Estimated inventory shrinkage is not a reserve - or is it?

Taxpayers that maintain perpetual inventory systems and perform a physical inventory other than at the tax year-end may have an opportunity to make further adjustment for estimated shrinkage under a recent case. In Dayton Hudson Corp., 101 TC No. 30 (1993), the Tax Court, in a reviewed decision, concluded that a shrinkage estimate does not, as a matter of law, cause an accounting method to fail to clearly reflect income.

Dayton Hudson, engaged primarily in retail sales through various divisions and subsidiaries, maintained a perpetual inventory system. Physical inventories were performed at all of the stores, although not at its February 28 year-end. As a result of the physical inventory, adjustments were made to the books to record "shrinkage." At year-end, and estimate of shrinkage believed to occur subsequent to the physical inventories, but prior to year-end, was also recorded, based "on records of verified shrinkage in prior years and other information."

The IRS moved for summary judgment arguing that, as a matter of law, estimation of shrinkage was not in accordance with Regs. Sec. 1.471-2(d) and, accordingly, did not clearly reflect income. The taxpayer argued that the regulations do not prohibit an adjustment for estimated shrinkage and, therefore, whether the method clearly reflects income is a question of fact that may not be resolved by summary judgment.

Judge Halpern, writing for the majority, did not agree with the Service's argument that a physical inventory must be taken at year-end to make an adjustment for shrinkage. First, the regulations did not require that a taxpayer take a physical inventory at year-end, but only at "reasonable intervals." Second, the court looked to the history of the present regulation. The 1921 regulations explicitly required that physical inventories be taken at year-end. The 1922 regulations removed this year-end requirement and replaced it with "reasonable intervals." The court concluded that it was not the Treasury's intent to remove unambiguous language and replace it with an ambiguous requirement with precisely the same meaning.

In addition, the court did not agree that a physical count was the only way to adjust for shrinkage:

Moreover, the regulation appears to permit any means of adjusting book inventories for shrinkage, so long as (1) such book inventories are maintained in accordance with a sound accounting system, (2) such system values goods at actual cost, and (3) book inventories are verified by physical inventories at reasonable intervals. (Emphasis added by court.)

The court concluded that the taxpayer met all three tests.

The IRS argued further that an "adjustment for estimated shrinkage without verification by a physical inventory is a deduction for a 'reserve'," citing Thor Power Tool Co., 439 US 522 (1079). The court concluded that a reserve is to cover future expenses while estimated shrinkage covers losses that have already occurred and, accordingly, did not meet the definition of reserve.

The court stated that "the regulation clearly allows the maintenance of book inventories and... is not on its face hostile to any adjustment for shrinkage." (Emphasis added by court.) This case was distinguishable from Thor, in which the Supreme Court concluded that a write-down in the value of "excess" inventory was "a current deduction for an estimated loss" that "was plainly inconsistent with the Regulations." Accordingly, the Tax Court concluded that Thor did not apply and "the general unavailability of a deduction for reserves is inapposite."

The phrases used by Judge Halpern, such as "the regulation appears to permit any means of adjusting book inventories for shrinkage" and "the general unavailability of a deduction for reserves is inapposite" appear to open almost unlimited opportunities to deduct estimated shrinkage. This is borne out by Judge Gerber, who wrote the dissenting opinion: "The majority has interpreted... [Regs. Sec. 1.471-2)d)] in a manner which would permit any approach to computing inventory which is not expressly prohibited." The dissent criticized this decision further, stating: "The majority reasons that the regulation does not expressly prohibit taxpayers from estimating shrinkage and that, therefore, estimates are permissible. If this theory is correct, then taxpayers also can estimate their purchases and sales, because the regulation does not expressly prohibit such a practice."

While quite obviously a taxpayer would not estimate sales and purchases, opportunities appear to exist when dealing with shrinkage. Although the dissent interpreted the majority reasoning to conclude that estimates were permissible, the majority merely concluded that shrinkage estimates were not prohibited as a matter of law. The majority noted that the taxpayer's estimated shrinkage was based on prior years' experience and "other information" which, apparently, the IRS did not dispute. Accordingly, it is doubtful that even the majority would accept an unsupported estimate as a clear reflection of income.

Taxpayers that presently perform their physical inventories at periods other than at tax year-end may have an opportunity to adjust the year-end perpetual book inventory by a supportable shrinkage factor. This does not apply to taxpayers using the last-in/first-out (LIFO) method, which requires that inventories be reported at cost. In addition, adopting such a technique, if other than in the first tax year, would probably be considered a change in an accounting method, requiring advance IRS approval, which is unlikely. New entities, however, not subject to carryover methods (e.g., Sec. 381 transactions), should consider this case in determining their year-end inventories.