Sikich Series on Tax Reform: Changes NOT Included in Tax Cuts and Jobs Act Offer Opportunity – LIFO Inventory Method

An “Interest-Free Loan” from the Government – Compliments of LIFO

Are you a manufacturer or distributor interested in an interest-free loan from the government? If so, then please complete the following short “loan” checklist to see if it’s right for you:

1. Does your business have inventory?
2. If so, have you experienced or do you anticipate rising costs, perhaps from tariffs (or threat of tariffs) or other reasons, for the materials that go into your inventory?
3. Does your business pay income taxes, or expect to in the near future?
4. Could your business benefit from increased cash flow to your operations?
5. Would you be interested in an interest-free loan from the government that could grow over time, but does not need to be shown on your balance sheet, and could possibly be deferred indefinitely?

If you answered “yes” to this list of questions, you may qualify for an interest-free loan from the government by adopting the “Last In – First Out” (“LIFO”) inventory valuation method.

Background on LIFO

LIFO is an inventory valuation method alternative to the traditional “First In – First Out” (“FIFO”) inventory method. The LIFO inventory method assumes that the most recently purchased items are sold first. As a result, the inflationary impact of the inventory is removed from the inventory on the balance sheet and currently deducted from taxable income. Instead, the inflation is recorded as an inventory reserve, which continues to grow year after year as the impact of inflation on the product costs continue. It is important to note that an inventory valuation method such as LIFO is simply a costing method used to calculate your company’s cost of goods sold, net income, and inventory value on the balance sheet. It does not affect or reflect the actual physical flow of goods.

Tax Benefits of LIFO

The primary reason and benefit for a business to change to LIFO is the current tax savings it produces. LIFO allows businesses to deduct the most recent costs of purchased inventory against their current sales. LIFO matches current sales with current costs of those sales. If inflation is producing rising product costs, the cost of goods sold is increased under LIFO, which creates a higher cost of goods sold deduction and, thus a lower taxable income. This tax benefit is, in effect, the “interest-free loan” noted above. As with most tax savings opportunities, it is important to realize the tax savings created by adopting LIFO during an inflationary period represent a deferral of income and the corresponding tax on this income. If inflation goes away and product prices decline or if all the inventory is liquidated, the deferred income will be recognized and the related tax paid. Thus, these tax savings generated over a number of years would be repaid, but at no interest charge. For businesses in industries or markets which generally see inflation (even if it is as little as one to two percent), however, the tax savings from LIFO will continue to grow year after year.

Tax Reform and LIFO

The LIFO inventory method has been around for many years. Some companies have been on the LIFO method for 40 to 50 years or more and deferred significant amount of tax during these years, especially during periods of high inflation. As the tax reform efforts moved forward last year, there was speculation that with the lower corporate tax rates, expanded CapEx deductions, and other changes, the LIFO method might be repealed. This could have resulted in the repayment of all prior LIFO tax savings and loss of LIFO savings on future inflation. The loss of the LIFO method would have significantly impacted businesses using LIFO. In some cases, the LIFO tax benefit (built up over an extended period of time) might exceed what the net equity of the business is and could have severely affected the ongoing viability of the business. Last year’s tax legislation, the “Tax Cuts and Jobs Act,” however, did not make any changes with LIFO. Thus, prior LIFO savings were preserved and any future LIFO savings opportunities remain for impacted manufacturers and distributors. It is important for any businesses using LIFO (and those considering it) to monitor any proposed legislation involving the LIFO method.

LIFO Considerations

The following considerations are important for any company analyzing whether it should adopt the LIFO inventory method:

1. Explore the benefit side of the LIFO analysis. An analysis of the potential first year tax savings of LIFO can be done for little cost simply based on information regarding the business’ current FIFO inventory amount and its general product description or inventory. The initial analysis of estimated LIFO tax savings will demonstrate whether the tax savings will surpass the additional administrative costs of adopting LIFO, and thus show if the business is a good LIFO candidate.

LIFO Example. Wisco Widgets has inventory of $4,000,000. For Year 1, there is 10% inflation with its inventory. Thus, the LIFO adjustment would be approximately $400,000 and the related tax savings would be ~$120,000 (based on Wisco Widget’s tax bracket). For Year 2, the inventory level stays the same, but there is 8% inflation resulting in a Year 2 LIFO adjustment of $320,000 and a tax savings of about $96,000. The cumulative tax savings after Year 2 would be $216,000.

2. Tariffs – Making Lemonade out of Lemons. Over the past year, the US Government has imposed tariffs on certain products coming into the U.S. Other countries have countered and imposed tariffs on U.S. exports. These trading policies have led to some uncertainty in the marketplace. Without getting into the issues of whether or not to impose tariffs, and if so, on what products and in what amounts, one opportunity that emerges from these higher prices caused by the tariffs is the possible use of LIFO. Higher product prices in certain industries, whether caused by tariffs, the threat of tariffs, or other reasons may generate a larger LIFO benefit. For companies already using LIFO, they should look at their situations closely to see if higher inflation exits in 2018 will have more of an impact. For other companies not on LIFO, this may be the year to investigate LIFO (see point four below on how and when to adopt the LIFO method).
3. Next, there are several alternative LIFO methods to choose from with varying complexities and tax benefits. One commonly used LIFO method is known as the “Inventory Price Index Computation” (“IPIC”) method, and it is generally the preferred LIFO method by the IRS. The IPIC method reduces complexities as it measures inflation based on published indexes that are tracked and maintained by the U.S. Department of Labor and its Bureau of Labor Statistics (“BLS”). The inflation determined by the BLS indices is used instead of measuring inflation based on changes in actual costs for each inventory item of a business. The IPIC method sometimes results in higher inflation than a company is experiencing internally.
4. Adopting the LIFO Method. LIFO is different from other types of accounting methods. In fact, it has its own unique form (Form 970) and set of rules. Two key items to note with adopting LIFO:

First, the adoption or change to the LIFO method can be done up through the extended due date of the tax return for the year. For example: A calendar year company (not on LIFO) for the 2018 year conducts a LIFO analysis after its year closed (say in February 2019), in which it incurred 12% inflation for the 2018 year. With a sizable projected LIFO benefit, the company decides to pursue LIFO and then gathers the information for its Form 970 and files this by the due date of its company return. This could be up until September 15, 2019 if the company is an S Corporation or a Partnership, or by October 15, 2019 if it is a C Corporation. Thus, adopting LIFO is a tax benefit that can be realized even after the tax year is closed. But, once that extended due date has passed for the tax return, the company can not go back and adopt LIFO for that prior year – it would need to adopt it for the upcoming year.

Second, another key aspect to adopting LIFO is that a business using LIFO for tax purposes must also use LIFO for book purposes, or with its financial statements. This is referred to as the “conformity requirement.” Often this conformity causes businesses to hesitate to adopt LIFO as they (and their financial statement users) are accustomed to a different inventory method, often FIFO. Again, with rising prices, LIFO will often show lower taxable income (and save taxes), but also less income on its financial statements. Bank covenants may, therefore need to be revised and ratio analyses updated so that the lower net income resulting from LIFO and corresponding lower inventory amounts on the balance sheet will be understood in comparison to the company’s actual operating results. It should be noted that the company can still provide FIFO based information and calculations in the footnotes of the financial statements. Many banks and other creditors are familiar with LIFO, but it is still something to discuss with them when a company is considering LIFO. As they gain a better understanding of how LIFO works, they begin to realize the cash flow savings from lower taxes helps the company’s overall financial stability.

5. LIFO may not make sense in every situation, and it is always easier to make an informed decision with an actual cost vs. benefit analysis. There are certain requirements or “costs” to adopting LIFO. The costs of adopting LIFO often include additional administrative costs to file for a change of accounting method with the taxpayer’s income tax return in the year of the change and to calculate the annual LIFO inventory reserve. Next, as noted above, the business must also be willing to use LIFO for financial statement reporting purposes—this is a key consideration in the LIFO analysis. Thus, while LIFO can be adopted up to the filing of the taxpayer’s tax return for that year, it is important to plan so the appropriate information can be gathered; an informed cost versus benefit analysis can be done; financial statement users can be educated; and an actual LIFO inflation analysis completed in time for both the financial statement issuance and the tax return filing.

Key Takeaways

It is important for taxpaying businesses to take action and measure potential LIFO tax savings now. Every year they hesitate even to quantify the potential LIFO benefit, is a year of inflation and tax savings lost. Some businesses hesitate because of several legislative proposals to repeal LIFO. Many thought LIFO would be repealed in last year’s tax bill; however, this did not happen. LIFO remains and has renewed life now that inflation has resurfaced in many markets. Yes, there are complexities and issues to address in switching to the LIFO method, but the tax savings make this exercise well worth it.   

Please consult with your Sikich tax advisor to discuss the merits of adopting the LIFO method of inventory valuation or email Jim Brandenburg at jim.brandenburg@sikich.com.