There are few businesses that have been able to escape the impacts of rising inflation and increasing costs resulting from tariffs and other economic/geopolitical disruptions. For businesses whose bottom lines have been squeezed by rising prices, there may be a path for some relief. The last-in, first-out (LIFO) inventory accounting method can provide tax deductions for the rise in inventory costs. Here’s what you need to know.
LIFO tax benefits created from rising inflation and tariffs
The LIFO method is a method of inventory accounting that allows taxpayers to assume that goods sold during the year come out of the taxpayer’s most recently purchased or manufactured inventory. As a result, cost of goods sold (COGS) for the year is associated with the newest inventory. In periods of inflation and increasing input costs, the cost of goods deducted is higher, resulting in lower taxable income. If LIFO is adopted, ending inventory is valued as if it were purchased at the beginning of the year — removing any price increases, or inflation, incurred throughout the year.
We have seen this scenario play out over the past years with double- and triple-digit inflation. The reason for this differs across segments of the economy, but the common thread is increasing input costs for almost all businesses. The reasons cover general inflationary pressures, freight costs and supply chain disruptions resulting from geopolitical disruptions, increasing tariffs around the world, multilateral trade negotiation disruptions, and even impacts of the COVID-19 pandemic that continue to linger across parts of the economy. All of these factors have led to an increased cost of goods.
Important considerations when switching to LIFO
Although LIFO has tax benefits during periods of rising costs, there are several factors taxpayers should consider before adopting LIFO. The LIFO method can be adopted with a timely filed return, but the LIFO conformity rule requires taxpayers to also use LIFO on any financial report or statements that are issued to creditors and shareholders. Taxpayers who have already issued their financial statements using a non-LIFO method are prohibited from using the LIFO method until a subsequent year when they apply LIFO on their financial statements. The conformity requirement can be violated even without the issuance of formal financial statements, even if monthly or other preliminary financial information is provided that separately or together covers the entire fiscal year and doesn’t include LIFO.
In addition, taxpayers should consider how the LIFO method would impact loan covenants or other financial metrics and may want to consider modifying such agreements to reverse out the impacts of LIFO. As such, taxpayers should start planning in advance of year-end for a potential LIFO adoption.
The benefit of adopting LIFO compounds over years as costs continue to rise. While significant cost increases in the year of adoption might help to kick off the LIFO method with meaningful tax savings, the real focus shouldn’t be on the level of cost increases in Year 1. The focus should really be on how costs are expected to behave over the next several decades. If history provides any lesson, it’s that most industries will see costs increase over that time frame and LIFO will provide tax-saving benefits. The real question is how much tax savings will it produce.
Key takeaways
- LIFO can generate tax savings during periods of inflation, tariffs, and rising inventory costs by increasing deductible inventory expenses and reducing taxable income.
- Businesses considering a switch to LIFO should evaluate financial reporting requirements, LIFO conformity rules, and potential impacts on loan covenants and other financial metrics before adoption.
- The greatest value of LIFO is often realized over the long term, as tax savings may compound when inventory costs continue to increase over multiple years.
- While there are some complexities surrounding the adoption of LIFO, the current tax savings make it worthwhile for many businesses.
