Authored by:
Brian Kennett, Partner
What’s Happening on the LIFO Front
There hasn’t been a whole lot to talk about on the LIFO (Last-in, First-out) inventory front for quite a while. However, as we approach tax return deadlines for the 2009 tax year, it has garnered a great deal of discussion. Inventory levels are at historic lows for many dealers, and as a result, concerns about LIFO recapture — and the higher tax liability that comes with it — have come to the forefront.
Despite the legitimate level of concern about LIFO recapture from an operational standpoint, many of the recent articles I have read on the subject, and comments I have heard, seem to be geared less toward providing dealers with useful information, and more toward scare tactics designed to grab their attention. Some have gone so far as to suggest that dealers should have purchased significant inventories prior to year-end in an effort to stave off recapture, or even elect off of LIFO altogether to be able to spread the recapture income over a few years instead of recognizing income this tax year.
While these measures maybe appropriate for a very few, most would not benefit from them — and many cases, they could do more harm than good.
LIFO Inventory Accounting – The Basic Concept
First, let’s do a mini-refresher course on LIFO. The Last-In, First-Out method of valuation inventory allows the taxpayer to price the value of the inventory at the end of the year at previous years’ costs and thereby shifting the current year’s pricing (generally higher due to inflation) to the cost of the vehicles sold during the year resulting in less gross profit. Less gross profit means less taxable income and therefore less tax. It is that simple. The computation is a much more complicated but that is why you have good automotive tax accountants. Less tax is why roughly seventy five percent (75%) of the dealer body uses LIFO.
The computation itself is a much more complicated — it is a function not only of the inventory you have on hand at year-end, but of changes in the cost of that inventory relative to prior years. Where new vehicle LIFO is concerned, there are services that specialize in tracking this cost data, and complex software programs designed to assist in calculating the reserve. Due to the complexity involved, the outcome of the LIFO calculation may not always be intuitive.
The Benefit of LIFO
Generally, I believe that almost all dealers should be on LIFO for new vehicles. Most dealers benefit from LIFO, especially in the long-run. The LIFO reserve represents deferred taxable income, and is effectively an interest-free loan from the government on the tax that would otherwise be due on that income. The interest saved from the free use of those funds will almost always exceed the computation cost. The longer you are on LIFO and the larger the reserve becomes, the more benefit you stand to receive.
This may seem like an oversimplification, but as costs rise over time, the basic premise underlying LIFO should hold true. It won’t change unless Congress decides to take away the LIFO method altogether. (See the “Real News with LIFO” below.)
2008 and 2009 Year Ends
I don’t have to tell you that the last two years have been quite challenging for the automobile business. The 4th quarter of 2008 was one of the worst quarters in decades for new vehicle sales. It led to bulging new vehicle inventories for most — especially domestic dealers whose manufacturers were dumping inventory to stay afloat. Many dealers saw their LIFO reserves increase at year-end due to the increase in inventory levels.
The end of 2009 was just the opposite. Whatever you thought the “Cash for Clunkers” program, it certainly was very good for most dealers. Many of my clients had record profit months. The program, however, really took a toll on inventories (in some cases it was a great thing for dealers to rid themselves of a few vehicles that had been aged). With many manufacturers having previously shut down plants, building those inventories back up was a challenge, if not impossible. That combined with some Chrysler and GM dealers losing brands and dealers really managing their inventories, many dealers ended up with very low inventory levels across most lines.
Conventional wisdom would have you believe that when inventory is up you have increase in LIFO reserves and that when they go down the opposite is true and the reserves go down. This is not necessarily the case and in fact, you can have a LIFO increase with a small decrease in inventory levels. That said, it is true that a significant decrease in inventory it likely to bring at least some recapture of LIFO reserves. It is this situation that some of the other articles are using to scare dealers to grab their attention.
Inventory Levels and the Use of LIFO
Whatever those other articles may say, this fact remains: a dealer should keep the level and mix of inventory to meet their individual sales needs and goals, and let the LIFO calculations fall wherever they may. I highlight this statement because it is extremely important. A dealer should never just add inventory for the sake of the LIFO reserve.
To change the level and mix of your new vehicle inventory to maximize the LIFO tax deduction is a dangerous game. It seems unlikely that manufacturers will have the inventories to support extra allocations of high-demand models. The units you end up with are likely to be the ones that are a harder sell. This can, of course, easily lead to over-aged inventory and all the negatives that come with it — increased floorplan costs, more lot attendant time to maintain it, and a potential drag on the morale of sales staff, not to mention stress at the manager and owner level from the “weight” of the inflated inventory.
These costs — explicit and implied — can wipe out, or certainly reduce significantly, any tax savings you may garner by artificially supporting your inventory at year-end. You never want to have the tax savings “tail” wag the operational “dog.”
The Decision to Elect Out
There are only a couple of situations where a dealer should consider drastic decision of terminating of their LIFO election. One such case is with a few single point dealers — that are phasing out their operations and have no other new vehicle franchises to bolster their inventory. The other such case is one year before the sale of all of the dealership’s assets. In both scenarios, it may be to the dealer’s advantage to terminate their LIFO election. That way, the taxable income from the recapture of the reserve would be spread out over the next four years, instead of essentially having it brought in over two years — 2009 and 2010 — as new vehicle inventory is reduced to zero. But these situations are fortunately few, and the dealer need not make this decision until the filing of the return, giving the dealer time to consider other options.
To terminate a LIFO election just because year-end inventories are low, however, could be short sighted. Not only is there a possibility that the recapture in 2009 might not be as great as you think, you would preclude yourself from realizing the benefit of future deductions as inventory levels are restored in 2010 and forward. Once you elect to go off of LIFO, you are not only locked into bringing the entire reserve into income, you cannot elect to go back on LIFO for a period of five years.
The Real News with LIFO
The real news to consider where LIFO is concerned is not the prospect of short-term recapture due to low inventory levels, but rather a few significant voices in Congress advancing an argument that LIFO should be repealed altogether. To many automotive CPAs, including myself, it is this that dealers should really be worried about.
If the LIFO method is taken away, it will not only be off the table for future years, but those who are currently on LIFO will be required to bring their reserves into income. Under most proposals, this recapture is spread out over a number of years — in some cases a longer period than is provided if a dealer voluntarily elects to go off of LIFO under existing law. This may be of little consolation, however, to a dealer whose reserves are running in the millions, especially when combined with the prospect of increased tax rates.
The Take-away
The use of the LIFO method of valuing inventories is almost always a good thing for dealers. Inventory level should always be what you need for your operational and sales goals and efficiencies and should not be influenced by the potential LIFO or other tax ramifications. While 2009 year end inventories will generally be low, only a very few should consider terminating their LIFO election. Your qualified automotive tax accountant will be able to assist you with these kinds of challenges.
I hope this begins to answer some of the questions that have been posed by certain articles posted in various automobile dealership publications and/or suggestions from twenty group leaders and others. As with this issue and any other tax or accounting issue please contact a qualified automotive CPA.
This article was written by Brian Kennett, a Partner in the firm’s Automotive Niche. Please do not hesitate to contact him should you have any questions. (206) 382-7777.
