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 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.

April 13, 1998 22 1998–15 I.R.B.

.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 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.