Car dealerships of all sizes are facing large income tax bills this year due to an old standard accounting practice, Last-in-First-Out (LIFO), causing them to ask the U.S. Treasury Department to enact a provision in a 42-year-old law that would provide relief to auto dealers across the country.
What is LIFO?
LIFO is a method for calculating how much an automotive dealership spent on automobiles they sold over the year. The LIFO technique determines the cost of products sold by assuming that the most recently purchased units are sold first. LIFO often results in a deferral of income due to a rise in cost of goods sold during periods of rising prices and stable inventory levels. This method is used by around half of the nation’s dealerships.
The basic design of LIFO relies on a continual flow of inventory to keep deferment afloat from years to decades. Due to the COVID-19 pandemic, car dealerships have been entirely lacking new vehicles from their lot due to supply chain issues and microchip shortages. This is a scenario that was nearly impossible to imagine before the pandemic. To deal with this issue, dealer and manufacturing associations, along with Senators and U.S Representatives, are forming a coalition to persuade the U.S. Treasury Department to act.
NADA and AICPA Seek Relief
The National Automobile Dealers Association (NADA) and the American Institute of Certified Public Accountants (AICPA) have issued letters to the U.S. Treasury concerning this issue and possible solutions. Section 473 of the Internal Revenue Code, amended in 1980, outlines three scenarios where LIFO could be temporarily paused, allowing dealerships to replenish their inventories to normal levels. One of the scenarios states that LIFO can be paused if there is a “major foreign trade interruption” which could describe the supply chain disruption that occurred in the auto industry.
Under LIFO rules, dealers can change their LIFO method to another specific method. The Inventory Price Index Computation (IPIC) method uses the Bureau of Labor Statistics data from the Consumer Price Index or Producer Price Index to determine inflation versus the actual invoice prices of inventory. An auto dealer using the IPIC method must use that method in determining the value for all goods for which the auto dealer elected to use the LIFO method.
The LIFO method requires separate pooling, while IPIC allows all inventories to be pooled together. If a dealership is experiencing significant declines in new car inventory, expanding the LIFO election to cover used vehicle inventory and parts and then combining those into a single LIFO pool could offset the new vehicle decreases. Before dealers decide to switch to this method, they should consider how this change could impact their future. In the past five years if taxpayers changed their LIFO methods, then they may not be eligible to switch to IPIC. When a dealer switches to IPIC, they are required to remain on that method for five years which means inflation could dramatically change in that time, potentially reversing the benefits gained in 2021. Making the change would require the filing of a Form 970, to cover inventory not currently on LIFO and filing of a Form 3115, to change to the IPIC method for all LIFO inventory and combine LIFO pooling. This can be implemented with the filing of the current year tax return after year end, including extensions. Dealers should consult with their tax advisor before switching methods.
Discontinuance of LIFO Method
One option is to discontinue the LIFO method of accounting through an accounting method change which will result in a taxpayer recognizing into income the entire amount of the LIFO reserve. The benefit of this approach is that the income is recognized over a 4-year period as opposed to a current year LIFO recapture; therefore, allowing some deferral of the tax implications. This would require the filing of a Form 3115 and the taxpayer would be prohibited from re-electing LIFO for 5 years.
As of right now, the U.S. Treasury Department has not acted since NADA first reached out in November 2020, which means auto dealerships using the LIFO accounting method could face large tax bills for failing to replace sold inventory this tax season. We will continue monitoring the situation and will provide an update should Section 473 relief be granted.
Contact your BSSF tax advisor to calculate what LIFO recapture may look like for your dealership or if you have any questions about the tax implications surrounding LIFO.