If your company produces a product, or buys or sells merchandise, you may be able to reduce taxes by switching from the first-in, first-out (FIFO) inventory method to the last-in, first-out (LIFO) approach. And paying less current tax means more cash to run and grow your business.
But an accounting method switch could affect something beside your tax bill ”“ namely, your financial statements. So it”™s not an endeavor to take lightly. Nonetheless, comparing FIFO to LIFO every so often is worth your while just in case now would be a good time to make the change.
Head-to-head matchup
FIFO assumes that merchandise is sold in the order it was acquired or produced. Thus, the cost of goods sold is based on older, and often lower, prices. The LIFO method operates under the opposite assumption: It allocates the most recent costs to the cost of sales.
If your inventory costs generally rise over time, LIFO offers a definite tax advantage. By allocating the most recent and, therefore, higher costs first, it maximizes your cost of goods sold, which minimizes your taxable income. Keep in mind, though, this method involves more sophisticated record keeping and calculations than FIFO.
Issues to address
If you”™re contemplating a switch, there are various issues to address and forms to complete, so be fully informed and consult your tax and financial advisers first.
For example, beware of the tax law”™s “LIFO conformity rule.” It generally requires you to use the same inventory accounting method for tax and financial statement purposes. Switching methods may reduce your tax bill, but it could also depress your current earnings and reduce the value of inventories on your balance sheet, thus giving the appearance of a weaker financial position.
It also can create a problem if your inventory levels are declining. As higher inventory costs are used up, you”™ll need to start dipping into lower-cost “layers” of inventory, triggering taxes on “phantom income” the method previously has allowed you to defer.
If this phantom income becomes significant ”“ and the trend is likely to continue ”“ consider switching to FIFO. It will allow you to spread out the tax on phantom income over a four-year period while giving your balance sheet a boost.
Another caveat: If your business is structured as a C corporation and you change your structure to an S corporation, you”™ll have to include a “LIFO recapture amount” in income for the C corporation”™s last tax year. The recapture amount is the excess of your inventory”™s value using FIFO over its value using LIFO. But you can spread out the tax payments over four years in equal, interest-free installments.
Additional challenges
One of the biggest challenges in using LIFO is the need to measure changes in inventory costs. If you currently use that method, you may be able to enjoy additional savings by electing to use the inventory price index computation (IPIC) method. It may enable you to reduce administrative costs ”“ and it might even generate greater tax benefits ”“ if you rely on government indexes to calculate LIFO values rather than developing an internal index.
In addition to simplifying computations, IPIC may increase your tax savings because government indexes often reflect greater inflation than internal data will. Also, you may be able to complete your calculations sooner by using an index published before your year end.
One last thing to bear in mind about LIFO: It may not be around much longer. If the SEC moves forward with tentative plans to switch from the long-adhered-to Generally Accepted Accounting Principles (GAAP) to the newer International Financial Reporting Standards (IFRS), private companies may feel compelled to follow (or be required to by their lenders or other stakeholders). And LIFO isn”™t allowed under IFRS.
Also, some business tax reform proposals have also included the elimination of LIFO as well as other tax breaks in exchange for overall lower tax rates.
Norman G. Grill Jr., CPA, is managing partner of Grill & Partners L.L.C., certified public accountants and consultants with offices in Fairfield and Greenwich. Reach him at N.Grill@GRILL1.com.
Very good summary of LIFO basics!