Inflation Breathes New Life into LIFO
3.14.22 | Industry Insights
There is nothing new about LIFO, the Last In, First Out method to account for inventory that records the most recently produced items as sold first. What is new and apparently here for an unwelcomed long stay is inflation. Taking the ravages of inflation as a given, there are ways to leverage the LIFO approach to your tax advantage.
Option to Consider
Products purchased recently came in at a higher cost than those same items purchased months earlier. Following a LIFO strategy can deduct the increased cost of recently purchased inventory against current sales, resulting in a potentially substantial tax deferral. It is important to value your inventory for GAAP and tax purposes correctly. Make certain that your cost of goods (COGs) is accurate, as it will be key to making the most of your deductions with a view towards minimizing your tax bill.
The benefits of taking a higher cost of goods deduction can include:
- lower margins,
- reduced taxable income,
- a tax liability deferral and
- a potential improvement in cash flow.
Should the current inflationary spike go on for a number of years, the benefits of a LIFO strategy could increase each year as long as inventory quantities at year-end don’t decline.
The FIFO Model
With the sister strategy of First In First Out (FIFO), the business initially moves older inventory that came in at a lower cost. The newer inventory that arrived at a higher cost remains. In the short term, the business sells the cheaper inventory at inflation-driven prices and enjoys higher gross profit and improved net income and, as a result, makes higher income tax payments. The business would then be paying taxes on phantom profits.1 This is by no means an enjoyable prospect.
Electing to Go with LIFO
Businesses making the LIFO election must use Form 9702 Application to Use LIFO Inventory Method and attach it to their income tax return for the first tax year to which the election will apply. In doing so, the business is required to present all annual financial statements made to creditors, shareholders, and other parties on a LIFO basis. This is known as the conformity requirement.
For 2021, consult with your tax advisors to see if there are any timing issues since most financial statements are finalized well before taxes are filed. A LIFO election can be made at any point up to the tax return’s extended due date. If that hurdle has been covered, businesses raked by the recent inflation may benefit from a significant reduction in taxable income.
In the first year of the LIFO election, the business may enjoy a substantial tax deferral, which, if inflation continues, could increase further. If the product costs go down or if inventory is liquidated, the tax deferral created by LIFO will be recognized and the relevant tax paid. In the meantime, the business can invest those savings to develop new business, purchase or update equipment and software, improve cybersecurity, or pursue other profitable endeavors.
In the future, as circumstances change and the business would like to revoke the LIFO election, it must file a Form 3115 Application for Change in Method of Accounting.3 The IRS considers this decision an automatic change that must be filed with a timely filed tax return, including extensions. Be aware that electing off LIFO is only an automatic change after being on LIFO for five years. Until then, the change would be considered a non-automatic method change which the IRS National Office might approve or deny depending on the facts and circumstances. The automatic consent procedures allow you to change from a LIFO method to any other permitted method. The business changing from the LIFO method must calculate, as of the beginning of the year, the difference between the income that would have been recognized under the new method and what income was actually recognized under the LIFO method. That difference is a 481(a) adjustment, which is picked up ratably over a four-year period, starting with the year of the change. Certain circumstances can accelerate the recognition of the 481(a) adjustment, including the business making an S-Corp election.
Once the business has filed a Form 3115 to revoke the LIFO election, it will not be able to re-elect LIFO for five years, starting with the year of the change, except under specific circumstances. If the business meets one of the exceptions to re-electing LIFO within five years, the change is made using Form 3115. If the business chooses to re-elect LIFO after five years, it must file another Form 970. Note that switching to LIFO does not mean disrupting your Enterprise Resource Planning (ERP) or pricing models. You can conduct your inventory management as you usually would since LIFO is a year-end calculation only.
Be aware that LIFO benefits can be impacted by any eventual inflation or even deflation, which cannot be predicted. Also, over time, any decreases in inventory could reduce the LIFO benefits that have accumulated.
The current inflationary cycle has had its beginning, is continuing, and will end at some point in the near or distant future. Now is an excellent moment to consult with your financial advisors to determine if the time may be ripe for LIFO.
Berdon LLP New York Accountants