Many manufacturing companies, and other businesses, have long accounted for their inventory on the last-in-first-out (LIFO) basis. LIFO assumes that inventory acquired most recently is sold first, usually resulting in matching higher-cost inventory with current sales. A company with LIFO inventory that experiences a decrease in their inventory levels may often recognize additional taxable income as a result of the LIFO decrement. A LIFO decrement is the excess of the prior period ending inventory minus the current period ending inventory. Decrements result in a reduction of LIFO layers created in earlier years, thereby creating taxable income. In other words, the capitalized lower-cost products are not being deducted in the cost of goods sold, resulting in higher taxable margins.
Many conditions related to the COVID-19 pandemic severely limited manufacturing capacity and caused major interruptions in the global supply chain. In addition, some businesses exhausted current inventory to assist relief efforts during the early stages of the pandemic. These events made it extremely difficult for U.S. companies to maintain their inventory levels in 2020, often resulting in a substantial reduction in inventory levels. These difficulties have continued into 2021 and, in many instances, have intensified. While the overall economy has rebounded strongly since last year, the spread of the Delta variant has added a great deal of uncertainty to many businesses that may have liquidated their inventory in the past eighteen months.
As a result of these circumstances, many companies are likely to see a decrement in their LIFO inventories and will realize additional taxable income and the associated tax liabilities. This will further exacerbate the recovery efforts of these companies, as the additional cash outlay may prove to be an undesirable drain on their finances.
Sec. 473 of the Internal Revenue Code provides relief for eligible taxpayers that experience liquidations of LIFO inventories as a result of a “qualified inventory interruption.” Sec. 473 can be applicable if a business has had an interruption in the ability to obtain replacement inventory due to a trade embargo or other international event. Under Sec. 473, the company would have three additional years to replenish the liquidated inventory. A “qualified inventory interruption” occurs under Sec. 473(c)(2) when the Treasury Secretary, “after consultation with the appropriate Federal officers, determines that…any embargo, international boycott, or other major foreign trade interruption has made it difficult or impossible to replace any class of goods for any class of taxpayers during the liquidation year, and the application of Sec. 473 to that class of goods and taxpayers is necessary to carry out the purpose of Sec. 473, he shall publish a notice of such determinations in the Federal Register, together with the period to be affected by such notice.”
The AICPA has written two letters, in April and August 2021, including detailed examples, requesting that the Department of the Treasury and the Internal Revenue Service apply the relief measures afforded in Sec. 473 for businesses that were unable to maintain their prior inventory levels due to the effects of COVID-19 on the global supply chain. Specifically, the letters requested a safe-harbor method and expedited relief in this scenario. In particular, the AICPA recommended that the safe harbor provide that the taxpayer would disregard the liquidation for this year and would retain the LIFO layers related to the opening inventory. This would alleviate the burden of paying additional taxes on the related income.
As of this date, there has not been a response from the Department of Treasury or Internal Revenue Service. However, taxpayers should be aware of these potential consequences due to the disruption of the global supply chain and reduced inventory levels.
Please contact HBK Manufacturing Solutions if you would like to discuss the possible effects of a LIFO inventory reduction and any potential relief.