Inventory Price Index Computation (IPIC) on LIFO for Automobile Dealerships

By Scott Lewis, CPA, MSA

Inventory Price Index Computation (IPIC) on LIFO for Automobile Dealerships

If an automobile dealership has elected New Vehicle LIFO (Last-in, First-Out), chances are that they are using the Alternative New Vehicle LIFO method. The Alternative New Vehicle LIFO reserve method creates a tax deferral for the dealership. LIFO is based on rising prices and sometimes, rising inventory levels. Generally, when prices or inventory levels rise, LIFO taxable deductions occur, and conversely, when prices or inventory levels decrease, the potential for LIFO recapture exists, or ordinary taxable income. The inflation index is more important than the actual inventory level. It is possible that inventory levels can drop, yet the prices may increase dramatically, resulting with no significant taxable income impact.

As we are all painfully aware, most new vehicle dealerships are experiencing considerable decreased levels of new vehicle inventory, and more likely than not, will be facing LIFO recapture income as we close out 2021.

We want to bring to your attention another LIFO methodology called the Inventory Price Index Computation (IPIC), which can be applied to all inventory pools including new and used vehicles, as well as parts. The calculations involve tracking various inflation indexes from the Bureau of Labor Statistics (BLS), at a macro level, such as the Producer Price Index (PPI) and Consumer Price Index (CPI). Historically, these indexes have been lower than the inflation indexes generated from the Alternative New Vehicle LIFO method, but in 2021, the opposite is true. High demand for new and used vehicles in the marketplace has contributed to higher prices per vehicle, which in turn, has increased the inflation factors and these indexes are currently in the 15% to 20% range.

Electing this other LIFO method would then seem intuitive in 2021. It involves higher inflation indexes and used vehicles and parts can be added into the calculations to help offset the reduced amounts of new vehicle inventory. This could be an option in 2021 to lessen the LIFO recapture income which will occur. If the dealerships are currently on LIFO, the prior year reserves would need to be recalculated, and the IRS Form 3115, Application for Change in Accounting Method would need to be filed. Once filed, the method for computing LIFO cannot be changed again for five years.

However, we believe that this a short term and short-sighted solution. Although the BLS inflation indexes are currently higher than those calculated by Alternative New Vehicle LIFO, this will reverse over time. The BLS indexes are blended with used vehicles, which are temporarily at all-time highs. When they do, LIFO recapture income will occur, even as early as 2022. The election of IPIC is only deferring eventual taxes to be paid for one more year which, as outlined below, may have undesirable tax consequences based on potential changes in tax law.

For 2021, assuming the dealership is organized as a pass-through entity, such as a S-Corporation or partnership, this income would generally be eligible for the 20% Qualified Business Income (QBI) deduction. If the recapture income is $1 million as an example, taxable income would be reduced by 20% to $800,000, and the use of the QBI is guaranteed. There have been provisions in the current administration’s tax proposals to eliminate this tax deduction which is currently not scheduled to phase out until December 31, 2025. Although this has been removed from the latest version of the Build Back Better bill, it could potentially be on future drafts, as this bill has currently not passed and is being modified. There is also a provision that is in the current bill for active pass-through income to be subject to a 3.8% surtax, called the net investment income tax (NIIT), which is only currently applicable to passive income such as interest and dividend income. Any recapture income in 2022 and beyond would be subject to higher taxes than in 2021.

Finally, if used vehicles are incorporated into this method, or any LIFO method, write-downs are not permitted. When used vehicle pricing start to eventually cool down, the option to record used inventory to lower of cost of market and take the cost of goods sold tax expense will no longer be allowed.  

We are not recommending this method to any dealerships that are currently using Alternative New Vehicle LIFO, but we are presenting the above for information purposes. Any decisions or additional options should be discussed with your tax professionals. We do advise, as LIFO year-end calculations are currently being prepared, to include all in-transit vehicles that may exist. We have already seen reductions in the potential LIFO recapture (i.e. less income) on calculations performed than estimating using the final vehicle schedule only, when in-transits are included.

For any questions on how this impacts you or your business, please click here to contact us.

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