While tax reform has been a presidential agenda item for decades, the current administration appears to be close to releasing a blueprint for broad reform. There are, however, more unknowns than knowns at this point given the closed-door nature of discussions in Washington. To date, it is not clear if the proposal to cut the corporate tax rate would provide a permanent fix or whether Congress will pass a temporary solution to allow reconciliation. If revenue neutrality, or “pay fors,” are required, the impact to incentives such as LIFO could be dramatic.
LIFO, or last-in-first-out accounting, is a GAAP-approved inventory accounting method that was adopted in 1939. It is not, nor has it ever been, considered a tax expenditure. Instead, LIFO is a method to track products and costs and appropriately align the cost of goods sold with the cost of replacement inventory. The need for LIFO has not changed since its inception, which is why it has existed for nearly 80 years and is used by hundreds of thousands of US companies across many industries.
LIFO was designed to respond to price fluctuations, mitigate the negative impact of inflation and trigger income during times of deflation. During the recession, for example, many small businesses used LIFO reserves to fund payroll. This prevented them from being forced to lay off workers or close their doors altogether. Repealing LIFO would reduce GDP, federal revenue and cost jobs, and it would disproportionately harm small businesses, which operate on tighter margins and use LIFO to maintain necessary inventory levels. Repeal would mean a retroactive recapture of deductions that many businesses have taken for decades. While recapture would theoretically happen over eight years, if the tax rate cut is ultimately temporary, small businesses would end up losing the benefits of LIFO and paying higher corporate tax rates.
Given the multitude of ideas being floated in Washington and the lack of specifics surrounding all of them, trading an 80-year-old, well-proven accounting method for the promise of a “better” outcome with tax reform is a frightening prospect for any small business that currently uses LIFO. While the threat of repeal has been around for years, it has never been more urgent to communicate the need to keep LIFO. For more information on how to share your thoughts with Congress, click here.
While there is no current timetable for the adoption of International Financial Reporting Standards (IFRS) for U.S. companies, the looming conversion has long been a source of concern for companies using the Last In First Out (LIFO) method of accounting. Because IFRS does not recognize the LIFO method, full adoption of IFRS by the Securities and Exchange Commission would force companies off of LIFO for tax purposes, since the conformity rule requires companies using LIFO for tax purposes also use LIFO for financial statement reporting.
However, recent developments should provide LIFO taxpayers relief and cause less worry about the impact IFRS conversion may have on their business. In a recent memo addressed to The LIFO Coalition, Les Schneider, Tax Counsel to The LIFO Coalition, explains that it is increasingly unlikely that the SEC will fully adopt IFRS or disallow the LIFO method. It is very possible, under the form of convergence currently being contemplated by the SEC, that LIFO will remain an acceptable method in spite of the fact that it is not recognized by IFRS.
LIFO repeal has also been a threat on the legislative front, appearing in President Obama’s budget multiple years. While there is currently no pending legislation calling for the repeal of LIFO for tax purposes, an argument always used by legislators when discussing LIFO repeal is the impending IFRS convergence. With it being increasingly unlikely that a full IFRS adoption and disallowance of LIFO for financial statement purposes will take place, legislator’s LIFO repeal argument has certainly become less valid. Any future legislative efforts arguing the use of LIFO for tax purposes will certainly become more difficult.
LIFO is an established tax method that has been a part of U.S. tax law for over 80 years and is used by hundreds of thousands of companies that carry inventory across all types of industries.
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Chris Henderson, VP of Operations
SourceCorp recently experienced a situation where an auto dealer was notified by the IRS that their 2008 and 2009 tax years were the subject of a routine IRS exam. The IRS also indicated it would be looking at §263A issues during the exam. After some negotiation, the IRS said it was willing to drop prior year §263A issues if the auto dealer elects the Safe Harbors as outlined in Rev. Proc. 2010-44. In addition, the IRS required the dealer to adopt the Safe Harbors via Form 3115 for the 2010 tax year by the 9/15 extended due date.
The IRS’ willingness to allow the dealer to move to Safe Harbor methods is in keeping with what IRS Motor Vehicle Specialist Terri Harris relayed late last year when the Safe Harbor guidance came out. Terri’s comments indicated that the IRS would be lenient on dealers for the 2010 and 2011 tax years, giving them time to transition to the Safe Harbors method. After that, dealers may face less forgiving IRS agents.
SourceCorp works with many auto dealers and their CPAs and has developed a seamless solution for the adoption of both safe harbors. We continue to monitor this issue closely and will post additional updates to our blog as they arise. For further information, contact me directly at firstname.lastname@example.org.
A manufacturer of safety and personal protective equipment had been experiencing steady increases in material costs. The company had utilized the LIFO inventory method in the 1990s, but elected off of LIFO due to the complexities associated with the method. They decided to consider LIFO again as a means to free up cash to reinvest in the business for the 2010 tax year. A no cost analysis by SourceCorp Professional Services showed the company was experiencing 4% inflation, which yielded a first year LIFO Reserve of over $4.1 million – a tax deferral of over $550,000 in year one, which the company used to expand their business. They were also able to eliminate the concerns and complexities presented with their prior LIFO method by utilizing SourceCorp’s services.
An aluminum distributor with roughly $20 million in inventory had been on LIFO for 15 years. While their current method had produced a sizeable LIFO Reserve over the years, the company was open to considering other LIFO methods. By changing to the IPIC LIFO method, the company was able to increase their LIFO Reserve by $2.5 million above their prior method for the 2010 tax year. The audit protection received as a result of the method change proved to be an additional benefit of electing IPIC.
While most people cringe at the thought of inflation, companies using the LIFO method of inventory valuation will be pleased to know that inflation is back. We’re finally starting to see good levels of inflation in many industries. For example:
• In the last year, Petroleum, lubricating oils, and greases, along with kerosene, jet fuels, and gasoline have experienced significant amounts of inflation.
• Copper, nickel ores and nonferrous metal ores are experiencing 31%-41% inflation so far in 2011.
Other industries experiencing inflation are:
• Recyclable Materials – Inflation was very high in 2010, and is still at 20% – 30% in 2011
• Animal and Pet Food manufacturing – Dog and cat food, along with other animal feeds are on the rise and currently at about 12% inflation.
• Yarn, thread, and fabrics – These have been consistently rising since early 2010, and inflation in 2011 is currently showing as much as 13% inflation.
• Grocery Items — Grocery items have been consistently on the rise for the last year and are currently experiencing 15% plus inflation.
• Paint and painting supplies and Wallpaper – Inflation has been on the rise and is about 7%.
• Cigarettes – Inflation averaged 6% in 2010, and is showing 8% in 2011.
While the word inflation generally has a bad connotation, in today’s economy inflation is a positive sign of growth. I’ll be making additional posts in the coming weeks outlining specific case studies of how inflation benefits many companies.
Companies on LIFO should explore the IPIC LIFO method as a way to potentially increase their LIFO benefit for 2010. There are some key dates related to this type of method change. Once a company has completed their 2010 LIFO calculation, an IPIC LIFO estimate should be performed to determine the tax benefit of moving to the IPIC LIFO method. SourceCorp can prepare this estimate at no cost– the estimate phase typically takes 7 to 10 business days.
If a company does decide to make a method change and elect the IPIC LIFO method, the company has until the extended due date of the tax return to make the change. An IPIC LIFO implementation generally takes four weeks to complete. This means that if a 12/31/10 year-end company plans on filing a timely tax return on March 15, 2011, SourceCorp should begin the estimate phase by mid-January.
Should a LIFO taxpayer decide to evaluate the IPIC method after the return is filed on March 15, there is still time to make a method change for the 2010 year-end. Because a taxpayer has until the extended due date to make the method change, an amended tax return can be filed as late as 9/15/2011. This applies only to taxpayers already using a form of LIFO that included a LIFO adjustment when filing the annual financial statements for the 2010 year end.
To learn more about a no-cost analysis of the IPIC LIFO method, please contact me at Chandry.Jimenez@sourcecorptax.com.
Taxpayers on LIFO are likely familiar with the conformity requirement, which states that companies using the LIFO method for tax purposes must also use the LIFO method for financial reporting purposes. Because of this, some LIFO taxpayers are hesitant to maximize their LIFO reserve due to concerns that doing so may cause covenant issues with their banks or other lenders. Where LIFO is concerned, the more tax savings generated from the LIFO method results in the appearance of lower profits from a financial reporting standpoint.
What LIFO taxpayers may not be aware of is the fact that the conformity requirement does not demand taxpayers utilize the same LIFO method for book and tax purposes. This exception allows companies on LIFO the opportunity to utilize a more beneficial LIFO method for tax purposes while using a different LIFO method for book purposes. Generally, the IPIC (Inventory Price Index Computation) LIFO method is the most advantageous LIFO method for tax purposes.
Unlike traditional LIFO methods, IPIC measures inflation based on published indexes that are tracked and maintained by the Bureau of Labor Statistics (BLS). In most cases, the published indexes result in higher inflation than companies experience internally. Any company interested in maximizing their LIFO reserve for tax purposes, while minimizing the LIFO impact for book purposes, should explore converting to the IPIC LIFO method. SourceCorp Professional Services can perform a no-cost analysis to determine the potential tax savings of moving to the IPIC method.
Summary: The SEC is still getting comments on the IFRS work plan in Release No. 33-9109. According to the AICPA, public companies will have an easier time making the switch if the SEC ends the uncertainty and sets a firm date.
The AICPA said the SEC needs to make clear its commitment to adopting IFRS and abandoning U.S. GAAP. “The U.S. financial reporting system will take substantive, definite steps to ready itself for IFRS only when the SEC makes a decision to require IFRS and announces a date certain for adoption of IFRS,” the AICPA wrote in an October 14, 2010, comment letter. “We believe completion of the work plan will provide a solid foundation for the SEC to make a determination in 2011 on whether and how to incorporate IFRS into the financial reporting system for U.S. issuers,” the AICPA wrote in reference to Release No. 33-9109, Commission Statement in Support of Convergence and Global Accounting Standards.
In August the SEC issued Release No. 33-9134, Notice of Solicitation of Public Comment on Consideration of Incorporating IFRS Into the Financial Reporting System for U.S. Issuers, requesting comments on three topics from the work plan in Release No. 33-9109. The SEC sought comments on the effect of a switch on issuers’ compliance with contractual arrangements that require the use of U.S. GAAP; issuers’ compliance with corporate governance requirements; and the application of certain legal standards tied to amounts determined for financial reporting purposes.
To get feedback to take into consideration when preparing its comments, the AICPA held two conference calls with its members from business and industry who have backgrounds working with public companies. In its comment letter which can be viewed on its website at http://www.aicpa.org/Press/PressReleases/DownloadableDocuments/AICPAComment%20Letter_IFRS%20Work%20Plan_Final.pdf, the AICPA said it views contractual arrangements as “a distinct work stream” in an IFRS conversion process.
According to the AICPA, companies will have to review contracts and agreements and determine how they will be affected by adoption of IFRS. When the financial reporting requirements of a contract are based on U.S. GAAP, contracts may need to be amended to allow IFRS as the basis of financial reporting. Contracts with features such as lender covenants that are based on U.S. GAAP will be more of a challenge.
The AICPA said the effort required will be determined on a company-specific basis. Some organizations may have a large volume of contracts that need to be addressed, while others have only a few. The AICPA said its research indicates that companies will need five years to prepare for switching if the SEC is going to require two years of historical comparative financial statements. If only one year of comparative financial statements is required, a four-year transition should be sufficient. The AICPA said it will support a decision to require only one year of comparative statements and will also support an early adoption option.
The comment period for Release No. 33-9134 ends October 18.
Source: WG&L Accounting & Compliance Alert Checkpoint 10/18/2010