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

• Author: Kalis, Frank J., Jr.

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...