What a Decrease in Inventory Means for Your LIFO Reserve

Most automobile dealerships value at least some part of their inventory using the Last-In-First-Out (LIFO) accounting method. In periods of rising prices and stable inventory levels, LIFO usually results in a deferral of income by way of an increase in cost of goods sold. When prices are falling and/or inventory levels decline, the opposite can happen – that deferral of income reverses. This is known as LIFO recapture. Historically low levels of inventory brought on by the COVID-19 pandemic, subsequent recovery of demand and now chip shortages, coupled with the potential that low levels may persist through the end of 2021, are a potential threat for LIFO recapture this tax year. Depending on the magnitude of the inventory decrease from 2020 to 2021, this recapture could be significant. To prepare for this possible recapture, dealers can start modeling now to assess the materiality of the issue and their specific situation.

During the onset of COVID-19 pandemic, consumers were not buying new vehicles nor were they trading in old ones, so the market saw concurrent suppressed demand and supply in the dealership industry. At the same time, demand for consumer electronics swelled, and chip producers reallocated production to fill that need. Now that the U.S. economy is rebounding, and shoppers are heading back to dealerships, the reallocation of production back to automotive supply chains is sluggish. Additional recent setbacks include a power outage, a production pause and a fire at various chip manufacturing plants. The fragility of the supply chain continues to plague dealerships. It is also possible that a long-term reliance on outdated technology was triggered at the onset of the pandemic.

Requests have been made to the Department of Treasury (Treasury) and the Internal Revenue Service (IRS) to consider a LIFO “Holiday” to postpone LIFO recapture until inventory levels return to normal levels. Organizations like the National Automobile Dealers Association (NADA) are advocating for LIFO relief policies, specifically asking for Internal Revenue Code Section 473 relief by arguing that the COVID-19 pandemic has caused a qualified inventory interruption. Under Section 473, taxpayers would not recognize income attributable to the liquidation of LIFO layers if the inventory is completely replaced by the end of a replacement period. While there has been no traction from these requests to date, hope still remains, and it seems the advisable action is to continue this conversation within the industry.

An inventory reduction will affect LIFO reserves based upon the history of inventory levels and inflation as well as the current level of inflation. This will vary from dealer to dealer, manufacturer to manufacturer and the mix of cars versus trucks, as trucks trend more inflationary than cars. New vehicle industry data from June 2021 shows Alfa Romeo, Chevrolet cars, Ram trucks and Infiniti trucks/SUVs are at the top of the inflationary charts with Volvo trucks/SUVs and Lincoln, Jaguar and Buick cars holding at the bottom at around 1.00, zero inflation/deflation. Newer dealerships with less layer history have trended somewhat better than those with a long layer history dating back decades, so keep in mind that a decrease in inventory does not necessarily equate to LIFO recapture. The current year inflation and the cumulative LIFO index play major roles in the calculation. Used vehicle LIFO pools continue to fare well, with surging used prices driving inflation to record levels. June industry data shows inflation in the used market of approximately 20 percent; however, there are signs that used vehicle price hikes may be dropping soon and those levels of inflation could be much different by year-end.

Dealers should consider modeling minimum inventory levels and estimates of their LIFO layers starting in October. With only two months to year-end, this will be appropriate timing to minimize inflation fluctuations that would affect the calculations and still allow time to implement planning. A minimum inventory level can give dealers the estimated point at which minimum deduction or income may result from valuing their inventory at LIFO, and an estimate calculation can provide dealers an approximation of deduction or income resulting from a change in the LIFO reserve.

For dealers facing significant LIFO recapture, there are a few options to consider. Some accounting method options or changes to one’s year-end could be explored to possibly lessen the impact. However, these options are very fact-specific and may not be available to everyone. A change from alternative LIFO to IPIC LIFO may be a viable solution where new vehicles are pooled with used vehicles and parts, spreading out the effects and softening the blow. However, IPIC may only be a short-term solution, since the Producer Price Index (PPI) and Consumer Price Index (CPI) used in the IPIC method historically produce lower inflation indexes and, in turn, potentially less future benefit. Changing from alternative LIFO to IPIC LIFO requires a Form 3115. If none of these options are right for you, and LIFO recapture is imminent, there is some consolation in that dealers could be paying less taxes on the recapture now if tax rates will be higher in future years.

DHG is prepared to help you address LIFO recapture as it affects you and your dealership. For questions or more information, reach out to us at dealerships@dhg.com.

ABOUT THE AUTHORS

Amanda McCage
Senior Associate, Tax

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