LIFO Considerations and Tax Planning for Dealerships

We can all agree that 2021 has been an interesting and challenging year as the dealership industry has struggled with new vehicle inventory. Dealerships who have elected and are maintaining LIFO reserves should be planning and assessing the impact now of reduced inventory levels.

Pandemic and new vehicle inventory

Due to government shutdowns, supply chain issues, and chip shortages, there has been a significant reduction in new vehicle inventory levels. We have recently been on-site at a buy/sell closing where there was only one new vehicle on the lot.

LIFO and year end planning

LIFO is short for Last In/First Out. The purpose of the LIFO inventory method is to permit taxpayers to match current costs, reflecting price increases attributable to inflation, with current revenue from comparable items. In times of rising inventory levels, typically LIFO reserves increase and when inventory levels are decreasing, LIFO reserves can be recaptured. The majority of dealers are on LIFO just for new vehicle inventory. Now is the time to take a look at estimated year end inventory levels to estimate your year end LIFO reserve. This will help you determine how much LIFO recapture you might be facing.

Tax rate considerations

The first thing you should consider is the tax rate differential. With the anticipation of tax law changes and increased tax rates, one consideration is to make no changes and pay the tax on LIFO reserve recapture for 2021. As inventory levels recover in future years, your dealership would have an increased LIFO reserve which would result in a tax deduction at a higher tax rate. This could result in a permanent tax rate difference.

Entity conversion

Another consideration would be entity conversion. If your dealership is a C corporation and you have been contemplating making a conversion to an S corporation, January 1, 2022 could be the time to evaluate that. When converting from a C corporation to an S corporation, the LIFO reserve is recaptured over a four year period at the current C corporation tax rates. The first tax due date for recapture is due with the final C corporation income tax return and the remaining three installments would be due with the S corporation income tax return.

Electing off LIFO

One option is to elect off LIFO which results in a recapture of the LIFO reserve over a four year period. When an entity does that, it would not be eligible to elect LIFO again for a five year period. Another item of note is that if you elect off LIFO, you recapture the entire reserve over a four year period instead of the amount of the current year LIFO recapture that would be less than the entire reserve. In short, if your current year LIFO recapture would have only been 80% of your total reserve that would still be less than recapturing 100% of your LIFO reserve over a four year period.

LIFO pooling and LIFO methods

Most dealers account for LIFO with their new vehicle inventory under the Alternative LIFO Method. Another method to consider is Inventory Price Index Computation (IPIC). This method uses consumer or producer price indexes to determine inflation versus the actual prices of inventory and new vehicles. Used vehicles and parts could be combined into a single LIFO calculation. The combined pool of new vehicles, used vehicles, and parts inventory helps to insulate a LIFO reserve recapture when one of the three inventory components experience a decline. To make this change, a Form 3115 is required along with Form 970 by the due date of your income tax return (including extensions).

Under Revenue Procedure 2008-23, dealers are allowed to combine cars and light duty-trucks into a single pool. If you are still using separate pools, now would be the time to consider if a Form 3115 should be filed to combine vehicle pool methods. Pooling inventory in one pool helps with LIFO reserves, especially if new car inventory levels are decreasing while new truck inventory levels are rising.

Section 473 relief

Internal Revenue Code Section 473 provides relief for taxpayers that experience qualified liquidations of LIFO inventories. Section 473 applies if a business had an interruption in the ability to replace inventories resulting from major foreign trade interruptions. Under Section 473, the company would have three additional years to replenish the liquidated inventory. The NADA, AICPA, and other organizations are lobbying for this relief to occur, but it is not a guarantee. This is a topic that should be followed closely but not relied on.

What should you do?

Dealers using the LIFO method need to be planning now and preparing for possible LIFO recapture and increase of taxable income. Reach out to your tax advisor to see which option is best tailored for your tax situation.