How to Avoid Post-tariff LIFO Reserve Recapture

Tariffs & LIFO Series: Part Three

A common concern regarding first-time LIFO adoptions is the risk of having to pay back a material portion of the election year LIFO tax benefit in future periods. This is because during deflationary periods, a certain amount of the LIFO reserve & tax benefit accumulated in previous periods will be recaptured into taxable income, which is commonly referred to as LIFO recapture.  In many industries, infrequent or occasional deflation is inevitable, and in other industries, deflation can occur somewhat frequently (oil and gas prices often swing from inflation to deflation from one year to the next).

Historically speaking, tariffs normally create above average inflation in the period they’re put into effect. With that being said, deflation can also occur if/when previously-imposed tariffs are lifted. Because of this, it’s important to be aware of the probability and size of future LIFO recapture. There are a variety of effective strategies to avoid material LIFO recapture in periods subsequent to the election year, and they can be organized into two groups. The first set of strategies must be employed in the period of electing LIFO; the second set of strategies are available in periods subsequent to LIFO adoption.

Election Year Strategies

In the period of adoption, many are often primarily focused on the current tax benefits created from LIFO. But it’s equally important to understand LIFO’s potential future risks and rewards prior to adoption because doing so allows for preemptive planning and the ability to minimize or eliminate certain risks. There are many strategies that can be explored in the year of the LIFO election to minimize the chance of future material LIFO recapture. The most notable ones are listed below.

Appropriately time the LIFO election

The best time to elect LIFO is a period where the inflation & tax benefits are far higher than the historical averages. For example, a company with 2% historical average annual inflation rate and a 10% current year inflation rate could potentially adopt LIFO in a period where the tax benefit will be 5x higher than a period of normal inflation. Electing LIFO in a period where the tax benefit is far higher than average is one of the most effective strategies to eliminate, or at least minimize, the probability of future LIFO recapture. This is because when the election year LIFO reserve represents many years’ worth of inflation and tax benefits, the potential LIFO recapture created from deflation in future periods is more likely than not to be immaterial in comparison to the existing LIFO reserve.

To illustrate, lets assume a company has 10% inflation in the year LIFO is elected, a 20-year average annual inflation rate of 2% (5x LIFO tax benefit multiplier). Let’s further assume the company has 2% deflation in their second year on LIFO. If this was the case, the company would still have 80% of their election year LIFO reserve. Furthermore, the company would have a cumulative inflation rate of 8% and average annual inflation rate of 4% after their second year on LIFO, which is double their 20-year average annual inflation rate of 2%.

Although some amount of LIFO recapture occurred in the second year in the above example, it was completely offset by the election year LIFO reserve, and the majority of the first year LIFO reserve was retained by electing LIFO in a period where the inflation was well above the historical average. To contrast, let’s assume the company described above had an election year inflation rate of 1%, and 2% deflation in their second year on LIFO. If this were the case, the company would recapture all of their LIFO reserve after their second year on LIFO, they’d have cumulative inflation of -1% and average annual inflation of -0.5%, which means the company had a higher tax liability from using LIFO than non-LIFO method alternatives after year two.

Utilize submethods that create highest LIFO tax benefit

For most companies, there are multiple LIFO submethod options, and in many cases, the difference amongst the alternatives can be material. Because of this, companies should perform comparative LIFO calculations in the year of election using the available submethod alternatives in the year of election to determine which method will create the highest LIFO tax benefit. One specific submethod option is the inflation measurement source. The two primary options are as follows:

• • Internal index: Uses actual quantities on hand by the most detailed record or stockkeeping unit and actual purchase costs (or purchase costs as approximated by chosen costing method such as FIFO or average cost) to measure an internally calculated current year inflation index
  • External index: Also known as the IPIC method. Items are defined as the Bureau of Labor Statistics Consumer/Producer Price Index (BLS CPI/PPI) categories that contain the goods on hand. Year-end inventory balances by BLS category are used as weighting factor & BLS category inflation index is calculated by dividing current & prior year’s CPI/PPI to compute a current year inflation index.

In many cases, the difference between the external vs. internal inflation and LIFO tax benefits can be substantial and failing to perform comparative internal and internal inflation index LIFO calculations in the year of election can result in the use of submethods that are suboptimal from a tax benefits perspective. Identifying and choosing the LIFO submethod alternatives that creates the highest election year LIFO tax benefit reduces the probability of material LIFO recapture in subsequent periods because a higher LIFO reserve starting point also increases the threshold for any future deflation and LIFO income to be considered material.

To further illustrate, let’s assume a company considering a LIFO election performs comparative internal and external index calculations that results in 5% current year internal index inflation and 20% current year external index inflation. Since the 20% external index inflation was 4x higher than the 5% internal index inflation, the company elected LIFO using an external inflation index. Let’s further there was 5% deflation in the second year on LIFO, meaning that despite facing some amount of LIFO recapture, the company would still have ¾ of its original LIFO reserve after year two, cumulative inflation of 15% and average annual inflation of 7.5%.

To further illustrate from the above example, let’s assume the company elected LIFO using the 5% internal index inflation instead of an external index because they failed to perform comparative internal & external inflation calculations. In this example, the 5% deflation in the second year would cause all of the election year LIFO tax benefit to be recaptured after year two. This may seem like an extreme example, but it’s fairly common for the internal vs. external index inflation and LIFO tax benefits to be materially different, and because of this, performing comparative election year LIFO calculations can maximize the first year LIFO tax benefits and minimize the chance of future material recapture.

Compare election year tax benefits of valuing selected vs. all goods on LIFO

Valuing some goods using LIFO and other goods using a non-LIFO method is known as a selective LIFO election scope. When considering the LIFO election scope, the highest tax benefits will often be achieved by placing all goods on LIFO because the larger the total inventory valued using LIFO, the larger the tax benefit. Despite this, when exploring a LIFO election, the following questions should be answered prior to determining whether some or all goods will be valued using LIFO:

• • Whether any of the goods have historically been deflationary, and if so, if the deflationary goods represent a material portion of the total inventory value
  • Whether any of the goods have deflation in the year of the LIFO election, and if so, if the deflationary goods represent a material portion of the total inventory value
  • Whether any of the goods have historically had much more price volatility and/or deflation frequency than other goods, and if so, if those goods represent a material portion of the total inventory value

If a material portion of inventory has deflationary either historically or in the period of election, a strategy for maximizing the election year LIFO reserve and/or minimizing future LIFO recapture is to consider excluding those goods from the LIFO election scope. Similarly, if a material portion of goods have much more historical deflation levels and/or frequency, one should consider also excluding those goods from the LIFO election scope. Such approaches could provide meaningfully higher LIFO tax benefits in the year of election, less long-term LIFO recapture risk and reduce the level of LIFO recapture in future periods.

Post Election Strategies

Change to alternative submethod(s): In many cases, companies fail to adequately evaluate LIFO and consider submethod alternatives prior to implementation. When this occurs, companies are often faced with subsequent LIFO tax benefits that are a fraction of those achieved in the election year, and in other cases, subsequent material LIFO reserve recapture can occur. This can lead companies to ponder whether the risks of LIFO to be greater than the benefits, which sometimes leads to a decision to terminate the LIFO election.

One of the most effective post-election strategies to minimize future LIFO recapture risk and maximize tax benefits is making an accounting method change from an internal to an external index, which is commonly known as the IPIC method. LIFOPro has assisted hundreds of companies switch to the IPIC method, and the majority of our clients use the IPIC method. The primary reason why many companies have switched to the IPIC method are as follows:

• Often provides materially higher LIFO tax benefits than an internal index
• Often provides higher inflation frequency than an internal index, which reduces the probability of periods with LIFO recapture
• Often provides less pronounced swings between inflationary and deflationary periods compared to an internal index, which reduces the overall size of LIFO recapture when it does occur
• Is an IRS safe harbor method, meaning it’s prone to less scrutiny and audit risk when compared to an internal index
• Change to IPIC method is applied prospectively, deadline for affecting the change is the extended filing return deadline (meaning the decision to change to the IPIC method can be made post year-end) and change is made under automatic consent procedures (meaning no IRS User’s fee)
• Provides audit protection from prior period LIFO errors

Companies already on LIFO using an internal index who’re either facing material LIFO reserve recapture or experiencing below average LIFO tax benefits (or accruing much lower tax benefits when compared to when LIFO was originally adopted) should explore a change to the IPIC method because it’s one of the most effective means of maximizing the long-term LIFO reserve and reducing if not eliminating substantial LIFO recapture.

Change LIFO election scope to add inflationary inventories historically valued using non-LIFO methods

As discussed above, there are valid reasons for excluding certain goods from the LIFO election scope. For example, including only inflationary goods in the election scope in the year of adoption is an effective strategy for maximizing first year LIFO tax benefits (especially if the difference between a 100% vs. selective election creates materially different results). In other cases, it’s not uncommon for companies that are on LIFO to acquire or merge with a company that’s not on LIFO (or vice versa), and for the pre- vs post-acquisition inventory methods to remain unchanged. Aside from goods that have historically been deflationary that and are also expected to be deflationary in the future, exploring a LIFO scope expansion to include some or all inventories that are currently valued using a non-LIFO method can create meaningful short-term and material long-term tax benefits.

Another potential benefit of expanding the LIFO election scope to include goods previously valued under non-LIFO methods is that it diversifies the product mix used to calculate LIFO inflation and the resulting tax benefits, which in turn can reduce deflation frequency and the size of the LIFO recapture when deflation does occur.  For example, let’s assume a manufacturer has substantial raw materials and work-in-progress inventories, but no finished goods inventories because all finished goods are immediately drop-shipped upon once they’ve become a finished product. Let’s further assume the company values their raw materials using LIFO but values their WIP goods using a non-LIFO method. Oftentimes, raw materials are much more prone to frequent and pronounced cost fluctuations due to the fact that they’re subject to change based on the ebbs and flows of commodities supply/demand (inflationary peaks and deflationary troughs). In contrast, WIP and finished goods are less prone to frequent and sudden price changes since additional cost components such as labor and overhead are much more consistent and constant variables than the raw materials.  Following the company expanding its LIFO election scope to include the WIP inventories, the resulting LIFO tax benefits were higher in the period that the expansion was made, the future occurrences of LIFO recapture decreased, the size of subsequent LIFO recapture amounts also decreased, and the long-term LIFO tax benefits were noticeably higher than they would have been compared to valuing only the raw materials using LIFO.

Expansion of the LIFO election scope only requires for the same form used to elect LIFO to be filed (IRS Form 970), meaning no IRS Form 3115 is required to expand the LIFO election scope. Since a LIFO scope expansion is applied prospectively, companies usually choose to do so in a period where the post vs. pre scope expansion LIFO tax benefit is higher (companies should wait to expand the scope in a period where more LIFO expense is obtained from the proposed vs. present election scope).

Key Takeaways

• Companies exploring a LIFO election can maximize LIFO tax benefits and minimize future LIFO recapture is to obtain through analysis prior to electing LIFO to enable important considerations to be made, such as:
  • Choosing to elect LIFO in a period where the inflation is above average or much higher than the historical averages (i.e., times when unexpected economic circumstances or foreign policy changes such as a pandemic or tariffs creates elevated inflation)
  • Evaluating LIFO submethod alternatives (to ensure the highest election year LIFO tax benefit is achieved)
  • Considering the scope of the goods to be valued using LIFO (to avoid deflationary goods from reducing the election year LIFO tax benefit)
• Companies already on LIFO can minimize or eliminate material LIFO recapture or tax benefits that are underperforming past results and/or current expectations by exploring the following options:
  • Making an accounting method change, such as switching from an internal to external inflation index (IPIC method)
  • Exploring LIFO scope expansion

Actionable Items

• Learn more about LIFO by scheduling a discovery call with the LIFOPro team
• Companies not on LIFO should explore a LIFO election by obtaining a complimentary LIFO election benefit analysis from LIFOPro
• Companies already on LIFO should explore submethod alternatives by obtaining a complimentary LIFO review from LIFOPro