Electing and retaining the last-in, first-out (LIFO) method of inventory accounting provides the most significant tax benefits when a company’s raw materials increase in price from year to year.
This is because relatively more expensive raw materials purchased in the current year are deducted before less expensive materials that were purchased in prior years.
Inventory count is the key to this tax benefit. It needs to sustain or increase from the previous year to be beneficial.
Otherwise, the LIFO reserve may be recaptured and deferred income must be recognized in the current year.
Taxpayers currently using LIFO can possibly reduce year-end surprises – positive or negative – by tracking the commodity markets throughout the year.
Price changes are tracked by the Bureau of Labor Statistics (BLS) and are used to calculate monthly industry price changes for the Consumer Price Index (CPI) and Producer Price Index (PPI).
Several factors cause changes in commodity prices: supply and demand, regional and global economic growth, inflation, deflation, and more.
By tracking commodity price trends, you may be able to purchase raw materials when prices are favorable. Or, you can find cheaper alternatives when they become more expensive.
Should I elect LIFO now?
Consider this example.
A manufacturer whose primary raw material is steel has $10 million in inventory at year-end and $1 million in net income using the first-in, first-out (FIFO) method of inventory accounting.
The PPI for steel mill products has increased 3% between October 2015 and 2016.
For this manufacturer, electing LIFO could result in additional cost-of-goods-sold deductions and decrease the net income by $300,000.
This amount represents a deferral of income. It’s also the LIFO reserve that the manufacture can collect as income in the future.
As this example shows, LIFO has significant tax advantages when commodity prices increase over time. In this case, with a 34% tax rate, the current tax savings from making the LIFO election are $102,000.
What you should know
The process of electing and implementing LIFO can seem overwhelming at first.
However, it’s been simplified over the years by allowing taxpayers to elect to use the Inventory Price Index Computation or IPIC method. IPIC uses the commodity and product groupings based on monthly PPI tables provided by the BLS.
The accurate and timely filing of tax returns to elect LIFO is imperative to ensure the election isn’t revoked by the IRS. Once elected, proper documentation and compliance must be maintained.
Have questions about commodity prices and LIFO? Let’s talk!