Many dealers know that LIFO stands for the "last-in, first-out" inventory valuation method and that it produces sizable interest-free loans from the U.S. Treasury. These loans last as long as moderate inflation continues and inventory levels do not drop considerably.
At the end of 2020, you may have had significantly lower ending new-vehicle inventories than you had the year before. This may have caused you to incur significant reductions in your LIFO reserves — also known as LIFO reserve recapture or repayment — and this may have caused you to have a significant increase in your taxable income for 2020.
But, unlike Paycheck Protection Program loans, this repayment is not likely to be forgiven. That compels me to offer some alternatives you can discuss with your advisers if you're in a quandary over what to do.
1. Stay on LIFO. Grin and bear it. Pay the tax on the increase in taxable income caused by the recapture of the LIFO reserve. Whether there is a significant increase in taxable income depends upon your specific LIFO layer history.
Dealers are often surprised to see how small the LIFO recapture is, even though their inventory levels have dropped significantly at year end. Others may be shocked at the size of their LIFO reserve recapture. The result depends on the buildup of your inventory over recent years and how much inflation is embedded in the calculations.
2. Get off LIFO. Terminate your LIFO election effective for 2020. If you do this, the entire amount of your LIFO reserve as of the beginning of the year (i.e., as of Dec. 31, 2019) is reported in your tax returns over four years, pro rata, 25 percent per year, for 2020-23. In tax-speak, this is known as a positive Section 481(a) adjustment.
Getting off LIFO spreads the impact of the repayment of the entire LIFO reserve as of Dec. 31, 2019, over four years, instead of reflecting 100 percent of the large impact of the reduced 2020 year-end inventory in your 2020 tax return. Thus, the difference between these alternatives is that by staying on LIFO, you will take the big hit in your 2020 tax return, rather than terminating the LIFO election for 2020 and leveling the impact of recapturing the LIFO reserve at the beginning of the year over four years.
If you're going to stay on LIFO, there are some ways to at least partially offset the increase in income in your 2020 tax return due to LIFO reserve recapture on new vehicles. One is to consider expanding the LIFO election to used vehicles for 2020. Another is to consider changing to a Bureau of Labor Statistics variation LIFO method. A third way is to eliminate certain inventory costs if you are not already doing so.