It is not uncommon for businesses to utilize first-in-first out (“FIFO”) for internal reporting purposes but use the Last-In-First-Out (“LIFO”) method for external reporting purposes, such as for US GAAP and federal income tax. FIFO assumes that assets produced or acquired first are sold or used. Alternatively, LIFO assume the most recent items that were purchased into inventory will be the ones to sell first. Are you thinking I don’t select newer inventory versus older inventory when I ship my product to my customers? That is true, LIFO and FIFO are not reality, but an agreed upon method of how a business will calculate their Cost of Goods Sold (“COGS”).
Utilizing LIFO when costs are rising due to inflation is generally advantageous for income tax purposes because sales prices are offset by higher inflated purchase costs. Additionally, LIFO taxpayers can trap lower inventory cost into ending inventory each year if they maintain or increase their inventory year over year. These layers compound over time and create a significant tax deferral.
However, the advantage of LIFO is recaptured when businesses have less inventory on hand at the end of the year when compared to the beginning of the year. Business owners who are having serious supply chain woes could pay significantly higher tax due to LIFO recapture.
Let’s review simple example. Company A sold widgets in 2021 for $150 per unit. In addition, Company A’s inventory was as follows:
Assume Company A sold 275 units in 2021. It would recognize $41,250 (275*$150) of gross receipts reduced by $27,500 (275*$100) of costs of goods sold (COGS) resulting in $13,750 of gross profit.
However, gross profit will be higher to the extent that the company needs to utilize the inventory layers prior to 2021. This is where the supply chain, coupled with inflation, can have a major impact. Let’s assume in 2021 that they were only able to purchase 110 units at $100 per unit, but still sold 275 units.
The gross receipts would remain at $41,250 but COGS would utilize the 2020 inventory layer. The total COGS would be $11,000 (110 x $100) from 2021 and $13,200 from 2020 (165 x $80), totaling $24,200. Company A would recognize taxable income of $17,050, increasing their taxable income by 24%, even though the same number of sales took place. This could be a surprise to many taxpayers and may only get worse through the 2022 taxable year.
While you might view the examples that were provided as immaterial, industries that commonly use LIFO – including pharmaceutical distributors, specialty retailers, industrial equipment, farm equipment, furniture businesses, and the automotive industry- are seeing significant increases in their tax bills. For example, the National Automobile Dealers Association estimates approximately 50% of dealerships use the LIFO accounting method and projects that supply chain disruptions could lead to an additional $1.7 billion in taxes for the industry in 2022. That is a significant tax increase for an unexpecting taxpayer, and even with other potential increases in operational expenses, such as salaries and wages, could still require an increased federal tax payment.
So, is there any relief available? Potentially. Taxpayers should be monitoring their COGS and higher sales prices due to inflation. If a business is required to utilize inventory layers that are related to the prior taxable years that are significantly less than current costs, the potential taxable income increase should be identified, and tax planning should be considered.
Wait and See
Businesses may intentionally choose to stay on the LIFO method. Provided that the supply chain gets better, and inventory can be restored, the ability to build back a LIFO reserve deferral could be quicker than one would anticipate due to the inflated purchase costs. Recognizing income at a time that is generally considered to be a low tax period could be advantageous. In addition, the ability to offset future income with higher priced inventory could lead to even more benefit if the tax rates increase.
If it is decided to remain on a LIFO method, potential benefit may be achieved if there is an adjustment from a specific identification method to a pooled index method. For example, an automobile dealer using specific identification for new car inventory could consider a pool method including used cars and parts for a potential planning solution. If inventory pools are already utilized, the taxpayer should review the inventory pools to see if any adjustment can be made to limit the taxable income impact.
Elect out of LIFO
A potential solution could be for the taxpayer to elect out of LIFO to another permissible method. While this will still require an income inclusion of the entire LIFO reserve, the inclusion could be spread over four years as opposed to picking up a large amount all in one year. The limitation on making such a method of accounting change is that the taxpayer would be required to wait 5 years before being able to utilize LIFO again for US GAAP and tax purposes.
When choosing what permissible method could be used going forward when electing out of LIFO, taxpayers should confirm they are not eligible for small business inventory exceptions. Small businesses are generally defined as corporations or partnerships that have an average of less than $26,000,000 (2021) or $27,000,000 (2022) gross receipts when evaluating the 3 previous taxable years. Some businesses might fall under this exception if their gross receipts were severely impacted during the 2020 and 2021 taxable years due to the pandemic. If this exception is met, for tax return purposes the business is no longer required to account for inventories but can deduct amounts paid to acquire or produce materials and supplies in the taxable year in which the material and supplies are first used or consumed in the taxpayer’s operations. Essentially allowing small business taxpayers to not report inventory for tax purposes or worry about UNI
Will there be any help from the IRS or Congress?
The AICPA and the National Automobile Dealers Association have urged the IRS and Congress to extend the relief provided under IRC Section 473 for companies using LIFO that experienced a decrease in their closing inventories caused by government actions in response to COVID-19. The most recent proposal was introduced by Senator Sherrod Brown (D-OH) on April 28 in bipartisan bill (S. 4105) which was specifically focused on the motor vehicle industry.
Under Section 473, if the requirement to utilize LIFO layers is beyond the taxpayer’s control (such as a trade embargo or other international event) the taxpayer can elect to reduce gross income for the taxable year where it was required to utilize previous inventory layers if the business replaces the inventory within a three-year period. Specifically, Sec. 473 authorizes Treasury to issue a notice in the Federal Register that a qualified inventory interruption of LIFO inventories has occurred.
The mechanics are seen in the following example. Assume OPEC refused to sell petroleum products to U.S. companies and a U.S. petroleum company was forced to liquidate $8,000,000 of its LIFO reserve of petroleum in the 2005 taxable year. The Treasury department publishes a notice stating the event was a qualified inventory interruption. In 2006, the company replaced the petroleum at a cost of $10,500,000. The corporation’s qualified liquidation amount would be $2,500,000 (10,500,000-8,000,000) and under Section 473 the company would be able to elect to amend their 2005 tax return to exclude that amount of gross income.
Under the various safe harbor proposals, the amendment of a prior return would not be necessary. Instead, the taxpayer would not be required to recognize income attributable to the liquidation of the LIFO layers in the year of utilization if the taxpayer completely replaces the inventory by the end of the replacement period. Such a modification alleviates the burden of paying additional taxes on the related income.
Even though such a safe harbor is supported by many, the probability of passing is small. However, it is worth monitoring to see if any momentum can be built.
Businesses have faced a variety of hurdles over the least few years, and it appears that different challenges are on the horizon. The increasingly changing business environment and modification of tax law, including the TCJA sunset provisions and new administrative guidance, requires all businesses to be working closely with their tax advisors on planning to ensure that there are no unwelcome surprises to cash income tax payments and effective tax rates.