Another Pandemic Problem – Taxable Income from Decreases in LIFO Inventories

Dealerships have been extremely resilient over the past 18 months.  From adapting their sales processes and operations during the height of the pandemic, to finding ways to counter inventory shortages, dealers have remained creative and weathered the storm.  In fact, many have reported record years, despite the COVID-19 pandemic.  However, another challenge has come front and center.

The Problem

• Continued supply chain issues impacting the automotive industry have caused significant decreases in dealers’ inventory.
• For those dealerships utilizing a LIFO inventory method, unexpected taxable income may be triggered by these involuntary decreases in overall inventory levels.

LIFO Inventory Impact

• A given dealer’s LIFO inventory reserve depends on the brand of vehicles, history of inventory levels and inflation.
• Recapture of the reserve is not necessarily proportionate to the decrease of inventory.
  • A 60% decrease in inventory might only be a recapture of 30% of the LIFO reserve into taxable income.
  • No two dealers will have the same impact – depends entirely upon the historical LIFO layers and how the decrease applies to each layer.

IRC §473 – A Hidden Gem?

• An old provision within the Internal Revenue Code is a potential fix.
• A “qualified inventory interruption” permits taxpayers to reduce taxable income for the year in which the involuntary liquidation occurs.
  • Foreign trade interruptions due to the COVID-19 pandemic meet the definition of a qualified inventory interruption.
  • Taxpayers can replace the liquidated inventory within three years, to restore their typical inventory levels.
  • If restored within this time period, the taxable income for the liquidation year can be reduced.
  • There are still many unknowns about the application of this provision to the situation faced by dealerships.

Advocates for Relief

• NADA and American Institute of Certified Public Accountants (AICPA) are well aware of the potential adverse effect to dealerships. Both have sought clarification from the Internal Revenue Service regarding IRC §473.
  • The AICPA sought commentary from tax practitioners to include in its April 2021 letter to Treasury.
  • Suggestions for relief and safe harbors for dealers on how to apply the rules of §473 to mitigate the taxable income impact of the decline in inventory levels were requested.
  • The AICPA specifically asked Treasury to issue a Notice addressing all concerns and options for relief – guidance on which dealerships can rely.

While dealerships have navigated through the pandemic with much success, the impact is still being felt.  Even though 2020 inventory levels substantially decreased industry-wide, 2021 is tracking to be even lower.  Hence, the potential LIFO impact hasn’t stopped.

Have questions on LIFO and the impact of the pandemic?  Please reach out to your Brady Ware advisor for assistance.