Some taxpayers may automatically change their method of accounting for inventory shrinkage.

On March 30, 1998, the IRS released Rev. Proc. 98-29, which provides an automatic procedure for certain taxpayers to change their method of accounting for inventory shrinkage. This procedure implements the change enacted in the Taxpayer Relief Act of 1997 (TRA '97), which allowed the use of shrinkage estimation methods and overruled the IRS's litigating position. Taxpayers should file their Form 3115, Application for Change in Accounting Method, as soon as possible to maximize their ability to receive audit protection for prior years.

Background

The TRA '97 provides that a taxpayer will not be deemed to use an inventory accounting method that does not clearly reflect income solely because the taxpayer accrues for inventory shrinkage. The taxpayer must conduct regular and consistent physical inventory counts at each location where inventory is held and must adjust its shrinkage estimates and estimating methods to reflect the results of the physical counts. Further, the IRS was directed to publish a revenue procedure to permit a taxpayer to automatically change to the retail safe harbor method, which would be deemed to result in a clear reflection of income.

Eligibility

As expected, the revenue procedure provides an automatic procedure for certain taxpayers to change to either the retail safe harbor method or to a self-developed method that clearly reflects income. For a taxpayer within the scope of Rev. Proc. 98-29, it is the exclusive procedure for such a change to the described methods. The retail safe harbor method is only available to a taxpayer primarily engaged in the resale of personal property to the general public. All retailers, regardless of whether or not they currently use a shrinkage estimation method, are eligible to automatically change to the retail safe harbor method; only taxpayers currently not using a shrinkage estimation method, however, are eligible to automatically change to a self-developed shrinkage estimation method. Therefore, taxpayers currently using a self-developed shrinkage estimation method that want to change their method must file a Form 3115 under the terms and conditions of Rev. Proc. 97-27.

Retail Safe Harbor Method

The method may only be used by a taxpayer primarily engaged in retail trade. The taxpayer must normally take physical inventories at least annually. The fact that the taxpayer did not actually take a physical inventory in a particular year would not appear to bar use of the retail safe harbor method, provided it normally did take annual inventories.

The taxpayer must compute a historical ratio of shrinkage to sales, by dividing actual shrinkage established by all physical inventories taken during the most recent three tax years (including the taxpayer's current tax year) by the sales for the related periods (by store or department). A retailer has the option of determining its historical shrinkage reserve by department or store. Once a methodology is elected, however, the taxpayer must use it consistently. The estimated shrinkage is determined by multiplying the historical. ratio for each store or department by its sales for the period between the date of its last physical inventory and the end of the tax year

Although the revenue procedure states that the retail safe harbor method is deemed to clearly reflect income, the method must be used consistently and the taxpayer's inventory methods must otherwise also clearly reflect income. Therefore, a taxpayer's use of the retail safe harbor method may be jeopardized if its inventory costing method is not in compliance with Sec. 263A.

Self-Developed Methods

A taxpayer changing to a self-developed method must demonstrate that the method clearly reflects income. If the District Director or the IRS National Office determines that the taxpayer's method of accounting for shrinkage does not clearly reflect income, it will be treated as having made an unauthorized accounting method change.

Some taxpayers currently accrue shrinkage based on a fixed or historical percentage of sales or an amount of pro-rated shrinkage verified by a physical count after year-end. Taxpayers that have been accruing inventory shrinkage must be prepared to defend their shrinkage estimation method, because the Service is likely to continue to challenge self-developed shrinkage estimation methods; see, e.g., Dayton Hudson Corp., TC Memo 1997-260; Wal-Mart Stores, Inc., TC Memo 1997-1; and Kroger, Co., TC Memo 1997-2.

Terms and Conditions

Automatic changes in method of accounting for accruing inventory shrinkage to either the retail safe harbor method or to a self-developed method that clearly reflects income are made under the general terms and conditions of Rev. Proc. 97-37, with certain modifications:

* A taxpayer under examination before Appeals or before any Federal court is permitted to change its accounting method for shrinkage to the methods provided in the revenue procedure; however, such a taxpayer would not receive audit protection for prior years if shrinkage is an issue under consideration on the date of filing the Form 3115. Sec. 3.09 of Rev. Proc. 97-37 provides that an issue is under consideration for the tax years under examination if the taxpayer receives written notification (e.g., by examination plan, information document request or notification of proposed adjustments or income tax examination changes) from the examining agent, specifically citing the treatment of the item as an issue under consideration.

* A taxpayer not currently under examination (or a taxpayer under examination if the shrinkage issue is not an issue under consideration) does receive audit protection for prior years on changing to the retail safe harbor method.

* Unlike prior automatic revenue procedures, the audit protection for prior years is not limited to issues under consideration as of the date of issuance or publication of the revenue procedure, but is based on the date of filing Form 3115. For example, a taxpayer not currently under examination could be contacted for examination; if the examining agent immediately notifies the taxpayer that the shrinkage issue is an issue under consideration, the taxpayer would not have audit protection for prior years.

* Rev. Proc. 98-29 extends the due date for filing Form 3115 to Aug. 11, 1998, for a taxpayer that files its original tax return by June 12, 1998, for the first tax year ending on or after Aug. 5, 1997 (effective date of the TRA '97).

* A taxpayer changing to a self-developed shrinkage estimation method must provide a detailed description of all aspects of its method.

* The taxpayer may use a different shrinkage estimation method for each separate trade or business.