Does your company hold at least $1 million of inventory? Is there cost inflation in your inventory components? If so, you may be a good candidate to use the LIFO (or “Last-in-First-out”) methodology to report inventory.
Under LIFO, the most current year inventory purchases are reflected in cost of goods sold. LIFO produces savings by moving inflationary costs from the balance sheet where inventory is listed to the income statement. LIFO can be applied to a variety of products and goods, such as furniture, equipment, trucks, trailers, machinery, HVAC, construction materials, farm supplies, groceries and many more.
Benefits of using LIFO
For companies with inflationary inventories consistently above one percent, LIFO acts like an annuity that provides annual returns. Long-term benefits include:
- Reduced net income
- Improved cash flow
- Significant tax deferral
Dispelling LIFO myths
Complicates inventory management: LIFO does not need to add any additional layer of management for inventory. Companies can use their costing method of choice throughout the year. The LIFO calculation can be conducted outside of the inventory management system. Your RKL advisor will then manually adjust the general ledger to reflect the updated ending inventory balances and cost of goods sold.
Only works for companies with slow inventory turnover: In fact, turnover rate for inventory is irrelevant to LIFO. The only amounts that factor into this methodology are the year-end inventory balances and amount of inflation.
Works best with constantly increasing inventory levels: Once again, levels of inventory is a nonfactor with LIFO. Unless your inventory dramatically drops off, the rate of inflation is the central factor in calculating benefits
How LIFO works
While LIFO tax savings are directly related to a company’s unique financial and inventory circumstances, here is a formula to produce an estimate of benefits:
Estimated Year-End Inventory Balance x Estimated Calendar Year Inflation = Current Year Taxable Income Reduction
Current Year Taxable Income Reduction x Tax Rate = Current Year Income Tax Reduction
What makes a good LIFO candidate?
As with all tax strategies, there are certain criteria for LIFO to produce the maximum benefit, so your RKL advisor can assess your unique situation and decide if your company is a good candidate.
Some of the best candidates for 2020 (those with the highest inflation) include home centers, convenience stores, jewelry stores, mobile home dealers, wholesale lumber, as well as any manufacturer or distributor that has concrete, asphalt, safety equipment, building paper or building board mill used in their inventory products.
RKL advisors have helped dozens of companies reap tax savings using LIFO. Here are just a few examples:
- An Eastern Pennsylvania distributor adopted LIFO in 2018 and will have cumulatively deferred over $400,000 in taxes by the end of 2020.
- A Central Pennsylvania manufacturer adopted LIFO in 2015 and will have cumulatively deferred over $1,500,000 in taxes by the end of 2020.
- A Central Pennsylvania wholesaler adopted LIFO in 2019 and will have cumulatively deferred over $75,000 in taxes by the end of 2020.
Let’s find out if this strategy is right for your organization. Contact your RKL advisor to discuss before year’s end.