Is LIFO Still the Right Answer for Dealerships?

November 11, 2021
couple buying a white car

As the semiconductor shortage continues to idle auto factories and automobile inventory production, dealerships are continuing to see large inventory reductions. This trend appears likely to carry into 2022, leaving dealerships who use the LIFO (last-in, first-out) inventory method at risk of having to recapture substantial portions of their LIFO reserve. This recapture can increase income for both financial reporting and income tax purposes and generate unanticipated tax liabilities.

Both the National Automobile Dealers Association (NADA) and the AICPA have lobbied Treasury over the past year for LIFO reserve recapture relief without success thus far. The relief requested is for the IRS to certify that the foreign trade interruptions due to the COVID-19 pandemic are “qualified inventory interruptions” under Internal Revenue Code Section 473. This would allow dealers three years to replenish their inventory to pre-COVID levels and avoid the recapture of their LIFO reserve.

In the past, relief granted under Section 473 has not allowed taxpayers to disregard the LIFO reserve recapture in the year of the inventory decrease. Instead, taxpayers were allowed to amend the tax return for the year of the inventory decrease to restore the LIFO reserve and receive a refund of the tax paid if inventory levels were replenished within the three-year period. The relief request made by NADA and AICPA goes a step farther and requests a safe harbor method that would disregard the LIFO reserve recapture until after the three-year replacement period has passed.

Our advisors are meeting with dealership clients to estimate year-end inventory levels given the supply shortage. Based on these estimates, we can project the LIFO reserve recapture and the resulting tax liabilities and cash flow impacts if no relief is granted.

Options for Dealerships if IRS Doesn’t Provide Relief

Without relief from the government, dealers are left with two choices. The first is to remain on LIFO and recognize the taxable income generated by the LIFO reserve recapture resulting from the decrease in inventory levels. Remaining on the LIFO inventory method allows for potential future LIFO reserve accumulation, resulting in reduced tax liability in future years provided that inventory levels and inventory costs increase.

While increasing inventory costs generally are likely over a period of time, the prospect of increasing inventory levels is less certain. Some dealers and manufacturers may determine that they prefer a lower inventory, higher gross profit model, resulting in lower inventory levels as compared to historical levels. These taxpayers will realize less benefit from remaining on the LIFO method.

The second option is to consider electing out of the LIFO inventory method. The advantage of electing out of the LIFO inventory method is that the recapture of the entire LIFO reserve can be spread equally over four years. This may lessen the tax impact for the 2021 tax year as compared to remaining on the LIFO inventory method. However, eligible taxpayers electing out of LIFO will be required to pick up the remaining LIFO reserve balance in income over the next 3 years and will not be able to re-elect the LIFO inventory method for five years.

Consider Accelerating the Recapture of the LIFO Reserve into Income in 2021

Given the potential for future tax rate increases, some taxpayers may consider accelerating the recapture of the LIFO reserve into income in 2021. The use of the LIFO method allows taxpayers to defer paying tax on the LIFO reserve but does not eliminate the future tax liability. Upon sale of the dealership, the LIFO reserve will generate ordinary income at the applicable tax rate in the year of sale. As a result, if a sale is imminent, taxpayers may wish to trigger a portion of that income in the current year and take advantage of the potentially lower current tax rates.

As a reminder, the current Section 199A Qualified Business Income deduction can allow for an up to 20% deduction associated with any LIFO reserve recapture income (assuming all other requirements are met).

Start Tax Planning Now by Seeking Assistance

Reach out to a dealer-specific tax advisor to discuss your situation as soon as possible.

The time is now to decide your tax planning strategy regarding LIFO inventory method. Our dealership tax advisors can help you make an informed decision.

Expand Full Article

We're Here to Help

We are here to help
From business growth to compliance and digital optimization, Eide Bailly is here to help you thrive and embrace opportunity.
Speak to our specialists