Wal-Mart Stores, Inc. v. Commissioner
| Decision Date | 02 January 1997 |
| Docket Number | Docket No. 27022-93. |
| Citation | 73 T.C.M. 1625 |
| Parties | Wal-Mart Stores, Inc. and Subsidiaries v. Commissioner. |
| Court | U.S. Tax Court |
Alexander Zakupowsky, Jr., Frederick Brook Voght, Jean Ann Pawlow, and Carol Ann Johnson, Washington, D.C., for the petitioners. Albert L. Sandlin, Jr., Thomas R. Ascher, James P. Dawson, and Martin L. Osborne, for the respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
Wal-Mart Stores, Inc., & Subsidiaries, petitioned the Court to redetermine respondent's determination of deficiencies in their Federal income tax. Respondent determined the following deficiencies:
Taxable Year Ended Deficiency
Jan. 31, 1984 (1983 taxable year) ...... $9,937,545
Jan. 31, 1985 (1984 taxable year) ...... 4,084,255
Jan. 31, 1986 (1985 taxable year) ...... 9,381,626
Jan. 31, 1987 (1986 taxable year) ...... 8,206,962
Following concessions by the parties, we must decide whether petitioners' estimates of inventory shrinkage at yearend are permissible. We hold they are. Section references are to the Internal Revenue Code in effect for the subject years. Rule references are to the Tax Court Rules of Practice and Procedure. Dollar amounts are rounded to the nearest dollar. The term "shrinkage" refers to the excess value of book inventory over actual inventory. The term "overage" refers to the excess value of actual inventory over book inventory. The term "physical inventory" refers to the counting of the goods that are actually in inventory.
Some of the facts have been stipulated and are so found. The stipulated facts and exhibits submitted therewith are incorporated herein by this reference. Petitioners comprise an affiliated group of corporations that use an accrual method of accounting for financial accounting and tax purposes. They filed Federal consolidated income tax returns and amended Federal consolidated income tax returns for the subject years. Their common parent is Wal-Mart Stores, Inc. (Parent). Parent's principal place of business was in Bentonville, Arkansas, when it petitioned the Court.
At all relevant times, Kuhn's-Big K Stores Corp. (Kuhn's) and Big K Edwards, Inc. (Edwards), were two of Parent's subsidiaries, and Sam's Wholesale Clubs (Sam's) was one of Parent's divisions.
Sam's operated its stores (clubs) on a discount warehouse basis. Wal-Mart operated its stores as mass discount retailers. Each Wal-Mart store contained up to 37 departments, and, in the aggregate, these departments carried a wide range of merchandise, including home furnishings, electrical appliances, automotive and hardware items, electronics, toys, candy, and pet supplies, as well as apparel for men, women, boys, and girls.
Inventory is petitioners' most essential and valuable asset, and it is critical to their success. Petitioners strive to maintain enough inventory to satisfy their customers' needs, while at the same time minimizing the dollar amount of their inventories. One measure of the effectiveness of Wal-Mart's inventory management is its impressive rate of inventory turnover (sales/inventory). Wal-Mart's inventory turned over 4.5 times in its 1983 taxable year, while the average turnover for Wal-Mart's competitors was approximately 2.8 times. Another indication of the effectiveness of Wal-Mart's inventory management was that many other companies (both domestic and foreign) sought advice from Wal-Mart on inventory management.
Respondent issued petitioners two notices of deficiency, one for their 1983 and 1984 taxable years and the other for their 1985 and 1986 taxable years. Both notices reflected an increase to petitioners' ending inventories on account of respondent's disallowance of their estimated inventory shrinkage.1 Respondent determined that petitioners' ending inventories as reported understated their taxable income by the following amounts:2
Taxable Year Understatement
1983 ........................... $24,276,994
1984 ........................... 7,837,122
1985 ........................... 20,394,840
1986 ........................... 1,196,045
The shrinkage disallowed by respondent relates to the period of time referred to by the parties as the "stub period". In general, the stub period is the time between the date of the last physical inventory prior to the taxable yearend and the taxable yearend. In some cases, Wal-Mart took a physical inventory in January and booked the inventory in February of the next year. In those cases, the stub period is the time between the date of the physical inventory immediately prior to the January physical inventory and the taxable yearend. In other cases, Wal-Mart booked two consecutive January inventories in February. In those cases, the stub period is the time between the first January inventory and the taxable yearend following the second January inventory. In the case of a new store for which a physical inventory was not taken before the taxable yearend, the stub period is the period beginning with the date of the store opening and ending with the taxable yearend.
Wal-Mart is one of the largest operators of mass merchandise retail stores in the United States. During the subject years, the numbers of Wal-Mart's stores and Sam's clubs were as follows:
Taxable Year Wal-Mart Sam's
1983 ......................... 642 3
1984 ......................... 745 11
1985 ......................... 859 23
1986 ......................... 980 49
Many of these stores were open to the public 24 hours a day.
During the subject years, Wal-Mart purchased and sold products labeled with the manufacturer's name (name brands), as well as products with its own name brand. The dollar amounts of petitioners' purchases and the retail values of its net sales were as follows:
Purchases Sales
------------------------------- -------------------------------
Year Wal-Mart Sam's Wal-Mart Sam's
1983 ............................ $3,543,245,308 $ 41,192,081 $4,566,514,170 $ 37,364,011
1984 ............................ 4,808,957,832 232,156,657 6,068,673,313 221,585,916
1985 ............................ 5,855,108,264 749,927,690 7,501,658,005 776,483,444
1986 ............................ 8,037,262,151 1,608,040,382 9,933,879,035 1,670,806,324
A typical Wal-Mart store averaged 53,000, 55,000, 57,000, and 59,000 square feet in the respective taxable years, and petitioners' total square footage of retail space increased from 27.7 million in the 1983 taxable year to 63 million in the 1986 taxable year. Wal-Mart's stores carried between 60,000 and 90,000 specific types of merchandise (stock keeping units or SKU's).3 Sam's clubs carried between 3,500 and 5,000 SKU's.
Wal-Mart received approximately 80 percent of its merchandise through petitioners' distribution system. Wal-Mart's distribution centers increased from 6 in 1984 to 10 in 1987. In the later year, petitioners' total distribution center space was over 7 million square feet, and each distribution center received and shipped in excess of 30 million cases of merchandise a year, the equivalent of 96 trailer loads per working day.
Inventory accounting requires allocating each period's cost of goods available for sale between: (1) Cost of goods sold and (2) the value of ending inventory. Taxpayers may use either the perpetual or periodic inventory system for this allocation. Under both systems, the cost of each purchase is recorded contemporaneously with the purchase, and the revenue from each sale is recorded contemporaneously with each sale. But for these similarities, recording differs depending on whether the taxpayer uses a periodic or a perpetual system.
Under the periodic system, an entry is not made to record the quantity or cost of an item of merchandise when it is sold. A physical count is generally performed at yearend to ascertain the items in and value of the ending inventory. The cost of goods sold is the residual amount. No distinction is made between the cost of the goods that were actually sold during the period and the expense of shrinkage.
Under the perpetual system, the cost and/or quantity of goods sold are contemporaneously recorded at or about the time of sale. Thus, the perpetual system continuously reveals the cost and/or quantity of goods sold since the beginning of the current period and the cost and/or quantity of goods that are (or should be) on hand at any given time. Physical inventory counts are performed periodically to confirm the accuracy of the inventory as stated in the taxpayer's books, and adjustments are made to the books to reconcile the inventory stated therein with the actual inventory.
Petitioners maintained a perpetual inventory system. Wal-Mart used the Last In, First Out (LIFO) method of identifying items in ending inventory, see sec. 1.472-1, Income Tax Regs., and the retail method of pricing inventories, see sec. 1.471-8, Income Tax Regs.4 Wal-Mart determined the cost of the LIFO inventories using the dollar value LIFO method, see sec. 1.472-8, Income Tax Regs., and it valued any increase in inventory quantities based on the cost of the earliest acquisitions during the year, see sec. 1.472-2, Income Tax Regs. At the end of each month, Wal-Mart applied a cost complement to convert its inventory...
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