Manufacturers, auto dealers, distributors and retailers have experienced severe supply chain disruptions, chip shortages and idle factories resulting from the pandemic — leading some to significantly reduced inventory levels.
A significant reduction in inventory may be even more concerning for those using the Last-in-First-Out (LIFO) method of accounting. Many taxpayers using LIFO could see a significant recapture of their LIFO reserves, creating large income recaptures and ultimately resulting in the need to “add back” tax deductions taken in previous years. It’s important to know your options to place your company in the best tax position.
LIFO is essentially a deferral. This valuation method assumes the last inventory in is the first inventory out. Assuming inflation, new inventory generally has greater costs than older inventory; therefore, you can take more of a deduction in the current year under LIFO than you would using another inventory method, such as FIFO (First-in-First-Out). This holds true if inventory quantities stay the same or grow, as long as there is price inflation.
Unless you are lucky and can boost your inventory levels by year-end, you may be faced with picking up more income — and paying more tax — than you had planned.
Currently, there are three options to explore and consider.
If you choose to elect out of LIFO, you can spread out the income pickup over four years as opposed to picking up a large amount in the current year. To elect out of LIFO, you would file a change of accounting method (Form 3115) with your timely filed tax return.
The pro in this scenario is income pickup can be spread out over four years. The con is that once you elect out of LIFO, you must wait five years before you can elect back into it.
Another option is to stay the course. Sticking with LIFO when inventory has significantly decreased likely means an income pick-up in the current year. However, with inflation at a 30-year high, future increases in inventory could quickly build back your LIFO reserve deferral, potentially at a time when tax rates are higher than they are today. Also consider your inventory pools and LIFO calculations to determine if you can do anything to limit the impact of the recapture this year. For example, if you have a pool for new trucks and a pool for new cars, combining the two pools may result in a smaller reduction of the LIFO reserve.
Additionally, consider the historically low tax environment today. Recognizing additional income at low rates and building back the deferral during a potential higher tax rate environment may more than offset a short-term loss of the deferral.
There’s always the chance of the IRS or Congress taking action, even passing a bill that includes LIFO relief. However, it’s probably not a realistic, or imminent, option.
While Internal Revenue Code (IRC) Section 473 provides relief for taxpayers who experience interruptions due to a major foreign trade issue, at this point Sec. 473 is not viewed as a valid option for many taxpayers. This is especially true for those in the auto industry who have lobbied for relief under Sec. 473.
The bottom line is if you have reduced inventory levels and currently use LIFO, you will want to consider all the factors and options as well as discuss them with your tax adviser before making a proactive decision as to which course to take.
Contact Tarik Awad at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.
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