Over the past two years, manufacturers and resellers have struggled to maintain inventory levels due to global supply chain issues, and are now facing the highest rates of inflation since 1981. Unfortunately, a deteriorated supply chain and increased inflation will most likely increase the corporate tax bill. that use the LIFO accounting method.
It is not uncommon for companies to use the first-in, first-out (“FIFO”) method for internal reporting purposes, but use the last-in-first-out (“LIFO”) method for external reporting purposes. , as for the American GAA.
Using LIFO when costs rise due to inflation is generally advantageous for income tax purposes because selling prices are offset by higher inflated purchase costs. Additionally, LIFO taxpayers can trap a lower inventory cost in ending inventory each year if they maintain or increase their inventory from year to year. These layers build up over time and create a significant tax deferral.
However, the advantage of LIFO is recouped when companies have less inventory on hand at the end of the year compared to the beginning of the year. Business owners with severe supply chain issues could pay significantly higher taxes due to the LIFO clawback.
Let’s walk through a simple example. Company A sold widgets in 2021 for $150 each. In addition, Company A’s inventory was as follows:
Suppose Company A sold 275 units in 2021. It would have $41,250 ($275*150) in gross receipts less $27,500 ($275*100) in cost of goods sold (COGS), which would be 13,750 $ gross profit.
However, the gross margin will be higher as the business needs to use the inventory diapers before 2021. This is where the supply chain, coupled with inflation, can have a major impact. Suppose in 2021 they were only able to buy 110 units at $100 per unit, but still sold 275 units.
Gross revenue would remain at $41,250, but COGS would use the 2020 inventory layer. Total COGS would be $11,000 (110 x $100) from 2021 and $13,200 from 2020 (165 x $80), for a total of $24,200. Company A would recognize taxable income of $17,050, increasing its taxable income by 24%, even if the same number of sales had occurred. This may come as a surprise to many taxpayers and is only likely to get worse in the 2022 tax year.
While you may consider the examples provided to be intangible, industries that commonly use LIFO – including pharmaceutical distributors, specialty retailers, industrial equipment, agricultural equipment, furniture companies, and the automotive industry – see their tax bills increase considerably. For example, the National Automobile Dealers Association estimates that approximately 50% of dealerships use the LIFO method of accounting and predicts that supply chain disruptions could result in an additional $1.7 billion in taxes for the industry in 2022. This is a significant tax increase for an unexpected taxpayer. , and even with other potential increases in operating expenses, such as wages and salaries, could still necessitate an increase in the payment of federal taxes.
So is there any relief available? Potentially. Taxpayers should watch their COGS and higher selling prices due to inflation. If a business is required to use layers of inventory related to previous tax years that are significantly lower than current costs, the potential increase in taxable income should be identified and tax planning should be considered.
wait and watch
Businesses may intentionally choose to stay on the LIFO method. Provided the supply chain improves and inventory can be restored, the ability to replenish a LIFO reserve carryover could be faster than expected due to inflated procurement costs. It may be advantageous to recognize income at a time generally considered to be a low tax rate period. Additionally, the ability to offset future income with higher priced inventory could result in even greater benefits if tax rates rise.
If it is decided to stay on a LIFO method, a potential advantage can be gained if there is an adjustment from a specific identification method to a cluster index method. For example, a car dealership using specific identification for their new car inventory might consider a pool method including used cars and parts for a potential planning solution. If inventory pools are already in use, the taxpayer should review the inventory pools to see if an adjustment can be made to limit the impact on taxable income.
A potential solution could be for the taxpayer to opt out of LIFO for another permitted method. While this will still require an income inclusion of the entire LIFO reserve, the inclusion could be spread over four years instead of picking up a large amount in one year. The limitation to making such an accounting change method is that the taxpayer would be required to wait 5 years before being able to use LIFO again for US GAAP and tax purposes.
When choosing the permitted method that may be used in the future when electing to exit LIFO, taxpayers must confirm that they are not eligible for the small business inventory exceptions. Small businesses are generally defined as corporations or partnerships that average less than $26,000,000 (2021) or $27,000,000 (2022) in gross revenue when assessed for the previous 3 tax years . Some businesses could fall under this exception if their gross receipts were severely impacted in the 2020 and 2021 tax years due to the pandemic. If this exception is met, for tax reporting purposes, the business is no longer required to account for inventory, but may deduct amounts paid to acquire or produce materials and supplies in the year of operation. taxation in which materials and supplies are first used or consumed in the taxpayer’s business. operations. Essentially allowing small business taxpayers to not report inventory for tax purposes or worry about UNI
Will there be help from the IRS or Congress?
Under Section 473, if the requirement to use LIFO layers is beyond the taxpayer’s control (such as a trade embargo or other international event), the taxpayer may elect to reduce the gross income for the tax year. imposition where it was required to use the previous inventory layers if the company replaces the inventory within three years. Specifically, Sec. 473 authorizes the Treasury to issue a notice in the Federal Register that a qualified inventory break of LIFO inventories has occurred.
The mechanisms are seen in the following example. Suppose OPEC refuses to sell petroleum products to US companies and a US oil company is forced to liquidate $8,000,000 of its LIFO oil reserve in tax year 2005. The Treasury Department publishes a notice indicating that the event was a qualified stock-out. In 2006, the company replaced the oil at a cost of $10,500,000. The corporation’s eligible liquidation amount would be $2,500,000 (10,500,000-8,000,000) and under section 473 the corporation could elect to amend its 2005 tax return to exclude this amount from income raw.
Under the various safe harbor proposals, the modification of a prior declaration would not be necessary. Instead, the taxpayer would not be required to recognize income attributable to the disposal of LIFO diapers in the year of use if it completely replaces the inventory before the end of the replacement period. Such a modification alleviates the burden of paying additional taxes on the corresponding income.
Even if such a refuge is supported by many, the probability of passing is low. However, it is worth watching to see if any momentum can be built.
Businesses have faced a variety of hurdles over the past few years, and it looks like different challenges are on the horizon. The increasingly changing business environment and changing tax laws, including the TCJA sunset provisions and new administrative guidelines, require all businesses to work closely with their tax advisors on planning to ensure there are no surprises regarding cash income tax payments and tax efficiency. rates.