growing popularity of private label brands or house slotting allowances are used to quizlet products manufactured by others but sold exclusively by a particular retailer under its own label.
Examiners should be alert to identifying all private brands when determining packaging costs.
Costs related to designs which were suggested but rejected may be applied to subsequent designs and become part of their costs.
For some products, such as aspirin, standard containers provided by the manufacturer are used and retailers incur only label design costs.
In the past, all costs associated with creating a package design were deducted by retailers as current expenses.
Elections were available, however, allowing amortization over a specified period.
From the retailer's perspective, the private label represents an important economic benefit by identifying goods specific to the retailer.
The value of this intangible asset is typically determined by the cost to replace the design and production elements of the private label brand.
This would include a specific color scheme, name logo, and background graphics.
All private product labels then would be a variation of this brandmark.
For example, a can of private label corn and a can of private label peas would have the same master label, varying only by the picture of the product on the front of the can.
The retailer might contract with an outside consultant to develop the brandmark, but use in-house personnel to apply that look to each individual product.
The basis of this intangible asset is usually determined by taking the difference between the present value of the market rate and the lease agreement rate.
The basis determination will include renewal periods if renewal is probable.
An unfavorable lease will result in a deferred credit that is amortized over the life of the lease.
This includes literary content, graphics, sound, and video.
All other content is capitalized if it has a useful life extending beyond the current year.
The nominal annual domain name registration fees are generally deductible.
The retailer is paying for a property interest that meets the definition of a purchased intangible.
Software includes computer programs of all classes such as operating systems, compilers, translators, assembly routines, utility programs, and application programs.
Software may be developed, purchased, or leased.
Under this provision, excluded purchased computer software is depreciated on a straight-line basis over a 36-month useful life.
When computer software is bundled with computer hardware, without being separately stated, the cost of the bundled software is capitalized and depreciated as part of the computer hardware.
This distinction is important in analyzing the federal tax consequences of computer software costs.
In some situations, software costs closely resemble research and experimental expenditures and, consequently, may be expensed in the same manner as research and experimental expenditures.
More frequently than other industries that make use of operating leases, retailers make leasehold improvements on top of the leased property.
Retailers commonly obtain concessions from landlords to defray all or part of their leasehold improvement costs.
For example, a retailer may sublease a former store or certain departments within a current store.
As a result, leases, while not unique to the retail industry, can be a significant area impacting business operations and income.
A liability account is required to reflect the amount of unpaid rent at the end of the accounting period.
Whether a lease is a true lease is based on all the facts and circumstances.
The classification of lease transactions as well as the recognition of income and deductions associated with lease transactions is often different for tax and financial reporting purposes.
Thus, lease terms exceeding several years usually contain a rent escalation clause.
The base rent can be adjusted by a dollar amount, a fixed percentage, or a fixed index such as the Consumer Price Index CPI.
The CPI is commonly used to escalate rent for leases of retail space.
The constant rental method rent leveling applies only if an agreement is a disqualified leaseback or long-term agreement.
If the term of a rental agreement is in excess of 75 percent of the statutory recovery period of the leased property 19 years for landthe rental agreement qualifies as a long-term agreement.
A rental agreement is a leaseback if the lessee or a related person had any interest in the property other than a de minimis interest at any time during the two-year period ending on the date the agreement was entered into.
A long-term agreement or leaseback is disqualified only if the Commissioner determines that a principal purpose for providing increasing or decreasing rent is the avoidance of Federal income tax.
To meet the constant rental accrual rent leveling exception, the rent holiday must be a consecutive period that is either three months or less and at the beginning of the lease term, or it must be of reasonable duration based on commercial practice in the locality where use of the property occurs and not exceed the lesser of 24 months or 10 percent of the lease term.
A rent holiday is a period where no rent or reduced rent is charged.
The period is usually short term in nature and granted for the period of store construction.
Typically, a free rent period allows the tenant to use money that would otherwise be used to pay rent for payment of construction costs.
Generally, rent free periods of 12 months or less, dependent upon local customary practices, are reasonable.
A longer rent-free period is acceptable in certain circumstances.
For the retailer, this provision provides an opportunity to establish an overall cost and budget for operating its business at the location.
In particular, it allows a retailer to align the payment of rent with actual cash flow.
Percentage rent is calculated as a percentage of the tenant's annual sales in excess of a fixed dollar amount made in or from the premises.
The fixed dollar amount is often referred to as the breakpoint.
Defining what constitutes a sale for purposes of calculating percentage rent, and determining what may be excluded or deducted, often is the subject of negotiation between landlord and tenant.
Anchor stores usually agree to operate a store for a period of 15 years in exchange for receipt of an inducement.
As lessees, retailers are responsible for the build-out or finishing work of leased space they will occupy.
Tenant improvement costs often represent a significant percentage of the total value of a retail lease.
Negotiation of a construction allowance is a major part of many lease transactions.
The purpose of a construction allowance is to offset the construction costs to the leased space.
Tax ownership is distinct from legal ownership.
A short-term lease is a lease or other agreement for occupancy or use of retail space for 15 years or less as determined pursuant to IRC 168 i 3.
Retail space is nonresidential real property that is leased, occupied, or otherwise used by the lessee in its trade or business of selling tangible personal property or services to the general public.
The term retail space includes not only the space where the retail sales are made, but also space where activities supporting the retail activity are performed such as an administrative office, a storage area, and employee lounge.
A taxpayer is selling to the general public if the products or services for sale are made available to the general public, even if the product or service is targeted to certain customers or clients.
An ancillary agreement between the lessor and the lessee providing for a construction allowance, executed contemporaneously with the lease or during the term of the lease, is considered a provision of the lease agreement for this purpose provided the agreement is executed before payment of the construction allowance.
If the retailer conducted a cost segregation study, which reallocated costs from IRC 1250 to IRC 1245 property, determine if the study considered the receipt of construction allowances in the computation of any IRC 481 a adjustment.
Thus, the seller of the property becomes the seller-lessee, and the buyer of the property becomes the buyer-lessor.
A retailer may consider this arrangement when it wants a new store, distribution center, headquarters, or other building built to its own unique specifications and does not want to tie up capital in real property.
The lease is usually a triple net lease, i.
A secondary audit consideration is whether the transaction, if determined to be a sale, reflects the fair market value of the property.
The transaction must be viewed as a whole, and each step, from commencement to consummation, is relevant.
A loss may result from an unreasonable selling price.
A loss may represent, in part, a real economic loss and a deferred loss such as a prepayment of rent.
Rental payments on the leaseback may be set higher than the prevailing market to compensate the seller-lessee for a selling price that is set below fair market value.
The examiner should consider the character of the gain or loss if a true sale occurred.
Shopping center owners recover their operating expenses through a mechanism called the common area maintenance charge or CAM.
Examples of common CAM charges include mall security, parking lot and hallway maintenance.
CAM charges are usually allocated on a pro rata basis among the shopping center tenants.
A lease is usually for a stated period of time and includes a specific periodic cost.
The lease of retail space generally consists of base rent and percentage rent.
The retailer files its tax return on a fiscal year ending in January, but the lease year runs from September 1, 2008 to August 31, 2009.
The primary penalty to which a retailer may be subject is the economic detriment associated with the existence of leasehold improvements which might be impaired if it chooses not to continue the use of the leased property.
The economic burden of executory costs usually falls on the lessee even though the lessor may share or even pay all of the costs.
Accordingly, most leases require retailers to pay executory costs.
A retail lease may be either a gross lease or a triple net or net lease.
The landlord absorbs and includes in the base rent the property costs.
Tenants typically reimburse a landlord for normal inflationary type cost increases that may occur in later years.
The property costs are allocated and charged directly to the tenants proportionately.
Triple net leases are commonly used for leased retail space because retailers have greater control over their leased space without having to own the building.
For tax reporting purposes, however, no deduction is allowed for liabilities that might never occur.
The contingency element is a very strict consideration in assessing whether the liability is fixed for tax reporting purposes.
Consequently, a liability does not accrue for tax purposes as long as it remains contingent.
These liabilities normally arise in the ordinary course of business.
In other words, did the retailer accrue the liability and deduct the related expense prematurely?
Expenses, liabilities, or losses of one year cannot be used to reduce the income of a subsequent year.
Under this test, all events that establish the fact of the liability must have occurred, and the amount of the liability must be capable of being determined with reasonable accuracy.
Further, in determining whether a liability has been incurred, the all events test is not treated as met any earlier than when economic performance with respect to such liability occurs.
For liabilities arising out of the use of property provided to the taxpayer, economic performance occurs ratably over the period of time the taxpayer is entitled to use the property.
For services or property provided by the taxpayer, economic performance occurs as the taxpayer incurs costs in connection with the satisfaction of the liability.
Economic performance for all other liabilities including workers compensation, torts, breach of contract, violation of law, rebates, refunds, awards, prizes, jackpots, insurance, warranty contracts, service contracts, and taxes occurs when the taxpayer makes payment to the person to whom the liability is owed.
Future liabilities often create premature accruals, which provide an economic benefit to retailers from the time value of money.
The longer the period between the date a liability is accrued and the date the liability is satisfied, the greater the economic benefit.
The IRS interprets the definition to include both exclusions and deductions.
Under this interpretation, an amount otherwise allowable as a capitalized cost or as a cost taken into account in computing cost of goods sold is included in the definition.
Tax law considers deductions of the full amount of obligations payable in the future to overstate the true cost of the expense by failing to take into account the time value of money.
The test is based on the legal obligations for the current period, not on future obligations.
The principal requirement is that the taxpayer's liability be fixed, which occurs when payment is unconditionally due.
Tax law is well-settled that regardless of how statistically certain that a liability will eventually be incurred, a reserve for expenses, which is acceptable in financial accounting, is not generally deductible unless specifically allowed by statute.
Inventory is one area where reserves are specifically allowed.
The IRS has relied upon United States v.
General Dynamics, 481 U.
Until then, the expense does not meet the all events test since all the events determining the fact of the liability have not occurred.
This rule is contrary to the financial accounting treatment of contested liabilities, which provides that for pending or threatened litigation and actual or possible claims and assessments, an estimated loss should be accrued if it is probable that an asset has been impaired or a liability incurred, and the amount of the loss can be reasonably estimated.
An item is treated as recurring if it can generally be expected to be incurred from one taxable year to the next.
A taxpayer may treat a liability as recurring in nature even if it is not incurred in each taxable year.
A liability that has never previously been incurred by a taxpayer may be treated as recurring if it is reasonable to expect that the liability will be incurred on a recurring basis in the future.
The recurring item exception does not apply to a liability for interest, workmen's compensation, tort, breach of contract, violation of law, or other liabilities described in Treas.
If these overlapping items do not materially distort income, they may be included in the years in which the taxpayer consistently takes them into account.
In determining the correct year for a deduction, the examiner should consider the all events test and the economic performance test.
Retailers recognize that some sales are eventually returned for refund.
Retailers use sales incentives such as price rebates, discounts, store coupons, loyalty points, and other promotional incentives as marketing tools to stimulate consumer spending and retain customer patronage.
Sales incentives, which may be offered on a limited or continuous basis, provide retailers with opportunities to build price flexibility into their marketing strategies.
Common reserves include allowances for doubtful accounts and self-insurance reserves.
General liability costs relate primarily to litigation that arises from store operations.
Liabilities associated with risks retained by retailers are usually estimated considering historical claims experience, frequency and severity, a change in factors such as the business environment, benefit levels, medical costs, the regulatory environment and other actuarial assumptions.
Third party coverage is usually obtained to limit exposure to these claims.
Retailers close stores before lease expiration when they believe these locations are not generating acceptable profit levels.
These reserves are generally established at the time a decision is reached to close such stores.
Common prepaid income items include the sale of gift cards and certificates, layaway sales, club membership fees and extended service plans offered in connection with the sale of certain products e.
The cost of these assets is allocated in a systematic manner over the actual or anticipated life of the assets so as to offset revenues over that period.
Costs and expenses which cannot be determined with a reasonable degree of accuracy at the time they would otherwise be charged against income of a particular period should be deferred until such determination is possible.
Examples include uncollectible receivables, product warranty costs, and pending or threatened litigation claims.
At the time a retailer closes a store or because of changes in circumstances that indicate that the carrying value of an asset may not be recoverable, a retailer will evaluate the carrying value of the asset in relation to its expected future cash flows.
These accrued liabilities usually represent provisions for costs that are not immediately payable because the accounting period and the contractual or obligatory period do not coincide.
For financial reporting, the accrued liabilities are recorded because the related expense has been incurred during the accounting period.
The accruals usually require computation and are seldom substantiated currently or later by a specific invoice as in the case of accounts payable.
Alternatively, retailers may allocate a part of the total sales price of goods to reserves for future expenses.
These various factors are reflected and embodied in the all events test.
The regulations, which set forth the all events test for the accrual of deductions and the accrual of income, use nearly identical language in describing the test.
For income accrual, Treas.
Three Supreme Court decisions illustrate this principle and other principles discussed in this section of the manual.
See Automobile Club of Michigan v.
United States, 367 U.
Consequently, most retailers establish a reserve for sales returns and allowance.
Technically, sales returns and allowances represent two distinct types of transactions, but are generally reported on the same tax return line.
Sales returns occur when customers return defective, damaged, or otherwise undesirable products to the retailer.
Sales allowances occur when customers agree to keep such merchandise in return for a reduction in the selling price.
Retailers anticipate that a portion of these sales will be returned.
Consequently, retailers normally record gross income net of actual and estimated sales returns and allowances.
This liability may be recorded to more than one account in the general ledger.
The accrual is sometimes made by taking a percentage of year-end sales.
Accruals for sales returns and allowances are common in the retail industry.
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