Friday, July 15, 2011

Proposal To Repeal LIFO: Closing A Loophole, Or Harming Inventory-Based Business?

One of the tax proposals made by President Obama in his 2012 budget, as well as in his budgets for earlier years, is to repeal the election to use the last-in, first-out (LIFO) method of computing net profit from sales of inventory. This article addresses arguments for and against repealing LIFO, and the anticipated financial consequences of any such repeal.

Background. Taxpayers may elect, with IRS's approval, an inventory accounting method generally known as the last-in, first-out (LIFO) method. (Code Sec. 472) Under this method, regardless of whether the goods on hand can be specifically identified and matched against invoices, the goods sold during the year are considered to be those most recently acquired, while the goods on hand are considered to be those earliest acquired. The LIFO method is in sharp contrast to the first-in, first-out (FIFO) method of determining the cost of intermingled goods, under which the goods on hand are considered to be those most recently acquired. (Reg. §1.471-2(d))

Under either method, there is no difference in the physical inventory. Only the amount allocated to the inventory as its cost will vary. Since the valuation of the closing inventory is a factor in determining the cost of goods sold, the valuation method chosen by the taxpayer will affect the computation of taxable income.

In a period of rising prices, LIFO locks in a lower cost of closing inventory, thus increasing the cost of goods sold. This in turn reduces taxable income, resulting in tax savings as compared to use of the FIFO method under the same circumstances. Part or all of these savings will be retained so long as the cost of inventory items remains above their value at the beginning of the year LIFO is adopted. If prices rise even higher in future years, the difference between the cost of closing inventory under LIFO and under FIFO will widen, thus increasing the tax savings from LIFO.

Calls for repeal. In addition to proposing repeal of LIFO in his 2012 budget, President Obama also did so in his 2011 and 2010 budgets. Former Ways and Means Committee Chairman Charlie Rangel (D-NY) also proposed LIFO repeal in 2007, and Senator John McCain (R-AZ) proposed it during his 2008 presidential run, demonstrating that repeal may arguably have some level of bipartisan support.

The President's 2012 proposal would require taxpayers currently using LIFO to write up their beginning LIFO inventory to its FIFO value in the first tax year beginning after 2012, essentially recapturing the financial benefit from using LIFO. The resulting increase in income would be taken into account ratably over ten years beginning with the first tax year beginning after 2012. (JCS-3-11)

In combination with Obama's other corporate tax proposals, it appears that repealing LIFO may well be part of his overall plan to reform the corporate tax system by broadening the tax base and reducing the corporate tax rate. In general terms, the idea is to simplify the system and level the playing field for all corporate taxpayers, in a largely revenue-neutral way.

Arguments in favor of repeal. Proponents of LIFO's repeal argue that it preferentially allows certain taxpayers to defer tax, on an indefinite or near-permanent basis, and that it serves no bona fide nontax function. Additionally, according to proponents, LIFO has long been complex and burdensome and has generated a good deal of controversy between taxpayers and IRS over the years.

LIFO is also prohibited under the International Financial Reporting Standards (IFRS). Although IFRS is not yet binding on U.S. taxpayers, the U.S. is expected to transition from Generally Accepted Accounting Principles (GAAP) to IFRS sometime in the next few years.

Observation: Although somewhat counterintuitive, the relationship between LIFO and IFRS is cited by parties on both sides. The fact that LIFO is prohibited under IFRS seems to clearly favor repeal. However, presuming that LIFO's repeal is an eventuality, some question whether it's worthwhile to do so only a few years ahead of that time. Thus, while IFRS doesn't favor retaining LIFO permanently, it arguably supports a delay of its repeal.

The Joint Committee on Taxation estimated in its analysis of the President's 2012 budget that repealing LIFO would generate almost $70 billion in tax revenue over ten years. (JCX-19-11)

Arguments against repeal. Opponents argue that repealing LIFO would force companies that use it to eliminate jobs or restrict their ability to invest. (JCS-3-11) They claim that taxing accumulated LIFO reserves would be akin to imposing a tax on nonexistent funds since any purported inflation-based “profit” is unrealized, and that the tax imposed on the recapture could be significant.

Opponents further claim that LIFO provides a more accurate reflection of a taxpayer's current income because it matches current costs with current revenues. They also argue that, absent LIFO, inventories are taxed more heavily than comparable items like equipment, which benefit from deductions such as accelerated depreciation—and in this respect, LIFO can be viewed less as a preferential tax break, and more as a tax equalizer.

Observation: The actual financial consequences of a repeal would likely depend largely on the context in which it was passed—i.e., as a stand-alone measure, or as part of broader corporate tax reform.

Conclusion. Whether LIFO will be repealed, and to what extent it is being considered in the current budget and debt ceiling talks, is unclear. However, whether ultimately resolved by the convergence of IFRS and U.S. accounting standards or by repeal, the issue doesn't appear likely to go away anytime soon.

References: For the LIFO method, see FTC 2d/FIN ¶G-5200; United States Tax Reporter ¶4724; TaxDesk ¶452,001; TG ¶6703.

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