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Weighing the benefits of LIFO

January 26, 2015

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Many dealerships use an inventory accounting method known as LIFO to defer their income tax liabilities. But using LIFO, which stands for “last in, first out,” requires some additional recordkeeping. It also may make your dealership appear less profitable to outsiders. So, it’s important to compare the pros and cons before deciding whether to use LIFO or not.

How LIFO benefits taxpayers

Manufacturers and retailers often opt for LIFO when they expect the prices of their products to increase regularly each year. The method enables dealerships to count the last vehicles that came onto their lot as the vehicles that were sold first. This contrasts with the “first in, first out” (FIFO) accounting method in which the first vehicles that came onto the lot are counted as the vehicles sold first. In addition to being used for new or used vehicles, the LIFO method can be applied to parts and accessories inventory.

Here’s a simplified example of how LIFO works: Suppose that ABC Dealership bought a 2014 vehicle in May for $10,000 and then bought the 2015 model of the same vehicle in October for $11,000. It sells one of these vehicles in November for $14,000.

If the dealership counts the vehicle it bought in May — the one that was “first in” — as the one sold, it would owe income tax on a profit of $4,000. But, if it counts the vehicle it bought in October — the one that was the “last in” — as the one sold, it would owe income tax on a profit of only $3,000.

The tax benefits of LIFO can accumulate, resulting in a LIFO reserve that can become substantial over time. In essence, you get an interest-free loan from the IRS over the length of your time that you’ve used LIFO.

Potential drawbacks of LIFO

While it might sound like using the LIFO method is a no-brainer for dealerships, some potential drawbacks exist. Perhaps the biggest negative is the fact that, if LIFO is used for income tax purposes, it also must be used for financial statement reporting, and dealerships usually want to increase net income on their financial statements. So publicly held dealerships may not choose LIFO, because they’re typically more financial statement–driven than income tax–driven.

LIFO also might not be the best inventory accounting method to switch to if you’re selling the business in the near future. That’s because the cost of making the LIFO election may not be recouped before you sell.

Another consideration: Upon the sale of a dealership, a dealer on LIFO will be required to recapture into income the amount of the LIFO reserve, if the sale transaction is an asset sale. If the sale transaction is a stock sale, the tax effect on the LIFO reserve is typically accounted for through the purchase price.

As mentioned, LIFO does require some extra work — notably, recording the LIFO reserve in your accounting records and performing annual LIFO valuations. Using LIFO is typically more beneficial when inventory is growing or staying steady. In times of decreasing prices or inventory reductions, LIFO liquidation may occur, and this will eat away at your LIFO reserve. The liquidation may cause your dealership to pay higher taxes in a particular year than it would have under FIFO or other accounting methods.

On the chopping block

For many years, there has been talk in Congress about eliminating LIFO. And it will remain an easy revenue-raising target for politicians — especially if the new Congress takes up serious tax reform.

But while it’s still an option, the LIFO inventory accounting method remains an effective tax deferral mechanism for many dealerships. If LIFO is eliminated from the tax code, you would likely be permitted to gradually recognize the LIFO reserve as income over several years, rather than taking the hit in a single tax year.

Talk it over

If you’re contemplating adopting or terminating LIFO, contact your CPA. He or she can walk you through the potential benefits and pitfalls of changing your inventory accounting method.

© 2014

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.

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