LIFO Strategies: Evaluate Your Key Factors

Continued low inventory levels are causing dealers to question using the LIFO inventory methodology. For 2021, inventory declines are generating significant taxable income, as the LIFO reserve deteriorates. Key factors—looming tax rate increases, continued supply chain struggles, and future inflation—must be evaluated when considering a possible change from LIFO.

What strategies are available to address this taxable income increase?

Discussions continue between industry advocacy groups, tax practitioners, and Treasury regarding relief from LIFO recapture using Internal Revenue Code §473.  This provision in the tax law allows LIFO inventory levels to be restored over three years if the inventory liquidation was due to a qualified inventory interruption.  Proponents believe the supply chain problems facing the automotive industry because of the COVID-19 pandemic qualify as a major foreign trade type of qualified inventory interruption.  One strategy is to wait and see if Treasury approves the use of this provision.  Many dealerships and their owners are discussing filing extensions on March 15 and April 15, 2022, with the hope this relief is granted.

Another option being considered is changing the LIFO methodology from the Alternative method to the Inventory Price Index Computation (IPIC) method.  The Alternative and IPIC methods use different inflation measurement sources: the IPIC calculation relies on either the Consumer Price Index (CPI) or Producer Price Index (PPI).  For 2021, the CPI is producing levels of inflation substantially greater than the Alternative method.

Changing from the Alternative method to IPIC requires a 5-year commitment – it’s an accounting method change under the federal tax rules and must be used for this amount of time before a taxpayer could switch back to the Alternative method.  Additionally, all inventories – new vehicles, used vehicles and parts – must change to be valued using IPIC.  If used vehicles were previously valued using lower of cost or market, any used vehicle writedown must be reversed and pulled into taxable income over three years.

For 2021, dealerships likely would receive a substantial benefit from changing to the IPIC method.  However, the question becomes how will the CPI/PPI indices fair over the next four years?  Since 2002, many years have shown them to be negative (deflationary), which would result in an income pickup during that year.  The decision becomes will the potential increase to taxable income in years 2-5 at arguably higher tax rates be less overall than the income pickup in 2021?

Final Thoughts

Absent relief from Treasury, there is no clear yes or no answer to this question.  While a change to IPIC could be a solution for 2021, the unknown lies in the next four years.  Will the IPIC indices be inflationary (good) or deflationary (bad)?  All variables must be considered in a dealer’s analysis of whether to remain on a LIFO inventory methodology or not.