Many companies, especially those in the food & beverage sector, have been experiencing issues with supply chain disruptions, which many blame on the lingering effects of COVID-19, and are having trouble replenishing depleted inventory levels. These supply chain disruptions have consequences not only from a business operations perspective, but they can also have a possible negative tax impact for those companies that maintain their inventory on the Last in First Out (“LIFO”) method of inventory. A company’s depleted inventory levels can cause them to have income under LIFO due to what is known as inventory layer erosion.
LIFO works on the premise that the most recently produced or purchased inventory items are sold first. This means the cost of the most recently purchased or produced items are expensed to the cost of goods sold first, leaving older purchased or produced items remaining in ending inventory. In times of rising prices, LIFO works to a company’s advantage, from an income tax perspective, since the higher-priced inventory that is more recently bought is expensed sooner – hence, creating a larger tax deduction than would have been recognized under an alternative inventory valuation method. Many companies in the food & beverage sector utilize this inventory valuation method, as they feel it more accurately matches current costs and revenues.
The way the LIFO calculation works is by starting with the base year, at cost. LIFO layers, calculated annually, are then added to the base year. These layers are increased based on inventory levels and adjusted for inflation or deflation each year. In any year in which inventory levels decrease, layers of inventory are removed from the company’s LIFO calculation. This removal can create income for the company due to the removal of the inflation element in the respective LIFO layer.
However, there may be an option to help mitigate the negative effects of depleted LIFO inventory, in certain circumstances. A provision exists in the tax code under Internal Code (“IRC”) Section 473, titled, “Qualified Liquidations of LIFO inventory”. It is an elective provision that provides the taxpayer a specified period of time to replace the inventory from what is called a “Qualified Inventory Disruption.” If the taxpayer qualifies, this provision can mitigate the income that would have been recognized as a result of the decreased inventory levels caused by the disruption.
IRC 473 defines a qualified liquidation as a decrease in the closing inventory, in the liquidation year, from that year’s opening inventory, but only if the taxpayer establishes to the IRS that such a decrease is attributable directly and primarily to a qualified inventory interruption.
Qualified inventory interruptions are determined by the IRS and Department of Treasury, in consultation with Federal officials, and include events such as embargos, international boycotts, or other major foreign trade interruptions that have made it difficult, or impossible, for the replacement of goods during the liquidation year.
Many businesses and other organizations, including the American Institute of Certified Public Accountants (“AICPA”), are petitioning the IRS and Department of Treasury to make inventory disruptions caused by COVID-19 a foreign trade disruption under IRC 473.
The AICPA has requested that affected taxpayers be allowed to make the election under IRC 473 by attaching an election statement to their tax return. The recommended qualified liquidation year would include taxable years ending March 30, 2020, to June 30, 2021, and the inventory replacement period would be three years from the taxable ending year. However, recent supply chain shortages would seem to indicate that qualified inventory disruptions would require tax years ending beyond June 30, 2021, to be included. They also recommended allowing taxpayers to elect a safe harbor provision in which they would disregard the LIFO layer erosion that took place during the liquidation year and keep the LIFO layers in opening inventory. The taxpayer will not recognize any income attributable to the liquidation of the LIFO layers if they replace the inventory during the replacement period, which would generally be three years from the inventory disruption year.
For taxpayers that qualify for a qualified inventory disruption and have already filed their tax return, the AICPA had requested they be allowed to amend their return or file a change in accounting method, Form 3115, within a certain time if the IRS announces a qualified inventory disruption has occurred.
If you think your company may have experienced a qualified liquidation of LIFO inventory, please do not hesitate to reach out to an expert in SobelCo’s Food & Beverage Practice to discuss your individual situation.
