Last In First Out (LIFO): Accounting for Dealership Inventory
“A vast majority of our dealership clients use LIFO because they are matching inventory costs to revenue. Newer vehicles often carry a higher price tag than older models. So dealerships use the LIFO method to show a higher cost of goods sold and reduce their taxable income.”
The last in first out (LIFO) method of accounting for dealership inventory is a hot topic these days. In this episode of Savvy & Sensible, Holly Ferguson and Matt Pore provide auto dealers with details about the LIFO method, including issues related to today’s environment, possible solutions, and the auto industry’s response.
Using the LIFO method of accounting for inventory allows auto dealers to match inventory costs to revenue. Newer vehicles often carry a higher price tag than older models, so dealerships use the LIFO method to show a higher cost of goods sold and reduce their taxable income. As client inventories grow year over year, they create LIFO layers. And at the end of every year, there would be an analysis of their LIFO inventory to determine if there’s either an increment or a decrement to their LIFO reserve, which takes into account current inventory levels, product mix, and inflationary index.
The issue in today’s environment is that, in the current market, auto dealers have seen a significant decline in their inventories due to strong sales years and, now, hard-to-access new inventory from the manufacturers. A decline in the inventory levels will have an impact on the LIFO reserve and likely cause phantom taxable income.
Section 199(a) of the Tax Cuts and Jobs Act (TCJA) of 2017 created a pass-through deduction in which any income recognized from a decline in the LIFO reserve will be taxed at the highest federal tax rate of 29.6%, which is 80% of the highest rate of 37%. So, from a tax perspective, it may not be a bad year to pay taxes. In previous years, when clients were increasing their inventory and creating their LIFO layers, they were getting deductions at the highest rate of 39.6%. Now, they’re recognizing income at lower tax rates.
Filing a change of accounting method to elect off of LIFO could provide some relief to dealerships with significant declines in inventory levels this year. The dealership will be required to recognize their LIFO reserve as taxable income through a section 481(a) adjustment. If the unfavorable adjustment is greater than $50,000, the dealer will be required to recognize the income over four years, which means you could be deferring the income into a year with a higher tax rate. Once the election has been made, a dealership may not elect back on LIFO for five years.
The Treasury has historically provided LIFO relief to other industries (pursuant to Section 473), under which businesses that had an interruption in their ability to obtain replacement inventory to a trade embargo or other international event were granted three additional years to replenish the liquidated inventory. The National Automobile Dealers Association (NADA) has been meeting with The Treasury in an effort to persuade them to grant similar relief to dealers with LIFO problems. But we won’t see any movement with NADA and The Treasury before April, so dealers need to discuss how they’re gonna handle the issue now.
We’re Here To Help
ARB’s Auto Dealership Tax & Advisory Services Team is well versed in the issue. We are happy to walk you through the issue and help you consider all of your options. If you have any questions, contact Matt Pore today.