There are few businesses that have been able to escape the impacts of rising inflation. For businesses whose bottom lines have been squeezed by rising prices, there may be a path for some relief. The last-in, first-out (LIFO) inventory accounting method can provide tax deductions for the rise in inventory costs. Here’s what you need to know.
LIFO tax benefits created from rising inflation
The LIFO method is a method of inventory accounting that allows taxpayers to assume that goods sold during the year come out of the taxpayer’s most recently purchased or manufactured inventory. As a result, cost of goods sold (COGS) for the year is associated with the newest inventory. In periods of inflation, the cost of goods deducted is higher, resulting in lower taxable income. If LIFO is adopted for tax purposes in 2022, ending inventory is valued as if it were purchased at the beginning of the year — removing any price increases, or inflation, incurred throughout the year.
We have seen this scenario play out over the past year with double- and triple-digit inflation due in part to the COVID-19 pandemic. Freight costs and supply chain disruptions have decreased the supply of goods, and in an environment of increasing demand, the cost of goods has increased.
Important considerations when switching to LIFO
Although LIFO has tax benefits during periods of rising inflation, there are several factors taxpayers should consider before adopting LIFO. The LIFO method can be adopted with a timely filed return, but the LIFO conformity rule requires taxpayers to also use LIFO on any financial report or statements that are issued to creditors and shareholders. Taxpayers who have already issued their financial statements using a non-LIFO method are prohibited from using the LIFO method until a subsequent year when they apply LIFO on their financial statements.
In addition, taxpayers should consider how the LIFO method would impact loan covenants or other financial metrics and may want to consider modifying such agreements to reverse out the impacts of LIFO. As such, taxpayers should start planning now for a potential 2022 LIFO adoption.
Inflation has continued to rise during 2022, but taxpayers should still consider the potential impact if costs decrease. In that case, the tax benefit of LIFO may decrease, but there would still be overall tax benefits as long as costs don’t decrease below the level they were at when LIFO was adopted. Generally, once elected, LIFO must be used for five tax years before a taxpayer can change its method of accounting for inventory.
How we can help
While there are some complexities surrounding the adoption of LIFO, the current tax savings make it worthwhile for many businesses. Our experts can help you evaluate whether LIFO makes sense for your business based on your unique circumstances. Contact your Plante Moran advisor to discuss how switching to LIFO could generate tax savings for your business.
