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Samuel Hoffman | The Journal Gazette
LIFO allows companies to build inventory without punishing them for their stockpiles.

Is LIFO as we know over?

Local business owners await fate of complicated income tax break

Auto dealerships can benefit from LIFO tax breaks.
Photos by Samuel Hoffman |The Journal Gazette
Kelley Automotive Group stopped using LIFO three years ago. CFO Gary Thelen said the system is a burden to get off.

Some local business owners are closely watching Washington to see whether a tax break they’ve used for years will be phased out.

And if it is, how long will the companies have to absorb the financial hit?

LIFO – which stands for last in, first out – is one method of reducing a company’s income tax bill. Some manufacturers and retailers use the LIFO inventory accounting method when the product they’re selling gets more expensive every year.

But President Barack Obama’s 2014 budget proposal to Congress calls for ending the accounting method. The LIFO Coalition, which includes 122 trade associations, is among those lobbying to allow LIFO to live on.

Examples of businesses that can benefit from LIFO include dealers who sell cars, trucks, tires and farm equipment. Manufacturers are also candidates if their raw materials include commodities with ever-escalating prices, such as petroleum or copper.

“It’s definitely not a one-size-fits-all methodology,” certified public accountant Jeremy Carnahan said about LIFO. “But it can be really powerful when used.”

Carnahan is a senior manager at BKD LLP’s Fort Wayne office. Some of his clients use LIFO, which allows them to defer paying taxes on income.

CFO magazine reported in 2008 that 36 percent of survey respondents, including chief financial officers, used LIFO. Carnahan believes that percentage has declined since the poll was taken. He said two or three clients elected to get off it during the recession, when their earnings were down.

Another local CPA, Jeff Sanderson, estimated that about 20 percent of the companies that could use LIFO do use it. The rest use FIFO – or first in, first out.

LIFO lingo

So, how does LIFO work?

Basically, businesses are required to pay taxes on their net income – just as individuals and couples do.

Net income – or profit – is calculated by subtracting the costs of doing business from all the money taken in. The more that companies can legally claim in costs, the lower the profit is.

The lower the profit, the less the company owes in federal and state taxes.

Likewise, individuals and couples can claim tax breaks for making home mortgage payments and donations to their church.

U.S. companies might lower their tax bills by using LIFO accounting.

Let’s say a manufacturer makes 100 copper pipes in its first year of business and sells 90 of them. Ten are left in the warehouse. Same thing happens the next year – 100 made, 90 sold, 10 left. And again, and again and again.

The stockpile is now 50 pipes.

Companies using LIFO claim their warehouses – or car lots – are filled with older items that cost less to make – or buy – while the products that were sold were the most expensive ones.

With prices going up, the most expensive ones were the last ones in the door.

Last in, first out.

Now, remember what we said just a few paragraphs ago? When companies report as many legitimate costs as possible, they can chip away at the net income total. That holds down taxes.

The original idea behind LIFO was to keep people working, said Gary Thelen, chief financial officer for Kelley Automotive Group. The accounting method allows a business to build inventory without punishing the company for having that stockpile.

The approach works only in the U.S. because International Financial Reporting Standards banned LIFO.

‘A real burden’

Kelley Automotive stopped using LIFO three years ago, Thelen said.

That’s when Keith Busse, co-founder of Steel Dynamics Inc., bought a significant interest in the company that was restructured as Dealership Holdings LLC, its legal name. Kelley Automotive is the marketing name.

“For anyone on LIFO, it’s a real burden to get off,” Thelen said.

It’s also a hassle to use.

Going back to the example above, those 50 copper pipes aren’t all the same. The company’s cost to manufacture the pipes varied depending on the price of copper each year.

To claim the tax deferral, the company has to keep detailed records of how many pipes were added to inventory each year and how much manufacturing costs were during that year. Each year is a LIFO layer.

BKD has clients whose inventories list items from the 1950s and 1960s.

“It’s a pain in the neck to keep the separate inventory records,” said Sanderson, director of taxation for Baden Gage & Schroeder LLC.

LIFO valuations are complex, relying on indexes, pools and layers. Some LIFO calculations are 30 or 40 pages long, he said.

Carnahan referred to an unidentified client’s calculations. Its inventory cost $268,000 to build but last year was valued at $162,000 under LIFO.

The $106,000 difference is the company’s LIFO reserve, he said.

Some longtime manufacturers have built up LIFO reserves of $5 million or more, Sanderson said.

LIFO reserves can be used only as long as inventory stockpiles keep growing – or at least remain steady. If inventory falls, the company has to delve into its oldest LIFO layers and report some deferred income, Sanderson said.

Because LIFO requires big inventories to support it, companies that use a just-in-time manufacturing schedule don’t embrace the accounting strategy.

It’s a strategy, by the way, that isn’t literal. Tire dealers using LIFO don’t have 30-year-old tire sitting in warehouses. It’s all done on paper.

“It’s a weird concept,” Carnahan said. “It’s a weird theory for people to sometimes get their head around. That’s what makes it open to political attack.”

Jade West, of the National Association of Wholesaler-Distributors, doesn’t expect legislation that targets LIFO specifically.

But, the senior vice president for government relations said, “as both the Senate Finance Committee and the House Ways and Means Committee move forward with plans to consider comprehensive tax reform, the LIFO Coalition is fully engaged, and will remain engaged, in urging lawmakers not to include LIFO repeal in their tax reform proposals.”

“Both tax-writing committees could be starting to write legislation as soon as (August),” West added in an email.

A graceful exit

Previous calls to end LIFO have included provisions to give companies as long as 10 years to move their reserves to the income side of the ledger.

If a business owner chooses to move off LIFO now, they would have a shorter span – just four years – to claim the deferred income.

In the $5 million example, Sanderson said, that would mean claiming $1.25 million in additional income in each of the following four years. The IRS would demand its cut – even though the company didn’t really take in $1.25 million extra during those years.

But if the owner could spread that $5 million over 10 years, it would boost reported profits by $500,000 a year. The corresponding tax hit would be a bit easier to swallow, Sanderson said.

Thelen, of Kelley Automotive, said businesses have limited resources. If more cash is paid in income taxes, the companies have less to invest in things such as expansions. Some employers might even cut jobs as they scramble to raise cash, he said.

The CFO thinks any change to LIFO rules shouldn’t be effective until 2015. And he’d like to see a 15-year phase-out.

“Businesses need time to adjust,” Thelen said.

It’s unclear how vigorously local companies will lobby to save their way of counting inventory.

Sanderson predicted that some of his clients will fight the death of LIFO, but others are resigned that we’re almost at the end of LIFO.