Consider Adopting LIFO to Soften the Impact of Higher Prices from Tariffs

Many imposed or proposed tariffs on imported products have the potential to result in higher prices for manufacturers and distributors. Add to that ongoing supply chain issues, product shortages and a host of other challenges, and businesses are expected to see higher costs of doing business. Companies facing these unexpected hikes in product costs may want to explore the LIFO (last-in, first-out) inventory method, which is a tax savings opportunity with no set time for repayment—sometimes thought of as an interest-free loan from the government. Please note that it is uncertain when or if this “loan” needs to be repaid, and it has the potential to increase with future price hikes.

LIFO Background

LIFO is an alternative inventory valuation method to the traditional first-in, first-out (FIFO) method. The LIFO method assumes the most recently purchased items are sold first. As a result, the inflationary impact of the inventory is deducted from taxable income and removed from the balance sheet. The inflationary impact is recorded as an inventory reserve, which continues to grow with the annual inflation on a company’s product costs. Remember that an inventory valuation method, such as LIFO, is a costing method used to calculate a company’s cost of goods sold and inventory value on the balance sheet. It does not reflect the actual physical flow of goods.

Tax Benefits of LIFO

The primary benefit to a business adopting the LIFO method is the current tax savings it produces. LIFO allows businesses to deduct the most recent higher costs of purchased inventory against their current sales. LIFO matches current sales with the current costs of those sales. If inflation (through new tariffs or otherwise) triggers higher product costs, the cost of goods sold is increased under LIFO— this creates a higher cost-of-goods-sold deduction and lower taxable income.

As with most tax savings opportunities, it is important to realize that the savings created by adopting LIFO during an inflationary period represent a deferral of income and the corresponding tax on this income. If inflation vanishes and product prices decline instead, or if the inventory is liquidated, the deferred taxable income from LIFO is recognized and the related tax paid. These tax savings generated over the years would be repaid but with no interest cost.

LIFO has been around for many years, with businesses using it to defer a significant level of taxes, especially when inflation is higher. While changes to or a repeal of LIFO have not been advocated by congressional leaders, potential tax changes are on the docket in Congress, so it is important for businesses using LIFO to monitor proposed legislation.

LIFO Considerations

Any company considering LIFO should analyze the following:

1. Explore the benefits of LIFO. A rough analysis of the potential first-year LIFO savings can be done based on a business’s current FIFO inventory amount and its general product description. The estimated LIFO tax savings may show whether the tax savings will exceed the costs of adopting LIFO and if the business is a good candidate for LIFO. Higher product prices may generate sizable LIFO tax savings. However, until a company does an analysis and realizes the possible benefits of adopting LIFO, it may dismiss it by focusing instead on the modest drawbacks of LIFO.
2. Alternative LIFO methods. There are several types of LIFO methods to select from. One commonly used method is the “Inventory Price Index Computation” (IPIC). The IPIC method reduces complexities, as it measures inflation based on published indicators determined by the Department of Labor’s Bureau of Labor Statistics (BLS). The inflation is determined by the BLS indices instead of measuring inflation based on actual product costs of a business. The IPIC method sometimes results in higher inflation than a company is experiencing internally. IPIC is also the preferred LIFO method of the IRS.
3. Adopting the LIFO method. LIFO is different from other types of accounting method changes. In fact, it has its own unique form (Form 970) to file and set of rules. Two key items to note when implementing LIFO include:
   • First, the adoption of LIFO can be made up through the tax return’s extended due date. Therefore, adopting LIFO is a tax benefit that can be realized even after the tax year is closed. The LIFO method could still be adopted for tax purposes with a company’s 2024 tax return filing. However, once the extended due date has passed, a company cannot go back and adopt LIFO for a prior year to recognize previous years’ inflation.
   • Second, a business using LIFO for tax purposes must also use LIFO for book purposes. This is known to as the “conformity requirement.” LIFO will show lower taxable income (and save taxes), but it will also show less income on the company’s financial statements. As a result, bank covenants may need to be revised so the lower income from LIFO and corresponding lower inventory amounts on the balance sheet are understood by all parties. The company can still provide FIFO-based information in the footnotes of its financial statements.
4. LIFO may not make sense in every situation: conduct a detailed cost-benefit analysis. Certain expenses in adopting LIFO often include added costs with the tax return in the year of change and for future years’ LIFO calculations. As noted, a business must also be willing to use LIFO for financial statement purposes. While LIFO can be adopted up to the tax return filing date, plan ahead so there is time for the information to be gathered, the financial statements changed to reflect LIFO, the detailed LIFO analysis completed, and the LIFO impact communicated with all interested parties.

LIFO Example

Example of a company using LIFO. XYZ Bots, Inc. manufactures high-end widgets and other metals parts and maintains an inventory level of $8 million. It currently utilizes the FIFO inventory method of accounting. For the current year, the inflation with its inventory is 6%. If XYZ adopts the LIFO inventory method for the current year, it could see a LIFO reserve of approximately $480,000, which would in turn reduce its taxable income for the year by $480,000. This would save the company approximately $140,000 in taxes in the current year. If XYZ then experiences inflation of 5% in the following year, it would realize an additional tax savings of $120,000 for a total tax savings of $260,000 in the first two years of using LIFO.

Key Takeaways

With higher product costs, it is important for manufacturers and distributors to consider the tax savings of LIFO. While there are complexities to address in switching to LIFO, there are also significant tax savings. Please contact our team leaders to request an estimate of adopting the LIFO method within your business.

About Our Authors

Jim Brandenburg, CPA, MST, possesses extensive experience and knowledge in corporate and partnership tax law, mergers and acquisitions, and tax legislation. His expertise includes working with owners of closely held businesses to identify tax planning opportunities and assist them in implementing these strategies.

Tom Bayer, CPA, CExP, has specialized expertise in the areas of business succession planning, tax planning and compliance, and business advisory. He has deep experience providing a range of accounting, tax, and business advisory services to commercial clients across industries.

Jerry Murphy, CPA, CMA, CGMA, is the leader of Sikich’s Manufacturing and Distribution Services team. He specializes in assurance services and provides business advisory services in areas such as operations improvement, strategic planning, and mergers and acquisitions.