Using LIFO to Ease the Sting of Inflation
Is your business affected by rising oil or other commodity prices? If so, you may save significant income taxes by electing LIFO.
The spike in commodity prices is causing a ripple effect across the economy that is expected to trigger inflation in the prices of a broad range of products. Use of the last-in, first-out (LIFO) method of tax accounting for inventories is beneficial in an inflationary economy because it permits a taxpayer to compute a higher cost of goods sold deduction by using inflated current cost rather than a lower cost of goods sold deduction based on the lower historic cost. A higher cost of goods sold deduction produces lower margins, lower taxable income, and thus, a tax liability deferral and improved cash flow. If inflation continues for a number of years, the benefit of LIFO will increase each year as long as inventory quantities at year-end do not decline.
A company may defer the decision whether to elect LIFO until after the end of its taxable year when the benefit of the LIFO election is readily ascertainable from published indices and the quantity of goods on hand at year-end. However, for the election to be valid, the company must also use the LIFO method in preparing its financial statements for the first year of the election. The requirement that financial statements be reported on a LIFO basis for all years for which the LIFO method is used for tax purposes is the so-called “conformity rule.” Generally, this rule is violated if 12 monthly or 4 quarterly statements that aggregate to full-year performance have been issued to shareholders or creditors using a non-LIFO method. Taxpayers that are unable to make a LIFO election for 2010 due to the operation of the conformity rule may still benefit from an election for 2011. With a 2011 election, a taxpayer has ample time to plan the initial quarter in which to use the LIFO method as its financial reporting method.
The benefit of a LIFO election in 2010 can be illustrated with a simple example. Assume a company with an inventory of synthetic rubber products elects the LIFO method and chooses to use a simplified method of determining the LIFO adjustments under the Bureau of Labor Statistics (BLS) inflation index for synthetic rubber products. The inflation percentage for synthetic rubber products in 2010 was 13%. If inventory on a first-in, first out (FIFO) method at year-end is $10 million, LIFO inventory would be approximately $8.8 million and 2010 taxable income would, as a consequence, be approximately $1.2 million less. The combined federal and state tax liability at 38% would be $456,000 less, giving the company $456,000 more cash to use in its business operations. If inflation continues and inventory quantities grow, the LIFO benefit will grow each year until the company has a decrease in inventory levels (a decrement), the BLS index reflects deflation, or the LIFO election is either voluntarily or involuntarily terminated.
There are a number of reasons a company may want to terminate a LIFO election voluntarily, the most common being that the inflationary environment which initially made LIFO attractive may not continue. Companies may also find continued compliance with the conformity rule burdensome, or have other reasons for reverting to being a FIFO taxpayer. In the case of a voluntary termination, the company would not necessarily see an immediate reversal of its LIFO benefit; generally, that reversal would be spread over four years. As a result, a company that elects LIFO in the midst of an inflationary “spike” may see a cash flow benefit for years after the inflation has cooled or reversed course.
A LIFO election may be terminated involuntarily by legislative or regulatory changes. If the proposed International Financial Reporting Standards are adopted by the Financial Accounting Standards Board, LIFO may no longer be available for some or all companies. Similarly, if Congress acts to repeal or limit the use of LIFO (as it has indicated that it might do), LIFO may no longer be available for some or all companies. However, it is expected that, if LIFO were to be no longer available for either of these reasons, there would be a transition period over which LIFO benefits would be recaptured. This transition period is likely to be long enough that companies adopting LIFO in 2010 or 2011 could still achieve a discounted cash flow benefit.
On the other hand, if a LIFO election is terminated involuntarily by Internal Revenue Service because the company does not sufficiently comply with the LIFO requirements, the reversal of the LIFO benefit could be retroactive and immediate. Prior years affected by an “improper” LIFO methodology could be adjusted, and the company may be exposed to penalties and interest. The lesson: If a company wishes to avail itself of the benefits of LIFO, it must exercise due care in doing so.
A company considering a LIFO election will need to notify lenders, shareholders, employees, and other users of financial information of the change to the LIFO method and perhaps modify contracts that are based on a computation of financial reporting or taxable income. Debt covenants, bonus plans, and earn-out agreements are a few of the contracts that may be affected by a change to the LIFO method and all might require revision.
If you are considering electing the LIFO method for your business, a tax advisor can assist with estimating the potential benefit of LIFO and advising on the tax technical and business issues that result from the election. This evaluation should also consider the impact of a potential future reversal of the LIFO method. Notwithstanding the technical and business issues and the potential future reversal of the LIFO method, the short-term benefit of LIFO may be significant enough to make the election of LIFO a course of action that warrants serious consideration by businesses operating in an inflationary environment.
