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Tax Tip: Marking Down Taxes with New Inventory Rules

Posted: April 19, 2012, 1:30 p.m. EDT


By Mark E. Battersby

Understanding and managing inventories is an extremely critical factor when it comes to determining the success—and the tax bill—of every retail business. Inventory helps ensure that the pet dealer, retailer or business will have the right products available at the right time so customers can make purchases on demand.

The use of inventories at the beginning and end of each tax year is, in fact, required where the production, purchase or sale of merchandise is an income-producing factor. Inventories must also be used wherever necessary to clearly reflect income. Not too surprisingly, many retailers use the so-called “retail inventory” method to determine the ending value of their inventory.

calculating retail inventory for tax purposes
Because many pet stores list inventoried merchandise only at its retail selling price, any attempt to trace each item back to its original invoice cost is often impracticable. Fortunately, under our tax rules (Reg. § 1.471-8), a retail inventory method may be used instead of valuing inventory at cost or lower of cost or market. In other words, the retail method is an averaging method, and has historically been more convenient for inventorying most merchandise, especially as volume increases.

The Internal Revenue Service recently proposed rule changes that clarify and restate the computation of ending inventory value under the retail inventory accounting method in plain language. The proposal would add rules on the treatment of sales-based vendor allowances, vendor markdown allowances and margin protection payments.

Today, any allowance, discount or price rebate related to, or intended to compensate for, a permanent markdown of retail selling prices is considered a reduction in the cost of merchandise sold. While it doesn’t reduce the inventory cost, or the value of goods on hand at the end of the tax year, the IRS’s proposed revisions exclude any sales-based vendor allowance, discount or price rebate earned by a business for selling specific merchandise (a sales-based vendor allowance), from the value of beginning inventory plus the cost of goods purchased during the year. 

Although the retail inventory method is a better method for tax purposes, it isn’t always the best method if a retailer uses the value of inventory to obtain credit. The retail inventory method also provides slightly distorted results because it relies on weighted averages rather than the exact cost of each item. For the same reason, however, the retail inventory method requires less effort to implement than other valuation methods.

Whether or not a pet business is already taking advantage of the retail inventory method, professional assistance is strongly recommended when it comes to determining the benefits of the newly proposed and clarified regulations. 

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