Retailers will expand their operations by opening new stores. When land is purchased or leased for these activities, examiners should look for internal departments of the taxpayer that are actively involved in the land acquisition. These could be located in corporate development, store planning, real estate, or other departments that are responsible for new store locations. Generally, a company will have a strategic plan that has been developed by executives indicating where the company will expand. Another department will be responsible for analyzing several possible cities that come within these plans, choosing the proper location in the desired city, then negotiating the purchase of that property. Employees will be responsible for obtaining the necessary zoning for the project, installing the required utilities and arranging for highway access. The cost of operating this land acquisition department should be capitalized as part of the cost of the land.

There will be employees who are responsible for overseeing the construction, ordering the necessary furniture and fixtures, and arranging their installation. These departmental costs are part of the cost of the store and fixtures.

Whenever a major new construction or remodeling project is undertaken it is necessary to allocate the project costs between the various asset classes. First, assets must be classified as either tangible personal property or a land improvement (including building/structural components). Then, these two categories can be further broken down into MACRS asset classes.

Many taxpayers allocate an excessive amount of a construction/remodeling project to personal property. It is necessary to thoroughly review the taxpayer’s allocation studies by correlating all items to the drawings, bid/specification packages, and invoices. Since a retailer may open dozens of locations in a given year, studies may only be done on representative stores and the percentage allocations that result from the studies may be applied to all similar projects. To properly examine the allocations, the examiner must determine that projects have been grouped according to similar features such as construction type (one-story, two-story, mall, freestanding), construction quality (block, brick, poured cement, wood), size (based on square footage), and utility (apparel, shoes, department, grocery, other specialty, distribution center).

After the grouping of projects has been reviewed, it is necessary to analyze a select number of allocations in detail. Internal Revenue Service engineers may perform this task. Sometimes the allocation analysis must be done without a taxpayer’s detailed allocation study; for example, the taxpayer may have used a relative percentage allocation based on allocation studies done in prior years. Generally, it is more efficient to do a detailed analysis on projects which the taxpayer also has analyzed.

To analyze the projects in detail, first collect all pertinent documents (drawings, bid/specification packages, contractor payment invoices, vendor invoices, etc.). Then tie the documents to the costs in the taxpayer’s allocation study. It may be necessary at some point to tour and photograph the location being analyzed.

Tours should be carefully planned. Taxpayer personnel at a store may not be knowledgeable about the allocation study or how to identify assets listed in the study. Therefore, ensure that persons knowledgeable about the allocation study are included on the facility tour. It is also important that taxpayer personnel be present on the tour who can tie the assets listed on the allocation study to the actual assets located at the facility being toured.

If a tour cannot be arranged, a detailed analysis can be accomplished through a series of meetings with the taxpayer to work through the study and drawings. The taxpayer may be able to provide photographs as an aid.

Many position papers exist for most of the common assets at issue in construction remodeling projects including ceiling tile, restroom components, fire prevention, emergency systems, communication systems, security systems, electrical systems, and mechanical systems (Heating, Ventilation, Air Conditioning: HVAC/HEVAC). Please contact the Retail Technical Advisor for further information.

Remodeling and new construction are common in the retail industry. Most retailers produce such projects either by paying outside contractors or by using employees to perform the construction. To maintain parity among taxpayers, it is important that a retailer involved in production use the same standards to measure the cost of a project as a retailer purchasing a completed asset outright.

The UNICAP interest capitalization rules address this need for parity, paralleling in some respects the generally accepted accounting principles (GAAP) requirements of Financial Accounting Standards Board (FASB) 34. The objective of both is to identify interest incurred by a taxpayer relative to asset production and to include such cost as part of the total basis of the asset, recoverable over its useful life. Treas. Reg. 1.263A–8 through 1.263A–15 stipulate how capitalizable interest costs pertaining to produced property should be computed for tax purposes.

Many of the aspects of the UNICAP interest capitalization computation are methods of accounting. The examiner should be aware that changes made in the calculation may constitute a change in method.

To thoroughly examine this complex issue, determine if the taxpayer was involved in the production of any assets during the examination cycle. Remember that certain dollar thresholds and/or production period thresholds must be met before any interest is capitalized (see Treas. Reg. 1.263A-8(b)(4)).

If it is established that the taxpayer did produce any assets, study Treas. Regs. 1.263A-8 through 1.263A-15 to become familiar with the terminology and methodology of UNICAP interest capitalization. See Exhibit 4.43.1-9 for audit steps using these regulations.

Issue an Information Document Request for the following data:

The examiner should request UNICAP interest workpapers and computations which include:

Listed below are other sources of information to consider:

Real estate taxes incurred during the production period should be capitalized for self-constructed assets. The taxpayer may be capitalizing its estimate of property taxes for the project and not adjusting the estimate to the actual amount on the property tax statements.

Taxpayers that lease property may be liable for the real estate taxes on the property and pay them separately. These taxes still should be capitalized during the production period.

Layaways are purchases of goods made in two or more installments. The retailer will usually remove the merchandise from the sales area but may not deliver the goods to the customer until the final installment has been made.

The installment sales method has been revoked for dealers in personal property by IRC section 453(b)(2)(B), therefore layaways now are under the same general rules as gift certificates. The advanced payments are reported as income at the time of receipt unless the method under Treas. Reg. 1.451-5 is elected. If an election is made, a deferral of the recognition is allowable as explained in IRM 4.43.1.4.17 above.

Unlike the case with gift certificates, the merchandise sold under a layaway plan is usually identifiable before the customer takes possession. A substantial advance payment is therefore not deemed to have occurred until the last day of the taxable year in which layaway payments received equal or exceed the reasonable costs of the goods sold. The two year deferral period provided by Treas. Reg. 1.451-5(c)(1)(i) begins from this date.

The retailer is also allowed a deduction for the cost of the goods at the time the income is recognized under Treas. Reg. 1.451-5(c)(1)(i) because the goods are identifiable. This deduction (or an estimate of the cost of the goods sold) must be claimed at this time even if no goods are on hand when the income is recognized. The deduction for the cost of the goods sold is lost if it is not claimed at this time. Any variance between the actual costs and the deduction claimed is corrected at the completion of the installment obligation.

Some retailers sell extended warranties or service contracts on durable goods, such as electronics and home appliances, which are in addition to the warranty provided by the manufacturer. The coverage provided is usually for a number of years and the consumer usually pays the entire cost of the coverage up front.

Normally, all of the income is recognized in the year the contract is sold and any expenses related to providing the services are allowed only in the year they are incurred. Revenue Procedure 92-98 allows the taxpayer an election to defer the service contract income in certain situations where the taxpayer purchases an insurance policy to cover its service contract obligations. This method is known as the service warranty income method and provides for a better matching of income and expenses. Revenue Procedure 92-97 describes the necessary steps to get the approval to change to this new method of accounting. If this method is not elected, then the income is recognized when received and the costs of the insurance must be amortized over the life of the policy.

Vendor rebates and allowances are incentives paid by manufacturers to wholesalers, brokers, and retailers. The evolution of slotting fees and other types of payments made by manufacturers to retailers has been commonly attributed to the increase in the relative power of retailers. This power arose from developments such as:

Some retailers account for “performance related” vendor allowances, such as cooperative advertising or slotting allowances, as a reduction to purchases. This improperly defers taxable income by understating ending inventory. For example:
Facts: Taxpayer has $50 performance related vendor allowance. It reduced Purchases by $50 instead of reporting the allowance as Gross Income:

In recent years some retailers have deferred advance payments from vendors. For example, a retailer receives advance payments to make a vendor the exclusive supplier for a five-year period. The retailer subsequently amortizes the payment over that five-year period or over a period based upon a percentage of the total required purchases. Sometimes the retailer will classify the advance payment as a loan, trade discount, or deposit from the vendor. These are all generally impermissible accounting treatments for federal income tax purposes. Income from rebates or credits is includable when the right to receive it becomes fixed and certain. Letter Ruling 9719005, January 10, 1997, thoroughly discusses the applicable law and potential taxpayer positions regarding this issue. Do not cite this Technical Advice Memorandum (TAM) as precedent per IRC section 6110(k)(3). In Revenue Ruling 84-31, the Service ruled that all the events that fix the right to receive income occur on the earliest of when:

Negotiation of the terms of the merchandise purchase is a major responsibility of a retail buyer. The buyer is responsible for assuring that the merchandise to be acquired can be sold at a retail price that will generate the targeted profit percentage. Some retailers desire a no frills purchase for the lowest possible price. In most transactions, however, there are numerous incentive allowances or rebates offered or demanded as part of the overall negotiated price.

The details of the negotiated agreement will either be entered into the product data records or maintained by the buyer. It is in the retailer's best interest to monitor its progress in earning incentive allowances and rebates to ensure that all potential recoveries are earned. See also IRM 4.43.1.4.18.2, Vendor Recoveries and Post Payable Audits.

Often, the retailer determines the amount of the allowance or rebate and issues a purchase credit or charge-back to the vendor. In other instances the vendor sends a notice to the retailer, after the earning period has expired, which reflects the final computation of the rebate monies, possibly accompanied by payment. When amounts are in dispute, the retailer will in most instances shift the burden of proof to the vendor, simply by withholding payment for merchandise purchases.

Some of the more common vendor allowances and rebates are as follows:

Some audit techniques to discover the various allowances are:

Fixture allowances are frequently paid to retailers (e.g. department stores) to provide space and assets, including fixtures, which promote the image of the vendor and to display the vendor's goods. The assets may include flooring, fixtures, ceilings, walls and other assets (I.R.C. sections 1245 and 1250 assets). The retailer owns the assets and pays for all insurance, property tax and maintenance attributable to the property. The retailer generally hires and pays contractors to install the assets and is reimbursed by the vendor.

When fixture allowances are paid to a retailer for assets owned by the retailer, the retailer has an accession of wealth. The payment should be included in the retailer's gross income in the taxable year in which all the events that fix the right to receive income occurs and should not reduce the basis in the retailer's assets.

When reviewing the construction or renovation workpapers, examiners should be alert to credits that reduce the basis of the assets. Receivables from vendors or substantial credits in vendor payables may disclose vendor fixture allowances. Correspondence files between the vendor and retailer may disclose the fixture allowance agreements

Although vendor rebates and allowances are determined between the buyer and the vendor at the time of purchase, for various reasons some of them may not actually be claimed by the company and are lost.

In exchange for a percentage of lost incentives that are located, accounts payable auditing firms analyze a company’s accounts payable and determine a dollar figure for incentives that the company was entitled to but did not claim. The frequency of an accounts payable audit varies among retailers but may be performed as often as once per month. Fees, generally ranging between 15 to 50 percent of the incentives recovered, are usually paid directly by the retailer to the auditing firm.

The auditors use a combination of accumulated knowledge and creative auditing techniques to identify the lost incentives. They are aware of vendors who do offer discounts, and the types of discounts that are offered. They access a retailer’s computer system and also perform manual checks of invoices and other documents as part of their review. Other items, including freight charges and cost comparisons of prices paid among stores in the same chain, may also be part of their analysis.

Depending upon the parties involved and the procedures which have been established, either the retailer or the auditing firm may notify the vendor to claim the lost incentives. Vendors process the claims in various ways, including direct payment to the retailer or reduction of accounts receivable from that retailer. Although occasionally a vendor may refute the findings of the auditing firm, in most cases the claims are correct and are honored.

Treas. Reg. 1.451-1(a) provides that generally under an accrual method of accounting income should be reported when all the events have occurred which fix the right to receive such income and the amount can be determined with reasonable accuracy (the "all-events" test). Taking this test into account, the examiner should determine when the retailer is reporting income from the recovery of lost incentives.

Because of their experience and knowledge of the accounts payable, auditing firms produce few errors in identification of lost incentives. At the point in time a claim for said incentives is submitted to the vendor, the amount of the claim should be included in income. The amount claimed represents income to the retailer because the gross cost of the product was originally deducted through cost of goods sold or another expense account, and now the gross price has been reduced.

Some retailers report the recovery of lost incentives when they receive cash payment or notification of a reduction in amounts due to the vendor. Other retailers may debit accounts payable at the time the claim is filed, but credit the amount to a reserve for claims outstanding; thus, recognition of income is delayed until the vendor has processed the claim and notified the retailer of its approval. Any method of reporting income relative to the recovery of lost incentives, other than recognition when the claim is filed, is incorrect.

Relative to this issue, the examiner should issue an IDR and ask for the following data:

A taxpayer may utilize in-house personnel to audit its accounts payable rather than an outside firm. Many of the above questions would be equally applicable in such a circumstance to determine if the recoveries were timely reported.

Numerous retailers who sell products such as appliances or electronics also offer the customer an extended warranty. This warranty or extended service contract is usually a separate agreement, which generally commences after the original warranty period expires and continues for an established period of time. Some agreements may also reduce or eliminate the deductible or co-payment aspect of the basic warranty which comes with the product. The customer may have several options as far as coverage duration and quality. The fee charged by the retailer for the protection is related to the time span as well as the product value and reliability.

The mechanics of the agreements may vary from one retailer to another. Some taxpayers may perform the contract covered service work themselves while others may have a third party perform the work. Some taxpayers are principals of the plan, retaining the contingent liabilities which arise from the coverage, or possibly paying a third party to assume total or partial responsibility. Other retailers are acting as the agents of a third party, which is the principal of the plan. As an agent the retailer’s involvement could be limited to selling the service contract to their customers, for which they would receive a commission. The third party referred to above, which is paid to assume the risk, increasingly involves a contract written with an off-shore insurance company.

All documents pertaining to the contracts and agreements should be requested and reviewed. There may be multiple types involved. Also secure the procedural guide stating how the taxpayer accounts for these monies.

The examiner should encounter few problems when the retailer is merely an agent which retains or receives commissions generated by the sale of extended product warranties or service agreements. They would relate to the normal year-end timing issues.

In situations where the retailer is the principal of the agreement sold to the customer there can be a number of potential issues involved:

A large portion of retail sales are in cash, therefore it is important to evaluate internal controls when examining retailers. As a general rule, the larger and more decentralized the retailer, the better the internal controls will be. It is to the owner's benefit to install effective internal controls over all facets of the business whenever the owner cannot oversee these details personally, to avoid losses due to error, embezzlement, and theft by employees. Good internal controls will free the examiner to thoroughly review the accounting system, rather than test the accuracy of individual transactions.

Timing of income can be a source of material adjustments. Examiners should be alert to the existence of balance sheet accounts, both asset and liability, with growing credit balances. The credit balance may represent income which is being improperly deferred. In addition to the discussion below, see also rebates for advertising (IRM 4.43.1.4.19), coupon income (IRM 4.43.1.4.18), gift certificates (IRM 4.43.1.4.17), layaway income (IRM 4.43.1.4.17.1), and vendor rebates and allowances (IRM 4.43.1.4.18.1).

Omissions of income can be another source of adjustment. Retailers may receive prizes and/or trips from vendors. Since these types of items fall outside the normal data stream, they are easily omitted from income. Similar situations apply to free merchandise received from vendors as part of promotions. If such transactions are booked at all, they may be run through cost of sales. Interviews with officer/shareholders regarding trips taken, prizes won, meetings attended, etc., can be a productive technique.

A Rent-to-Own (RTO) dealer regularly enters into contracts with customers for the use of consumer property. Consumer property means tangible personal property of a type generally used within the home for personal use. It does not include, for example, real property, aircraft, boats, motor vehicles, or trailers.

RTO contracts typically contain the following terms and conditions:

The total payments under the RTO contracts are substantially more than the average retail sales price of the personal property at non-RTO stores. The term of the contract is less than the useful life of the personal property.

Lease vs. Sale Issue: Revenue Procedure 95-38 allows taxpayers to report the income from most RTO contracts of consumer durable property as rental income for Federal income tax purposes.

The Taxpayer Relief Act of 1997 shortened the depreciation period of RTO property from five years to three years under MACRS.

A taxpayer’s assets are assigned class lives and depreciation is computed using MACRS. See IRM 4.43.1.3.5, for a general discussion of fixed asset records. IRM 4.43.1.4.13.2 addresses techniques for examining the allocation of costs for new construction or remodeling projects.

Generally, a retailer’s tangible personal property is either 5 year property under MACRS asset classes 57.0—Distributive Trades and Services, 00.12—Information Systems, 00.13—Data Handling, and 00.241/ 00.242—Trucks; or, 7-year property under MACRS asset class 00.11—Office Furniture, Fixtures, and Equipment.

A retailer’s land improvements are either 15-year property under MACRS asset class 00.3—Land Improvements or 39-year property which is specifically assigned to nonresidential real property (IRC section 168(c)), including elevators and escalators section(IRC section 168(e)(2)(B)). Nonresidential real property placed in service before May 13, 1993, had a 31.5-year class life (building and structural components).

Other than the issue of personal property versus land improvement (discussed in IRM 4.43.1.4.13.2), a common issue is whether an asset identified as tangible personal property is 5-year property under Class 57.0 or is 7-year property under Class 00.11. The decision is based entirely on the asset’s use rather than its inherent nature. If a table is used on the retail floor for display or for cutting material, then it is 5-year property under Class 57.0. That same table, however, in the store manager’s office, is not used directly in retailing and therefore becomes 7-year property under Class 00.11.

In regards to leasehold improvements, lessees are treated as any other owner-taxpayer for the purpose of determining MACRS deductions for lessees' improvements subject to MACRS rules. Thus, a lessee's deductions for the property are determined without regard to the lease term, (IRC section 168(8)(8)). This means that the lessee depreciates property over its MACRS recovery period even if the lease term is shorter or longer.

If the lease terminates before the end of the MACRS recovery period for the lessees' improvement, and the lessee does not retain the improvement, the lessee has a gain or loss for the remaining unrecovered basis of the property. The remaining basis of the unamortized leasehold improvements that are left behind is a deductible loss. A gain would arise if, for example, the tenant is paid to terminate the lease and the payment exceeds the basis of the leasehold improvements, including lease acquisition costs, if any.

Although not unique to the retail industry, leases are a significant area in the examination of a retailer due to the large number of stores or sites a typical company will have. While the retailer is the tenant in most examinations, retailers are often landlords as well. They may sublet former store sites, and leased departments (such as a cosmetic counter in a department store or the butcher department in a grocery) are very common.

Retailers purchase a variety of supplies to be used in daily operations. Some become incidental parts of items available for sale, including size and price tags, labels, and meat wrapping paper. Memo pads, pens, and cardboard signs are examples of other supplies used by retailers within store locations. Individually, each of these supply items may cost as little as a fraction of a cent. Even aggregated for many stores the cost of a particular item may be small. Other supplies may be more costly but have a useful life of less than one year.

Some retailers do not keep a record of supply consumption and do not take a physical inventory of supplies. No controls are exercised over their use and no established reorder procedures exist. The supply costs are charged to an expense account and deducted as a period cost for tax purposes.

Many retailers monitor supply usage and/or take physical inventories of supply items. Some of these retailers maintain an inventory balance for supplies and do not deduct their cost for book and tax until consumed. Others, however, carry an inventory balance only for book and deduct the cost of supplies as purchased for tax.

Treas. Reg. 1.162–3 stipulates that three criteria must be met in order for any taxpayer to currently deduct supplies. A taxpayer that fails to meet even one of the three criteria must wait until the supplies are consumed to deduct their cost. Examiners should apply the following criteria during their examinations to determine if an adjustment is appropriate.

The timing of the deduction of costs for supplies constitutes a method of accounting which may not be changed without the approval of the Commissioner.

Relative to this issue, an Information Document Request should be issued considering the following information:

As inventory merchandise becomes old (i.e., shelf life expiration, new product introductions, fashion trend changes, seasonal changes, technical obsolescence, etc.), the retailer must exercise disposal options. Inventory that remains unsold after all markdowns must either be scrapped, sold in any available after markets (i.e., jobbers or discounters), or donated to charities.

An exception to the general rule limiting charitable contribution deductions to inventory basis is provided by IRC section 170(e)(3)(A). If certain requirements are met, a C corporation that contributes property (i.e., inventory used in a trade or business) may deduct an amount in excess of the property’s basis. Primarily, the property must be used by the donee solely for the care of the ill, the needy, or infants, and in a manner related to the donee’s exempt purpose. If all requirements are met, the starting point for calculating the amount of a corporation’s charitable contribution deduction is the fair market value (FMV) of the donated inventory less one half of the amount of gain that would not have been long-term capital gain if the contributed property had been sold at its FMV (i.e., the unrealized appreciation in most cases). The resulting amount must be reduced by any amount in excess of twice the property’s basis. That portion of the contribution in excess of cost will be reflected on Schedule M–1 of the Form 1120.

To establish FMV, the examiner must determine the composition, nature, character, and condition of such inventory immediately before donation. Whether such inventory has marketability to a retailer’s customers has a definite bearing on the worth of such merchandise for donation purposes when applying the guidelines of Treas. Reg. 1.170A–1(c)(2) and (3).

The examiner must look to the pattern of giving to help establish donative intent. The retailer may be motivated to give its merchandise to charities because it is truly benevolent as a donor to the ill and needy. However, the retailer’s actions may be primarily business motivated, and the deduction for such disposal actions limited to inventory basis (i.e., an IRC section 162 ordinary and necessary expense).

The condition and quality of contributed inventory should be verified.

Verifying the retailer’s FMV and donative intent actions should not overshadow the examiner’s requirement to substantiate the basis of contributed property.

The Tax Reform Act of 1986 repealed the allowance of the deduction for the addition to the reserve for bad debts for all taxpayers who were entitled to the deduction under IRC section 166(c), effective for taxable years beginning after December 31, 1986. Prior to repeal, many retailers employed the reserve method of accounting for bad debts. Any taxpayer who maintained a reserve for bad debts for the last taxable year beginning before January 1, 1987, who is required by this repeal to change its method of accounting for any taxable year will have the change treated as if it initiated the change. The change will be treated as if made with IRS consent. The net amount of adjustment which is determined to be necessary solely by reason of this change in order to prevent amounts from being duplicated or omitted, in accordance with IRC section 481(a), are to be taken into account ratably in each of the first four taxable years beginning after December 31, 1986.

For years beginning after December 31, 1986, the only method available to taxpayers is the specific charge-off method, which allows the write-off no earlier than the year during which a debt becomes totally or partially worthless. Actual worthlessness of a debt is a condition precedent to a bad debt deduction. Whether a debt has become worthless is a question of fact. Treas. Reg. 1.166–2 states that all pertinent evidence, including the value of collateral, if any, securing the debt and the financial condition of the debtor should be considered. Where the surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgement, a showing of these facts will be sufficient evidence of the worthlessness of the debt for the purposes of the deduction under IRC section 166.

The partially worthless business bad debt deduction is limited to a specific portion of a debt which has been charged off for book purposes in that year or an earlier year. Generally most large retailers would not identify portions of accounts to write-off. If a customer is not satisfied with the price paid for the merchandise acquired, as a result of subsequent knowledge of a competitor’s price or the determination that the product’s quality was not acceptable, a retailer would generally debit sales and credit accounts receivable, rather than treat the transaction as a partially worthless bad debt.

The bulk of the totally worthless business bad debts claimed by retailers would result from customer charge accounts or customer checks not honored by the bank.

The examining agent should request and review the charge account agreements and procedures referred to above. Compare the amount of recoveries with charge-offs over a period of time. Is there any trend? A high rate of recovery is an indicator that the write-off criteria is identifying accounts which are slow paying, or customers who have had some type of temporary financial setback, in addition to those which are totally worthless.

Determine if the accounts had any different payment pattern immediately after the write-off, possibly as a result of more aggressive collection on the part of the taxpayer or its collection agency. Did the taxpayer take into account all of this post-write-off, pre-year-end payment data in determining if the account was totally worthless as of year-end?

Review the taxpayer’s returned check handling and collection policies along with the recovery rate to determine if the criteria employed generates only totally worthless bad checks.

If the examination involves a large taxpayer who may have hundreds of thousands or even millions of customer accounts receivable and is writing off accounts as of each billing cycle month end computer analysis may be required. Select a sample day or several dates and review the taxpayer’s accounts receivable records for each of the accounts written off. Determine if the taxpayer followed its own write-off criteria by reviewing the payment history of each account. Determine if the account was totally worthless as of year-end. If the deduction includes accounts which are not totally worthless, consider using a computer audit specialist to apply the proper criteria for write-offs to either a statistically valid sample of the population or to all accounts. Refer to the computer assisted audit techniques for accounts receivable in IRM 4.43.1.5.7.

Retailers with a large number of store locations and employees have a high risk of exposure to fire, tort liabilities, workmen’s compensation claims and other hazards. Insurance coverage is a large expense item.

Self- (or retrospective) insurance policies are purchased by retailers for many types of coverage, including auto, general liability, product liability, workmen’s compensation and other coverage. Self-insurance arrangements may be known as cash flow plans, excess loss coverage and other names. The contracts generally contain the following terms and conditions:

A policy may show a standard annual premium that is accrued by the taxpayer as a current expense; however, separate premium payment agreements and/or endorsements may reveal terms described in IRM 4.43.1.4.19.6(2) above.

The amount ultimately payable by the taxpayer under the self-insured arrangement is based on the actual losses of the taxpayer for that period, and where no risk of loss is shifted or distributed by the taxpayer, the portion of the amount billed that represents an estimate of losses expected to be incurred by the taxpayer is not an insurance premium deductible under IRC section 162.

In order to obtain a deduction under IRC section 162 for amounts billed under the self-insured policy, taxpayer must establish the portion of the amount billed that is attributable to the insurance elements of the arrangement.

Unpaid premiums that have been accrued will generally be found in the accrued insurance, other current liabilities, accrued protection expense, or some other general liability account. The composition of the accrual will be the cumulative excess of the estimated liabilities over the amounts paid for all open policy years.

Retailers may be required to maintain a deposit with the insurance company to cover payments to claimants that are not due and owing. The insurance company considers the deposit a liability due the insured, therefore no deduction is currently allowable for the deposit.

When there are indications that self-insurance contracts are present, the following examination techniques should be utilized:

Many techniques are available to examiners for the audit of expenses.

Retailer’s expenses are directly related to the type of operation conducted by the particular store or chain under examination. The techniques shown above should help the examiner identify potential issues for examination.

Examiners should be aware of package audit requirements during their examination of other areas, including miscellaneous expense accounts.

Examination of miscellaneous expenses may lead to the discovery of potential liability for excise taxes.

Examiners should verify that contributions to qualified cash or deferred arrangement plans are not attributable to compensation earned by plan participants after the end of the taxable year under examination. Many employers have accelerated deductions of payments made after the end of their tax year to an IRC section 401(k) retirement-savings plan with a different year-end.

Revenue Ruling 90-105 determined that the contributions to a qualified cash or deferred arrangement plan within the meaning of IRC section 401(k) or to a defined contribution plan as matching contributions within the meaning of IRC section 401(m) are not deductible by the employer for a taxable year, if the contributions are attributable to compensation earned by plan participants after the end of that taxable year. This ruling applies regardless of whether the employer uses the cash or accrual method of accounting and applies to tax returns filed after December 6, 1990.

Many retailers spend considerable money in researching, selecting, and obtaining the most desirable locations for new projects. A number of studies may be done for a particular site including soil tests for construction suitability, environmental studies to identify potential site cleanup costs, and asbestos studies to assess liabilities from existing properties. The costs of these studies for sites which are purchased should be capitalized as part of the acquisition. The costs of the internal staff (e.g., legal, engineering and planning) who work with these studies should also be capitalized. Identification of the studies, their costs, and to what sites they pertain may be difficult because many of the studies are completed prior to the purchase of the property. A review of accounts payable, particularly in legal and professional accounts, may provide useful information relative to this issue.

Taxpayers should capitalize all of the costs associated with acquiring a parcel of land or an existing building. Many of the costs will be incurred prior to the purchase and may not be associated with the parcel or asset in the taxpayer’s property accounting. For example, soil tests or environmental studies could be performed on a parcel of land or an asbestos analysis may be conducted on an existing asset. The costs of the internal staff that works with these studies should be capitalized as part of the acquisition.

These types of costs are often found during a review of accounts payable, particularly in legal and professional fees. The taxpayer’s chart of accounts may reveal a specific account in which such costs are accumulated.

Many taxpayers license software from a supplier and then pay annual fees to renew the license, maintain the software, and obtain software upgrades. Frequently the taxpayer capitalizes the initial licensing fee but then expenses maintenance and upgrade costs. The nature of maintenance and software upgrades should be reviewed by the examiner to determine if they provide a benefit exceeding one year and should be capitalized.

Revenue Ruling 89-62 held that video cassettes are depreciable under IRC section 167 in accordance with the straight line method or the income forecast method over the useful life of the cassette in the taxpayer’s business. Where the taxpayer is able to demonstrate a useful life not in excess of one year, such video cassettes may be deducted under IRC section 162 of the Internal Revenue Code.

It is generally found that new high demand movies have a tape life of under one year, while classics have a tape life of three or more years and other tapes may have a life somewhere in-between. It is common to find an average useful life for all tapes to be two years.

Investment tax credit issues interact with the "Allocation Between Personal Property and Land Improvements" discussed in IRM 4.43.1.4.13.2.

The Work Opportunity Credit (formerly known as the "Targeted Jobs Credit"), as amended by the Small Business Job Protection Act of 1996, encourages retail operations to employ eligible individuals who are members of a targeted group as defined by IRC section 51 (d).

The credit allowed under this section shall be equal to 40 percent of the qualified first-year wages, as defined by IRC section 51 (b), not to exceed $6,000 per year ($3,000 for summer youth employees).

In order to qualify for the credit the retailer must, on or before the day on which the individual begins work, receive or request in writing such certification from the designated local agency that the individual is a member of the targeted group. The agency is designated by the Department of Labor, who administers the Work Opportunity Credit. The examiner should review such receipts or requests by comparing postmarks (or receive dates) with dates the individual actually begins work.

Retailers who routinely employ members of targeted groups often rely on independent employment firms who pre-screen the individuals to ensure that all the qualification and certification requirements are met for the retailer. An additional review of these qualifications by a designated local agency should satisfy any concerns the examiner may have as to proper designation of an individual to a specific targeted group.

Non-qualified individuals include a rehiree who was previously employed by the employer at any time, and individuals transferred to a different business location by the same employer after previous qualification and wage limits have been met.

Wages paid to an eligible employee cannot be considered for credit purposes unless the individual is employed by the employer for at least 120 hours of service, as per IRC section 51(i)(3)(B). Accordingly, wages below $618 ($5.15 minimum wage x 120 hours) should be reviewed.

A reduction in credit to 25 percent (from 40 percent) occurs for an individual who has performed at least 120 hours, but less than 400 hours of service, as per IRC section 51 (i)(3)(A). Accordingly, wages below $2,060 ($5.15 minimum wage x 400 hours) should be reviewed.

If a large number of targeted individuals are employed, the examiner may perform a statistical sample to ensure that all IRC section 51 requirements have been met.

The New Market Tax Credit, IRC section 45D as added by the Community Renewal Act of 2000, is a new tax credit created to spur investment in low-income or economically disadvantaged areas.

As part of the general business credit, the New Market Tax Credit is five percent of a qualified equity investment in a qualified community development entity (CDE) as of the original issue date. The five-percent rate is for the first three allowance dates and increases to six-percent for each of the four remaining allowance dates. The allowance dates are the initial offering date and the first six anniversary dates of the initial offering date. The total credit is, therefore, 39 percent and is claimed over seven annual allowance periods. Credit limitations for each calendar year are applicable.

Also as part of the general business credit, the New Market Tax Credit is subject to the limitations of IRC section 38 and the carryover rules of IRC section 39. However, the credit may not be carried back to tax years before January 1, 2001.

A qualified equity investment is the cost of any stock in a corporation or any capital interest in a partnership that is a qualified CDE, as certified by the Secretary of the Treasury, if:

If, during the seven years from the original issue date of the qualified equity investment, a recapture event occurs with respect to the investment, then the new markets tax credit must be recaptured. The recapture penalty is severe. Although only the credits claimed (i.e. those credits for which the taxpayer received a tax benefit) are recaptured, the underpayment interest begins to accrue from the due date of the return without extensions for each year the credits were claimed. Additionally, the interest may not be deducted as a reasonable and necessary business deduction. Finally, the recapture amount is treated as an increase in the tax after the regular tax liability and the alternative minimum tax liability are determined.

The Secretary of the Treasury shall prescribe regulations for this section that:

Employers are entitled to a credit on the first $15,000 of wages paid to each full- or part-time employee who is a resident of an empowerment zone designated by the Secretary of Housing and Urban Development and the Secretary of Agriculture.

Per IRC section 1396 to qualify for the credit the employee must:

The following employees do not qualify for the credit if they are:

The credit percentage varies depending upon the empowerment zone and the year that wages are paid or incurred. This credit is claimed on Form 8844 and is a component of the general business credit. No unused portion of the credit may be carried back to a tax year ending before 1994. The amount of the credit claimed may not be deducted as wages.

Examiners can verify whether an employer's business location or employee's abode is located within an empowerment zone at the website, www.ezec.gov. Specifically, from the EZ/EC home page, select “EZ/EC Communities” and then select “Interactive Locator”. Input the particular address and zip code in order to verify whether it is located within an Empowerment Zone.

Many IRC section 482 issues involve very substantial resources, both on the part of the taxpayer and of the Internal Revenue Service. Many of these issues have been successfully resolved before the taxpayer's return is filed, or before the Service brings up the issue in an audit context, through the use of Advanced Pricing Agreements (APAs). An APA is an agreement between the Service and the taxpayer on a transfer pricing method (TPM). This methodology may be applied to any apportionment or allocation of income, deductions, credits, or allowances between or among two or more organizations, trades, or businesses owned or controlled, directly or indirectly by the same interests. The APA process is designed to be a flexible problem-solving process, based on cooperative and principled negotiations between taxpayers and the Service. The taxpayer initiates the request. APAs exist under our various tax treaties and are consummated through each country's Competent Authority office's referral procedures. A more extensive description of APAs can be found in the Tax Treaty Related Matters of IRM 4.60.3.

More extensive audit techniques for IRC section 482 issues are found in IRM 4.61.3. International Examiners have special training on IRC section 482 issues. Consideration should be given to making a referral to International Exam. Referral criteria and procedures are found in IRM 4.60.5