Opinion ID: 757357
Heading Depth: 2
Heading Rank: 1

Heading: Use of Shrinkage Estimates to Reduce Ending Inventories

Text: 21 The general rule for inventory accounting is that: 22 Whenever in the opinion of the [Commissioner] 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 [Commissioner] 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. 23 I.R.C. § 471(a). 8 Determining the propriety of a taxpayer's reduction of ending inventories by estimated shrinkage requires construction of the relevant sections of the Internal Revenue Code (Code) and the regulations. 9 Thus, this issue presents a question of law subject to plenary review. See Musco Sports Lighting, Inc. v. Commissioner, 943 F.2d 906, 907 (8th Cir.1991). 24 It is undisputed that the use of inventories is necessary to determine income because the Taxpayer is engaged in the sale of merchandise. See Treas. Reg. § 1.471-1. An inventory method must (1) conform as nearly as may be to the best accounting practice in the trade or business, and (2) clearly reflect income. See Treas. Reg. § 1.471-2(a). The tax court analyzed the Taxpayer's inventory method under this two-prong test. The Commissioner contends that independent of this two-prong test, Treasury Regulation section 1.471-(2)(d) precludes the use of all shrinkage estimates. The regulation provides in relevant part: 25 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 (including the inventory at the beginning of the 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 verified by physical inventories at reasonable intervals and adjusted to conform therewith. 26 Treas. Reg. § 1.471-2(d). 27 The Commissioner interprets the regulation to provide that (1) the Taxpayer's book inventories, without adjustment for estimated shrinkage, will be deemed to reflect the costs of goods on hand at year-end, and (2) book inventories may be adjusted to reflect shrinkage only when a physical count is conducted. The Taxpayer contends that adjusted book inventories are deemed to reflect the cost of the goods on hand at year-end, if the adjustment is made in accordance with a sound accounting system. 28 The regulatory scheme recognizes that shrinkage occurs, as it provides that book inventories should be verified by physical inventories at reasonable intervals and adjusted to conform therewith. The Commissioner does not dispute that the proper way to account for verified shrinkage is to reduce book inventories, resulting in an increase to cost of goods sold. Nonetheless, the Commissioner asserts that book inventories may be reduced only by verified shrinkage and not with estimates. Nothing in the text of the regulation, however, distinguishes between estimated shrinkage and shrinkage that has been verified by physical count. We will not read in such a distinction. 29 Our reading comports with the background of the Commissioner's regulatory scheme. Prior regulations construing the predecessor to section 471 provided that physical inventories must be taken at year-end. See Regs. 45, art. 1588(3)(B) (1921). The Commissioner dispensed with that requirement in 1922. See Regs. 45, art. 1582, as amended by T.D. 3296, I-1 C.B. 40 (1922) (providing that physical inventories need not be taken at year-end, but only at reasonable intervals). In removing the burdensome year-end physical inventory requirement, the Commissioner opened the door to the industry practice of estimating shrinkage during the stub period. Nothing in the Commissioner's regulatory scheme, which provides that book inventories may substitute for year-end physical inventories, prohibits the reduction of ending inventories to account for estimated inventory shrinkage. Moreover, the accrual method of accounting contemplates the use of estimates. See, e.g., Treas. Reg. § 1.461-1(a)(2)(ii). Accordingly, we construe Treasury Regulation section 1.471-2(d) to provide that book inventories, as adjusted for estimated stub period shrinkage, are deemed to be the cost of the goods on hand provided that (1) such inventories are maintained in accordance with a sound accounting system; (2) goods are valued at actual cost; and (3) physical inventories are taken at reasonable intervals. 30 Here, the second and third criteria are not at issue. The only controversy is whether the Taxpayer maintain[ed] book inventories in accordance with a sound accounting system. The regulations do not define sound accounting system, and we find no plausible construction of the phrase that would exclude the use of shrinkage estimates. See Dayton Hudson I, 101 T.C. at 468. In mandating a sound accounting system, we find that the regulation prescribes no higher standard than that of section 471(a), which requires that an inventory method must conform to the best accounting practice in the industry and result in a clear reflection of income. 10 I.R.C. § 471(a). 31 The phrase best accounting practice in the industry is synonymous with GAAP. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532, 99 S.Ct. 773, 58 L.Ed.2d 785 (1979). The tax court found, and the Commissioner concedes on appeal, that the Taxpayer's use of shrinkage estimates conformed to GAAP. We thus conclude that Treasury Regulation section 1.471-2(d) permits the Taxpayer's method of estimating shrinkage provided that such method resulted in a clear reflection of income. We will analyze the Taxpayer's particular method in Part IIB. 32 We reject the Commissioner's argument that permitting the reduction of ending inventories by estimated shrinkage runs afoul of the Supreme Court's decision in Thor Power Tool. In Thor Power Tool, the taxpayer, in accordance with GAAP, wrote-down certain excess inventory to its net realizable value, which in most cases was its scrap value. 439 U.S. at 530, 99 S.Ct. 773. However, despite taking the inventory write-down, the taxpayer continued to offer the inventory for sale at full price. See id. at 529, 99 S.Ct. 773. The Court applied the regulations to the facts and held that the Commissioner properly disallowed the taxpayer's write-down as not clearly reflecting income because the taxpayer's method was plainly inconsistent with the Regulations. Id. at 538, 99 S.Ct. 773. In Thor Power Tool, the regulations clearly articulated when a taxpayer could value inventory below its market value, which is distinct from the present situation because, here, the Taxpayer's method is not clearly covered by the relevant regulations. 33 The Commissioner additionally contends that the Taxpayer's reduction of ending inventories for estimated shrinkage was actually a deduction for a reserve, which may not be taken unless Congress has specifically so provided. See id. at 541-44, 99 S.Ct. 773. A reserve is used to set aside funds for an estimated future loss or expense. Id. at 542, 99 S.Ct. 773. Here, the Taxpayer estimated the amount of shrinkage that had actually occurred during the stub period, not a loss that may occur in the future. Therefore, estimated shrinkage is not an impermissible reserve. 34 In sum, the Commissioner's arguments are unavailing, and we find nothing within the relevant statutes, regulations, or case law that prohibits the use of shrinkage estimates. 35