rp-98-29.pdf

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Part III - Administrative, Procedural, and Miscellaneous
26 CFR 601.204: Changes in accounting periods and in methods of
accounting.

(Also Part I, §§ 471; 1.471-2.)

Rev. Proc. 98-29

# SECTION 1. PURPOSE

This revenue procedure provides guidance for a taxpayer that
wants to change to a method of accounting for estimating inventory
"shrinkage" in computing ending inventory. "Shrinkage" refers
collectively to such items as undetected theft, breakage, and
bookkeeping errors. In addition, section 4 of this revenue procedure
provides interim guidance that describes the "retail safe harbor
method" for a taxpayer that wants to change to the retail safe harbor
method for estimating inventory shrinkage. The procedures for a
taxpayer within the scope of this revenue procedure to automatically
change to a method of accounting for estimating inventory shrinkage
are provided in Rev. Proc. 97-37, 1997-33 I.R.B. 18, as modified by
section 5.02 of this revenue procedure. This revenue procedure also
requests comments on issues that should be addressed in forthcoming
regulations under § 471 regarding proper methods of estimating
inventory shrinkage for taxable years ending after August 5, 1997.
SECTION 2. BACKGROUND

. 01 Section 471 (a) of the Internal Revenue Code provides that
whenever, in the opinion of the Secretary, the use of inventories is
necessary in order to clearly determine the income of any taxpayer,
inventories must be taken by such taxpayer on such basis as the
Secretary may prescribe as conforming as nearly as may be to the best

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accounting practice in the trade or business and as most clearly
reflecting income.

. 02 Section 1.471-2 (d) of the Income Tax Regulations provides
that when a taxpayer maintains book inventories in accordance with a
sound accounting system, the net value of the inventory will be deemed
to be the cost basis of the inventory, provided that such book
inventories are verified by physical inventories at reasonable
intervals and adjusted to conform therewith. Physical inventories are
used to determine and adjust book inventories for shrinkage.

. 03 Section 961 of the Taxpayer Relief Act of 1997 (Act) amended
§ 471 (b) to permit, under certain circumstances, adjustments to ending
inventory for estimates of inventory shrinkage. Section 961 (b) of the
Act provides that, in the case of any taxpayer permitted by § 471 (b)
to change its method of accounting to a permissible method for any
taxable year, the change is treated as made with the consent of the
Secretary and the period for taking into account the adjustments under
§ 481 by reason of such change is four years.

. 04 The legislative history (Conference Report and House Report)
accompanying the Act provides that a taxpayer is permitted by § 471 (b)
to change its method of accounting if the taxpayer is currently using
a method that does not utilize estimates of inventory shrinkage and
wants to change to a method that includes inventory shrinkage
estimates based on physical inventories taken at other than year-end.
H.R. Rep. No. 220 (Conference Report), 105th Cong., 1st Sess. 466, at
467-68 (1997) ; H.R. Rep No. 2014 (House Report), 105th Cong., 1st
Sess. 408, at 410 (1997). In addition, the Conference Report provides

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a safe harbor method applicable to taxpayers primarily engaged in
retail trade (the "retail safe harbor method"). The Conference Report
further provides that the conferees expect that the Secretary will
provide procedures allowing a taxpayer to automatically change to the
retail safe harbor method. Pursuant to the Conference Report, use of
the retail safe harbor method will be deemed to result in a clear
reflection of income, provided such safe harbor method is consistently
applied and the taxpayer's inventory methods otherwise satisfy the
clear reflection of income standard.

SECTION 3. SCOPE

. 01 Applicability. This revenue procedure applies to a taxpayer
requesting the Commissioner's consent to change to a method of
accounting for estimating inventory shrinkage in computing ending
inventory, using:

(1) the retail safe harbor method, regardless of whether
the taxpayer's present method of accounting estimates inventory
shrinkage; or

(2) a method other than the retail safe harbor method,
provided (a) the taxpayer's present method of accounting does not
estimate inventory shrinkage, and (b) the taxpayer's new method of
accounting (that estimates inventory shrinkage) clearly reflects
income under § 446 (b) .

. 02 Inapplicability. This revenue procedure does not apply to a
taxpayer requesting to change to a method other than the retail safe
harbor method of accounting for estimating inventory shrinkage in
computing ending inventory, if the taxpayer's present method of

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accounting estimates inventory shrinkage. A taxpayer requesting such
a change must file a Form 3115, Application for Change in Accounting
Method, with the Commissioner in accordance with the requirements of
$1.446-1 (e) (3) (i) and Rev. Proc. 97-27, 1997-21 I.R.B. 10.
SECTION 4. RETAIL SAFE HARBOR METHOD

. 01 The retail safe harbor method of estimating inventory
shrinkage, as described in sections 4.02 through 4.07 of this revenue
procedure, may be used in computing ending store inventory by
taxpayers that are primarily engaged in retail trade (the resale of
personal property to the general public), where physical inventories
are normally taken at each location at least annually.

. 02 The retail safe harbor method uses a historical ratio of
shrinkage to sales to estimate the inventory shrinkage that occurred
between the date of the last physical inventory and the end of the
taxable year. This historical ratio is based on the actual shrinkage
established by all physical inventories taken during the most recent
three taxable years and the sales for related periods. The most
recent three taxable years include the taxable year for which the
shrinkage estimate is to be made and the two prior taxable years. The
historical ratio, or estimated shrinkage determined using the
historical ratio, cannot be adjusted by judgmental or other factors
(for example, floors or caps) .

. 03 For stores with departments, a taxpayer must determine the
historical ratio separately for each store or each department in a
store. This determination must be done in the same manner for all
stores with departments that are in the same trade or business of the

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taxpayer. For stores without departments, a taxpayer must determine
the historical ratio separately for each store. If a taxpayer has a
new store (or a new department in a store) for which the taxpayer has
not verified shrinkage by a physical inventory in each of the most
recent three taxable years, the historical ratio is the average of the
historical ratios of the taxpayer's other stores (or other departments
in the store where the taxpayer computes the historical ratio on a
department basis) during the most recent three taxable years.

. 04 The estimated inventory shrinkage permitted by the retail
safe harbor method is determined by multiplying the historical ratio
for each store or each department in a store by its sales for the
period between the date of the last physical inventory and the end of
the taxable year.

. 05 Taxpayers using the last-in first-out (LIFO) inventory
method must allocate shrinkage among their various LIFO inventory
pools in a reasonable and consistent manner.

. 06 Estimated shrinkage determined in accordance with consistent
application of the retail safe harbor method may not be recalculated,
through a look-back adjustment or otherwise, to reflect the results of
physical inventories taken after year-end.

. 07 A taxpayer that changes to the retail safe harbor method
must use the retail safe harbor method consistently to determine the
ending inventory for all stores that comprise a separate trade or
business of the taxpayer. Use of the retail safe harbor method for
estimating inventory shrinkage results in the clear reflection of
income, provided this method is used consistently and the taxpayer's

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inventory methods otherwise satisfy the clear reflection of income
standard.

SECTION 5. CHANGING TO THE RETAIL SAFE HARBOR METHOD OR OTHER
METHOD OF ESTIMATING INVENTORY SHRINKAGE

. 01 In general. Any change in a taxpayer's computation of
ending inventory to estimate inventory shrinkage, or any change in the
computation of such estimate, is a change in method of accounting to
which the provisions of $$ 446 and 481 and the regulations thereunder
apply.

. 02 Automatic change. A taxpayer within the scope of this
revenue procedure that wants to change to a method of accounting for
estimating inventory shrinkage in computing ending inventory must
follow the automatic change in accounting method provisions of Rev.
Proc. 97-37, with the following modifications:

(1) The scope limitations in section 4.02 of Rev. Proc. 97-
37, as well as the application procedures in sections 6.03, 6.04, and
6.05 of Rev. Proc. 97-37, do not apply. However, if the taxpayer is
under examination, before an appeals office, or before a federal court
with respect to any income tax issue, the taxpayer must provide a copy
of the Form 3115 to the examining agent (s), appeals officer, or
counsel for the government, as appropriate, at the same time that it
files the copy of the Form 3115 with the national office. The Form
3115 must contain the name (s) and telephone number (s) of the examining
agent (s), appeals officer, or counsel for the government, as
appropriate.

(2) A taxpayer that, on or before June 12, 1998, files its

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original federal income tax return for its first taxable year ending
on or after August 5, 1997, is not subject to the filing requirement
in section 6.02 (2) (a) of Rev. Proc. 97-37, provided the taxpayer
complies with the following filing requirement. The taxpayer must
complete and file a Form 3115 in duplicate. The original must be
attached to the taxpayer's amended federal income tax return for the
taxpayer's first taxable year ending on or after August 5, 1997. This
amended return must be filed no later than August 11, 1998. A copy of
the Form 3115 must be filed with the national office (see section
6.02 (6) of Rev. Proc. 97-37 for the address) no later than when the
taxpayer's amended return is filed.

(3) A taxpayer, whose present method of accounting
estimates inventory shrinkage, does not receive audit protection under
section 7 of Rev. Proc. 97-37 in connection with a change to the
retail safe harbor method if, on the date the taxpayer files a copy of
the Form 3115 with the national office, the taxpayer's present method
of estimating inventory shrinkage is an issue under consideration
within the meaning of section 3.09 of Rev. Proc. 97-37.

(4) In addition to all the requirements and procedures in
Rev. Proc. 97-37, as modified by this revenue procedure, the following
rules apply to a taxpayer within the scope of this revenue procedure
that changes to a method other than the retail safe harbor method of
accounting for estimating inventory shrinkage. The taxpayer must
provide a detailed description of all aspects of the new method of
estimating inventory shrinkage (including, for LIFO taxpayers, the
method of determining inventory shrinkage for, or allocating inventory

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shrinkage to, each LIFO pool) in the Form 3115 filed by the taxpayer
for such a change. The District Director or national office
subsequently may review whether the new method clearly reflects the
taxpayer's income under § 446(b). If the District Director or the
national office determines that the new method of accounting does not
clearly reflect the taxpayer's income, the taxpayer will be treated as
having made a change in method of accounting without obtaining the
consent of the Commissioner as required by § 446 (e). See section 6.06
of Rev. Proc. 97-37.

(5) For a change in method of accounting within the scope
of this revenue procedure, the provisions of Rev. Proc. 97-37 are
effective for taxable years ending after August 5, 1997.

(6) The transition rules in section 13.02 of Rev. Proc. 97-
37 do not apply to any change in method of accounting within the scope
of this revenue procedure. The Service will return any Form 3115 if
it is filed with the national office pursuant to the Code,
regulations, or administrative guidance other than Rev. Proc. 97-37
and the change in method of accounting is within the scope of this
revenue procedure.

. 03 Future change. A taxpayer that changes to the retail safe
harbor method described in this revenue procedure will not be
precluded, solely by reason of such change, from changing to another
safe harbor method for estimating inventory shrinkage in computing
ending inventory in the first year that such other safe harbor method
is available.

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# SECTION 6. REGULATIONS AND REQUEST FOR PUBLIC COMMENT

The Service intends to issue regulations under $ 471 regarding
proper methods for estimating inventory shrinkage in computing ending
inventory for taxable years ending after August 5, 1997. Comments are
requested regarding safe harbor methods for estimating inventory
shrinkage (including the retail safe harbor method), and any other
issues that these regulations should address. Written comments should
be submitted by August 11, 1998, to: Internal Revenue Service, P.O.
Box 7604, Ben Franklin Station, Washington, DC 20044, Attn:
CC: DOM: CORP:R (IT&A BRANCH 7, Room 5226) . Submissions may be hand-
delivered between the hours of 8 a.m. and 5 p.m. to: Courier's Desk,
Internal Revenue Service, 1111 Constitution Avenue, NW, Washington DC,
Attn: CC: DOM: CORP:R (IT&A Branch 7, Room 5226) . Alternatively,
taxpayers may submit comments electronically at
http://www.irs.ustreas.gov/prod/tax_regs/comments.html
(the Service's internet site) . All comments submitted will be
available for public inspection and copying.

SECTION 7. EFFECTIVE DATE

This revenue procedure is effective for taxable years ending
after August 5, 1997.

SECTION 8. EFFECT ON OTHER DOCUMENTS

Rev. Proc. 97-37 is modified and amplified to include this
automatic accounting method change in the Appendix.

DRAFTING INFORMATION

The principal author of this revenue procedure is Jan L. Skelton of
the Office of Assistant Chief Counsel (Income Tax and Accounting) .

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For further information regarding this revenue procedure, contact Ms.
Skelton at (202) 622-4970 (not a toll-free call) .