department of the treasury employer_identification_number contact person - id number contact telephone number uil internal_revenue_service p o box cincinnati oh release number release date date date legend b website c state d organization name x scholarship name y college name z city state dear you asked for advance approval of your scholarship grant procedures under internal_revenue_code sec_4945 this approval is required because you are a private_foundation that is exempt from federal_income_tax you requested approval of your scholarship program to fund the education of certain qualifying students our determination we approved your procedures for awarding scholarships based on the information you submitted and assuming you will conduct your program as proposed we determined that your procedures for awarding scholarships meet the requirements of code sec_4945 as a result expenditures you make under these procedures won't be taxable description of your request your letter indicates you will operate a scholarship program called x also awards made under these procedures are scholarship or fellowship grants and are not taxable to the recipients if they use them for qualified_tuition_and_related_expenses subject_to the limitations provide in code sec_117 your purpose is to in engage charitable activities enhancing access to higher education specifically you provide scholarships to students who attend y located in z who meet the letter catalog number 58263t criteria to attend the college students who are residents of c and are attending y are eligible to apply for scholarships and you advertise the scholarship program on the b the number of scholarships that will be awarded each year and the amount of each scholarship will vary depending on the amount of funds available to be distributed you are required to annually distribute the greater of the net_income of the trust or the amount that must be distributed to satisfy code sec_4942 each year you advise the scholarship advisory committee of the amount of funds available to be awarded as scholarships your scholarship advisory committee consists of faculty members of y to assist in making the selections the members of the scholarship advisory committee review the scholarship applications and rank the applications based on the scholastic standings of such persons their moral character and financial need with special emphasis to students who are taking technical vocational training and members of the d your scholarship advisory committee then submits its recommendations to you and you make the final_decision all scholarships are awarded on an objective and non-discriminatory basis no scholarships may be awarded to any disqualified_person in code sec_4946 your scholarship advisory committee also makes a recommendation to you regarding the amount that should be awarded to each participant you will make the final_determination as to the amount awarded based on available funds scholarships can be renewed as long as the scholarship requirements are met by the recipient you pay the scholarship proceeds directly to y and provide a letter to y asking the college to advise you if any student does not register so that their share may be re- allocated you represent that you will arrange to receive and review grantee reports annually and upon completion of the purpose for which the grant was awarded investigate diversions of funds from their intended purposes and take all reasonable and appropriate steps to recover diverted funds you will ensure other grant funds held by a grantee are used for their intended purposes and withhold further payments to grantees until you obtain grantees’ assurances that future diversions will not occur and that grantees will take extraordinary precautions to prevent future diversions from occurring you also represent that you will maintain all records relating to individual grants including information obtained to evaluate grantees identify whether a grantee is a disqualified_person establish the amount and purpose of each grant and establish that you undertook the supervision and investigation of grants described above basis for our determination the law imposes certain excise_taxes on the taxable_expenditures of private_foundations code sec_4945 a taxable_expenditure is any amount a private_foundation pays as a grant to an individual for travel study or other similar purposes however a grant that meets all of the following requirements of code sec_4945 is not a taxable_expenditure letter catalog number 58263t the foundation awards the grant on an objective and nondiscriminatory basis the irs approves in advance the procedure for awarding the grant the grant is a scholarship or fellowship subject_to the provisions of code sec_117 the grant is to be used for study at an educational_organization described in code sec_170 a ii other conditions that apply to this determination this determination only covers the grant program described above this approval will apply to succeeding grant programs only if their standards and procedures don't differ significantly from those described in your original request the effective date of our approval is date which is the date your request was submitted e this determination applies only to you it may not be cited as a precedent you cannot rely on the conclusions in this letter if the facts you provided have changed substantially you must report any significant changes to your program to the cincinnati office of exempt_organizations at internal_revenue_service exempt_organizations determinations p o box cincinnati oh please keep a copy of this letter in your records you cannot award grants to your creators officers directors trustees foundation managers or members of selection committees or their relatives you should keep adequate_records and case histories so that you can substantiate your grant distributions with the irs if necessary all funds distributed to individuals must be made on a charitable basis and further the purposes of your organization you cannot award grants for a purpose that is inconsistent with code sec_170 b catalog number 58263t if you have questions please contact the person listed at the top of this letter director exempt_organizations letter sincerely


t c memo united_states tax_court dayton hudson corporation and subsidiaries petitioner v commissioner of internal revenue respondent docket no filed date p operated department stores p used cycle counting to conduct physical inventories of merchandise throughout the year p maintained book inventory records from which inventory closing balances could be determined at yearend p estimated losses from shrinkage factors eg theft and errors in billing occurring from the time of the last physical count of inventory to yearend and made an accrual of the estimate p calculated shrinkage accruals as a percentage of sales held p's systems of maintaining book_inventories do not clearly reflect income they are thus not sound within the meaning of sec_1_471-2 income_tax regs david r brennan and walter a pickhardt for petitioner reid m huey john c schmittdiel robert j kastl and robin l herrell for respondent memorandum findings_of_fact and opinion halpern judge respondent has determined a deficiency in petitioner's federal_income_tax for its taxable_year in the amount of dollar_figure and petitioner has claimed an overpayment of income_tax for that taxable_year in the amount of dollar_figure previously on respondent's motion for summary_judgment we addressed one of the issues presented in this case in 101_tc_462 we held that sec_1 d income_tax regs as a matter of law does not prohibit petitioner from making a shrinkage accrual in computing book_inventories the issue remaining for our consideration is the soundness of certain of petitioner's accounting systems that allow for the accrual of an estimate of losses from shrinkage factors eg theft and errors in billing in determining book_inventories unless otherwise noted all section references are to the internal_revenue_code in effect for the year in issue and all the claim for overpayment contests the disallowance of shrinkage accruals in computing the tax consequences of a prior settlement between the parties for the taxable_year in issue rule references are to the tax_court rules_of_practice and procedure findings_of_fact some facts have been stipulated and are so found the stipulations of facts filed by the parties with accompanying exhibits are incorporated herein by this reference the parties have made approximately separate stipulations of fact occupying pages and there are accompanying exhibits we will set forth only those stipulated facts that are necessary to understand our report along with other facts that we find i background a petitioner petitioner is a minnesota corporation with its principal office in minneapolis minnesota petitioner makes its federal_income_tax return on the basis of a fiscal_year ending during january of each year we shall refer to petitioner's taxable_year ending within a year simply by referring to that year eg for petitioner's taxable_year ending date during petitioner was a retailer operating big_number stores in states the district of columbia and puerto rico petitioner's operations included a rapidly growing low margin department store chain in states called target and a regional department store company called dayton's target and dayton's were divisions of petitioner target offered a merchandise mix of two-thirds convenience-oriented hardlines and one-third fashion softgoods target has had significant growth in the number of stores it has operated in target operated stores in it operated stores and in it operated stores dayton's included stores generally referred to as department stores and home stores specializing in furniture carpeting and draperies all stores were located in minnesota north dakota south dakota and wisconsin in target had gross_receipts of dollar_figure and dayton's had gross_receipts of dollar_figure b accounting procedures petitioner's annual_accounting_period and taxable_year was a 53-week year ending on the saturday closest to january petitioner used the accrual_method of accounting for both federal_income_tax and financial reporting purposes gross_income was calculated using inventories to account for the purchase and sale of merchandise book_inventories were maintained to determine closing inventories for taxable years for which no physical inventories were taken at the taxable yearend gross_income in a merchandising business means gross_receipts for the period in question less cost_of_goods_sold plus any income from investments and from incidental or outside sources cost_of_goods_sold slightly simplified equals opening_inventory plus inventory purchased during the period minus closing_inventory both target and dayton's used the cycle counting method of conducting physical inventories cycle counting is a method of conducting physical inventories at individual stores or departments within stores in rotation throughout the year most large retail companies do not perform a physical count of inventory on or near the last day of the annual_accounting_period large retailers prefer cycle counting to yearend counting because it is more accurate and less expensive and provides better inventory control cycle counting is also more efficient and practical in terms of the availability of internal resources and outside services to conduct physical inventories generally petitioner did not conduct physical inventories on the last day of the taxable_year in issue during and and for a number of years prior thereto petitioner maintained a perpetual or book inventory system for its divisions and subsidiaries including target and dayton's under its perpetual inventory system petitioner debited its inventory or stock accounts with the cost of goods purchased and credited those accounts with the cost_of_goods_sold the perpetual inventory system also showed the sales proceeds from goods sold during physical inventories were conducted on a store- by-store basis within the target division and on a departmental basis within the dayton's division physical inventories were not taken in target stores commencing operations during the results of a physical inventory often would indicate that inventory_shrinkage had occurred inventory_shrinkage is the difference between the amount of inventory the stock account shows as being on hand and the amount of inventory that is actually on hand when inventory is determined from book inventory records computed without any accrual for estimated shrinkage and the inventory so determined exceeds inventory determined by physical count the difference is termed shrinkage when book inventory so determined is exceeded by inventory determined by physical count the difference is termed overage factors that contribute to shrinkage and overage hereafter generally shrinkage include theft by employees customers and vendors and paperwork billing and other systems errors both target and dayton's experienced some or all of the listed shrinkage factors during the year in issue the occurrence of shrinkage factors is not limited to particular times during the year but generally each of the factors occurs throughout the year c accounting for shrinkage if inventory is not physically counted at the end of the annual_accounting_period year shrinkage as defined above cannot be determined for the period from the last physical count to the end of the year the physical-to-yearend period if cycle counting is used and the cycle for a particular store does not end on the last day of the year then losses from shrinkage factors for the physical-to-yearend period yearend shrinkage must be estimated if such yearend shrinkage is to be taken into account petitioner maintained a controller's manual containing a standard control procedure to set forth corporate policy for accounting for inventory_shrinkage and for planning and reporting physical inventory results that manual provided that all companies must take at least one complete physical inventory a year it further provided that e ach operating company controller is responsible for accounting for inventory_shrinkage in accordance with the accrual basis of accounting the manual defined the term inventory_shrinkage accrual rate as t he rate at which inventory is written off to cost of sales to provide for inventory_shrinkage the rate is stated as a percentage of net sales the manual further provided for the adjustment of physical inventory results as follows when physical inventory shortage is less than the provision ie the accrual for inventory_shrinkage cost of sales should be reduced for the calculated difference between the physical inventory shortage and the provision for inventory_shrinkage when physical inventory shortage is more than the provision for inventory_shrinkage cost of sales should be increased for the calculated difference between the physical inventory shortage and the provision for inventory_shrinkage petitioner estimated shrinkage factors for the periods between physical inventories and on a monthly basis accrued amounts on account thereof at the time of each physical inventory petitioner would take account of any difference between its accruals and the result of its physical inventory accrual error for each taxable_year petitioner's total adjustments for shrinkage factors would include any accrual for the period from the start of the year until the physical inventory date any adjustment for an accrual error and any accrual for yearend shrinkage such accrual for yearend shrinkage hereafter being referred to as shrinkage accrual shrinkage accruals reduced yearend inventories which had the effect of increasing cost_of_goods_sold and as a result decreasing gross_income in the retail industry the practice of making shrinkage accruals and of calculating such accruals as a percentage of sales is the prevalent if not virtually universal practice it is the best practice in that industry respondent disallowed petitioner's shrinkage accruals that had the consequence of decreasing cost_of_goods_sold and as a result increasing gross_income respondent has proposed a deficiency based upon that increased income ii target a accounting methods and procedure sec_1 in general target comprised stores that were organized into separate departments target maintained its inventory records by department and by store lifo retail_method beginning in and continuing through petitioner elected to value target's inventories using the lifo retail_method of inventory_valuation pursuant to sec_1_471-8 income_tax regs pursuant to sec_1_472-1 and sec_1_472-8 income_tax regs petitioner elected to use department store indexes prepared by the u s bureau of labor statistics bls petitioner aggregated target's departments into lifo pools that corresponded to merchandise groups as established by bls accrual rate for shrinkage target accounted for its inventory_shrinkage on the accrual_method by department and by store target accrued shrinkage as a percentage of sales using rates accrual rates that were set for each department in each store the accruals were posted directly to the perpetual inventory system on a monthly basis and adjustments were made to account for accrual errors target developed a companywide accrual rate for each taxable_year by reviewing the inventory results for prior physical inventory periods target generally reviewed the most recent to years of store and company experience in arriving at a companywide rate target also considered a variety of other factors known to affect the rate of shrinkage shrinkage rate including demographics crime levels management problems paperwork problems measures to improve shrinkage industry trends performance of warehouses and store acquisitions the next step in the process was the determination of accrual rates for each store after considering store-specific information target would assign a preliminary accrual rate to each store target then adjusted those rates so that the sum of the individual store rates multiplied by each store's projected sales figures would equal the projected shrinkage dollars at the company level as determined from the companywide accrual rate the adjustment for a specific store's accrual rate would not exceed percent of its projected annual sales lastly target adjusted accrual rates at the department level within each store based upon a 3-year average shrinkage rate for the department on a companywide basis those department rates were further adjusted to accord with the shrinkage rate for each store in proportion to each department's sales relative to the store's total sales during the most recent 12-month_period application of accruals for shrinkage target used its accruals for shrinkage for the following purposes financial and tax reporting to determine the budget that would be available for the purchase of inventory in a particular department to set goals for and to evaluate the performance of store managers and buyers and to determine the sources of shrinkage b target's physical inventorie sec_1 in general target employed an outside inventory service to conduct physical inventories of stores generally during the period beginning with the first weekend in february and ending in mid-october each store had its own physical inventory period target attempted to conduct a physical inventory at each store every to months however in rare instances as many as months elapsed between physical inventories except for stores opened during the year target usually inventoried every store once each year new stores target generally did not conduct physical inventories of new stores in the year that they were opened because target believed that such inventories produced meaningless results instead target conducted physical inventories of new stores in the year following the year of opening in most cases target set accrual rates for new stores by considering the average shrinkage rate for the district in which the new store was being opened target also considered the demographics of that district as well as the marketing plan of sister stores --stores that are located in areas with similar demographics and have merchandise mixes similar to that anticipated for the new store--in setting accrual rates for new stores warehouses during through physical inventories were performed at target's distribution centers and metro warehouses hereafter collectively referred to as warehouses once each year prior to the close of the taxable_year during the months of december or january the results of the physical inventories at the warehouses were taken into account in april of the subsequent taxable_year on a departmental basis by the target stores serviced by each particular warehouse the amount of shrinkage was allocated to the target stores based upon the store's use of a particular warehouse that practice reflected the determination that the warehouses' shrinkage generally reflected billing errors to stores c proposed deficiencies with respect to target in the notice_of_deficiency respondent disallowed shrinkage accruals for the lifo cost adjustment was dollar_figure which reflected a disallowance of shrinkage at retail for the post-physical inventory periods in the amount of dollar_figure target had sales for in the amount of dollar_figure during the periods between the dates of the physical inventories of target's stores and the end of target's sales were dollar_figure or percent of all sales for iii dayton's a accounting methods and procedure sec_1 in general dayton's comprised stores and each store had in excess of departments dayton's maintained its inventory records by department lifo retail_method petitioner elected to value the inventories of dayton’s using the lifo retail_method of inventory_valuation pursuant to sec_1_471-8 income_tax regs pursuant to sec_1 k and c income_tax regs petitioner elected to use department store indexes prepared by bls petitioner aggregated the departments of dayton's into lifo pools that corresponded to merchandise groups as established by bls accrual rate for shrinkage dayton's accounted for its inventory_shrinkage on the accrual_method by department dayton's accrued shrinkage as a percentage of sales using rates accrual rates that were set for each department for each taxable_year the accruals were posted directly to the perpetual inventory system on a monthly basis and adjustments were made to account for accrual errors dayton's established accrual rates as a percentage of sales on a departmental basis the department rate was applied throughout the dayton's division in setting a department accrual rate dayton's considered numerous factors including the most recent shrinkage history and shrinkage trends of the particular department the employment of new marketing strategies changes in demographics trends that were developing in related departments changes in security procedures and particular theft problems dayton's did not set a companywide accrual rate the companywide accrual figure was simply the aggregate of the accruals for all of the departments application of accruals for shrinkage dayton's used its accruals for shrinkage for the following purposes financial and tax reporting to determine the budget that would be available for the purchase of inventory in a particular department to evaluate the performance of department heads and to determine the sources of shrinkage b dayton's physical inventories dayton's conducted its physical inventories of its departments by counting inventory on the same day at every store that maintained a particular department in conducting physical inventories dayton's used its own employees and at times those employees were assisted by outside personnel the physical inventories of the departments were performed at various times throughout the year and during the year in issue they were performed as early as date and as late as date after a physical inventory was taken the perpetual inventory system would be adjusted as necessary and generally dayton's adjusted the department accrual rate for the balance of the taxable_year to reflect the most recent shrinkage experience c proposed deficiencies with respect to dayton's in the notice_of_deficiency respondent disallowed shrinkage accruals for the lifo cost adjustment was dollar_figure which reflected a disallowance of shrinkage at retail for the post-physical inventory periods in the amount of dollar_figure dayton's had sales for in the amount of dollar_figure during the periods between the dates of the physical inventories of the departments of dayton's and the end of sales for dayton's were dollar_figure or percent of all sales for opinion i introduction petitioner's principal business activities are the operation of department stores we are concerned here with petitioner's target division target and its dayton's division dayton's together the divisions during the taxable_year in issue the divisions used cycle counting to conduct physical inventories of merchandise under the cycle counting method physical inventories were taken in rotation at the various stores or departments within stores throughout the year also the divisions maintained book inventory records from which inventories could be determined without a physical count the divisions estimated losses from shrinkage factors eg theft and errors in billing during the physical-to-yearend period yearend shrinkage and made an accrual of that estimate shrinkage accrual that practice had the effect of increasing cost_of_goods_sold and decreasing gross_income respondent disallowed the divisions’ shrinkage accruals and we must determine whether that disallowance is an abuse_of_discretion ii statute and principal regulation sec_471 provides the following general_rule 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 as the regulations point out sec_471 establishes two distinct tests to which an inventory must conform it must conform as nearly as may be to the best_accounting_practice in the trade_or_business and it must clearly reflect the income sec_1_471-2 income_tax regs in accordance with the authority provided by sec_471 the secretary has promulgated rules for taxpayers maintaining a perpetual book entry system of keeping inventories in pertinent part sec_1_471-2 income_tax regs reads as follows where the taxpayer maintains book_inventories in accordance with a sound accounting system in which the respective inventory accounts are charged with the actual cost of the goods purchased or produced and credited with the value of goods used transferred or sold calculated upon the basis of the actual cost of the goods acquired during the taxable_year the net value as shown by such inventory accounts will be deemed to be the cost of the goods on hand the balances shown by such book_inventories should be the tax_reform_act_of_1986 publaw_99_514 sec_2 100_stat_2356 designated the quoted language as sec_471 before amendment the quoted language was the entirety of sec_471 verified by physical inventories at reasonable intervals and adjusted to conform therewith iii prior proceedings previously on respondent's motion for summary_judgment we addressed one of the issues presented in this case in 101_tc_462 we held that sec_1 d income_tax regs as a matter of law does not prohibit petitioner from making a shrinkage accrual in computing book_inventories we acknowledged however that respondent might yet argue that petitioner's accounting system including the making of shrinkage accruals is not sound within the meaning of the regulations or fails to clearly reflect income id pincite respondent acknowledges our holding in the earlier opinion but does not agree that it is correct we adhere to that holding iv are the divisions' systems of accounting for inventories including the making of shrinkage accruals sound because the divisions used cycle counting to conduct physical inventories of merchandise and generally no count was taken at yearend the divisions necessarily had to maintain book inventory records to determine yearend inventories for purposes of computing cost_of_goods_sold those book_inventories included an entry for shrinkage accrual we must determine whether those book_inventories were maintained in accordance with a sound accounting system sec_1 d income_tax regs we have recently addressed the question of what constitutes a sound accounting system under sec_1 d income_tax regs in kroger co subs v commissioner tcmemo_1997_2 we noted that sec_1 a income_tax regs provides two specific requirements with which acceptable inventory practices must conform we then stated first such practices must conform as nearly as may be to the best_accounting_practice in the industry second the practices must clearly reflect the taxpayer’s income sec_1_471-2 income_tax regs adds consistency of application from year to year as an important and explicit element of inventory practices that clearly reflect income the use of the adjective sound in sec_1_471-2 income_tax regs does not introduce an additional standard but only incorporates the previously articulated standards with the emphasis on the system or methodology employed to maintain book_inventories id therefore our inquiry is principally whether the divisions' systems of maintaining book_inventories including the making of shrinkage accruals conform to the best_accounting_practice and clearly reflect income v best_accounting_practice the parties have stipulated that for financial_accounting purposes petitioner’s financial statements for the taxable_year in issue were consistent with generally_accepted_accounting_principles gaap in 439_us_522 the supreme court stated that the phrase best_accounting_practice as it appears in sec_471 and sec_1_471-2 income_tax regs is synonymous with gaap petitioner followed the same accounting practices for both federal_income_tax and financial reporting purposes we find therefore that the divisions' systems of maintaining book_inventories conform to the best_accounting_practice within the meaning of sec_471 and sec_1_471-2 income_tax regs vi clear_reflection_of_income a methods_of_accounting and the legal requirement of clear_reflection_of_income the general_rule for methods_of_accounting is set forth in sec_446 taxable_income shall be computed under the method_of_accounting on the basis of which the taxpayer regularly computes his income in keeping his books a taxpayer has latitude however in selecting a method_of_accounting sec_1_446-1 income_tax regs provides it is recognized that no uniform method_of_accounting can be prescribed for all taxpayers each taxpayer shall adopt such forms and systems as are in his judgment best suited to his needs the accrual_method is a permissible method_of_accounting sec_446 sec_1_446-1 income_tax regs provides generally under an accrual_method income is to be included for the taxable_year when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy under such a method a liability is incurred and generally is taken into account for federal_income_tax purposes in the taxable_year in which all the events have occurred that establish the fact of the liability the amount of the liability can be determined with reasonable accuracy and economic_performance has occurred with respect to the liability the term liability as used in sec_1_446-1 income_tax regs is defined in sec_1_446-1 income_tax regs to include a cost taken into account in computing cost_of_goods_sold notwithstanding the latitude generally enjoyed by a taxpayer in selecting a method_of_accounting where inventories are employed accrual accounting is the general_rule to account for purchases and sales where inventories are employed purchases and sales must be computed on the accrual_method unless another method is authorized by the commissioner in order to avoid the distortion_of_income sec_1_446-1 income_tax regs 320_f2d_340 85_tc_485 in any event a taxpayer’s right to adopt a method_of_accounting is subject_to the requirement that the method must clearly reflect income sec_446 states that if the method adopted does not clearly reflect income the computation of taxable_income shall be made under such method as in the opinion of the secretary does clearly reflect income see also sec_1_446-1 income_tax regs the term clearly reflect income is undefined in the code in most cases generally_accepted_accounting_principles consistently applied will pass muster for tax purposes see eg sec_1_446-1 c ii income_tax regs the supreme court has made clear however that gaap does not enjoy a presumption of accuracy that must be rebutted by the commissioner thor power tool co v commissioner supra pincite the commissioner’s supervisory power under sec_446 permitting the rejection of a taxpayer’s method if it does not clearly reflect income and its substitution with a method that in the opinion of the commissioner does clearly reflect income was described by the supreme court in another case as leaving m uch latitude for discretion which should not be interfered with by the courts unless clearly unlawful 280_us_445 quoted with approval in thor power tool co v commissioner supra pincite b standard of review when the commissioner determines that a taxpayer's method_of_accounting does not clearly reflect income the taxpayer has a heavy burden to show an abuse_of_discretion e g 796_f2d_843 6th cir affg in part and revg in part akers v commissioner tcmemo_1984_208 revd per curiam on another issue 482_us_117 the court_of_appeals for the sixth circuit has stated sec_446 gives the commissioner discretion with respect to two determinations the commissioner first determines whether the accounting_method chosen by a taxpayer clearly reflects income if the commissioner concludes that the taxpayer's chosen method does not meet this standard he has the further discretion to require that computations be made under the method which in his opinion does clearly reflect income it would be difficult to describe administrative discretion in broader terms id pincite notwithstanding the authority conferred under sec_446 the commissioner cannot require a taxpayer to change to another method where the taxpayer's method_of_accounting does clearly reflect income even if the method proposed by the commissioner more clearly reflects income 71_f3d_209 6th cir affg 102_tc_87 104_tc_367 hospital corp of am v commissioner tcmemo_1996_105 nor will the courts approve the commissioner's change_of a taxpayer's accounting_method from an incorrect method to another incorrect method 223_f2d_418 10th cir revg 21_tc_781 91_tc_1101 affd 882_f2d_820 3d cir see also 95_tc_35 wells j concurring sec_446 authorizes respondent to require accounting changes that produce clearer reflections of income not greater distortions of income therefore in order to prevail in a case where the commissioner determines that a taxpayer's method_of_accounting does not clearly reflect income the taxpayer must demonstrate either that his method_of_accounting clearly reflects income or that the commissioner's method does not clearly reflect income see asphalt prods co v commissioner supra pincite kroger co subs v commissioner tcmemo_1997_2 c the divisions' shrinkage methods the divisions maintained book inventory records from which yearend inventories could be determined losses for the taxable_year occasioned by shrinkage factors taxable_year shrinkage were reflected in the divisions' book inventory records under methods individually target's shrinkage method and dayton's shrinkage method together when no distinction is intended the divisions' shrinkage methods that essentially involved three variables an estimate of losses from shrinkage factors for the portion of the taxable_year preceding the date of the physical inventory preinventory accrual the accrual error a measure of error in both the prior year's shrinkage accrual and the preinventory accrual and the shrinkage accrual for the taxable_year target accounted for shrinkage as a percentage of sales using rates accrual rates that were set for each department in each store for each taxable_year those rates were derived from a companywide accrual rate that was based on a combination of factors including historical shrinkage experience demographics crime levels management problems measures to improve shrinkage industry trends performance of warehouses and store acquisitions except for stores opened during the year target generally conducted a complete physical inventory of an entire store on a particular day once each year dayton's accounted for shrinkage as a percentage of sales using rates accrual rates that were set for each department for each taxable_year companywide department accrual rates were based on a combination of factors including the most recent shrinkage history and shrinkage trends of the particular department the employment of new marketing strategies changes in demographics trends that were developing in related departments changes in security procedures and particular theft problems dayton's conducted its physical inventories of its departments by counting inventory on the same day at every store that maintained a particular department the physical inventories of the departments were performed at various times throughout the year and during the year in issue they were performed as early as date and as late as date in sum both target and dayton's estimated losses from shrinkage factors as a percentage of sales using methods that essentially reflected verified shrinkage for the preinventory period an estimate of yearend shrinkage shrinkage accruals and accrual error attributable to the shrinkage accrual for the prior taxable_year d respondent's method respondent would permit the divisions to account for losses from shrinkage factors only when such losses are verified by physical inventories respondent's method respondent claims that that method is nothing more than application of the principle that taxpayers may not reduce income by unverified losses or expenditures or unreliable estimates upon closer analysis we conclude that respondent's method essentially estimates yearend shrinkage for the taxable_year based on yearend shrinkage for the prior taxable_year respondent's method would adjust the divisions' book_inventories by disallowing any shrinkage accrual the divisions' cost_of_goods_sold as determined by book_inventories would essentially include shrinkage for inventory cycles beginning in the prior taxable_year and ending in the taxable_year and not any portion of the shrinkage determined for inventory cycles beginning within the taxable_year and ending in the next taxable_year ie yearend shrinkage in sum the divisions’ cost_of_goods_sold for a taxable_year that included cross-year inventory cycles would include shrinkage accurately measured ie verifiable for some period other than that taxable_year ie an inventory year if it is assumed that there is yearend shrinkage then unless the amount of yearend shrinkage for the taxable_year is identical to the amount of yearend shrinkage for the previous year respondent’s method would produce only an estimate of the loss from shrinkage factors for the taxable_year the facts underlying that conclusion can be illustrated by the following diagram in which it is assumed that a physical inventory is taken semiannually on march and september and that the taxpayer is a calendar_year taxpayer taxable_year taxable_year taxable_year dec dec dec inventory year inventory year inventory year septdollar_figure mar sept mar sept mar sept under respondent’s method the taxpayer’s cost_of_goods_sold for a taxable_year would be computed by including shrinkage for the taxpayer’s inventory year ending september shrinkage for the inventory year might equal taxable_year shrinkage but the occurrence of that remote possibility is impossible to verify what is likely almost a certainty is that the taxpayer computing his cost_of_goods_sold under respondent's method would be making that computation using some figure for taxable_year shrinkage that was not the actual taxable_year shrinkage in other words the taxpayer would be forced to use what is almost certainly no more than an estimate of taxable_year shrinkage in computing cost_of_goods_sold respondent does not seriously claim that losses from shrinkage factors in a cross-year inventory cycle occur only in the latter year nor does respondent claim that losses from shrinkage factors do not occur generally throughout an inventory cycle on the record before us we have no doubt that on a regular basis the divisions experienced losses from theft billing errors and other shrinkage factors we also have no doubt that some of those losses were experienced during the physical-to-yearend period and gave rise to yearend shrinkage therefore the principal difference between the divisions’ shrinkage methods and respondent’s method is that respondent without admitting it accepts an estimate of yearend shrinkage while the divisions by making shrinkage accruals consciously attempt to estimate that shrinkage petitioner attempts to distort our understanding of respondent's method by stating that for target r espondent allows shrinkage at retail of dollar_figure or percent of sales petitioner also states that r espondent has not even allowed the shrinkage verified by physical inventories during the year of dollar_figure that characterization of respondent's method is misleading because it fails to recognize that respondent's adjustments for the year in issue are not isolated determinations but rather reflect a method change indeed in the petition petitioner alleges alternatively that a sec_481 adjustment would be required in the event that respondent's adjustments are sustained at trial however petitioner's counsel acknowledged that no evidence was submitted on that issue and that petitioner intended to rely on defeating respondent's determination of deficiency on brief petitioner's counsel cites respondent's failure to make an adjustment to opening_inventory as evidence of the arbitrariness of respondent's method adjustments to opening_inventory are the province of sec_481 petitioner having abandoned its sec_481 argument we continued e petitioner's expert testimony introduction petitioner relies on expert testimony to demonstrate that the divisions' shrinkage methods clearly reflect income respondent's method does not clearly reflect income or the divisions' shrinkage methods more clearly reflect income when compared to respondent's method in particular petitioner relies on such testimony to demonstrate a strong correlation between sales and shrinkage which correlation underlies the divisions' shrinkage accruals and petitioner's contention that respondent's method does not clearly reflect income petitioner presents principally the expert testimony of w eugene seago ph d dr seago is a certified_public_accountant and a professor of accounting at virginia polytechnic institute and state university correlation between sales and shrinkage statistical correlation r is a measure of the degree to which two variable quantities tend to change with respect to each other r is expressed in a range between positive one and negative one a correlation of positive one indicates that the two quantities change in exact proportion and in the same continued believe that it cannot show arbitrariness based on respondent's failure to make an adjustment to opening_inventory and we reject petitioner's attempt to distort respondent's method direction whether up or down a correlation of zero indicates that the two quantities change without reference to each other a correlation of negative one indicates that the two quantities change in exact proportion but in opposite directions when one goes up the other goes down in addition the square of the correlation coefficient is termed the coefficient of determination r2 generally r2 measures the predictive power of one variable with respect to another variable the principal experts in this case do not limit their use of the term correlation to represent r in the technical sense but rather use that term to signify r2 at times and also to signify the general relationship between two variables we shall conform for purposes of this report to the experts’ broad usage of the term correlation dr seago states in his rebuttal report that t he purpose of ascertaining whether shrinkage correlates to sales is to test whether target's use of sales to estimate shrinkage is appropriate dr seago acknowledges that testing the correlation of sales and shrinkage at the lifo_pool level for target would be highly relevant because tax effects occur at that level but since data to test that correlation does not exist he concludes that the next best thing is to examine correlation at the aggregate division level dr seago is of the opinion that the correlation between sales and shrinkage at the aggregate target-wide level is strong dr seago conducted a regression analysis of the relationship between sales and shrinkage at the aggregate target- wide level during the years through the 10-year correlation analysis for each target store he paired actual sales figures between inventory dates with verified shrinkage figures for the same period dr seago then aggregated the data according to the taxable_year in which the closing_inventory was taken he is of the opinion that for the years examined t he change in sales each year explained over of the change in shrinkage dr seago concludes that according to the statistical evidence sales is a nearly perfect predictor of the loss from shrinkage he did not conduct a similar analysis with respect to dayton's to compensate for the absence of data to test correlation at the lifo_pool level dr seago randomly placed individual target stores into surrogate pools and examined the correlation between sales and shrinkage for the fiscal years through dr seago concludes that the correlation between sales and shrinkage at the surrogate pool level is strong and that comparable results would be achieved if sales and shrinkage for the actual lifo pools were available shrinkage accrual accuracy analysis dr seago believes that the 10-year correlation analysis demonstrating a correlation between sales and shrinkage with respect to target leads to the conclusion that the divisions' shrinkage method sec_4 are theoretically correct methods dr seago acknowledges however that the next step is to determine whether those methods were properly applied he recognizes that a comparison of the shrinkage verified by physical count with the shrinkage claimed by petitioner for the taxable_year is of limited significance because the comparison would be of figures for two different periods in an attempt to analyze the accuracy of the divisions' shrinkage methods and to compare those methods with respondent's method dr seago developed a model to determine taxable_year shrinkage he applied that model to data for target during the taxable years that ended in through dr seago believes that when a physical inventory is taken at the close of a period that includes portions of taxable it should be noted that dr seago refers to both target' sec_4 shrinkage method and dayton's shrinkage method as dayton hudson's method without distinction although there are many significant similarities between the two methods this court will evaluate the two methods independently and refer to the two methods as the divisions' shrinkage methods only for convenience and when there are no relevant distinctions years and an accrual error is detected some portion of that error is attributable to each of the taxable years with support from the results of the 10-year correlation analysis dr seago assumed that sales and shrinkage were perfectly correlated throughout the year and thus determined that any accrual error should be allocated according to the relative sales between the two relevant taxable years to arrive at a figure for taxable_year shrinkage dr seago examined target's sales figures for the taxable years ending in and and determined that approximately percent of sales between physical inventory dates are allocable to the taxable_year prior to the taxable_year in which the physical inventory is taken as a result dr seago allocated percent of the applicable accrual error to the taxable_year prior to the taxable_year in which the physical inventory was taken and percent to the taxable_year in which the physical inventory was taken dr seago compared his resulting figures for taxable_year shrinkage sales-allocated taxable_year shrinkage with the shrinkage claimed by target for tax purposes and the shrinkage that would be allowed under respondent's method dr seago's analysis produced the following results these tables contain a few minor computational errors and we have taken the liberty of calculating the aggregate percentage difference using dr seago's numbers target's shrinkage method target book taxable sales- shrinkage minus difference as year target allocated sales-allocated percent of ending book taxable_year taxable_year sales-allocated in shrinkage shrinkage shrinkage shrinkage dollar_figure dollar_figure dollar_figure big_number big_number big_number big_number big_number -big_number -9 big_number big_number big_number big_number big_number -big_number -0 respondent's method - target division verified taxable loss sales- loss minus difference as year verified by allocated sales-allocated percent of ending physical taxable_year taxable_year sales-allocated in inventory_shrinkage shrinkage shrinkage dollar_figure dollar_figure -dollar_figure -13 big_number big_number -big_number -18 big_number big_number -big_number -11 big_number big_number -big_number -1 big_number big_number -big_number -10 dr seago determined that target's estimates of taxable_year shrinkage produced in the aggregate a net underestimate in the amount of dollar_figure for the taxable years ending in through when compared to sales-allocated taxable_year shrinkage he also determined that the maximum error under target's shrinkage method was dollar_figure percent of sales-allocated taxable_year shrinkage from that analysis dr seago concludes that the divisions' shrinkage methods produced a reasonably accurate measure of the loss occasioned by shrinkage factors dr seago notes that in contrast respondent's method yields a cumulative overstatement of income in the amount of dollar_figure dr seago concludes that respondent's method contains a systematic bias towards the understatement of losses during periods when sales are increasing sales percentage shrinkage analyses to further examine the accuracy of target's shrinkage method dr seago computed for each target store during the taxable years ending in through the verified shrinkage between physical inventory dates as a percentage of sales for that period actual shrinkage the shrinkage estimates accrued in book inventory as a percentage of sales for the same period estimated shrinkage and the difference between and dr seago hypothesized that if target could accurately predict shrinkage between physical inventory dates ie the difference between actual and estimated shrinkage is small target should likewise accurately predict shrinkage for the taxable_year dr seago's calculations revealed that over the period examined the simple average difference between actual and estimated shrinkage was dollar_figure percent of sales and the weighted average weighted by sales difference was dollar_figure percent of sales that difference represents approximately percent of actual shrinkage in addition dr seago performed a regression analysis comparing sales and shrinkage for each target store during the taxable years ending in through he determined an r2 of dr seago explains that finding by stating while an accrual based solely on the historical relationship between sales and shrinkage would result in substantial errors in predictions target personnel are able to significantly reduce the error by adjusting the accrual factor to take into account factors known to contribute to shrinkage in the particular store dr seago asserts that the demonstrated success of target in predicting store shrinkage suggests that target likewise accurately predicts shrinkage at the department level dr seago also presents a sales percentage shrinkage analysis for target at the aggregate division level he states that from through verified shrinkage has averaged percent of sales with a range of dollar_figure percent to dollar_figure percent dr seago states that target's estimates of shrinkage as a percentage of sales when compared to the verified percentage showed that the estimates deviated from the actual figures by no more than percent that analysis of the relationship between sales and shrinkage at the individual store level appears in dr seago's rebuttal report and is distinct from the 10-year correlation analysis dr seago's criticism of respondent's method dr seago states that the shortcomings of respondent's method are that the loss for the taxable_year is dependent on the date of the physical inventories and losses actually attributable to a prior taxable_year are included in the loss for the current_year and losses attributable to the current taxable_year are deducted in the following taxable_year dr seago asserts that respondent's method contains a systematic bias towards understating losses when sales are increasing f respondent's expert testimony introduction respondent presents the testimony of two experts dennis j gaffney ph d a professor of accounting at the university of toledo and david w larue ph d an associate professor of commerce at the university of virginia dr gaffney dr gaffney was requested to render an opinion as to whether the divisions' shrinkage methods were appropriate for financial_accounting and reporting purposes and if so the degree of error in estimating shrinkage that could be tolerated for those purposes although dr gaffney's opinions on those issues are not relevant with respect to the issue of clear_reflection_of_income for tax purposes we believe that dr gaffney's comparison of target's verified and accrued shrinkage in retail sales figures for inventory periods that ended in taxable years ending in through nevertheless provides an important perspective on sales and shrinkage data for target that comparison produced the following results target - comparison of verified and accrued shrinkage for inventory periods7 verified shrinkage accrued shrinkage accrued minus verified tye in dollar_figure sales dollar_figure sales dollar_figure sales difference big_number dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure dollar_figure big_number dollar_figure big_number dollar_figure -580 -dollar_figure -dollar_figure big_number dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure big_number dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure big_number dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure big_number dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure big_number dollar_figure big_number dollar_figure -big_number -dollar_figure -dollar_figure big_number dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure big_number dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure big_number dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure big_number dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure big_number dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure dr gaffney notes that the columns may not foot and crossfoot due to rounding in addition he notes that the data for which was provided by petitioner do not appear mathematically correct and the data include warehouse shrinkage that was computed separately in that year lastly we have taken the liberty of deleting dr gaffney's aggregate calculations because those calculations did not take into account the adjustment to book_inventories following physical inventories big_number dollar_figure big_number dollar_figure big_number dollar_figure dollar_figure dr gaffney observed that out of the years considered by him an overaccrual of shrinkage was made in of those years dr larue dr larue testified to among other things the tax effects resulting from the accrual of erroneous estimates of unverified shrinkage shrinkage estimation errors he designed simulation models to analyze shrinkage estimation errors that result from the use of cycle counting in conjunction with the lifo retail_method dr larue believes that the lifo retail_method imposes certain additional demands on any method of shrinkage estimation to better appreciate dr larue's assertion we must acquire a basic understanding of the lifo retail_method see sec_1_471-8 sec_1_472-1 sec_1_472-8 income_tax regs the lifo retail_method is a method of inventory_valuation designed to meet the special needs of high volume retailers dealing in a wide variety of merchandise in general terms the sales at retail for an accounting_period are subtracted from the retail value of goods available for sale during that period to produce a figure for the retail value of ending inventory that figure for the retail value of ending inventory must be converted into a figure for cost of ending inventory which can be subtracted from cost of goods available for sale during that period to produce a figure for cost_of_goods_sold in simplified terms the process of converting the current_year retail value of ending inventory to cost of ending inventory involves dividing the current_year retail value of ending inventory by the current retail price index which for retailers using u s bureau of labor statistics bls indexes is the current bls price index for the particular inventory_pool divided by the bls price index for the year in which that pool was adopted base_year to yield a figure for current_year retail value of ending inventory expressed in base_year dollars comparing that result to a similar figure computed as of the end of the immediately preceding accounting_period reveals whether an increment or decrement in the quantity of goods has occurred as of the end of the period as opposed to mere changes in retail price levels if there has been no decrement in the quantity of goods as of the end of the period cost of ending inventory is the sum of the prior year's cost of ending inventory plus the cost of the quantity of inventory in the current increment if any the retail value of the increment expressed in base_year dollars is multiplied by the current year's retail price index and then multiplied by the cost complement8 to arrive at the cost generally the cost complement is the weighted average relationship between the cost of current_year purchases and the continued of the increment in the quantity of goods in the event of a decrement the decrease is subtracted from the annual layers of the period's beginning_inventory in reverse chronological order those procedures are applied to each lifo_pool which generally maintains its own set of bls indexes cost complement layer structure and other pool attributes having acquired a basic understanding of the lifo retail_method we can better analyze dr larue's criticism of the divisions' shrinkage methods dr larue believes that the process of making corrections to shrinkage estimates in the subsequent year is inadequate because changes in lifo_pool attributes such as bls indexes and cost complements prevent corrections from accurately offsetting previous shrinkage estimation errors in the earlier year in addition dr larue asserts that the varying tax effects of shrinkage estimation errors among lifo pools which is a product of differing pool attributes even undermines the validity of a methodology that in the aggregate produces an accurate estimate of taxable_year shrinkage in sum dr larue believes that cycle counting and the lifo retail_method impose significant additional demands on the design and implementation of a methodology that might be continued retail value assigned to those purchases considered capable of producing sound accruals of shrinkage losses in addition dr larue considered target's shrinkage method and concluded as follows in my opinion the methodology employed by target to forecast its shrinkage experience and to then allocate that forecast to each of the departments in each of its stores for the purpose of accruing these losses in its books_and_records fails to evidence the objectivity and verifiability required to establish the overall process as a sound method that can be expected to clearly reflect its income that opinion according to dr larue is based on target's failure to directly consider a department's actual shrinkage experience in setting that particular department's shrinkage rate coupled with the inability of a disinterested party with full knowledge of all relevant data to independently reconstruct the forecasted shrinkage derived by target's shrinkage method dr larue disagrees with dr seago's conclusion that the divisions' shrinkage methods produce reasonably accurate estimates of losses from shrinkage factors dr larue believes that the tax effects of shrinkage estimation errors are not the result of errors at the aggregate level because shrinkage is accrued at the store and department levels and therefore minimal errors at the aggregate level are misleading dr larue states i think he dr seago is looking at the wrong phenomena i think it doesn't matter a whole lot it matters but it doesn't matter a whole lot whether our shrinkage estimation methodology produces very small or very large errors at the aggregate level shrinkage is not accrued at the aggregate level dr larue believes that notwithstanding a net figure of zero at the aggregate level the fact that retail dollars of shrinkage have to be converted into cost dollars among the various lifo pools which pools utilize diverse conversion processes ie differing bls indexes and cost complements undermines the significance of dr seago's shrinkage accrual accuracy analysis dr larue acknowledges however that a finding of low shrinkage estimation error at the aggregate level is not irrelevant indeed he believes that such a finding creates a presumption of a pretty good model in addition dr larue although in agreement with dr seago's mathematics questioned the significance of the high correlation between sales and shrinkage derived from the 10-year correlation analysis dr larue conducted his own analysis of target data and concludes that the correlation between sales and shrinkage disintegrates as the level of analysis moves from the target-wide level to the department and store levels g evaluation of expert testimony origin of shrinkage estimation errors an inquiry into the origin of shrinkage estimation errors provides the proper perspective to evaluate dr larue's criticism that the divisions' shrinkage methods are inherently flawed because the additional demands of the lifo retail_method prevent accurate subsequent year corrections of shrinkage estimation errors if physical inventories were required to be taken at yearend taxable_year shrinkage would be known with certainty and no estimate of yearend shrinkage would be necessary physical inventories however are not required to be taken at yearend sec_1_471-2 income_tax regs once the secretary decided not to require physical inventories at yearend see dayton hudson corp subs v commissioner t c pincite sec_1_471-2 income_tax regs and taxpayers began to exercise the privilege of computing yearend inventories from book inventory records estimations of yearend shrinkage became inescapable whether the method of estimating yearend shrinkage involves calculation the divisions' shrinkage methods or substitution respondent's method the realization that estimates of yearend shrinkage are an inescapable byproduct of cycle counting reveals that dr larue's criticisms are in fact a condemnation of cycle counting by means of highlighting the additional demands of the lifo retail_method which are just as applicable to respondent's method in other words errors resulting from respondent's method of substituting yearend shrinkage for the taxable_year with yearend shrinkage for the prior taxable_year are subject_to the same problems of varying tax effects arising from changing lifo_pool attributes and dissimilar pool attributes among pools respondent’s proposed adjustments will not eliminate the flaws perceived by dr larue it appears that only the practice of yearend physical inventories at all stores or departments could eliminate such errors that however would not be practical nor is it required by the regulations see sec_1_471-2 income_tax regs in sum we consider dr larue's objection as an inherent component of all estimates of yearend shrinkage dr seago as a preliminary matter dr seago in his report and in his testimony at trial made clear that his opinions regarding clear_reflection_of_income were made in the context of financial_accounting principles and not tax_accounting principles in addition dr seago at trial acknowledged that he had not reviewed directly any taxpayer's method_of_accounting for inventory_shrinkage other than the divisions' shrinkage methods although we consider dr seago's concessions in evaluating the weight of his testimony this court will focus on the substance of his analyses we first consider dr seago's shrinkage accrual accuracy analysis under the cycle method of counting used by the divisions yearend inventories are not ordinarily taken and thus whether the divisions’ shrinkage methods clearly reflect income is not a fact that petitioner can prove simply by comparing the shrinkage claimed by target and by dayton's for the taxable_year to actual taxable_year shrinkage figures petitioner must rely on an indirect method of proof that is why petitioner relies on the expert testimony of dr seago dr seago developed a model for determining taxable_year shrinkage first dr seago assumed that sales and shrinkage are perfectly correlated based on his findings in the 10-year correlation analysis supra section vi e as we have stated dr seago allocated percent of any accrual error to the taxable_year prior to the taxable_year in which the physical inventory was taken and percent to the taxable_year in which the physical inventory was taken that allocation of the accrual error in conjunction with the aggregate of monthly accruals for shrinkage for the relevant taxable years yielded in dr seago's opinion the best estimate of taxable_year shrinkage ie sales-allocated taxable_year shrinkage dr larue criticizes dr seago for aggregating sales and shrinkage figures at the target-wide level dr larue believes that variances in lifo_pool attributes and discontinuities in the timing of the physical inventories throughout the taxable_year render the aggregate data virtually meaningless although we appreciate dr larue's criticism we believe that an analysis of divisionwide or companywide data is not necessarily without merit especially when an analysis of such data exposes relative differences between methods at the aggregate level see kroger co subs v commissioner tcmemo_1997_2 accepting the taxpayer's presentation of an aggregate analysis which compared the taxpayer's method with the commissioner's method based on an allocation of cross-year inventory_shrinkage as a function of time this court found the aggregate analysis dispositive of whether there was an abuse_of_discretion by the commissioner taxable_year shrinkage estimates derived by a taxpayer's shrinkage method and by the commissioner's method must be subjected to the same indexes and cost complements when converting from retail to cost and thus relative differences between two methods at the aggregate level may be significant this court however agrees with dr larue when aggregate data is used for other purposes in particular we have difficulty accepting the significance of dr seago's 10-year correlation analysis which found a strong correlation between sales and shrinkage for target during the years through and which underlies dr seago's shrinkage accrual accuracy analysis at the most basic level it appears that changes in the divisions’ lifo_pool attributes from year to year differences in attributes among pools and discontinuities in the timing of physical inventories from year to year combine to produce sales and shrinkage figures that represent different variables from year to year we understand correlation for present purposes as a measure of the degree to which two variable but consistently constituted quantities tend to change with respect to each other and not as a measure of the degree to which two inconsistently constituted quantities change with respect to each other essentially dr seago has not persuaded this court that the strong correlation between sales and shrinkage derived from the 10-year correlation analysis is the product of the true relationship between sales and shrinkage and not the product of the confluence of varying lifo_pool attributes dr seago has failed to explain that apparently fundamental flaw in the 10-year correlation analysis that is not to say that we would never accept statistical analyses demonstrating a correlation between sales and shrinkage that is only to say that dr seago in this case has simply failed to prove the significance of the correlation derived from the 10-year correlation analysis dr seago recognizes that an it should be noted that in kroger co subs v commissioner tcmemo_1997_2 we stated although we accept dr bates' opinion as to the correlation between sales and shrinkage at the business level and we are impressed by dr bates' sales-based accuracy analysis we are hesitant to rest our conclusion as to the accuracy of the retailers' shrinkage method on a correlation whose significance we may not fully appreciate similarly in this case although we accept dr seago's opinion that the data he examined in the 10-year correlation analysis revealed a strong correlation dr seago has not demonstrated the continued analysis of the correlation between sales and shrinkage at the lifo_pool level would produce a more meaningful correlation and attempts to examine that correlation by the creation of surrogate pools in the absence of such data we are not convinced by dr seago's analysis of hypothetical pools of data derived from randomly placing individual target stores into pools because that approach divorces particular sales and shrinkage figures for each actual pool from the corresponding pool attributes the preservation of that relationship is precisely the purpose of analyzing sales and shrinkage data at the lifo_pool level because we are reluctant to accept dr seago's 10-year correlation analysis his shrinkage accrual accuracy analysis does not persuade us that target's shrinkage method clearly reflects income that respondent's method does not clearly reflect income or that target's shrinkage method more clearly reflects income when compared to respondent's method dr seago allocated accrual errors under the assumption which was derived from the 10-year correlation analysis that sales and shrinkage are perfectly correlated in addition target's monthly accruals for shrinkage were made as a percentage of sales therefore dr seago's estimate of the actual taxable_year shrinkage--sales- allocated taxable_year shrinkage--relies entirely on the critical continued significance of that finding to the issue of clear_reflection_of_income assumption that sales and shrinkage are sufficiently correlated so that the sum of aggregate monthly shrinkage accrued as a percentage of sales for the taxable_year adjusted for an allocation of any accrual error based on a ratio of relative sales between the relevant taxable years yields a figure for taxable_year shrinkage that would clearly reflect incomedollar_figure although we believe that sales have some value as a predictor of shrinkage at the target-wide level we simply cannot accept the critical_assumption that underlies dr seago's shrinkage accrual accuracy analysis dr seago did not conduct an analysis of the correlation between sales and shrinkage or a shrinkage accrual accuracy analysis for data derived from the operations of dayton’s we assume that petitioner wishes that we infer both a strong correlation between sales and shrinkage and a favorable shrinkage in addition this court has difficulty with dr seago's shrinkage accrual accuracy analysis for other reasons target's shrinkage method results in the accrual of shrinkage based on a rate set at the beginning of the taxable_year for each department within each store thus conceivably a department within a store could accrue shrinkage at two different rates during the cross-year inventory period eg percent of sales during the taxable year's physical-to-yearend period and percent of sales during the period prior to the physical inventory in the next taxable_year an allocation of any accrual error only as opposed to an allocation of total verified shrinkage is inconsistent with the underlying assumption that sales and shrinkage are perfectly correlated in the same vein dr seago allocates accrual error based on a ratio that is an approximation of the relative sales between the relevant taxable years and not the actual cross-year sales percentages accrual accuracy analysis for dayton's based on the analyses of target data even if this court were to engage in that type of speculation our rejection of the analyses with respect to target renders that method of proof ineffectual in addition petitioner presents evidence demonstrating that the aggregate estimated shrinkage rates of dayton’s for inventory periods spanning the taxable_year in issue are less than the verified rates of shrinkage for the same periods that evidence without more does not provide a basis to evaluate clear_reflection_of_income for the taxable_year in issue for the reasons set forth in our discussion that follows of dr seago's sales percentage shrinkage analyses based on target data dr seago presents analyses that compare actual and estimated shrinkage rates as a percentage of sales for physical inventory periods sales percentage shrinkage analyses see supra sec vi e those analyses were conducted at both the store and target-wide levels not only are we unimpressed by dr seago's results we have reservations about his assumptions dr seago's analyses compare results for inventory periods and not the taxable_year or any other taxable_year an identity of results between actual and estimated shrinkage rates as a percentage of sales for inventory periods does not tell us anything about the relative distribution of losses from shrinkage factors within those inventory periods thus unless sales and shrinkage are correlated evidence of an identity between actual and estimated shrinkage rates for an inventory period is no evidence that the shrinkage estimation rate for the inventory period is accurate for that portion of a taxable_year that falls within but is not identical to the inventory perioddollar_figure we rejected above a general correlation between sales and shrinkage based on the 10-year correlation analysis in addition dr seago derived only an r2 of from his disaggregated analysis of target stores during the taxable years ending in through in sum we cannot accept dr seago's assumption of a strong correlation between sales and shrinkage and therefore dr seago's sales percentage shrinkage analyses do not persuade us that the divisions' shrinkage methods clearly reflect income the requirement of the assumption that sales and shrinkage are correlated is illustrated by the following example assume that x co is a calendar_year taxpayer has an inventory period from apr to mar has no sales from date to date and dollar_figure of shrinkage for that period has dollar_figure of sales from date to date and no shrinkage for that period has no sales from date to date and dollar_figure of shrinkage for that period and accrued shrinkage at a rate of percent of sales for all relevant periods upon the physical inventory on date x co 's records would indicate dollar_figure of sales and dollar_figure of shrinkage during the inventory period thus verified shrinkage of percent of sales would correspond to accrued shrinkage of percent of sales the identity of results for the inventory period does not correspond to an identity of results for the taxable_year because actual shrinkage for the taxable_year wa sec_1 percent of sales that discrepancy exists because the example did not assume that sales and shrinkage are correlated lastly dr seago criticizes respondent's method as containing a systematic bias towards understating losses when sales are increasing the validity of that assertion also relies on a strong correlation between sales and shrinkage although respondent's method is merely another method of estimating losses from shrinkage factors for the taxable_year see supra section vi d dr seago's unproven assertion however does not convince us that respondent's method does not clearly reflect income h is respondent's determination that the divisions' shrinkage methods do not clearly reflect income and that respondent's method does clearly reflect income an abuse_of_discretion petitioner has a heavy burden to prove that respondent's determination that target's shrinkage method and dayton's shrinkage method do not clearly reflect income and that respondent's method does clearly reflect income is an abuse_of_discretion see supra sec vi b we find no such abuse_of_discretion here but cf kroger co subs v commissioner tcmemo_1997_2 finding an abuse_of_discretion wal-mart stores inc v commissioner tcmemo_1997_1 same petitioner relies on the testimony of dr seago who asserts that both target's shrinkage method and dayton's shrinkage method produce reasonably accurate shrinkage accruals and that those methods clearly reflect income dr seago also asserts that respondent's method does not clearly reflect income the critical_assumption upon which all of dr seago's conclusions rely is the existence of a strong correlation between sales and shrinkage derived from the 10-year correlation analysis we cannot take the inferential leap that is required to accept that assumption in light of respondent's broad discretion to determine clear_reflection_of_income this court cannot accept the significance of dr seago's 10-year correlation analysis because we cannot overlook the fact that aggregate sales and shrinkage data at the target-wide level consist of sales and shrinkage figures from numerous lifo pools which each have different pool attributes that vary from year to year in addition we are not persuaded by any of the other evidence presented by petitioner in this case therefore respondent's determination that the divisions' shrinkage methods do not clearly reflect income and that respondent's method does clearly reflect income is not an abuse_of_discretion vii conclusion the divisions' systems of maintaining book_inventories do not clearly reflect income they are thus not sound within the meaning of sec_1_471-2 income_tax regs to reflect the foregoing decision will be entered for respondent


department of the treasury internal_revenue_service washington d c tax exempt and son es mar uniform issue list haakkkkakakrkekeaeen kaaakkikaaakaaa ie hukaehakkkkkehkkkakae legend taxpayer a eere eere heed taxpayer b plan x t m heraekekaenaekkakkkkk hhaaekakkkaaakaatkkk employer a rakkeaauekkaakaraaee amount gan r rrr rar er rr rr dear rekkarkkatakkehaeceee this is in response to your request dated in which you request a waiver of the 60-day rollover requirement contained in sec_402 of the internal_revenue_code the code the following facts and representations have been submitted under penalty of perjury in support of the ruling requested taxpayer a represents that taxpayer b received a distribution from plan x totaling amount taxpayer a asserts that the failure to accomplish a rollover within the 60-day period prescribed by sec_402 was due to the fact that taxpayer b entered the hospital and passed away during the 60-day period taxpayer b ended his employment at employer a in unbeknownst to him plan x had a cash out’ provision that mandated complete distribution of plan assets upon the participant's attainment of years of age taxpayer b received a check for amount dated and initiated arrangements to move the funds to an individual in the meantime retirement account in order to maintain the funds in a tax free vehicle taxpayer b had deposited amount into a joint account with taxpayer a between the bp le sore e page time of the distribution from plan x and his scheduled rollover taxpayer b became ill and passed away taxpayer a sought to complete the rollover intended by her husband based on the facts and representations you request a ruling that the internal_revenue_service waive the day rollover requirement with respect to the distribution of amount contained in sec_402 of the code in this instance and allow taxpayer ato make a rollover_contribution to a tax-deferred vehicle in her name sec_402 of the code provides that if any portion of the balance_to_the_credit of an employee in a qualified_trust is paid to the employee in an eligible_rollover_distribution and the distributee transfers any portion of the property received in such distribution to an eligible_retirement_plan and in the case of a distribution_of_property other than money the amount so transferred consists of the property distributed then such distribution to the extent transferred shall not be includible in gross_income for the taxable_year in which paid sec_402 states that such rollover must be accomplished within days following the day on which the distributee received the property an individual_retirement_account ira constitutes one form of eligible_retirement_plan that the secretary may sec_402 of the code provides in relevant part waive the 60-day requirement under sec_402 where the failure to waive such requirement would be against equity or good conscience including casualty disaster or other events beyond the reasonable control of the individual subject_to such requirement only distributions that occurred after date are eligible for the waiver under sec_402 of the code sec_402 of the code provides that if any distribution attributable to an employee is paid to the spouse of the employee after the employee’s death the preceding provisions of this subsection will apply as if the spouse was the employee sec_401 provides the rules for governing direct transfers of eligible rollover distributions sec_1 a of the income_tax regulations question and answer-15 provides in relevant part that an eligible_rollover_distribution that is paid to an eligible_retirement_plan in a direct_rollover is a distribution and rollover and not a transfer of assets and liabilities revproc_2003_16 2003_4_irb_359 date provides that in determining whether to grant a waiver of the 60-day rollover requirement pursuant to sec_402 of the code the service will consider all relevant facts and circumstances including errors committed by a financial_institution inability to complete a rollover due to death disability hospitalization incarceration restrictions imposed by a foreign_country or postal error the use of the amount distributed for example in the case of payment by check whether the check was cashed and the time elapsed since the distribution occurred is consistent the information presented and documentation submitted by taxpayer a with her assertion that taxpayer b’s failure to accomplish a timely rollover was caused by the death of taxpayer b prior to a completed rollover deceased it is impossible for taxpayer b to complete the proposed transaction since amount was received by taxpayer b from plan x prior to taxpayer b’s death because taxpayer b is page taxpayer a is precluded from rolling the funds over into a tax-deferred account in her name under sec_402 of the code therefore the service declines to grant a waiver of the 60-day rollover period and allow taxpayer a to roll the funds over into a tax-deferred account in her name no opinion is expressed as to the tax treatment of the transaction described herein under the provisions of any other section of either the code or regulations which may be applicable thereto this letter is directed only to the taxpayer who requested it sec_6110 of the code provides that it may not be used or cited as precedent if you wish to inquire about this ruling please contact 8hehereasif e identification_number sooo iiiiihiny ot a please address all correspondence to hakkar eeaenihne sincerely yours coble werkins carlton a watkins manager employee_plans technical group


internal_revenue_service number release date index numbers ------------------------------------------------------------ ------------------------------------------------------------ ----- ------------------------------------- ---------------------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact ------------------- id no ------------------ telephone number ---------------------- refer reply to cc psi b01 plr-104427-18 date august legend x ----------------------------------------------------- ------------------------------------------------------------------ d1 d2 d3 d4 d5 country ------------------------ ---------------------- ------------------ -------------------- ----------------------- ----------------------- dear -------------- this is in response to a letter dated date submitted on behalf of x by its authorized representatives x requests a ruling that x’s election to be classified as an association_taxable_as_a_corporation was an initial classification election and not a change in classification for purposes sec_301_7701-3 of the procedure and administration regulations and an extension of time under sec_301_9100-3 to file an election under sec_301_7701-3 to be treated as a partnership for federal tax purposes plr-104427-18 facts according to the information submitted x was formed on d1 under the laws of country x intended to be treated as a partnership for federal tax purposes effective d3 however x inadvertently failed to timely file form_8832 entity classification election to be treated as a partnership for federal tax purposes effective d3 instead on d4 x filed a form_8832 entity classification election requesting to be classified as an association_taxable_as_a_corporation effective d2 prior to d3 x had no assets income deductions liabilities bank accounts business operations or board meetings and was dormant law and analysis sec_301_7701-3 provides guidance on the classification of a foreign eligible_entity for federal tax purposes generally a foreign eligible_entity is treated as an association if all members have limited_liability unless the entity makes an election to be treated otherwise a foreign eligible_entity with two or more members having limited_liability may elect to be treated as a partnership pursuant to the rules of sec_301 c sec_301_7701-3 provides that an entity classification election must be filed on form_8832 and can be effective up to days prior to the date the form is filed or up to months after the date the form is filed sec_301_7701-3 provides in part that except as provided in c iv and v an eligible_entity may elect to be classified other than as provided under b or to change its classification by filing form_8832 entity classification election with the service_center designated on form_8832 sec_301_7701-3 provides that if an eligible_entity makes an election under sec_301_7701-3 to change its classification other than an election made by an existing entity to change its classification as of the effective date of this section the entity cannot change its classification by election again during the sixty months succeeding the effective date of the election however the commissioner may permit the entity to change its classification by election within the sixty months if more than fifty percent of the ownership interests in the entity as of the effective date of the subsequent election are owned by persons that did not own any interests in the entity on the filing_date or on the effective date of the entity’s prior election an election by a newly formed eligible_entity that is effective on the date of formation is not considered a change for purposes of sec_301_7701-3 under sec_301_9100-1 the commissioner may grant a reasonable extension of time to make a regulatory election or a statutory election but no more than six months except in the case of a taxpayer who is abroad under all subtitles of the internal_revenue_code except subtitles e g h and i sec_301_9100-1 defines the term plr-104427-18 regulatory election as including an election whose due_date is prescribed by a regulation published in the federal_register sec_301_9100-1 through provide the standards that the commissioner will use to determine whether to grant an extension of time to make an election sec_301_9100-1 sec_301_9100-2 provides automatic extensions of time for making certain elections sec_301_9100-3 provides rules for requesting extensions of time for regulatory elections that do not meet the requirements of sec_301_9100-2 requests for relief under sec_301_9100-3 will be granted when the taxpayer provides evidence to establish that the taxpayer acted reasonably and in good_faith and that granting relief will not prejudice the interests of the government conclusion based solely on the facts submitted and the representations made we conclude that x’s corporate classification election was an initial classification effective d2 and not a change in classification for purposes of sec_301_7701-3 as such a subsequent election by x to change its classification will not be subject_to the sixty months limitation set forth in sec_301_7701-3 further we conclude that the requirements of sec_301_9100-3 have been satisfied as a result x is granted an extension of time of days from the date of this letter to make an election to be treated as a partnership for federal tax purposes effective d3 x should make the election by filing a properly executed form_8832 with the appropriate service_center a copy of this letter should be attached to the form this ruling is contingent on the owners of x filing within days of this letter all required returns for all open years consistent with the requested relief these returns may include but are not limited to the following forms i forms information_return of u s persons with respect to certain foreign_corporations ii forms return of u s persons with respect to certain foreign_partnerships and iii forms information_return of u s persons with respect to disregarded entities such that these forms reflect the consequences of the relief granted in this letter a copy of this letter should be attached to any such returns except as expressly provided herein no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter this ruling is directed only to the taxpayer requesting it sec_6110 provides that it may not be used or cited as precedent plr-104427-18 in accordance with the power_of_attorney on file with this office a copy of this letter is being sent to your authorized representatives sincerely associate chief_counsel passthroughs special industries joy c spies joy c spies senior technician review branch office of the associate chief_counsel passthroughs special industries enclosures copy of this letter copy for sec_6110 purposes