IRS issues prop. regs, on retail-inventory method.

• Author: Wilkins, Roger

Many department stores and large retailers use the retail-inventory method (RIM) as a way of determining the cost or lower of cost or market (LCM) value of inventory based on retail selling price and a cost-to-retail ratio, Regs. Sec. 1.471-8 defines the cost-to-retail ratio as the ratio of the value of the beginning inventory plus the cost of purchases to the retail selling price of the beginning inventory plus the initial retail selling prices of purchases, which may be illustrated by the formula in Exhibit 1.

Exhibit 1: Cost-to-retail ratio

Value of beginning inventory + Cost of purchases

Retail selling price of beginning inventory + Initial retail selling prices of purchases

According to the IRS in Field Directive LMSB-04-0910-026, under Regs. Sec. 1.471-8, a taxpayer computes the value of ending inventory under RIM by multiplying a cost-complement ratio by the retail selling prices of goods on hand at the end of the tax year. Thus, reductions in the numerator of the cost-complement ratio and reductions in the retail selling price of ending inventory both have the effect of reducing the value of ending inventory.

Under Regs. Sec. 1.471-3(b), the cost of purchases during the year generally includes invoice price less trade or other discounts for inventory valuation purposes. A discount may be based on a retailer's sales volume (sales-based allowance) or on the quantity of merchandise a retailer purchases (volume-based allowance), or it may relate to a retailer's reduction in retail selling price (markdown allowance or margin protection payment) (preamble to REG425949-10).

The IRS has consistently taken the position that sales-based royalties and inventory allowances are components of the cost of inventory rather than ordinary deductions or income. The tax treatment of sales-based royalties was addressed in Robinson Knife, 600 F.3d 121 (2d Cir. 2010), rev'g T.C. Memo 2009-9, which revolved around the capitalization of such costs for purposes of Sec. 263A. The Tax Court held that royalties made to a third party for the use of a patent, which gave the taxpayer the right to manufacture the third party's branded kitchen tools, were capitalizable to inventory under Sec. 263A because the patents directly benefited the taxpayer's production activities. The Second Circuit disagreed with the Tax Court, holding that royalties calculated as a percentage of the selling price and incurred only upon the sale of the inventory were deductible as ordinary...