Rev. Rul. 79-115

ISSUE

Should promotional markdowns be used in computing the cost complement for determining inventory value under the retail method of pricing inventories and last-in, first-out (LIFO) method of inventory valuation?

FACTS

The taxpayer is a domestic corporation that operates a department store. The taxpayer uses the accrual method of accounting and files its federal income tax returns on the basis of a fiscal year ending January 31. The taxpayer has properly elected to use the LIFO method of inventory valuation and the retail method of pricing inventories pursuant to section 1.471-8 of the Income Tax Regulations.

Under the retail pricing method inventories are initially valued at the retail selling price and then converted to cost by means of a percentage factor. The percentage factor or cost complement is computed by dividing the sum of the cost of the opening inventory and purchases made during the year by the sum of the retail price of the beginning inventory and purchases made during the year. The retail prices are adjusted for markups and markdowns to reflect the actual market value of the inventory. Section 1.472-1(k) of the regulations describes the retail method used in conjunction with LIFO.

In computing its cost complement, the taxpayer adjusts the retail prices for normal markdowns on subnormal goods but makes no adjustment for temporary markdowns on promotional merchandise. The taxpayer includes promotional goods in inventory at full retail price and promotional markdowns are taken only at the cash register when the sale is recorded at the reduced selling price. The promotional markdowns are eliminated at the end of the promotion period and the inventory is not adjusted for the promotional markdowns at any time.

LAW AND ANALYSIS

Section 471 of the Internal Revenue Code of 1954 provides that whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.

Section 1.471-8(a) of the regulations provides, in part, that under the retail method the total of the retail selling prices of the goods on hand at the end of the year in each department or of each class of goods is reduced to approximate cost by deducting therefrom an amount which bears the same ratio to such total as--

(1) The total of the retail selling prices of the goods included in the opening inventory plus the retail selling prices of the goods purchased during the year, with proper adjustment to such selling prices for all markups and markdowns, less

(2) The cost of the goods included in the opening inventory plus the cost of the goods purchased during the year, bears to (1).

The result should represent as accurately as may be the amounts added to the cost price of the goods to cover selling and other expenses of doing business and for the margin of profit.

Section 1.471-8(g) of the regulations provides that a taxpayer using the LIFO inventory method in conjunction with retail computations must adjust retail selling prices for markdowns as well as markups, in order that there may be reflected the approximate cost of the goods on hand at the end of the taxable year regardless of market values.

Section 1.472-1(k) of the regulations provides that if a taxpayer using the retail method authorized by section 1.471-8, elects to use in connection therewith the LIFO method, the apparent cost of goods on hand at the end of the year, determined pursuant to section 1.471-8, shall be adjusted to the extent of price changes therein taking place after the close of the preceding taxable year.

In computing the value of the ending inventory under the LIFO method only cost may be used. Thus, in computing the retail value of the inventory under the LIFO method, all markdowns actually made must be eliminated so that the cost of the inventory may be approximated. However, in the present situation the taxpayer did not take an actual markdown on its inventory: that is, the promotional markdowns were merely temporary reductions in price and did not reflect an actual reduction in the retail price of the goods in inventory. If promotional markdowns are reflected as an adjustment to retail prices in computing the cost complement this would result in actual costs being overstated, as illustrated by the following example:

                                                               Cost

Promotional markdowns should not be used in computing the cost complement in determining inventory valuation under the retail method of pricing inventories and the LIFO method of inventory valuation because the retail price of the inventory does not reflect promotional markdowns.