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The case for LIFO

October 15, 2021
By Woodward & Associates, Inc., Certified Public Accountants
 
Our office has been receiving numerous inquiries regarding dealer’s LIFO reserves, especially in light of the significant reduction of new inventory. Generally, our answer has been that it makes economic sense to remain on LIFO. This message is to briefly outline our position.
 
Some important facts:
1. For dealerships that are taxed as S-Corporations or partnerships, the current (tax year 2021) effective tax rate is 29.6%. It is currently being speculated that the future tax rate will be 39.6% (tax year 2022 and forward). This is a roughly 33% increase. For purposes of this message, we will round to 30% tax rate for 2021 and 40% for tax years 2022 and forward.
 
2. If a corporation elects off LIFO, it takes five years before they can elect back on to LIFO.
 
3. Generally, LIFO deduction is 2% inflation factor multiplied by the prior year new-car inventory (unless inventory goes down like it has in 2021).
 
4. The decision to elect off LIFO does not need to be made until you file your corporate income tax return. Please take time and consider all the facts before making a decision.
 
The pros for staying on LIFO:
1. LIFO essentially is an interest-free loan from the government. By removing the LIFO reserve, there will be less cash in the dealership because of the associated tax liability related to the income from taking the LIFO reserve to income. 
 
Right now, the industry is as strong as it ever has been. Who is to say that this trend continues and/or that you wouldn’t need this cash later? By keeping a LIFO reserve, the tax liability is reduced for the dealership annually, and as a result the cash stays in the business (vs paying the government) and is accumulative over time. This, in turn, allows the dealership to pay off floorplan or other debts (which increases profits) OR use this money to acquire other businesses or business assets.  
 
a. We have heard from many who said they want to take LIFO to income to remove the future liability. This is very shortsighted, as you can use this cash in your business to make money by paying down debt or acquiring other stores/businesses.
 
2. The tax rates are likely going to go up 10% in 2022. If you elect off LIFO, you cannot elect back on for several years. Therefore, your future tax liability will not receive the benefit of a LIFO deduction.
 
The pro for electing off LIFO:
1. If the business intends to sell sometime in the next few years, then it might make sense to take advantage of the low tax rates now and pay the income tax on the LIFO reserve.
 
A comprehensive example:
For purposes of this message, let’s assume a dealership generally has $10 million of new inventory and has a $1 million LIFO reserve. Let’s also assume that at the end of 2021 this dealership will have $4 million of inventory and $400,000 of LIFO reserve. This would result in a $600,000 LIFO reserve pickup in 2021, or $180,000 of tax (600,000 x 30%). This example does not consider any time value of money or other possible savings.
 
Option 1 – Remain on LIFO:
The dealership maintains LIFO after a large pickup in 2021. The 2021 tax liability will remain at $180,000 ($600,000 x 30%). By 2022, let’s assume the new inventory gets back to $10 million and remains at that value for the next 4 years. The 2022 LIFO deduction likely is $80,000 with the tax savings of roughly $32,000 (80,000 x 40%). In years 2023-2025, the annual deduction would be $200,000 annually; tax savings of $80,000 annually ($200,000 x 40%); the cumulative deduction for those three years would be $600,000 with savings of $240,000. The cumulative savings after five years would be $92,000 ($180,000 tax pickup for 2021, minus $32,000 savings in year 2, minus $80,000 a year for years 3 through 5).  
 
Option 2 – Elect off LIFO and spread over four years: 
The dealership will pick up ¼ of the LIFO reserve into  income each year from 2021 to 2024. The first year would cause a tax liability of $75,000 ($250,000 x 30%) and the subsequent three years of $100,000 per year ($250,000 x 40% per year). This would cause a cumulative $375,000 tax liability over four years.
 
Option 3 – Have large LIFO pickup in 2021 and then elect off LIFO and spread over the following four years: 
The dealership would pick up $600,000 in the first year, which would cause $180,000 of tax ($600,000 x 30%). Then spread the $400,000 over four years, which will cause $100,000 of income a year or $40,000 of tax a year ($100,000 x 40%). This would cause a cumulative $300,000 tax liability over four years.
 
**There is an option to pick up the entirety of the LIFO reserve into income in 2021 if the LIFO reserve is small enough.
 
Summary: There are pros and cons for each option. But as you can see, in this specific fact pattern, there are ways to mitigate tax liability if you choose to elect off LIFO. However, the best option to limit the tax liability is to remain on LIFO
 
 

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