Inflation Tax Planning for Companies with Inventory
May 17, 2022
At a glance
- The main takeaway: Consumers and businesses alike are facing inflation not seen in decades, with companies often paying double-digit price increases to replenish inventories. This in turn requires them to raise their prices, leading to higher gross revenues and illusory profits. In certain situations, businesses can get temporary relief from the tax burden on these fake profits by making a LIFO election.
- Impact on your business: Converting to the LIFO method of inventory accounting, if it’s a good fit for your business, can reduce your taxable net income by reflecting more accurately your current cost of goods sold. However, the election is not for everyone, and can present significant complexities to both your accounting and purchasing processes.
- Next steps: Unsure if the LIFO method is right for you? Aprio’s Tax team can help you determine whether electing to report your company’s inventory costs using the LIFO method can provide tax and cash flow benefits for your business and can guide you through the complex filling requirements.
Schedule a consultation with an Aprio Tax professional today.
The full story:
The post-pandemic economic landscape has brought about inflation not seen in at least 30 years. In fact, Simeon Wallis, Aprio’s Chief Investment Officer, expects inflation to last at least through mid-2023 and will remain higher than most executives and managers will have experienced in their careers, and advises business owners to utilize an “inflation playbook” to help their companies navigate decades-high price increases.
On the most basic level, price inflation — an increase in the cost of components and commodities —drives businesses to raise their prices to compensate for the higher price companies must pay to produce the goods and services they provide. However, when those businesses raise prices to consumers, this often results in increased gross revenues, leading to higher taxable income. This is generally the case if the company accounts for its inventory on a first-in/first-out (FIFO) basis. In this method of accounting, each sale is deemed as coming from the company’s oldest inventory item; during inflationary times, this creates illusory income, since the company will be required to pay a higher price to replenish each inventory item it sold.
Changing your inventory accounting method could help your bottom line
The most common inventory valuation method is FIFO, both for US companies and for businesses using international accounting standards. However, for many companies, changing their inventory accounting method to last-in/first-out (LIFO) can present a clearer picture of their current financial position and may provide a tax deferral benefit. Under LIFO, each sale is assumed to come from the most recent items added to inventory. During inflationary cycles, using LIFO will generally result in at least temporarily lower net income and, thus, a reduced income tax bill, since the Cost of Goods Sold (COGS) will be calculated at the current, higher price of inventory.
What’s more, companies realize a temporary tax deferral benefit in the year they elect LIFO, as inventories are revalued from prior tax reporting. The longer the current inflationary cycle lasts, the more significant the tax benefits of a LIFO conversion strategy may last, so long as companies continually replenish inventory items at higher current costs. However, this tax benefit is only temporary. At some future point, whether due to the inflationary cycle relaxing and prices reverting back to lower levels, or having to sell the older inventory, the price benefit of higher COGS will recede, and companies will see higher net book and tax income as a result.
LIFO is not for everyone
While utilizing LIFO can provide significant tax benefits, it is not a “one size fits all” solution, and there are several impediments to adopting LIFO as an inventory accounting method. As a practical matter, companies which deal in goods that are either perishable or subject to rapid obsolescence will not generally be able to employ LIFO. From an accounting standpoint, doing the calculations of inventory on hand using LIFO also can be significantly more complicated than FIFO due to the additional layers of aged inventory.
Another issue that creates complexity, is the “LIFO conformity rule.” The Internal Revenue Code requires that companies using LIFO for tax purposes must also use LIFO to report inventory on its financial statements and any other reports or statements issued to shareholders, partners, investors, or any other parties for purposes of stating its financial position or seeking credit. In practice, the conformity rule can be more complicated than it sounds. From a professional services standpoint, using LIFO is generally more expensive than FIFO as financial statement and tax preparation fees are generally higher due to the additional analysis steps required by both audit and tax teams.
For companies reporting under the US Generally Accepted Accounting Principles (GAAP), there are even more complications. Both GAAP and tax rules stress that a company may not make a one-time change to LIFO simply to reduce income taxes; financial reporting rules require that the company have business reasons apart from income tax to make the change. And, if the inflation landscape changes to become more favorable to use FIFO, companies can’t just jump back and forth between methods. Companies changing to LIFO must also restate inventories on their financial statements to reflect the impact of the method change.
Additionally, almost every other country besides the US – including all territories that report financial statements under the International Financial Reporting Standards (IFRS) – do not recognize or permit LIFO as a valid means of reporting inventory. The US and Japan are the only countries whose governments permit the use of LIFO for financial statement reporting. So, a US parent company using LIFO with foreign subsidiaries would be required to recalculate the inventories of their foreign subsidiaries to meet the LIFO conformity rule (since those subsidiaries are likely not permitted to present inventory in their country of residence under LIFO). Lastly, once a company elects to use LIFO, electing out can create tax and accounting complications, as well as restrictions on how often a company can elect in and out of LIFO.
The bottom line
For some companies operating in an inflationary environment, changing from a FIFO to a LIFO method of inventory accounting can provide valuable tax-deferral benefits by recalculating their cost of goods sold to reflect current market conditions. However, there are both GAAP and tax restrictions to consider, and the change would require business justifications beyond simply saving on income tax. Aprio’s dedicated tax advisors are here to help you assess whether your company is eligible and would benefit from a LIFO election and can guide you through the accounting and tax reporting challenges of making that determination.
Schedule a consultation with Aprio’s Tax team today.