[Federal Register Volume 79, Number 158 (Friday, August 15, 2014)]
[Rules and Regulations]
[Pages 48034-48037]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-19275]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9688]
RIN 1545-BJ64


Retail Inventory Method

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
retail inventory method of accounting. The regulations restate and 
clarify the computation of ending inventory values under the retail 
inventory method and provide a special rule for certain taxpayers that 
receive margin protection payments or vendor allowances that are 
required to reduce only cost of goods sold. The regulations affect 
taxpayers that are retailers and use a retail inventory method.

DATES: Effective Date: These regulations are effective on August 15, 
2014.
    Applicability Date: For date of applicability, see Sec.  1.471-
8(f).

FOR FURTHER INFORMATION CONTACT: Christopher Call, (202) 317-7007 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains final regulations that amend the Income Tax 
Regulations (26 CFR part 1) relating to the retail inventory method of 
accounting under Sec.  1.471-8 of the Income Tax Regulations. On 
October 7, 2011, a notice of proposed rulemaking (REG-125949-10) was 
published in the Federal Register (76 FR 62327). A public hearing was 
not requested or held. No comments were received during the comment 
period. Three comments were received after the end of the comment 
period and were considered, as discussed later in this preamble. The 
proposed regulations are adopted as amended by this Treasury decision.

Summary of Comments and Explanation of Revisions

    Section 471 of the Internal Revenue Code provides that a taxpayer's 
method of accounting for inventories must clearly reflect income. 
Section 1.471-2(c) provides that the bases of inventory valuation most 
commonly used and meeting the requirements of section 471 are (1) cost 
and (2) cost or market, whichever is lower (LCM). Section 1.471-3 
provides rules for determining inventories at cost. Section 1.471-4 
provides rules for determining inventories at lower of cost or market. 
Section 1.471-8 of the regulations contains rules specific to 
retailers, allowing them to approximate cost or LCM of the goods in 
their ending inventory by using the retail inventory method. Under the 
retail inventory method, a taxpayer computes the value of ending 
inventory by multiplying a cost complement by the retail selling prices 
of the goods on hand at the end of the taxable year. The numerator of 
the cost complement is the value of beginning inventory plus the cost 
of purchases during the taxable year, and the denominator is the retail 
selling prices of beginning inventory plus the initial retail selling 
prices of purchases. For taxpayers using the retail inventory method to 
value inventories at cost (retail cost method), the denominator of the 
cost complement is adjusted for all permanent markups and markdowns. 
Taxpayers using the retail inventory method to value inventories at LCM 
(retail LCM method) generally do not make adjustments to the 
denominator for markdowns.
    The proposed regulations provided that a taxpayer using the retail 
LCM method may not reduce the numerator of the cost complement by the 
amount of an allowance, discount, or price rebate that is related to or 
intended to compensate for a permanent reduction in the taxpayer's 
retail selling price of inventory, often called a margin protection 
payment or a markdown allowance. The proposed regulations also provided 
that a taxpayer using the retail inventory method (whether valuing 
inventories at LCM or at cost) may not reduce the numerator of the cost 
complement by the amount of a sales-based vendor allowance.
    Commenters suggested that taxpayers using the retail LCM method to 
value inventories should reduce the numerator of the cost complement 
for all vendor allowances and discounts, including margin protection 
payments and sales-based vendor allowances (but should not be required 
to reduce the denominator by the related price reduction), because all 
allowances and discounts reduce the cost of inventory and allow 
retailers to achieve their margin goals. The commenters asserted that 
if the numerator of the cost complement is not reduced for margin 
protection payments and sales-based vendor allowances, taxpayers' 
income will not be clearly reflected, the economics of the underlying 
business transaction will be ignored, and small retailers would be 
adversely affected. The commenters suggested that small

[[Page 48035]]

retailers have less bargaining power than large retailers and are less 
able to negotiate purchase-based discounts from vendors.
    The final regulations do not adopt these comments. A margin 
protection payment, unlike other types of allowances, is inherently 
related to a markdown that will be reflected in the retail selling 
prices of the items remaining in ending inventory. When a taxpayer 
using retail LCM reduces the numerator of the cost complement by the 
amount of a margin protection payment without reducing the denominator 
by the amount of the corresponding markdown, ending inventory value 
does not clearly reflect income, and does not reflect the economics of 
the underlying transaction. Taxpayers using the retail cost method to 
value inventories, as opposed to retail LCM, are allowed to reduce the 
numerator of the cost complement by the amount of a margin protection 
payment because these taxpayers also reduce the denominator of the cost 
complement by the amount of a related markdown, maintaining the 
relationship between cost and retail price.
    With regard to sales-based vendor allowances, the final regulations 
adopt, with a modification, the proposed rule that the numerator of the 
cost complement is not reduced for sales-based vendor allowances. 
Proposed regulations under Sec.  1.471-3(e) provided that sales-based 
vendor allowances (the amount of an allowance, discount, or price 
rebate that a taxpayer earns by selling specific merchandise) reduce 
cost of goods sold and do not reduce ending inventory value. Because 
the retail inventory method produces an ending inventory value and 
sales-based vendor allowances could not be allocated to ending 
inventory, the proposed regulations under Sec.  1.471-8 provided that 
sales-based vendor allowances do not reduce the numerator of the cost 
complement. The final regulations under Sec.  1.471-3(e) (TD 9652, 79 
FR 2094) apply specifically to only one type of sales-based vendor 
allowance, a sales-based vendor chargeback, and reserve rules for other 
types of sales-based vendor allowances. To conform to this 
modification, these final regulations under Sec.  1.471-8 provide that 
sales-based vendor allowances that are required to reduce only cost of 
goods sold under Sec.  1.471-3(e) do not reduce the numerator of the 
cost complement. This rule will apply only to sales-based vendor 
chargebacks until further guidance is issued under Sec.  1.471-3(e).
    Commenters also requested that the final regulations allow retail 
LCM taxpayers to reduce the numerator of the cost complement by margin 
protection payments and sales-based vendor allowances because requiring 
taxpayers to track margin protection payments and sales-based vendor 
allowances separately from other types of allowances would create 
burdensome recordkeeping requirements. This comment is not adopted 
because, as discussed earlier in this preamble, allowing a retail LCM 
taxpayer to reduce the numerator of the cost complement by the amount 
of a margin protection payment without reducing the denominator by the 
amount of the corresponding markdown would not clearly reflect income 
and would not reflect the economics of the underlying transaction. 
Nonetheless, as discussed later in this preamble, to ease taxpayers' 
compliance burden, the final regulations provide alternative methods 
and procedures for computing the cost complement for retail LCM 
taxpayers.
    The preamble to the proposed regulations requested comments on an 
alternative method for retail LCM taxpayers to account for margin 
protection payments when computing the cost complement. The method 
described in that preamble would have permitted retail LCM taxpayers to 
reduce the numerator of the cost complement for all non-sales-based 
allowances, discounts, or price rebates, including margin protection 
payments or markdown allowances, and also would have required a 
reduction of the denominator of the cost complement for permanent 
markdowns to which the margin protection payments or markdown 
allowances relate (related markdowns). Although commenters did not 
address this proposal explicitly, they stated that in some cases, based 
on the nature of their business dealings with vendors and the variety 
of allowances offered, taxpayers have difficulty distinguishing between 
the different types of vendor allowances their vendors provide. For 
example, commenters contend that it might be difficult for a taxpayer 
to distinguish the amount of a margin protection payment or markdown 
allowance received from a vendor from the amounts of other types of 
allowances received from that vendor, thus making it difficult to 
determine the amount by which they were required to reduce the 
numerator of the cost complement under the proposed regulations.
    The final regulations address these comments and ease taxpayers' 
compliance with the regulations by allowing retail LCM taxpayers to use 
a method similar to the method described in the preamble to the 
proposed regulations that does not require taxpayers to distinguish the 
amounts of margin protection payments from the amounts of other vendor 
allowances (except for vendor allowances required to be allocated to 
cost of goods sold under Sec.  1.471-3(e)). Under the alternative 
method provided in the final regulations, retail LCM taxpayers reduce 
the numerator for margin protection payments and must quantify and 
reduce the denominator for the related markdowns. This alternative 
method results in a reduction of the numerator of the cost complement 
by all vendor allowances other than those required to reduce cost of 
goods sold under Sec.  1.471-3(e). This alternative method accordingly 
reduces the compliance burden for taxpayers that cannot distinguish 
margin protection payments from other allowances, but that can identify 
the markdowns related to those margin protection payments.
    Commenters also stated that some accounting systems cannot 
sufficiently track the related markdowns. Accordingly, a second 
alternative provided in the final regulations allows taxpayers that are 
able to determine the amount of their margin protection payments to 
reduce the numerator of the cost complement for the margin protection 
payments and adjust the denominator by the amount that, in conjunction 
with the reduction of the numerator, maintains what would have been the 
cost complement percentage before taking into account the margin 
protection payments and related markdowns. This second alternative 
method assumes that a margin protection payment maintains the 
taxpayer's profit margin after a related markdown in retail selling 
price. Thus, if before taking into account the margin protection 
payment and the related markdown the cost complement is 50 percent 
($10/$20), and the taxpayer receives a margin protection payment of $2, 
the taxpayer must reduce the denominator by $4 to maintain a cost 
complement of 50 percent ($8/$16) under this second alternative method.
    A retail LCM taxpayer must use one of these three methods (the 
general method and the two alternative methods) for computing all of 
its cost complements. A change from one to another of these methods is 
a change in method of accounting.
    The final regulations further facilitate identifying margin 
protection payments and related markdowns by allowing retail LCM 
taxpayers to use statistical sampling in accordance with Rev. Proc. 
2011-42 (2011-37 IRB 318), see

[[Page 48036]]

Sec.  601.601(d), in conjunction with any of the three methods. A 
retail LCM taxpayer using statistical sampling must use it for all 
margin protection payments and related markdowns associated with the 
inventory items valued by a particular cost complement. However, a 
retail LCM taxpayer that calculates more than one cost complement is 
not required to use statistical sampling for all cost complements. A 
change from using to not using statistical sampling, or from not using 
to using statistical sampling, to identify margin protection payments 
and related markdowns is not a change in method of accounting.
    The proposed regulations provided that a taxpayer may apply the 
retail inventory method to a department, a class of goods, or a stock-
keeping unit. A commenter suggested that the final regulations specify 
that a taxpayer may use the retail inventory method to value ending 
inventory for a sub-class of goods, style of goods, or other similar 
category of goods to avoid the implication that the scope of the retail 
inventory method is limited to those groupings specifically identified 
in the proposed regulations. The categories suggested by the commenter 
are already encompassed by the terms department, class of goods, or 
stock-keeping unit. Accordingly, the final regulations do not adopt 
this comment.
    A commenter suggested that the final regulations should allow 
taxpayers to calculate their cost complements using a measurement 
period shorter than the entire taxable year and should clarify whether 
beginning inventory may or must be eliminated from the cost complement 
of a last-in, first-out (LIFO) taxpayer using the retail inventory 
method. These issues were not addressed in the proposed regulations and 
therefore are not addressed in the final regulations. However, the 
final regulations do not reflect a change in established administrative 
practice regarding whether LIFO taxpayers using the retail inventory 
method may exclude beginning inventory from the cost complement.

Effective/Applicability Date

    These regulations apply to taxable years beginning after December 
31, 2014. For taxable years beginning before January 1, 2015, see Sec.  
1.471-8 as contained in 26 CFR part 1, revised April 1, 2014.

Special Analyses

    This Treasury decision is not a significant regulatory action as 
defined in Executive Order 12866, as supplemented by Executive Order 
13563. Therefore, a regulatory assessment is not required. Section 
553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does 
not apply to these regulations and, because the regulations do not 
impose a collection of information on small entities, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to 
section 7805(f) of the Internal Revenue Code, the notice of proposed 
rulemaking that preceded these final regulations was submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business. No comments were received from 
the Small Business Administration.

Drafting Information

    The principal author of these regulations is Natasha M. Mulleneaux 
of the Office of Associate Chief Counsel (Income Tax and Accounting). 
However, other personnel from the IRS and the Treasury Department 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority:  26 U.S.C. 7805 * * *


0
Par. 2. Section 1.471-8 is revised to read as follows:


Sec.  1.471-8  Inventories of retail merchants.

    (a) In general. A taxpayer that is a retail merchant may use the 
retail inventory method of accounting described in this section. The 
retail inventory method uses a formula to convert the retail selling 
price of ending inventory to an approximation of cost (retail cost 
method) or an approximation of lower of cost or market (retail LCM 
method). A taxpayer may use the retail inventory method instead of 
valuing inventory at cost under Sec.  1.471-3 or lower of cost or 
market under Sec.  1.471-4.
    (b) Computation--(1) In general. A taxpayer computes the value of 
ending inventory under the retail inventory method by multiplying a 
cost complement by the retail selling prices of the goods on hand at 
the end of the taxable year.
    (2) Cost complement--(i) In general. The cost complement is a ratio 
computed as follows:
    (A) The numerator is the value of beginning inventory plus the cost 
(as determined under Sec.  1.471-3, except as otherwise provided in 
this section) of goods purchased during the taxable year.
    (B) The denominator is the retail selling prices of beginning 
inventory plus the retail selling prices of goods purchased during the 
year (that is, the bona fide retail selling prices of the items at the 
time acquired), adjusted for all permanent markups and markdowns, 
including markup and markdown cancellations and corrections. The 
denominator is not adjusted for temporary markups or markdowns.
    (ii) Vendor allowances required to reduce only cost of goods sold. 
A taxpayer may not reduce the numerator of the cost complement by the 
amount of an allowance, discount, or price rebate that is required 
under Sec.  1.471-3(e) to reduce only cost of goods sold.
    (3) Additional rules for cost complement for retail LCM method--(i) 
In general--(A) Margin protection payments. A taxpayer using the retail 
LCM method may not reduce the numerator of the cost complement by the 
amount of an allowance, discount, or price rebate that is related to or 
intended to compensate for a permanent reduction in the taxpayer's 
retail selling price of inventory (a margin protection payment).
    (B) Markdowns. A taxpayer using the retail LCM method does not 
adjust the denominator of the cost complement for markdowns (and 
markdown cancellations or corrections). Markups must be reduced by the 
markdowns made to cancel or correct them.
    (ii) Alternative methods for computing cost complement--(A) In 
general. In lieu of the method described in paragraph (b)(3)(i) of this 
section, a taxpayer using the retail LCM method may compute the cost 
complement using one of the alternative methods described in this 
paragraph (b)(3)(ii). A taxpayer using an alternative method under this 
paragraph (b)(3)(ii) must use that method for all cost complements.
    (B) Adjust numerator and denominator. A taxpayer using the retail 
LCM method may reduce the numerator of the cost complement by the 
amount of all margin protection payments if the taxpayer also reduces 
the denominator of the cost complement by the amount of the permanent 
reduction in retail selling price to which the margin protection 
payments relate (related markdowns).

[[Page 48037]]

    (C) Deemed adjustment to denominator. A taxpayer using the retail 
LCM method that is able to determine the amount of all margin 
protection payments but cannot determine the amount of the related 
markdowns may reduce the numerator of the cost complement by the amount 
of all margin protection payments if the taxpayer also reduces the 
denominator by the amount that, in conjunction with the reduction of 
the numerator for the margin protection payments, maintains what would 
have been the cost complement percentage before taking into account the 
margin protection payment and the related markdown. A taxpayer that can 
determine the amount of a related markdown but not the associated 
margin protection payments may not use this method to compute an 
adjustment to the numerator.
    (iii) Statistical sampling. A taxpayer using the retail LCM method 
may use statistical sampling in accordance with Rev. Proc. 2011-42 or 
any successor (see Sec.  601.601(d) of this chapter), in conjunction 
with any method of computing the cost complement described in this 
paragraph (b)(3), to determine the amount of margin protection payments 
and related markdowns. A taxpayer using statistical sampling must use 
it for all margin protection payments and related markdowns associated 
with the inventory items valued by a particular cost complement, but is 
not required to use it for every cost complement.
    (4) Ending inventory retail selling prices. A taxpayer must include 
all permanent markups and markdowns but may not include temporary 
markups or markdowns in determining the retail selling prices of goods 
on hand at the end of the taxable year. A taxpayer may not include a 
markdown that is not an actual reduction of retail selling price.
    (c) Special rules for LIFO taxpayers. A taxpayer using the last-in, 
first-out (LIFO) inventory method with the retail inventory method uses 
the retail cost method. See Sec.  1.472-1(k) for additional adjustments 
for a taxpayer using the LIFO inventory method with the retail cost 
method.
    (d) Scope of retail inventory method. A taxpayer may use the retail 
inventory method to value ending inventory for a department, a class of 
goods, or a stock-keeping unit. A taxpayer maintaining more than one 
department or dealing in classes of goods with different percentages of 
gross profit must compute cost complements separately for each 
department or class of goods.
    (e) Examples. The following examples illustrate the rules of this 
section:

    Example 1. (i) R, a retail merchant who uses the retail LCM 
method and uses a calendar taxable year, has no beginning inventory 
in 2012. R purchases 40 tables during 2012 for $60 each for a total 
of $2,400. R offers the tables for sale at $100 each for an 
aggregate retail selling price of $4,000. R does not sell any tables 
at a price of $100, so R permanently marks down the retail selling 
price of its tables to $90 each. As a result of the $10 markdown, 
R's supplier provides R a $6 per table margin protection payment. R 
sells 25 tables during 2012 and has 15 tables in ending inventory at 
the end of 2012.
    (ii) Under paragraph (b)(2)(i)(A) of this section, the numerator 
of the cost complement is the aggregate cost of the tables, $2,400. 
Under paragraph (b)(3)(i)(A) of this section, R may not reduce the 
numerator of the cost complement by the amount of the margin 
protection payment. Under paragraph (b)(2)(i)(B) of this section, 
the denominator of the cost complement is the aggregate of the bona 
fide retail selling prices of all the tables at the time acquired, 
$4,000. Under paragraph (b)(3)(i)(B) of this section, R does not 
adjust the denominator of the cost complement for the markdown. 
Therefore, R's cost complement is $2,400/$4,000, or 60%.
    (iii) Under paragraph (b)(4) of this section, R includes the 
permanent markdown in determining year-end retail selling prices. 
Therefore, the aggregate retail selling price of R's ending table 
inventory is $1,350 (15 * $90). Approximating LCM under the retail 
method, the value of R's ending table inventory is $810 (60% * 
$1,350).
    Example 2.  (i) The facts are the same as in Example 1, except 
that R permanently reduces the retail selling price of all 40 tables 
to $50 per unit and the 15 tables on hand at the end of the year are 
marked for sale at that price. The additional $40 markdown is 
unrelated to a margin protection payment or other allowance.
    (ii) Under paragraph (b)(3)(i)(B) of this section, R does not 
adjust the denominator of the cost complement for the markdown. 
Therefore, R's cost complement is $2,400/$4,000, or 60%.
    (iii) Under paragraph (b)(4) of this section, R includes the 
permanent markdowns in determining year-end retail selling prices. 
Therefore, the aggregate retail selling price of R's ending 
inventory is $750 (15 * $50). Approximating LCM under the retail 
method, the value of R's ending inventory is $450 (60% * $750).
    Example 3.  (i) The facts are the same as in Example 1, except 
that R computes the cost complement using the alternative method 
under paragraph (b)(3)(ii)(B) of this section.
    (ii) R reduces the numerator of the cost complement by the 
margin protection payments of $240 ($6 * 40) and reduces the 
denominator of the cost complement by the related markdowns of $400 
($10 * 40). Therefore, R's cost complement is $2,160/$3,600, or 60%.
    (iii) Under paragraph (b)(4) of this section, R includes the 
permanent markdown in determining year-end retail selling prices. 
Therefore, the aggregate retail selling price of R's ending table 
inventory is $1,350 (15 * $90). Approximating LCM under the retail 
method, the value of R's ending table inventory is $810 (60% * 
$1,350).
    Example 4. (i) The facts are the same as in Example 1, except 
that R cannot determine the amount of its related markdowns and 
computes the cost complement using the alternative method under 
paragraph (b)(3)(ii)(C) of this section.
    (ii) R reduces the numerator of the cost complement by the 
margin protection payments of $240 ($6 * 40). R reduces the 
denominator of the cost complement by the amount that, in 
conjunction with the reduction in the numerator, maintains the cost 
complement percentage before taking into account the margin 
protection payments and the related markdowns. R's original cost 
complement was 60% ($2,400/$4,000). The numerator of R's new cost 
complement is $2,160 ($2,400-$240). Therefore, R reduces the 
denominator by $400, which maintains the cost complement of 60% 
($2,160/$3,600).
    (iii) Under paragraph (b)(4) of this section, R includes the 
permanent markdowns in determining year-end retail selling prices. 
Therefore, the aggregate retail selling price of R's ending table 
inventory is $1,350 (15 * $90). Approximating LCM under the retail 
method, the value of R's ending table inventory is $810 (60% * 
$1,350).
    Example 5.  (i) The facts are the same as in Example 1, except 
that R uses the LIFO inventory method. R must value inventories at 
cost and, under paragraph (c) of this section, uses the retail cost 
method.
    (ii) Under paragraph (b)(2)(i)(A) of this section, R reduces the 
numerator of the cost complement by the amount of the margin 
protection payment. Under paragraph (b)(2)(i)(B) of this section, R 
includes the permanent markdown in the denominator of the cost 
complement. Therefore, R's cost complement is $2,160/$3,600, or 60%.
    (iii) Under paragraph (b)(4) of this section, R includes the 
permanent markdown in determining year-end retail selling prices. 
Therefore, the aggregate retail selling price of R's ending 
inventory is $1,350 (15 * $90). Approximating cost under the retail 
method, the value of R's ending inventory is $810 (60% * $1,350).

    (f) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2014. For taxable years beginning 
before January 1, 2015, see Sec.  1.471-8 as contained in 26 CFR part 
1, revised April 1, 2014.

 John Dalrymple,
 Deputy Commissioner for Services and Enforcement.

    Approved: July 30, 2014
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2014-19275 Filed 8-14-14; 8:45 am]
BILLING CODE 4830-01-P