Is There Relief in Sight for Undesirable Results of Supply Chain Interruptions?

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.

About the Author(s)

Jim is a Principal of HBK CPAs & Consultants and the National Director of HBK Manufacturing Solutions, a group of specialists focused on manufacturing clients and their unique needs.

After joining the firm in 1988, Jim has spent his career working in a variety of industries, including manufacturing and distribution. As the National Director of HBK Manufacturing Solutions, Jim advises manufacturing clients on issues including tax planning, finance, succession planning, mergers and acquisitions, and ESOP transitions. In addition, he shares his knowledge and experiences with manufacturing specialists throughout the firm as well as local and regional organizations and trade associations focused on the manufacturing industry. To recognize his accomplishments, Jim was named Business Professional of the Year in August 2019 by the Youngstown Warren Regional Chamber of Commerce.

In addition to his HBK role, Jim is Chairman of the Board of the Youngstown Business Incubator, an internationally recognized incubator focused on programs including the use of additive manufacturing and advanced manufacturing technologies in the Mahoning Valley and Northeast Ohio.

Hill, Barth & King LLC has prepared this material for informational purposes only. Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.