Why the inventory crunch has car dealers seeking U.S. relief from big tax bills

Thousands of small and midsize U.S. dealerships and even some large ones may need unprecedented government intervention as they face abnormally large income tax bills this spring because of a decades-old standard accounting practice. It's a scenario that was hard to imagine before a pandemic and ensuing microchip shortage left their lots devoid of new vehicles.

LIFO — or last in, first out — is a widely used tax deferment strategy among U.S. businesses that regularly carry inventories of big-ticket items with rising prices, such as automobiles. About half of the nation's dealerships employ the method.

But here's the problem: LIFO's basic design relies on a continual flow of inventory to keep the deferment afloat, often for years and even decades. Stop the flow of new vehicles and sell off much of what's left, which happened at dealerships in 2021, and a mountain of past-tax deferments come due at once.

It's like the morning after the greatest profit party in automotive history: The room is trashed, everyone's hung over, and an accountant has slipped a six- or seven-figure tax bill under the hotel room door.

How big a problem is it? A coalition including dealer and manufacturer associations, Democratic senators and a large, bipartisan group of U.S. representatives is working to try to stave off a potential calamity for auto dealers of all sizes using LIFO.

"It's a nonissue if you're not on it," said John Hosmer, owner of Hosmer Toyota and Hosmer Honda in Mason City, Iowa. The large publicly traded dealership groups don't use LIFO, and they don't face the same tax situation.

"But if you're on LIFO," he said, "you probably won't even think about it until you see the estimate from your accountant."

Hosmer, a former certified public accountant himself, now faces having to declare — and pay the requisite federal and state income taxes — on "six figures" of pent-up income this year from LIFO because his inventories dwindled to almost nothing in 2021. His two dealerships combined sold 519 new vehicles last year, about a hundred fewer than normal.

"For many dealers, [the LIFO reserve pool is] a fairly large number, and one that's accounted for very carefully," Hosmer explained.

But help may — and this is a very large "may" — be on the way.

That diverse coalition of interests — the National Automobile Dealers Association and the Alliance for Automotive Innovation, along with the bipartisan group of U.S. representatives and 19 Senate Democrats — is pushing toward one goal: persuading the U.S. Treasury Department to activate a never-before-used provision in a 42-year-old law that would provide relief to mom and pop dealers across the nation.

And the Senate Democrats have set a tight deadline — Tuesday, Feb. 15 — to get it done in time for tax season, before the bill for last year's profit party comes due and dealers nationwide with empty lots have to start writing enormous tax checks.

Unlike in the early days of the pandemic, when officials weren't quite sure what to do about the virus threat, the coalition has what members think will be an effective legislative vaccine, one that's already been approved, to inoculate dealers facing a LIFO crunch from being harmed by the inventory conditions well beyond their control.

It comes in the form of Section 473 of the Internal Revenue Code, which was amended in 1980 by the Windfall Profits Act to lay out three scenarios under which businesses using LIFO could temporarily pause the triggering mechanism in their calculations until their inventories could be restored to normal levels.

Two of those scenarios — embargoes and international boycotts — are human-caused events and easy enough to explain given the global politics at the end of the Carter administration.

The third was much more vague: a "major foreign trade interruption." It was so ill-defined that in the intervening decades, which have seen major wars, terrorist attacks, a near collapse of the global economy and seven presidencies, it's never been triggered. But those four previously unused words perfectly describe what happened to the global auto industry last year because of its worldwide supply disruptions and issues with COVID-19, according to NADA and its allies on the issue.

"The parts come from all over the world," said Paul Walser, the Minnesota dealer who is NADA's outgoing chairman. "There isn't a single vehicle that doesn't have parts from all over the world, especially microchips."

The goal isn't to evade the tax liability or have it forgiven, only to pause the automated inventory count that triggers that tax liability in the first place until automakers are able to normalize production. Eventually, every dealer will have to pay the tax on their full LIFO reserves.

NADA first reached out to the Treasury Department in November 2020, in the waning days of the Trump administration, asking that it trigger the Section 473 language on behalf of dealers who were beginning to see their new-vehicle lots emptying.

Then-Secretary Steve Mnuchin may have been sympathetic, but the administration dealt with other matters in the last days of 2020 and early 2021.

After President Joe Biden was sworn in, NADA renewed its request with Treasury through the acting officials in place while Biden's team, including new Treasury Secretary Janet Yellen, was being vetted by the Senate. No action was taken by Treasury, so NADA turned to Congress for assistance as dealer inventories shrank further and potential LIFO tax liabilities continued to grow.

To grant the relief, the Treasury secretary would need to issue a notice in the Federal Register invoking Section 473, followed by guidance on specific election and calculation procedures for those eligible — basically instructing accountants how to do something none has ever done before.

With income tax returns due as early as March 15 for many dealers, timing is critical.

"Affected small businesses need to know at the earliest possible date whether relief will be granted," Sen. Sherrod Brown, D-Ohio, and the other senators wrote in a follow-up letter to Yellen dated Feb. 4. The senators first sent a letter to the secretary Nov. 8.

Brown, in a statement to Automotive News, said he's confident the Biden administration "will recognize the challenges auto dealers are up against when it comes to global supply chain issues and grant this much needed tax relief" by the Tuesday deadline set by the senators.

The Treasury Department declined to comment for this report.

With the administration settling in, NADA sent another letter to the department in September, this time urging an official under the Biden White House to address the issue.

"We recognize that providing relief under Section 473 is unprecedented but the dire situation presently affecting auto and truck dealers on LIFO is similarly unprecedented," NADA wrote.

It was in November — nearly a year after NADA first petitioned the Treasury Department — that Congress joined the association in its push for relief.

Rep. Dan Kildee, a Michigan Democrat who led the bipartisan House letter to Yellen with Rep. Jodey Arrington, a Texas Republican, said "car dealerships are an integral part of our community."

"Like many small businesses, car dealerships and their operations have been impacted by the pandemic," Kildee said in a statement. "That's why I am working with Republicans and Democrats to provide tax relief under existing law to these small businesses."

Rep. Carol Miller, a West Virginia Republican, also signed the letter.

"It's vital considering the massive supply chain crisis that we've had for all businesses in America, not just the automobile business," Miller, whose family owns Dutch Miller Auto Group, said in a phone interview.

"The one thing business really depends upon is continuity. ... With this Section 473, I think it's very appropriate that we take whatever method we can to help businesses to continue on during this time from COVID," she said.

The Treasury Department responded Nov. 29 to both the Senate and House letters, arguing that businesses that primarily source and produce inventory in the U.S. are not eligible for Section 473 relief despite domestic closures of factories and production slowdowns during the pandemic.

The department said it will "continue to review reports that can demonstrate the major and primary reason for a taxpayer's inability to replace its inventory is due to a foreign disruption."

NADA, which also gained support from the National Association of Minority Automobile Dealers and the American Institute of Certified Public Accountants, next turned to the Alliance for Automotive Innovation, a group that represents most automakers in the U.S., to substantiate the impact of foreign supply chain disruptions caused by the pandemic.

In a letter sent last month to Yellen, the alliance wrote in support of NADA's requests for Section 473 relief and argued that "the well-documented global shortage of semiconductors — which are heavily dependent on international supply chains — has been the primary driver of a unique but prolonged disruption in auto manufacturing."

John Bozzella, CEO of the alliance, said in a statement: "These disruptions, especially the semiconductor shortage, have made it difficult or impossible for our members' franchised dealerships who inventory vehicles using a [LIFO] basis to obtain sufficient replacement vehicles."

The Treasury Department, as of press time, had not issued a notice in the Federal Register granting Section 473 relief.

Will De Filipps, a CPA who specializes in dealership tax issues including LIFO calculations and consulting, argues dealers don't need to wait for relief and advises them to work with their accountants on tax strategies that are available now.

That includes switching to the Inventory Price Index Computation LIFO method, which allows dealers to add used vehicles and parts inventories to their new-vehicle pool. De Filipps said doing so could result in significantly lower LIFO reserve paybacks.

"You see a bullet coming: Do you want to duck and get out of the way," De Filipps asked, "or do you want to take it?"