Close
Close

The new retail inventory method may require taxpayers to file accounting method change

RFP
New RIM may require accounting changeNow is the time for taxpayers using the retail inventory method (RIM) of accounting to pay close attention to IRS changes that take affect this year. The revised rules give the agency a new opportunity to challenge improper calculations.

The changes came in August 2014, when the IRS issued a final regulation, revised Reg. §1.471-8, detailing the proper tax calculation of ending inventory under the RIM. Taxpayers using the RIM for GAAP purposes, or taxpayers performing a separate tax RIM calculation, may have to file an accounting method change for tax purposes to be consistent with these final tax regulations, which are effective for tax years beginning after Dec. 31, 2014.

Specifically, taxpayers using the RIM need to review their retail inventory calculation that arrives at an ending inventory value for GAAP purposes, and compare their GAAP calculation to the tax rules as laid out in revised Reg. §1.471-8. If the result is a difference in ending inventory between the GAAP and the tax calculation, the taxpayer will need to file an automatic accounting method change pursuant to the procedures laid out in Rev. Proc. 2014-48. Additionally, taxpayers performing a separate tax RIM calculation to arrive at an ending inventory value for tax purposes must compare their tax calculation to revised Reg. §1.471-8 to determine whether their calculation conforms to the new regulations. If their current calculation isn’t in line with the final regulations, they will need to file an automatic accounting method change to be consistent with these regulations.

The RIM explained
Retailers are allowed to use the RIM to value their inventory. This method uses a formula to convert the retail selling price of ending inventory to an approximation of cost, or an approximation of the lower of cost or market (LCM). The value of ending inventory is computed as follows:

Retail selling prices of goods on hand at the end of the year × A cost complement = Value of ending inventory (Cost complement = Average relationship of cost to retail value for all merchandise available for sale during given time period)

The retail cost and the retail LCM methods: Similar but different
If a retailer converts the retail selling price of ending inventory to an approximation of cost, it is using the retail cost method. If a retailer converts the retail selling price of ending inventory to an approximation of LCM, it is using the retail LCM method. Both methods use the following formula to arrive at the cost complement:

Value of beginning inventory + Cost of goods purchased during the tax year
Retail selling prices of beginning inventory + Initial retail selling prices of goods purchased during the year

While both methods start with the same basic formula, each method requires specific adjustments to the formula to arrive at the cost complement. Retailers using the retail cost method adjust the denominator above for all permanent markups and markdowns. Retailers using the retail LCM method do not adjust the denominator above for markdowns (and markdown cancellations or corrections).

To summarize, retailers using either the retail cost or the retail LCM method multiply the retail selling prices of goods on hand at the end of the year by a cost complement. The cost complement formula is the same for both the retail cost and retail LCM methods, except that retailers using the retail cost method must adjust the denominator of the cost complement formula for all permanent markups and markdowns, while retailers using the retail LCM method do not adjust the denominator for markdowns.

The effect of revised Reg. §1.471-8 on these retail methods
Revised Reg. §1.471-8 provides clarification on the impact of markups and markdowns on the cost complement formula. These regulations state that the numerator of the cost complement should not be reduced for sales-based vendor chargebacks, which are amounts of an allowance, discount or price rebate that reduce only the cost of goods sold. Therefore, this change affects retailers that use either the retail cost method or the retail LCM method.

Retailers who use the retail LCM method are further affected by this revised regulation, which allows these retailers to apply either the general method or one of two alternative methods.

The general method for retailers using the retail LCM
Under the general method, retailers using the retail LCM method may not reduce the numerator of the cost complement formula by the amount of a margin protection payment. A margin protection payment is an allowance, discount or price rebate that ultimately compensates for a permanent reduction in the retailer’s retail selling price of inventory. Additionally, the denominator of the cost complement formula may not be adjusted for markdowns, i.e., markups must be reduced by the markdowns made to cancel or correct them.

First alternative method for retailers using the retail LCM
Under the first alternative method, retailers using the retail LCM method must reduce the denominator of the cost complement formula for markdowns related to the amount of the permanent reduction in the retail selling price to which margin protection payments are made. Only if the taxpayer adjusts the denominator may it also adjust the numerator, and the numerator is then reduced by the amount of margin protection payments.

Second alternative method for retailers using the retail LCM
Under the second alternative method, retailers using the retail LCM method that are able to determine the amount of the margin protection payments but cannot determine the amount of the related markdowns may be able to reduce the numerator of the cost complement formula by the amount of margin protection payments. They can do this if the denominator is reduced by an amount that, in conjunction with the reduction of the numerator for margin protection payments, maintains what would have been the cost complement percentage before taking into account the margin protection payment and related markdown.

Comparing the GAAP to tax RIM
These two charts, one for GAAP and one for tax, demonstrate the two methods and how they differ.

Retail inventory method 1

Retail inventory method 2

In summary

Taxpayers who have been using their GAAP RIM method for tax rather than performing a separate tax RIM calculation to arrive at an ending inventory value for tax purposes are likely to be using an impermissible method under the revised Reg. §1.471-8. Regardless of whether the taxpayer is currently following book or using a separate tax calculation, taxpayers using the RIM need to review their retail inventory calculation and compare their calculation to the tax rules as laid out in revised Reg. §1.471-8. If the computation is not in compliance with the new regulations, the taxpayer will need to file an accounting method change pursuant to the procedures in Rev. Proc. 2015-13, and if eligible, under one or more of the automatic changes in Section 21 of Rev. Proc. 2016-29.

Contact
Nola Showers
+1 215 656 3079

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.