Inflation And Supply Chain Disruptions May Be Increasing Your Tax Bill

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Over the past two years manufacturers and resellers have struggled to maintain inventory levels due to global supply chain issues, and are now facing the highest inflation rate since 1981. Unfortunately, a poor supply chain and increased inflation will most likely increase the tax bill for businesses. Those who use the LIFO method of accounting.

It is not uncommon for businesses to use the first-in-first-out (“FIFO”) method for internal reporting purposes, but the last-in-first-out (“LIFO”) method for external reporting purposes, e.g. for US GAA
P and federal income tax. FIFO assumes that assets previously produced or acquired are sold or used. Alternatively, LIFO assumes that the most recent items that were purchased in inventory will be the first to be sold. Are you wondering why I don’t choose new inventory versus old inventory when I ship my products to my customers? It is true, LIFO and FIFO are not actuals, but rather agreed upon how a business will calculate its cost of goods sold (“COGS”).

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Using LIFO when costs are rising due to inflation is generally beneficial for income tax purposes because the selling prices are offset by the higher increased purchase costs. Additionally, LIFO taxpayers can trap lower inventory costs in ending inventory each year if they maintain or increase their inventory year after year. These layers compound over time and create a significant tax deferral.

However, the benefit of LIFO is reaped if businesses have less inventory at the end of the year than at the beginning of the year. Business owners who have severe supply chain crises may pay significantly higher taxes due to the recapture of LIFO.

Let’s review a simple example. Company A sold widgets in 2021 for $150 per unit. In addition, Company A’s listing was as follows:

Let’s say Company A sold 275 units in 2021. This would identify $41,250 (275*$150) of gross receipts, reduced by $27,500 (275*$100) of cost of goods sold (COGS), resulting in $13,750 of gross profit.

However, gross profit will be higher to the extent that the company needs to use inventory layers before 2021. This is where the supply chain, coupled with inflation, can have a major impact. Let’s say that in 2021 they were only able to buy 110 units at $100 a unit, but still sold 275 units.

Gross receipts will remain at $41,250 but will use the COGS 2020 inventory layer. Total COGS from 2021 will be $11,000 (110 x $100) and 2020 from $13,200 (165 x $80), totaling $24,200. Company A would recognize taxable income of $17,050, an increase of 24% in their taxable income even though the same number of sales occurred. This may come as a surprise to many taxpayers and only worsen through the 2022 taxable year.

While you can see examples that were provided as nonmaterial, industries that commonly use LIFO include pharmaceutical distributors, specialty retailers, industrial equipment, agricultural equipment, furniture businesses, and the automotive industry. There is a significant increase in their tax bills. For example, the National Automobile Dealers Association estimates that approximately 50% of dealerships use the LIFO accounting method and projects that supply chain disruptions could cause an additional $1.7 billion in taxes for the industry in 2022. This is a significant tax increase for an unpredictable taxpayer. , and even with other potential increases in operating expenses, such as wages and wages, may still require increased federal tax payments.


So, is there any relief available? are likely to be. Taxpayers should monitor their COGS and higher selling prices due to inflation. If a business needs to use inventory layers that pertain to prior taxable years that are substantially less than current costs, an increase in potential taxable income should be identified, and tax planning considered. .

wait and see

Businesses may consciously choose to remain on the LIFO method. Provided that the supply chain gets better, and inventory can be restored, the ability to make back a LIFO reserve deferral may be faster than one would expect due to increased procurement costs. Identifying income at a time that is generally considered a lower tax period can be beneficial. In addition, the ability to offset future earnings with a higher price list could lead to even greater gains when tax rates rise.

If the decision is made to remain on the LIFO method, the potential profit can be achieved if an adjustment is made from a unique identification method to a pooled index method. For example, an automobile dealer using unique identification for new car inventory may consider a pooled method of including used cars and parts for a potential planning solution. If the inventory pool has already been used, the taxpayer should review the inventory pool to see if any adjustments can be made to limit the taxable income impact.


A possible solution could be for the taxpayer to opt for any other permissible method than LIFO. While this would still require income inclusion of the entire LIFO reserve, the inclusion could be spread over four years as opposed to taking a larger amount in one year. The limitation of making such a method of accounting change is that the taxpayer would have to wait 5 years before being able to use LIFO again for US GAAP and tax purposes.

When choosing which permissible method can be used when choosing from LIFO, taxpayers must confirm that they are not eligible for the small business listing exceptions. Small businesses are generally defined as corporations or partnerships that have average gross receipts of less than $26,000,000 (2021) or $27,000,000 (2022) when assessed over the past 3 taxable years. Certain businesses may be covered under this exception if their gross receipts were severely affected during the 2020 and 2021 taxable years due to the pandemic. If this exception is met, the business no longer needs to account for inventory for tax return purposes, but deduct the amounts paid to obtain or produce materials and supplies in the taxable year. in which the materials and supplies are first used or consumed in the taxpayer’s operation. Essentially allowing small business taxpayers not to report inventory for tax purposes or worry about UNI

Will there be any help from the IRS or Congress?

A and the National Automobile Dealers Association have urged the IRS and Congress to extend the relief provided under IRC Section 473 to LIFO-using companies that have closed their doors due to government operations in response to COVID-19. experienced a reduction in inventory. The most recent proposal was introduced by Senator Sherrod Brown (D-OH) on April 28 in a bipartisan bill (S. 4105) that focused specifically on the automotive industry.

Under Section 473, if the requirement to use LIFO layers is beyond the taxpayer’s control (such as a trade embargo or other international event) the business turns over the inventory within a three-year period. In particular, Sec. 473 authorizes the Treasury to issue a notice to the Federal Register that a qualified inventory interruption of LIFO inventory has occurred.

The mechanics are seen in the following example. Assume that OPEC refused to sell petroleum products to US companies and a US petroleum company was forced to deplete $8,000,000 of its LIFO reserve of petroleum in the 2005 taxable year. The Treasury Department publishes a notice stating that the event was a qualified inventory interruption. In 2006, the company replaced petroleum at a cost of $10,500,000. The corporation’s qualified liquidation amount would be $2,500,000 (10,500,000-8,000,000) and under section 473 the company would be able to amend its 2005 tax return to exclude that amount of gross income.

Under various safe harbor proposals, modification of prior return will not be necessary. Instead, the taxpayer would not be required to recognize the income attributable to the liquidation of LIFO layers in the year of use if the taxpayer completely replaces the inventory by the end of the replacement period. Such amendment reduces the burden of paying additional taxes on the respective income.

Even though such a safe harbor is supported by many, the chances of passing through are slim. However, it’s worth seeing if any momentum can be built up.

Businesses have faced a variety of obstacles at least over the years, and it appears that various challenges are on the horizon. The rapidly changing business environment and amendments to the tax law, including TCJA sunset provisions and new administrative guidance, require all businesses to work closely with their tax advisors to ensure that there is no undue exposure to cash income tax payments and effective taxation. Not surprised. rates.

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