The Perfect LIFO Storm

Remember the 2000 movie The Perfect Storm? Mother Nature provides a perfect storm that creates some great fishing waters, but proves disastrous to the fisherman caught in its wake.

Domestic auto makers may have created a perfect storm in regards to inventory and the effect on LIFO (Last In, First Out) reserves.

A little history. There are basically two inventory methods that dealerships employ. LIFO and Specific Identification.

Most dealerships new inventory is priced using the LIFO method. It provides a significant deferral of taxable income during periods of inflation and increasing inventory levels. It is a deferral, not a permanent deduction. But, if you can postpone paying taxes, you can essentially have an interest-free loan from Uncle Sam.

Back to the perfect storm.

Domestic auto makers are embracing a concept known as value pricing. It lowers sticker prices on various models to bring prices closer in line with what customers ultimately pay for a vehicle. This is an attempt to reduce the need for incentives to sell cars.

General Motors and Ford will cut prices on certain 2006 models. Chrysler has already cut prices on some 2005 models. These price cuts also extend to the dealer cost.

Whether value pricing is an effective sales tool remains to be seen. It will, however, be detrimental to LIFO. Value pricing with decreases in dealer prices reverses what we expect from LIFO.

The majority of dealers using the LIFO method employ the IRS-sanctioned “Alternative Method” in which inflation or deflation is measured by a comparison of the various models' base prices to dealers, excluding options and other charges.

If these prices fall from the prior year (as many will with value pricing), deflation and income will result for income tax purposes. How this affects each dealer depends on the type of franchise and the extent to which models offered by that franchise are affected by value pricing.

Some will see a reduced LIFO deduction. Others may experience considerable income. To avoid a surprise, dealers should estimate how they will be impacted.

The “employee discount” plans offered to consumers by domestic manufacturers may also have a negative impact on LIFO. These promotions helped clear inventory. Reduced inventory levels at tax year-end can result in LIFO recapture (taxable income caused by the loss of accumulated LIFO reserve).

The perfect storm may be arriving in December. What can we do about it?

Where dealers expect income, it may be viewed as a correction and accepted. If significant enough, dealers may consider changing to a different LIFO method, such as a method that measures inflation from the Producer Price Index (PPI) or the Consumer Price Index (CPI) (i.e., the IPIC method).

IPIC (Inventory Price Index Computation) possibly can provide a bail out in instances when inventory levels are low or when the manufacturer's specific price decreases under the Alternative Method.

Low inventory problems can be repaired under IPIC as you can pool all new inventory together. The effect of the decrease doesn't hurt as much when everything is together.

There are disadvantages. First, although IPIC can soften the LIFO hit in the short term, a negative aspect of IPIC is that, historically, it produces lower inflation indexes. IPIC likely would cause a lower LIFO reserve in the long term.

Second, if you decided to change to the IPIC method, you are prohibited from changing back to the Alternative Method for five years. You can't pick and choose which method you like best each year.

Should you be interested in a change in method, it can be accomplished by requesting the accounting method change on your 2005 tax return.

A tough decision. Look for the short-term advantage, or hang in there for the long term. Remember, everyone's circumstances are different. Discuss your situation with your tax advisors before taking any actions.

John A. Davis is a CPA with Dixon Hughes PLLC. He's at 404-575-8910 and [email protected].