LIFO Election Essentials

LIFOPro’s LIFO Election Essentials

• What are the advantages of LIFO?
  • It will reduce taxable income whenever there’s inflation (unless material inventory liquidation occurs)
  • Most companies remain on LIFO once they elect because the benefits will continue to accrue & there’s no limit on how long you stay on LIFO or cap on the size of your LIFO reserve. Because of this, we have many clients who have been on LIFO for over 50 years.
  • When using the correct methods and outsourcing the calculation, LIFO is merely a top-side adjustment that’s made once a year and requires minimal administrative burden. In other words, the benefits of LIFO FAR outweigh the outsourcing costs & administrative burden.
  • There’s a low likelihood of ever facing a complete LIFO reserve recapture since inflation is more common than deflation historically in nearly every industry other than consumer electronics, and LIFO is primarily driven by inflation
• What are potential disadvantages of LIFO?
  • LIFO recapture can occur from the following events/transactions:
    • Business is sold via asset sale: 100% of LIFO reserve is taken into income by owner in the year of asset sale
    • C to S Corp conversion: 100% of LIFO reserve will be taken into income, but is ratably recaptured over a 4-year period beginning in the year of S-corporation conversion
    • The recapture detail of the LIFO election essentials is something the experts at LIFOPro can help to explain + avoid as much as possible
    • Deflation: Will almost always cause LIFO recapture. Amount of recapture is dependent on the level of deflation & the preexisting LIFO reserve balance. For example, if you had 10% inflation in the election year & 2% deflation in the following year, you would 20% of your LIFO reserve would be taken back into income in the following year. The key takeaway is over a two year period, you’ve had 4% average annual inflation & you’re left with 80% of your original LIFO reserve after the second year
    • Substantial inventory liquidations: In many cases, LIFO recapture does not occur with small liquidations alone, and your LIFO reserve can actually grow when inventory values decline if there’s inflation. Amount of LIFO reserve recapture does not typically become material from inventory liquidations alone unless it were to be an unusually large decrease.
  • Inventory-related reserves and/or write-downs must be recaptured beginning in the year of electing LIFO
    • GAAP allows for inventory reserves and write-downs in addition to the LIFO reserve to be maintained since LIFO inventories are to be valued at the lower of cost or market (not net realizable value as required under non-LIFO methods such as FIFO and average cost). This means that a lower of cost or market, reserve or obsolete/slow-moving reserve can be maintained in addition to the LIFO reserve for financial reporting in addition to your LIFO reserve
    • IRS Regs. requires LIFO taxpayers to value inventories at cost even if reserves or write-downs are maintained for financial reporting.
    • This means that companies who’ve historically reported inventory net of reserves or write-downs on their tax return prior to adopting LIFO must recapture those reserves beginning in the year of election
    • IRS Regs. calls for this recapture to occur ratably over a 3 year period beginning in the year of election.
• How much could LIFO benefit my company or client this year?
  • Current year taxable income reduction from LIFO (aka LIFO expense) = PY ending inventory balance * CY inflation rate
  • CY cash savings from LIFO = CY LIFO expense * combined federal & state tax rate
  • Get a free LIFO election benefit analysis from LIFOPro today to get an estimate of how much you could benefit from LIFO this year
• What are the LIFO requirements incident & subsequent to election?
  • Companies who issue financial statements: LIFO conformity rule requires inventories to be valued using LIFO on financial reports in the period LIFO is being adopted for tax purposes (or show an estimated LIFO figure; contact LIFOPro to quickly obtain a free LIFO estimate that can be incorporated into financial statements & ensure LIFO conformity rule compliance)
  • All companies: (including companies who don’t issue financial statements):
    • Prepare & attach Form 970 Application to Use LIFO Inventory Method & statement to tax return
    • Ratably recapture non-LIFO inventory reserves or write-downs previously recognized on the tax return over a 3 year period beginning in the year of LIFO adoption (if applicable)
  • What are the LIFO election deadlines?
    • Companies who issue financial reports: Earlier of the two dates:
      • Financial report issuance date (unless financial reports are recalled, restated using LIFO method and reissued prior to electing LIFO for tax purposes)
      • Tax return filing date – will be extended filing date if extending
    • Companies who don’t issue financial reports: Tax return filing date (can be filed on extended returns; amended return can also be filed to elect LIFO. See below)
• What if LIFO has a material impact for financial reporting purposes?
  • IRS Regs. allow for different book & tax LIFO methods to be used while maintaining compliance with the LIFO conformity rule
  • Companies with a desire to minimize the LIFO charge reported on the income statement & maximize the LIFO benefit reported on the tax return are allowed to make separate book & tax LIFO calculations
  • Under such an approach, two separate pro forma calculations are made using different inflation measurement sources to determine the following:
    • The amount of inflation & LIFO expense (income) differential between the two methods both historically & in the election year
    • If desired, identify the LIFO methods that are most preferrable for financial reporting & maximize tax benefits
  • If it’s determined that one method will create a materially lower/higher amount of LIFO expense than the other method, than companies wishing to do so will consistently utilize different book & tax LIFO methods in the election year & in subsequent years and perform separate book & tax LIFO calculations. This aspect of LIFO election essentials is something LIFOPro can seamlessly handle
• What is the inflation measurement period under the IPIC method?
  • In the election year, a 12-month period must be used to calculate inflation, meaning the current & prior year’s BLS index appropriate months used for the election must equal a 12-month period. For example, if a November appropriate month was selected, then November ’22 ÷ November ’21 BLS indexes must be used to calculate category inflation indexes.
  • The determination of the appropriate months available to be used for the inflation calculation is dependent on the number of months purchases in ending inventory as well as the costing method used to determine the value of ending inventory. For example, if there are four months worth of purchases in ending inventory for a company with a December year end who uses the average cost method, then 12M ended September, October, November or December BLS indexes could be used to calculate inflation.
  • The key concept to understand is that in the election year, it’s important and often beneficial to perform a comparative analysis of the amount of inflation that’d result from using the range of appropriate month options available in the election year. For example, lets assume you have 4M of purchases in ending inventory & a December year end. Lets further assume the 12M ended December ’22 BLS inflation was 5%, but was 7% for 12M ended November, 9% for 12M ended October & 12% for the 12M ended September. Under such a scenario, your resulting election year LIFO expense/reserve would be more than double the amount using a September appropriate month when compared to using a December appropriate month. This is an important factor in LIFO election essentials
  • Since inflation was at record highs throughout 2021, but peaked and began to slow or moderate in 2022, the use of an earlier appropriate month in the election year will provide a great strategy for maximizing election year LIFO tax benefits
• Can I elect LIFO for a prior year’s tax return that has already been filed?
  • Companies can elect LIFO for a prior year’s tax return that has already been filed IF financial reports are not issued to external parties OR if financial reports were issued to external parties, but they are recalled, restated using LIFO method and reissued prior to electing LIFO for tax purposes
  • Steps to be taken to elect LIFO for a prior year’s tax return are as follows:
    • Complete the election period’s LIFO calculation
    • If applicable, recall, restate and reissue financial statements under LIFO method
    • Prepare IRS Form 970 & statement
    • Prepare & file an amended return for the period LIFO is to be elected showing inventories at LIFO value on the amended tax return
    • Attach the Form 970 & statement to the amended tax return
    • LIFOPro can handle all of these aspects of LIFO election essentials
  • Point of emphasis is the LIFO conformity rule prohibits electing LIFO on the tax return in a period where the election year financial statements were issued using a non-LIFO method. Knowing this, it’s important to understand that the election period financial statements are still required to show inventories at LIFO even when the election is made using an amended tax return.