The COVID-19 pandemic has created significant supply chain and manufacturing interruptions, which in turn have impacted the ability of businesses to maintain their inventory. These disruptions have greatly impacted auto dealers due largely in part to the shortages in semiconductors and microchips — vital components for newly manufactured cars. These shortages have left auto dealers unable to replenish their inventory.
For auto dealers using the “last-in, first-out” (LIFO) inventory accounting method, severe supply chain disruption may produce undesirable tax results. The auto dealer industry has been pushing for relief in this area for several years. A new bill recently introduced in Congress, if enacted, might provide this much-needed assistance. We share our thoughts on what this means for auto dealers and what might be coming next.
How inventory shortages can cause a LIFO problem
The LIFO method allows a taxpayer to assume that the newest inventory is sold first, and the oldest inventory is sold last. This means LIFO taxpayers deduct the cost of goods sold associated with the most recently purchased inventory, which generally results in a larger current deduction when prices are rising, and lower inventory costs remaining on the balance sheet. A “liquidation” of the old inventory costs occurs if the quantity of inventory at the close of the period is lower than the quantity at the opening period. This requires a taxpayer to recognize additional income since the old inventory cost is much lower than the actual cost paid for new inventory.
Tax law currently provides some relief to LIFO taxpayers facing inventory shortages, but the rules are narrow, and many supply chain interruptions don’t qualify for relief. Under IRC Section 473 — Qualified Liquidations of LIFO Inventories — businesses using the LIFO method that experience an inventory liquidation due to a “qualified inventory interruption” may qualify for relief, but only if the Treasury Department determines that acquiring replacement goods is made difficult or impossible by: a) “any Department of Energy regulation or request with respect to energy supplies,” or b) any “embargo, international boycott, or other major foreign trade interruption.”
If Treasury announces that a qualified inventory interruption exists, qualified taxpayers can reduce their gross income by the excess of the aggregate replacement cost of the liquidated goods over the LIFO cost of those goods as originally reflected in beginning inventory for the year. Taxpayers generally have three years to replace the inventory, and the reduction of gross income occurs in the liquidation year only when the inventory is replaced over that period. This could require taxpayers to file amended tax returns over the course of this period.
Currently, Treasury is the sole authority authorized to grant relief under Sec. 473, but Treasury has declined to announce relief for COVID-19-related inventory interruptions. Congress members have recently petitioned Treasury for Sec. 473 relief, but Treasury appears to have concluded that COVID-19-related inventory interruptions don’t qualify for this relief and has declined to act.
Proposed legislation offers possible LIFO relief
The Act was recently introduced in Congress to provide relief to auto dealers of new motor vehicles using the LIFO method that experience a qualified liquidation of inventory. The qualified liquidation of inventory must occur in a specified tax year ending after March 12, 2020, and before Jan. 1, 2022 (i.e., the 2021 and 2022 calendar years). The Act would allow auto dealers to:
- Assume that the requirements of a qualified inventory interruption under Sec. 473 are satisfied for any specified tax year.
- Provide an inventory replacement period extending through the last tax year ending before Jan. 1, 2026.
- Modify and simplify the adjustments to income that result from the relief.
A qualified auto dealer that experiences an inventory liquidation in a specified tax year wouldn’t need to recognize the inventory liquidation income and would only recognize the income in its 2025 tax year to the extent that the inventory was not replaced. Taxpayers that filed a tax return for a specified tax year prior to the enactment of the Act can retroactively elect these benefits on their next tax return and include any corresponding adjustment to income in the following year. This would avoid the need to amend previously filed tax returns.
What to expect
Currently, the Act has been introduced in the House of Representatives but has not yet advanced in the House Ways and Means Committee. A corresponding bill has not yet been introduced in the Senate, but certain senators have indicated an intent to pursue companion legislation. Although the Act offers welcome relief to auto dealers, the legislation is in early stages, and it’s uncertain that the Act will become law.
The White House and congressional leadership have identified supply chain issues and inflation as top priorities, but ongoing geopolitical issues such as the war in Ukraine, midterm elections, and other congressional priorities may pull Congress’s attention away from the Act this year.
Given the uncertainty around the Act, auto dealers looking to take advantage of LIFO relief should consider extending their 2021 tax returns to allow time for the bill to advance. However, when making necessary payments with tax return extensions, auto dealers should consider the potential for penalties and/or interest on late payments to the extent that relief is not ultimately provided.
Need help determining how the Act could impact your tax position, how best to plan for any potential Sec. 473 relief, or how to manage other LIFO-related tax planning strategies? Contact our experts today.
