Deductions for estimated inventory shrinkage.

• Author: Young, Barbara J.
• Position: Brief Article

The recent passage of the Taxpayer Relief Act of 1997 (TRA '97) should end years of litigation between retailers and the IRS over estimated inventory shrinkage. Many retailers cycle count their inventory; the inventory at various locations may be physically counted at least once each year, but all stores are not counted at the end of the year. If a physical count is not taken at yearend, shrinkage occurring since the last count will have to be estimated for financial reporting purposes and subsequently verified at the next inventory count.

Three recent Tax Court decisions demonstrate the Service's resistance to allowing a deduction for estimated inventory shrinkage. Dayton Hudson Corp., 101 TC 462 (1993), answered the threshold question of whether an estimate for inventory shrinkage could be deducted at all. The Tax Court held that a taxpayer's method of accounting may include the use of an estimate of shrinkage occurring through year-end, provided the estimation method is sound and clearly reflects income. Ultimately, the Tax Court decided that Dayton Hudson's particular method of determining estimated inventory shrinkage did not clearly reflect income; see TC Memo 1997-260. However, two other cases (Wal-Mart Stores, Inc., TC Memo 1997-1, and The Kroger Co., TC Memo 1997-2) held that the taxpayers' methods of determining estimated shrinkage clearly reflected income and were...