Wal-Mart Stores, Inc. & Subsidiaries v. C.I.R., WAL-MART

• Decision Date: 14 August 1998
• Docket Number: WAL-MART,No. 97-2693,97-2693
• Citation: 153 F.3d 650
• Parties: -5601, 98-2 USTC P 50,645 STORES, INC. & SUBSIDIARIES, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.
• Court: U.S. Court of Appeals — Eighth Circuit

Page 650

153 F.3d 650

82 A.F.T.R.2d 98-5601, 98-2 USTC P 50,645

WAL-MART STORES, INC. & SUBSIDIARIES, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.

No. 97-2693.

United States Court of Appeals,

Eighth Circuit.

Submitted March 10, 1998.

Decided Aug. 14, 1998.

Steven W. Park, Department of Justice, Washington, DC, argued (Teresa E. McLaughlin, Department of Justice, Washington, DC, on the brief), for appellant.

Alexander Sakupowsky, Jr., Washington, DC, argued (F. Brook Voght and Jean A. Pawlow, Washington, DC, on the brief), for appellees.

Before BEAM and HEANEY, Circuit Judges, and WATERS, ¹ District Judge.

BEAM, Circuit Judge.

This case presents the question whether a retailer may account for unverified inventory shrinkage, and if so, whether the method used by Wal-Mart Stores, Inc. & Subsidiaries is permissible. The Commissioner of Internal Revenue (Commissioner) appeals from the tax court's ² decision reversing the Commissioner's determination of federal tax deficiencies. We affirm the tax court.

I. BACKGROUND

The parties have stipulated the relevant facts. Wal-Mart Stores, Inc., was the parent company of a group of affiliated corporations, including Kuhn's-Big K Stores Corp. (Kuhn's), Big K Edwards, Inc. (Edwards), and Sam's Wholesale Clubs (Sam's). ³ The Taxpayer filed consolidated tax returns for the fiscal years ending in late January of 1984 (referred to herein as the 1983 taxable year), 1985, 1986, and 1987. The Taxpayer's principal place of business was in Bentonville, Arkansas.

During the taxable years at issue, Wal-Mart operated its stores as mass discount retailers, carrying between 60,000 and 90,000 different merchandise items in each store. Wal-Mart purchased more than $22 billion in merchandise, turning its inventory over as often as 4.5 times per year. Sam's ran its stores as discount warehouses, carrying between 3,500 and 5,000 different merchandise items, acquiring more than $2.6 billion in merchandise. The Taxpayer's operations grew at a resounding pace from 1983 to 1986. For example, the number of Wal-Mart stores increased from 642 to 980 and the number of Sam's stores increased from 3 to 49. The Taxpayer utilized an extensive distribution and tracking system to maintain optimal inventories at each store. The Taxpayer's inventory system is commonly revered as the finest in the retail industry.

For both financial reporting and tax purposes, the Taxpayer used the accrual method of accounting and maintained a perpetual inventory system. Under the perpetual inventory system, the cost or quantity of goods sold or purchased is contemporaneously recorded at the time of sale or purchase. The system continuously shows the cost or quantity of goods that should be on hand at any given time. The Taxpayer performed physical inventories to confirm the accuracy of the inventory as stated in the books, and made adjustments to the books to reconcile the book inventory with the physical inventory. ⁴

The Taxpayer's physical inventories were taken at its stores in rotation throughout the year. The Taxpayer did not take physical inventories during the holiday season (November, December, and the first week of January). The Taxpayer refers to this technique, which is common in the retail industry, as cycle counting. Cycle counting is necessitated by the difficulty in conducting physical inventories at every store on the last day of the year. This technique also provides management with feedback on the effectiveness of its inventory management and facilitates the use of experienced personnel to conduct the physical inventories.

Forty-five days prior to conducting a physical inventory in one of its stores, Wal-Mart's internal audit department would send the store a preparation package, which included instructions on how to prepare for the physical count. Each physical count was then conducted by a team of independent counters (18 to 40 persons) and representatives from Wal-Mart's loss prevention department (1 to 2 persons), internal audit department (1 to 3 persons), and operations division (1 to 2 persons). Wal-Mart's independent auditors, Ernst & Young, also sent representatives to randomly selected physical counts to test their accuracy. The independent counters generally counted every inventory item. The results of the physical count were then reconciled with the book inventory. The reconciliations were reviewed by Wal-Mart's internal audit department. Generally, Wal-Mart did not record the results of a physical inventory in its books until the following month. ⁵

Sam's conducted its physical inventories in the same manner except that physical counts were usually taken twice a year and recorded the very next day. Sam's also periodically conducted item audits, counting the goods on hand for a particular merchandise unit and recording those results the next day. The physical inventories of both Wal-Mart and Sam's usually revealed shrinkage.

Shrinkage (or overage) is the difference between the inventory determined from the perpetual inventory records and the amount of inventory actually on hand. Because shrinkage reduces profits, the Taxpayer has devoted extensive resources to monitoring and mitigating shrinkage. There are many causes of shrinkage, including employee theft, customer theft, vendor theft, damage, breakage, spoilage, accounting and recording errors, errors in marking retail prices, cash register errors, markdowns taken and not recorded, errors in accounting for customer returns, and errors in accounting for vendor receipts and returns.

Because the Taxpayer did not conduct a physical inventory at year-end, its perpetual inventory records did not account for any shrinkage that may have occurred during the period between the date of the last physical inventory and the taxable year-end. The parties refer to this period as the stub period. Left unadjusted, the Taxpayer's book records would overstate income because the stub period shrinkage results in a decrease to ending inventory, thus increasing the cost of goods sold and reducing gross income. ⁶

In adjusting its books to reflect stub period shrinkage, Wal-Mart estimated stub period shrinkage for each store monthly by multiplying a retail shrinkage rate by the store's sales during that month. At new stores, the retail shrinkage rate was fixed by management at 3% of sales in the 1983 and 1984 taxable years and 2% of sales in the 1985 and 1986 taxable years. Wal-Mart used that fixed rate from the date the store opened until its first physical inventory, which rarely took place less than six months after opening. After taking the first physical inventory at a new store, Wal-Mart computed a shrinkage rate for that store by dividing the store's shrinkage at retail, as verified by the first inventory, by the store's sales for the period starting with the date the store opened and ending on the inventory date. After Wal-Mart took a second inventory, it computed the store's shrinkage rate by dividing the store's shrinkage, as verified by the first two inventories, by the store's sales starting with the opening date and ending on the second inventory date. After the third inventory, it computed the shrinkage rate by dividing the store's shrinkage, as verified by the first three inventories, by the store's sales starting with the opening date and ending on the third inventory date. After taking a fourth and each subsequent inventory, the retail shrinkage rate was based on a rolling average of the historical shrinkage over the preceding three inventories.

The retail shrinkage rate was subject to certain floor and ceiling percentage limitations that were set by Wal-Mart's management, based primarily on a weighted five-year average of shrinkage. If the computed shrinkage rate was below the floor limitation, or if it was an overage, the computed rate was replaced by the floor limitation. Likewise, if the computed rate exceeded the ceiling limitation, it was replaced by the ceiling limitation.

Sam's consistently estimated the stub period shrinkage at .2% of sales. That rate was determined by management based on their analysis of historical results from warehouse operations.

Each physical inventory would reveal a difference (estimation error) between the estimated shrinkage, as reflected in the perpetual inventory records, and the verified shrinkage. At that time, the Taxpayer would adjust its inventory records to reflect any estimation error. Consequently, for each taxable year, the Taxpayer's total adjustments to its inventory records for shrinkage would include (1) any shrinkage estimates for the period from the start of the taxable year until the physical inventory date, (2) any estimation error adjustment, and (3) any stub period shrinkage estimates. The Taxpayer also recomputed the retail shrinkage rate for the store and used that new rate to estimate shrinkage until the next physical inventory. Thus, if the Taxpayer overestimated or underestimated a store's shrinkage in year one, it would adjust that store's shrinkage rate in year two. In accordance with the cycle counting technique, this was a continuous process throughout the year for each of the Taxpayer's stores.

Wal-Mart estimated shrinkage for each store, but not for each department within each store. It used a series of computations to allocate the estimated stub period shrinkage to each department. Once these allocations were made, Wal-Mart used the adjusted ending inventory to make its LIFO computations, see Treas. Reg. § 1.472-1, which were made on a division-wide basis and not at the individual store level.

The Taxpayer reported shrinkage on an aggregate basis for both financial and tax purposes. The practice of estimating shrinkage as a percentage of sales is prevalent in the retail industry. Ernst & Young issued unqualified opinions to the effect that the Taxpayer's financial statements for the subject years conformed with Generally Accepted Accounting...