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Take Advantage of Year-End LIFO Planning Opportunities

Even if you ruled out the LIFO (last-in, first-out) inventory method as a tax strategy in the past, now might be the time to give it another look. Until five years ago, many manufacturers' reasons for ruling out LIFO were likely justified. The calculations were too onerous to handle internally and were expensive to outsource.

In addition, the expansion of the global economy resulted in periods of stable or falling prices in many market segments. Significant outsourcing of manufacturing and reduction of inventory levels based on "just in time" manufacturing concepts also limited LIFO's potential benefit.

Perhaps it's time to consider LIFO

Increases in many commodity prices and related manufactured goods in recent years, coupled with the simplification of LIFO requirements by the IRS in 2002 via the IPIC (Inventory Price Index Computation) method, could mean LIFO is now a good choice for you.

You can quickly estimate your LIFO reserve by applying the IPIC method to your larger categories of inventory.

Almost all small companies—and many larger ones—that adopt LIFO choose the IPIC method primarily because it simplifies the calculation through the use of published government inflation indices. This method eliminates most of the difficulties inherent in internal index calculations, including the need to reconstruct base-year costs for new items.

What are other IPIC LIFO advantages?

Possible higher inflation indices. It is not uncommon for the governmental inflation index to be higher than the actual inflation experienced by individual companies.

Less volatility of LIFO inflation. Raw material prices are often the major component of LIFO internal indices for work in process and finished goods inventories, but the IPIC method uses the normally less-volatile finished goods producer price index category indices for these inventories.

IRS audit protection. If you are using LIFO but not IPIC, changing to the IPIC method affords you IRS audit protection for prior years.

How much will LIFO benefit you?

Ten million dollars in inventory used to be a common level at which companies adopted LIFO due to the costs to calculate. IPIC simplifies the calculations, lowers the costs and makes the benefits easier to realize.

Consider a taxpayer with $5 million in inventory and average annual inflation of 3%. This taxpayer would recognize an annual tax deduction of $150,000 with annual cash flow savings of $50,000 or more, assuming a combined federal and state tax rate of 30%.

Several clients with inventory in the range of $10–12 million have had first-year tax deductions in excess of $500,000. One steel manufacturer who adopted IPIC in 2004 has now seen a three-year total deduction in excess of $3 million.

So what's the catch?

If you adopt LIFO for tax, your inventory for financial statement purposes must be stated on a LIFO basis. While differences in LIFO methods for book and tax are permitted, it adds the complexity of maintaining two computations.

Calculations are becoming easier

There are competitively priced software programs that simplify IPIC LIFO calculations. It is possible to download the Bureau of Labor Statistics (BLS) indices directly into a spreadsheet and match the indices to your inventory by commodity code. The software automates the calculation from there.

As with any opportunity, there is work involved. To perform an IPIC LIFO calculation, you must sort your inventory by commodity code as listed in the BLS index.

Once you have the program sort your inventory by the BLS commodity code, the appropriate index is applied to calculate the LIFO reserve. These steps are much easier than the old methods of applying LIFO layers and pools.

The future direction of prices and global demand for commodities are uncertain. However, the historical long-term trend is that commodity prices increase. Growing demand in international markets in recent years has been fueling rising prices for many commodities.

Because of this and the lower cost of simplified IPIC calculations, LIFO is a tax-deferral strategy whose time has returned. Your Blackman Kallick representative can help you determine if LIFO and the IPIC method are right for your company.

Questions about LIFO?
Contact Mike Calahan at 312-980-2996.

Our thanks to Tom Franklin and Matt Deutsch for their assistance in writing this article.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.