New Vehicle LIFO: Tax Planning for 2021

by Scott Lewis, CPA, MSA, Partner

We can all agree that 2021 has been an interesting and somewhat challenging year in the automotive retail industry, specifically in maintaining new vehicle inventory. Between COVID-19 related temporary factory shutdowns by the Original Equipment Manufacturers (OEM) and their suppliers, combined with the global chip shortage, over 2 million new vehicles have been cut from production schedules in the U.S. alone, leading to empty new vehicle lots. Vehicle dealerships who have elected and are maintaining LIFO reserves should begin planning and assessing the impact on income now.

The Alternative New Vehicle LIFO (Last-in, First-Out) reserve method creates a tax deferral for the dealership. LIFO is based on rising prices and sometimes, 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 impact. Most new vehicle dealerships are experiencing decreased levels of new vehicle inventory, and more likely than not, will be facing LIFO recapture income in 2021. Here are some recommendations and observations that may mitigate the impact of this income.

  • Start planning now for year-end stock orders with the applicable OEM(s). Factory allocations are tight, so work together with the factory representatives to ensure enough units are ordered. For purposes of this exercise to mitigate LIFO recapture, do not order first year new models. Although they will increase the overall inventory balances, they have an inflationary index of 1, which does not help in these calculations. If possible, order units that have had an increase in price from 1% to 2% from the previous model years.

  • Keep track of all in-transits that exist at year-end and ensure that these are added to the year-end LIFO calculations. Ensure that the floorplan statement is reconciled to the accounting books. There may be many in-transit units that are not recorded because of internal processes. For example, units are not recorded on the books until they are physically at the dealership. They may be held up in actual transit, such as a delayed shipping vessel. Also, identify all units which are Freight on Board (FOB) shipping point, i.e., they belong to the buyer/dealership, but the units have not been added to the financing floorplan yet. These should still be considered as in-transit units.

  • Consider filing a tax Form 3115 – Application for Change in Accounting Method to elect “trade discounts” such as co-op monies or floorplan interest assistance, if not already doing so, as part of the new vehicle LIFO calculations. These amounts can create tax deferred income and can be expensed as a reduction in ending inventory costs in the current year. These amounts are brought back to income as units are sold in the subsequent year (2022). A new calculation would be performed at 12/31/22 (if a calendar year taxpayer) for year-end inventory and the net difference is either additional income or expense.

  • Some additional or alternative options (which would also involve the filing of a Form 3115 would be to:
    • Terminate new vehicle LIFO and bring in the taxable income over the next four years, rather than all at once.  
    • Consider electing used vehicle LIFO (if not already elected) which creates an additional tax deferred reserve. Used vehicle pricing has been at record highs so there would be some temporary tax benefits now, but once prices start to normalize, which we are seeing now, this will just come back to income, making this a short-term temporary benefit.
    • Consider electing parts LIFO (if not already elected) which will create some tax deferral, but unless maintaining large amounts of parts inventory, is generally not a material calculation.
    • Elect another LIFO methodology such as Inventory Price Index Computation (IPIC) for all inventories. The calculations involve tracking various inflation indexes from the Bureau of Labor Statistics, at a macro level, which are historically lower than the inflation indexes generated from the Alternative LIFO method.

Numerous associations, such as NADA and The American Institute of CPAs (AICPA) have been petitioning the IRS for tax relief under IRS Section 473, “Qualified Liquidations of LIFO Inventories” which provides detailed rules related to government shutdowns and other supply chain interruptions. This relief would allow dealers to defer LIFO recapture, and replace inventories over a three-year period. We have yet to see any action on the part of Treasury to put this into place.

Although we cannot help with obtaining inventories, our firm can assist now with specific “what-if” calculations, determining which new vehicle models to stock and inventory levels to minimize the impact of LIFO recapture, so there are no surprises at year-end.

If you have any questions on how this impacts you or your businesses, please click HERE to contact us.

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