These last 2 years have certainly been a rollercoaster ride for most automobile dealers. From the fear and uncertainties caused by shutdowns at the start of the pandemic, to labor shortages, to parts inventory delays and shortages, to government assistance programs, to record high used vehicle prices, to new vehicle inventory supply issues caused by the microchip shortage, all the way to record profits and cash flow surpluses. It has certainly been…well…interesting to say the least.
Most dealerships are still dealing with new and used vehicle supply issues, and record low vehicle inventory levels. Those dealers using the Last-In, First-out (LIFO) method to account for their inventory valuation, a method generally used to defer taxes, may be in for an unexpected tax liability caused by the significant reduction of their vehicle inventory levels. The sharp decrease of inventory could force LIFO reserves that were previously deferred, to be recaptured, therefore increasing taxable income and increasing the dealership’s tax liability. For some dealerships this unexpected tax liability could be substantial. Consider a dealership with a $1 million LIFO reserve, normally carrying 100 vehicles in inventory, is currently only carrying 10 vehicles in inventory due to supply shortages. This dealership will likely have to recapture a large majority of their LIFO reserve, which could result in upwards of $300,000 – $400,000, or more, of additional tax liability.
What options do dealers using the LIFO method have to help combat this potential tax burden? One option is to do nothing, record the LIFO recapture as taxable income, pay the tax, and move on. This may be the best option if your inventory decrease doesn’t cause a significant LIFO recapture amount.
A second option could be to change to another acceptable LIFO calculation method allowed under existing LIFO provisions. There are four methods allowable for automobile dealerships; the General Dollar-Value LIFO Method, the Simplified Dollar-Value LIFO Method, the Inventory Price Index Computation Method, and the Alternative LIFO Method (most commonly used method by dealerships). A dealership could also choose a LIFO method that also allows used vehicles and parts to be included in the inventory valuation. A change in the LIFO calculation method being used, and including additional inventory types in the LIFO calculation, could help offset the tax liability caused by the LIFO recapture. This option would require a Form 3115 be filed, and the new method must be kept for at least 5 years.
Another option is to elect out of the LIFO method by filing Form 3115 with the entity’s income tax return. This option requires that the entire LIFO reserve be recaptured, however the recaptured income would be spread over 4 years, allowing the tax liability to be paid over a 4 year period, potentially at lower tax rates. This could be a welcome option when faced with having to pay that tax liability all in one year. If the dealership choses this option and elects out of the LIFO method, it cannot re-elect to use the LIFO method again for at least 5 years. There is also uncertainty with how future tax law or tax rate changes could effect this decision. If Congress were to drastically increase tax rates, or limit the QBI deduction for pass-through entities, it could negatively affect the outcome of this option to elect out of the LIFO method by increasing the tax liability on the deferred portion of the LIFO recapture.
Could there be tax relief on the way? There has been recent activity that suggests that there could be the possibility of some tax relief coming from Congress or the U.S. Treasury Department. Organizations such as National Automobile Dealers Association (NADA) have been lobbying for the U.S. Treasury Department, U.S. Senators, and U.S. Congressmen to take action to provide relief for those impacted by unexpected tax liabilities caused by LIFO recapture. However, there is nothing certain at the time of writing this article.
It’s important to keep an eye on what’s happening in Washington, and to consult with a knowledgeable tax and accounting professional when determining which method or options are best for your dealership. If you have any questions, or need further information, please contact your trusted TBC advisor.