LIFO Election – Is It Right for Your Business?
Written by Ryan Carter, CPA
Over the past two years, we have all felt the impact of the current market inflation. From our personal lives to the businesses we run, inflation is all around us. With the current volatile times and more projected volatility to come, cost-saving opportunities are highly desired. One avenue for cost savings may be available through an unexpected source, your inventory.
Last-in, first-out (LIFO) is a term most accountants are familiar with; however, it likely does not come to mind as a tax savings method. We are here to explain some of the benefits that may be available to your business for 2021 or 2022, and subsequent years.
What is LIFO?
Inventory costing is an integral part of any business that carries inventory. Various options are available for inventory costing including weighted average cost, specific identification, first-in, first-out (FIFO), and LIFO. Each method of inventory costing has benefits and pitfalls; however, LIFO matches and most tax efficiently utilizes the most recent inventory costs which have proven to be beneficial in current times.
LIFO is defined under IRC Section 472 and is available to taxpaying companies engaged in either the production or resale of goods. LIFO is a method used to account for inventory that records the most recently produced items’ value in order to calculate the value of inventory sold. By electing to cost inventory using the LIFO method, a business can use current or expected upcoming costs of higher inventory to create current tax savings as compared to the tax due under the FIFO method. The current year’s tax savings from LIFO, similar to many tax reduction techniques, is a deferral of taxes that will reverse depending on future circumstances (e.g., cessation of business or the elimination of the LIFO reserve in a deflationary period, as discussed below).
When should I consider LIFO?
Labor shortage or increased prices have driven the current economic environment which is the highest inflationary period since the 1980s. The Fed has already raised rates in 2022, and additional raises appear to be on the horizon. This multitude of factors indicates that inflation is here to stay for the foreseeable future.
LIFO should be considered in inflationary periods, as costs of recently purchased inventory are likely higher than historical inventory held on the books. The result of this election in an inflationary period is lower profit, which will result in fewer taxes owed.
LIFO is subject to the conformity rule which requires businesses to make the same elections for book and tax purposes. Therefore, if LIFO is elected for inventory costing on a business tax return, it must be elected on the financial book records as well. This is something to consider before choosing the election of LIFO for businesses most concerned with maximizing profit for shareholders.
What does a transition to LIFO look like?
Businesses that track inventory on a FIFO basis still have the option to cost inventory using LIFO through the use of a LIFO reserve.
The LIFO reserve is established as a contra-inventory account to show the difference in inventory cost between methods. The establishment of a LIFO reserve creates a temporary difference which is then adjusted in subsequent periods. The LIFO reserve is increased in inflationary periods and decreased in deflationary periods until the reserve is zero.
The main benefit of establishing a LIFO reserve is that while a business does not have to change the method it uses to track inventory, it gets to see a full picture of inventory by comparing the LIFO and FIFO valuation.
How do I make the LIFO election?
LIFO elections are filed by attaching Form 970 “Application to Use LIFO Inventory Method” to the taxpayer’s income tax return the first year the election is made. As previously mentioned, the LIFO reserve is subject to the book conformity rule. This means that LIFO must first be elected as the inventory valuation method on a taxpayer’s annual financial statements in order to elect LIFO for tax purposes. BMSS recommends any business with inventory greater than $200,000 consider an analysis to determine if a LIFO election might be appropriate for your situation
If you have filed for an extension on your 2021 tax return and have not issued 2021 financial statements, the LIFO election may be an option for 2021. However, it is never too early to start planning for future periods. If you are interested in a LIFO election, please contact BMSS to see what tax savings opportunities may be available to you. Visit our website at www.bmss.com or call your BMSS professional at (833) CPA-BMSS.