LIFO REPEAL – TAX SAVINGS FOR THE SMALL BUSINESS?

The Tax reform Act, 2014 calls for a repeal of the Last in First Out (LIFO) method of inventory valuation. Despite the promise of reduced tax rates associated with LIFO repeal and other proposed changes, there has been strong opposition to the proposed repeal particularly from a group of over 120 companies coming together to form the LIFO Coalition in 2006. (LIFO Coalition, 2014)

The group contends that getting rid of LIFO would cause severe economic hardship to businesses and lead to loss of jobs. (Whitehouse, 2009).

WHAT IS LIFO?

LIFO is a method of accounting for inventory where the latest costs are charged to the cost of goods sold. This results in lower profits when prices are rising and higher profits when prices are falling. This translates to lower taxes in high price settings. LIFO is only used in the United States and is accepted by the Internal Revenue Service (IRS), providing the conformity requirements are met (IRC 472 (c) and (e)).

TAX ON DEFERRED LIFO INCOME

The proposed LIFO repeal will impose tax on deferred LIFO income. This is the amount by which the charge to cost of goods sold exceeded what the charge would have been if the First in First Out (FIFO) method had been used. This is also referred to as a LIFO reserve. The LIFO coalition argues that ‘the LIFO reserve could exceed retained earnings or net worth, in which case the business probably would liquidate, and might still owe tax’ (Whitehouse, 2009). The act offers some relief by allowing companies to pay this tax over four years and providing a tax rate reduction to 7% for businesses with 100 or fewer owners.

BENEFITS OF LIFO REPEAL

1. Tax rate reduction
The tax reform act proposes tax rate reduction and a special rate for businesses with 100 or fewer owners.
2. Global accounting standard
One of the few major remaining differences between US GAAP and International Financial Reporting Standards (IFRS) which is being adopted around the world, is the use of LIFO in the USA. LIFO is not used by any other country and it is not permitted by IFRS. (SEC, 2011 and House Ways And Means Committee,2013). LIFO repeal would eliminate this difference.
3. Tax treatment of Annuity withdrawals

Although not specifically addressed in the tax reform act, it can be argued that if LIFO is repealed the IRS should stop using this method for determining the amount of an annuity withdrawal that is taxable.

The current treatment for withdrawals from an annuity that was purchased with after-tax dollars is to consider any amounts withdrawn that is less than or equal to the total interest earned as taxable (IRS, 2014). This is a LIFO method since the balance in the annuity account represents basis first and interest last.

In summary, whether switching from LIFO to FIFO will result in tax savings depends on what’s happening with inflation. The tax reform act, 2014 promises lower tax rates and transition relief for affected companies. LIFO repeal would also bring the US one step closer to joining the rest of the world on the road to a global accounting standard.

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References:

House Ways And Means Committee (2013). The LIFO Coalition. Retrieved from http://waysandmeans.house.gov/uploadedfiles/the_lifo_coalition.pdf

House Ways And Means Committee (2014). Tax reform Act 2014. Retrieved from: http://waysandmeans.house.gov/uploadedfiles/tax_reform_executive_summary.pdf

IRC 472 (c) (nd). Retrieved from http://www.law.cornell.edu/uscode/text/26/472

IRS, (2014). Publication 575. Retrieved from http://www.irs.gov/publications/p575/index.html

LIFO Coalition (2014). Retrieved from http://www.savelifo.org/

SEC (2011). Letter from the LIFO Coalition to the SEC. Retrieved from: http://www.sec.gov/comments/4-600/4600-142.pdf

Whitehouse (2009). Letter from the LIFO Coalition to the President’s Economic Recovery Advisory Board. Retrieved from: http://www.whitehouse.gov/assets/formsubmissions/109/