By Zach Wimberger
For dealers on the new vehicle Last-In, First-Out (LIFO) method, potentially significant levels of LIFO taxable income recapture from prior years have become a major focusing point for year-end tax planning as new vehicle inventories are generally at their lowest levels. While many dealers have already started to feel the burden of these recaptures on their 2020 tax returns, recaptures for the 2021 year are expected to be much higher than last year. If you have dealerships that report under the LIFO method, it is highly recommended to discuss these potential income recapture scenarios with your tax preparer if you have not already done so.
For automotive dealers on LIFO, there are some options to consider as the year 2021 winds down. One is to perform the LIFO calculation as usual and record the taxable income on recapture. For pass-through entities such as S corporations and partnerships, this taxable income may be reduced by the 20% Qualified Business Deduction (QBI) at the individual shareholder or partner level, at least in 2021. There is discussion in proposed government bills to limit the use of this QBI deduction in subsequent years.
Another option is simply to elect out of LIFO. This election off LIFO would enable you to recapture the entire LIFO reserve over a 4-year period spread, as opposed to all in one year. If a dealership elects out of LIFO, it cannot file a re-election for at least 5 years. And again, QBI will reduce this income by 20% if applicable, in 2021. This QBI option maybe limited in 2022 and going forward, and there is also discussion of higher federal tax rates or additional federal surtaxes. It may be advisable to defer this election off LIFO until 2022 and record all calculated recapture LIFO income in 2021. In the future, the effect of inflationary pricing may lead to higher deductions as inventories begin to grow back, so before electing out of LIFO, take a hard look at when inventory levels may come back, as the inflation index is just as an important piece of the computation as inventory levels. If at the end of 2022, inventory is still at lower levels, the amount of the remaining new vehicle LIFO reserve will be much lower than at the end of 2021, and this maybe an opportune time to elect off LIFO. The amount of income subject to any increased tax rates or surtaxes over the 4-year spread beginning in 2022 will be much lower than if electing off in 2021.
There is a possibility of some tax relief in the form of an intervention from both the National Automobile Dealers Association (NADA) and Congressional leaders. On November 10, 2021, letters were signed and sent by representatives of both the House and Senate to the U.S. Department Secretary of the Treasury, asking for temporary relief for businesses that have been affected by the global supply chain problems. This includes auto dealerships with minimal new vehicle inventories because of the chip shortages affecting new vehicle production. The relief involves businesses utilizing the LIFO inventory methodology for tax purposes.
NADA had previously petitioned the Department of Treasury to allow the election under Section 473 of the Internal Revenue Code, for LIFO relief involving qualified liquidations of inventory. It allows businesses to replenish their inventory over three years instead of the one-year period and defers any LIFO recapture taxable income in the same period. It will allow dealers time to increase their inventory as factory production factory normalizes. The letters signed by Congress also asked the Treasury to invoke Section 473. Otherwise, dealers are facing significant taxable income in 2021 as the result of this recapture.
If there is any update on the status of the Congressional LIFO relief request, we will be sure to keep you notified, and if you have any questions, please reach out to our team by clicking here.