Bill Highlights Potential Downside of Using LIFO Accounting

Automotive retail is among the sectors hardest hit by recent supply chain shortages and global trade disruptions. In an April letter to Congress, the AICPA expressed its support for a bill that would provide tax relief to car dealers who use the last-in, first-out (LIFO) method of accounting for their new and used vehicle inventories. Here’s how the LIFO method works, along with some details of the proposed legislation and why the AICPA supports it.

How LIFO works

The LIFO method assumes that a seller purchased its goods at the price paid for the items that were most recently added to inventory. In an expanding economy or an inflationary environment, LIFO typically increases reported costs and lets companies report lower profits under U.S. Generally Accepted Accounting Principles (GAAP).

The “LIFO conformity rule” generally requires companies to use the same inventory accounting method for tax and financial statement purposes. So, by using this method, companies can minimize their tax obligations. But they also appear less profitable to stakeholders, and they report lower inventory on their balance sheets, thus giving the appearance of a weaker financial position.

In contrast, the first-in, first-out (FIFO) method assumes that merchandise is sold in the order it was acquired or produced. Thus, the cost of goods sold is based on older — and often lower — prices.

The use of LIFO can create a problem if inventory levels are declining, however. As higher inventory costs are used up, companies that use LIFO will need to start dipping into lower-cost layers of inventory, triggering taxes on “phantom income” that the LIFO method previously has allowed the company to defer.

In addition, if a C corporation elects S corporation status, the business must include a “LIFO recapture amount” in income for the C corporation’s last tax year. The recapture amount is the excess of the inventory’s value using FIFO over its value using LIFO. Under current tax law, taxpayers can spread out the payments over four years in equal, interest-free installments.

What’s changed

Many retailers and manufacturers are struggling to maintain adequate levels of inventory due to disruptions in foreign trade and the global supply chain. The disruptions have been caused by government restrictions that are intended to combat the spread of COVID-19. The automotive industry has been among those that were greatly impacted by the pandemic. Microchip and other parts shortages have dramatically reduced the supply of new vehicles, causing the prices of new and used vehicles to soar over the last few years.

Government restrictions “made it extremely difficult for U.S. companies to replace their inventories in 2020 and 2021, resulting in a significant reduction to inventory levels, and the difficulties have continued,” said John Lewis, chair of AICPA Tax Executive Committee, in a recent letter to Congress. Reduced inventory levels will, in turn, cause companies that use LIFO to realize additional taxable income and unexpected tax liabilities, hampering their recovery from the pandemic.

Why legislative action is needed

The U.S. Treasury lacks the authority to grant tax relief for taxpayers facing this situation. So, the AICPA strongly supports legislative measures to protect auto dealers that use LIFO.

On April 4, 2022, the Supply Chain Disruptions Relief Act was referred to the House Ways and Means Committee to offer Section 473 relief to eligible taxpayers. Specifically, the bipartisan bill would allow auto dealers to reduce the unanticipated income from a qualified liquidation of LIFO inventories by replacing the inventory over a three-year period.

The AICPA supports the bill because it would allow dealerships to choose to wait until as late as 2025 for their inventory to be replaced in order to determine the income attributable to the sale of inventory during 2020 or 2021.

“In particular, we appreciate that the bill also leverages principles of the AICPA safe harbor method. This problem is currently most acute for automobile dealers who use LIFO inventory method, who have clearly documented how pandemic-related global supply chain disruptions have made it extremely difficult to restock inventory,” Lewis wrote.

We can help

Under normal conditions, reporting inventory and its related costs can be challenging for internal accounting personnel. The complexities are even greater in today’s unprecedented market conditions. Contact Hood & Strong for the latest legislative developments and to help you understand how reduced inventory levels will affect your financial statements and tax obligations for 2022 and beyond.

 

Sidebar: Is LIFO still on the chopping block?

During the Obama administration, the White House unsuccessfully tried to get rid of LIFO for federal tax purposes. The change was intended to help close the federal budget deficit.

Obama’s 2013 proposed budget said that repealing the LIFO method “would eliminate a tax deferral opportunity available to taxpayers that hold inventories, the costs of which increase over time.” The change also would have simplified the tax code “by removing a complex and burdensome accounting method that has been the source of controversy between taxpayers and the Internal Revenue Service.”

The Biden administration’s budgets haven’t resurrected the LIFO proposal. But it’s important for auto dealers and other businesses that use this method for reporting inventory to monitor any tax law developments in this area.