Dayton Hudson Corp. v. Commissioner , 101 T.C. 462 ( 1993 )

Gerber, J.,

dissenting: I respectfully disagree with the majority’s holding that section 1.471-2(d), Income Tax Regs., permits taxpayers to use estimates in accounting for inventories. The majority has interpreted the regulation in a manner which would permit any approach to computing inventory which is not expressly prohibited. This interpretation conflicts with the express terms, internal consistency, and precedent that strictly construe inventory accounting methods in order to curb abuse.¹

Section 1.471-2(d), Income Tax Regs

The regulation provides taxpayers with an alternative to yearend physical inventories. The regulation is self-contained and describes a specific method under which the inventory account is “charged with the actual cost of goods purchased or produced and credited with the value of goods used, transferred, or sold”. Sec. 1.471-2(d), Income Tax Regs. Increases and reductions to the inventory are to be based on “actual cost”. It also provides that taxpayers should verify their inventory accounts with “physical inventories at reasonable intervals” and adjust the accounts to conform with the physical inventory. It should be noted that a physical inventory may reflect an actual inventory on hand which is larger or smaller than the one calculated by the book or regulatory method. Accordingly, although the regulation provides an alternative to physical counts of inventory, it contains recognition of the need to periodically take a physical inventory to determine any differences (i.e., shrinkage) between the ending balance under the regulatory method and a physical count.

The majority reasons that the regulation does not expressly prohibit taxpayers from estimating shrinkage and that, therefore, estimates are permissible. If this theory is correct, then taxpayers also can estimate their purchases and sales, because the regulation does not expressly prohibit such a practice. Interpreting the regulation in that manner simply does not make sense. Furthermore, in the abstract, it seems highly unlikely that an estimate of shrinkage will result in a clearer income reflection than a physical inventory or actual knowledge of the missing items.

Case Precedent Regarding Inventories

Petitioner’s use of estimates is conceptually synonymous with a prediction made without the benefit of actual knowledge of whether inventory is missing. Petitioner’s estimate with respect to the amount of inventory on hand is based on historical data, similar to the taxpayer’s approach in Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979), where the value of inventory items was estimated; an estimate which the Supreme Court did not allow.

In Thor Power Tool, the taxpayer reduced its inventory account to reflect a lower net realizable value for excess inventory on hand. Id. at 527. The taxpayer did not scrap the excess inventory or offer it for sale at the reduced value. Id. at 529. Instead, the excess inventory was held for sale at the original prices. Id. The Court held that the taxpayer’s inventory accounting method did not clearly reflect income for tax purposes because it violated the regulations under consideration in that case. Id. at 535; see secs. 1.471-2(c), 1.471-4(b), Income Tax Regs.

Total inventory value is composed of two components— number of items and value or cost. Multiplying the number of items in inventory by the value or cost of that item results in the composite concept of inventory — total inventory. The Supreme Court in Thor Power Tool Co. v. Commissioner, supra, would not allow the taxpayer to write down the cost or value factor of the inventory equation based on historical data. The Court stated that “If a taxpayer could write down its inventories on the basis of management’s subjective estimates of the goods’ ultimate salability, the taxpayer would be able * * * ‘to determine how much tax it wanted to pay for a given year.’” Id. at 536 (quoting Thor Power Tool Co. v. Commissioner, 64 T.C. 154, 170 (1975)). Despite this, the majority would allow taxpayers to estimate the item component of the same basic inventory equation.

The majority attempts to distinguish Thor Power Tool Co. v. Commissioner, supra, based on the fact that the Thor taxpayer violated specific regulatory language. See secs. 1.471-2(c), 1.471-4(b), Income Tax Regs.² However, the majority does not distinguish the principle and rationale expressed in the holding of Thor Power Tool. The Supreme Court’s approach and rationale in the inventory area conservatively favored respondent’s regulatory attempts to discourage abuse. The majority’s holding in this case flies in the face of this approach.

The majority attempts to further distinguish Thor Power Tool Co. v. Commissioner, supra, by reasoning that the Thor taxpayer was taking a current deduction for an estimated future loss, and in the present case petitioner is estimating a deduction for a current, not a future, loss. Such a distinction is illusory. Both the Thor taxpayer and petitioner wrote down their current total inventory to what they thought was the correct yearend balance. The Thor taxpayer made the adjustment by estimating value, and petitioner here made the adjustment by estimating the number of items in inventory.³ The deduction in both cases is a current adjustment to total inventory. The majority’s approach makes it possible for taxpayers to make such an adjustment by estimating one component of the equation, after the Supreme Court has prohibited taxpayers from estimating the other.

The Regulation Permits Adjustment for Any Verified or Detected Shrinkage of Inventory

Physical inventories are the most accurate method to account for shrinkage. Therefore, the regulation provides for physical inventories at reasonable intervals as a way to insure that shrinkage is accurately reflected. Conceptually, section 1.471-2(d), Income Tax Regs., anticipates a difference between book inventory and actual inventory on hand due to shrinkage, and requires taxpayers to adjust them accordingly. However, the regulation does not allow for such an adjustment before acquiring actual knowledge or before a physical count is taken.

The majority appears to believe that, under respondent’s interpretation, taxpayers would have to take a yearend physical count in order to get a year’s worth of shrinkage and taxpayers can only deduct shrinkage when physical inventories are taken. This interpretation is not correct. The regulation does not require, nor is respondent advocating, that a physical inventory be taken at yearend. Instead, under respondent’s interpretation, the regulation does not permit a deduction for the anticipated results of a yearend physical inventory when taxpayers choose not to take one. Furthermore, respondent’s interpretation does allow for a deduction without a physical inventory for any detected or verified shrinkage. If shrinkage was physically observed, there would be “goods used, transferred, or sold”, and a reduction of book inventory would be permissible under section 1.471-2(d), Income Tax Regs. This is so because the reduction for shrinkage would be based on verification as opposed to a mere probability.

The Issue Here Is Essentially a Matter of Timing and No Tax Benefit Is Lost

The majority seems to miss the point that the issue here is essentially a matter of timing. If a taxpayer does not take a yearend physical inventory, then the deduction for shrinkage is deferred until the physical inventory is taken. As long as a physical inventory is taken every 12 months, then a taxpayer will be allowed a deduction for a full year’s shrinkage. The regulation gives taxpayers a choice of either taking a yearend physical inventory or using the method described in the regulation. Petitioner seeks to have the benefit of both methods by not taking a physical inventory at yearend but taking a deduction as if it did.⁴

Estimates for Shrinkage Are Essentially Prohibited Reserves

The majority further states that petitioner’s estimate for shrinkage is not a reserve. A reserve is an account for an estimated expense which is attributable to the current taxable year but will not be recognized until a subsequent taxable year. Sec. 462 (repealed 1955). Accordingly, this Court in Altec Corp. v. Commissioner, T.C. Memo. 1977-438, characterized shrinkage estimates as a reserve. Former section 462 (repealed 1955) allowed taxpayers to deduct increases in reserves for certain estimated expenses. This section was repealed, and the law is well settled that only a few reserves acceptable in financial accounting are authorized by the revenue acts. Thor Power Tool Co. v. Commissioner, supra at 543-544 (citing Brown v. Helvering, 291 U.S. 193, 201-202 (1934)). An estimate for inventory shrinkage is a reserve; however, it is not the type of reserve expressly authorized by the revenue acts and is, therefore, not deductible.

For the reasons expressed, I respectfully dissent.

Parker, Wright, and Beghe, JJ., agree with this dissenting opinion.

1 The majority is correct in its holding that this is a proper matter for summary judgment. If, as a matter of law, the regulation prohibits estimates, it would be unnecessary to determine factually whether the use of estimates clearly reflects income. The focus of this inquiry, accordingly, does not depend upon the facts surrounding this petitioner’s estimates. Instead, we must consider whether any taxpayer, subject to the regulation under consideration, may estimate. If estimates are permitted, then a clear reflection factual inquiry may be necessary.

2 We note that the majority interpretation would permit taxpayers to estimate even though sec. 1.471-2(d), Income Tax Regs., requires actual cost and permits reduction only for “goods used, transferred, or sold” — events which in this case have not been determined to have occurred.

3 In this case petitioner used a flat percentage markup to increase cost of goods sold. As an example, each time a single item was sold by one of petitioner’s retail outlets, the cost of goods sold was increased by 102 percent of “actual cost”. The percent above 100 percent (which may vary in amount) is an estimate of the possibility that the physical inventory, when taken, may be short.

4 It should be noted that petitioner here did take annual physical inventories even though the regulation does not require an annual physical count. Because the regulation states that a taxpayer should take a physical inventory at “reasonable intervals”, under the majority’s approach taxpayers could estimate the amount of their shrinkage for several taxable periods. This would create additional potential for the type of abuse envisioned by the Supreme Court in Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979).