LIFO payback relief for car dealers has been here all along: Use it or lose it

With 2021 just ended, many dealers are rubbing their hands in delight over their supersized operating profits while scratching their heads over what to do about last in, first out (LIFO) recapture as vehicles vanishing from their lots as quickly as they arrive are carrying out large chunks of LIFO reserves in their back seats.

With fewer vehicles in inventory, collapsing LIFO reserves pose an even greater tax dilemma this year. However, for many dealers, there could be a happy ending, a win-win result, and LIFO could become one of their best friends. But this hasn't happened, because the U.S. Treasury Department has failed to respond in a meaningful way to letters from the National Automobile Dealers Association and others asking for relief under Section 473.

Here's why: Dealerships facing significant LIFO reserve recapture have only four alternatives.

1. Terminate their LIFO elections. File Form 3115 to notify the IRS that LIFO is over and repay all of the LIFO reserve at the end of last year by taking it into income over four years, 25 percent per year, starting with the 2021 income tax return.

2. Stay on LIFO using the alternative LIFO method for new vehicles and take the large LIFO reserve recapture into income completely in their 2021 income tax returns.

3. Continue using LIFO for new vehicles, but to some extent, offset the impact of the LIFO reserve recapture on the new vehicles by electing to use a similar method for used vehicles. This method analyzes each vehicle in ending inventory, based on pricing information taken from an official used-car guide to compute the inflation index.

4. Change from the alternative LIFO method to the inventory price index computation, or IPIC, LIFO method, and at the same time add used vehicles to the new-vehicle IPIC LIFO pool. Maybe even throw in parts and tire inventories. I encourage dealers to explore this alternative before committing to any of the above options or waiting for relief from the Treasury.

The inflation indexes in the Consumer Price Index Report can be used as part of this method, and for 2021, they are 11.8 percent for new vehicles and 37.3 percent for used vehicles. Properly computed inflation indexes under the alternative LIFO methods for separate pools of new and used vehicles are considerably lower than these CPI results.

This year we find that when new and used vehicles are combined under the IPIC method in a single pool, the weighted inflation rates for that pool are within the range of 18 to 32 percent. These double-digit inflation rates pulling up dealerships' LIFO reserves haven't been seen in 50 years. As a result, changing to this method has significantly reduced LIFO reserve paybacks under the IPIC method when compared with the alternative projected LIFO reserve paybacks under the alternative LIFO method. The extent of the benefit — the degree of dollar difference in results — depends on the mix or ratio of the inventory dollars at year end.

This is not a gimmick: The IPIC method is approved in Treasury regulations that are more than 50 years old: "The IPIC method will be accepted by the Commissioner as an appropriate method of computing an index, and the use of that index to compute the LIFO value of a dollar-value pool will be accepted as accurate, reliable and suitable."

We expect that, over the next few years, the significant differences between higher inflation indexes under the IPIC method and lower inflation indexes if they are properly computed for new vehicles under the other methods will continue to favor the IPIC method, although probably to some lesser extent.

Typically, it is not necessary to obtain permission from the IRS to make this change, although it is necessary to file Form 3115 (and Form 970, detailing how the calculations will be made) to notify the IRS that a change to IPIC has been made. There are other requirements relating to the treatment of used-vehicle write-downs and secondary filings involved in making this change, but they are less significant. Also, there are other side benefits from voluntarily changing to the IPIC method.

What about relief under Section 473? Since the change to IPIC gives much better results, is accepted by the IRS — no questions asked — and is far less complicated, waiting for relief from the Treasury does not seem to be a valid or reasonable strategy. Beyond these reasons, why am I skeptical about Treasury relief under Section 473?

First and foremost, I expect that any relief will come with all sorts of strings attached and adverse cash-flow consequences for dealerships that accept the Treasury's terms. Will dealerships have to pay the tax on the LIFO reserve recapture upfront when they file tax returns for 2021? Will their accountants have to track alternative calculations for a few years until higher inventory levels are restored? Will amended returns have to be filed for 2021 with inevitable delays in obtaining refunds from the IRS?

Also, will there be enormous burdens in amending multiple state tax returns and for dealerships operating as pass-through entities (S corporations, LLCs and LLPs) that will have to notify shareholders or partners in later years so they can reflect corresponding adjustments related to the relief provisions, either in their own tax returns or by making some manner of basis adjustments?

The complexity of this relief cannot really be appreciated until regulations spelling out all the details are actually written. It seems credulous to expect anything practical, relatively simple or easy-to-understand and implement to be forthcoming.

Many other businesses using LIFO to value their inventories need LIFO reserve recapture relief under some other administrative variation of Section 473. These businesses, too, may find tax relief in applying the IPIC regulations to their situations, or they may simply hope for the Treasury to help them in some fashion. However, I don't think waiting for relief from the Treasury is a viable option for auto dealers when a better alternative is right here in front of them.