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To LIFO or not to LIFO?

You almost literally can’t turn on a tv, radio (remember those?), or a computer without hearing or reading about inflation. Whenever that happens, tax and accounting geeks turn to a favorite topic – LIFO. If you don’t know or understand what LIFO is, there are a multitude of experts who have written thousands of articles on LIFO that you can check out at your pleasure.

If you’re still reading, let’s talk about why tax and accounting geeks talk about LIFO. In inflationary periods, LIFO can produce big tax benefits. In industries that largely live in inflationary environments (think manufacturing, commodities, oil and gas), LIFO is the norm. You get almost permanent tax benefits, and you match your most recent costs to your most recent revenue. In our current state of inflation, literally almost everyone can benefit from LIFO – at least in the short term.

So now that we’ve established that, let’s move to the next question – SHOULD you benefit from LIFO?  Sure, the tax benefits tend to be pretty good, but it’s not all rainbows and lollipops. The most notable downside of LIFO is that there is a conformity requirement between GAAP and tax. Thus, you can’t get the LIFO benefits for tax and at the same time issue financial statements on FIFO. This will lower your financial statement income and deflate your balance sheet. The other downsides aren’t discussed as much, and that’s why we’re here.

As long as prices keep rising, LIFO generally works well (assuming you can get past the GAAP aspect).  However, there are at least two potential speed bumps. The first one is called LIFO liquidation. This is exactly what it sounds like – in times of high demand for your product, you burn through all of your inventory faster than you can replace it. This eliminates your LIFO layers and, in effect, you’re back in the same place as if you hadn’t had gone on LIFO in the first place. If you’re new to LIFO or your reserve isn’t that big, no big deal. But, if you have a large LIFO reserve that you were planning on being available in perpetuity, you could be in for a tax surprise. But, having your inventory in such high demand that you burn through it isn’t the worst thing in the world, right?

The next speed bump is less of a speed bump and more of an economic hurricane made worse by a tax induced earthquake. The perfect storm we’re envisioning is one where a company elects to go on the LIFO method during record inflation (i.e. now) to get an immediate tax benefit, and then the unimaginable happens – deflation. This topic is rearing it’s ugly head more and more on the Twitterverse, and even the big names are starting to sound the alarm. The worst part is, that’s not it.  Close your eyes and picture a family-owned manufacturer taxed as an S Corporation. Let’s say this company is caught up in inflation and wants to maximize cash flow and minimize taxes, so they make a LIFO election and get a big current tax deduction. Now let’s fast forward two or three years, we’re in a recession, and deflation is the new inflation. Their big LIFO reserve is being depleted, and they’re now having to use their lowest cost inventory to offset sales, resulting in higher taxable income. No big deal, right? We deferred income and accelerated a big deduction. Yes – you did, but what if the flip is in 2026 and there’s been no tax legislation? The tax deduction you got when you elected LIFO was benefited at a federal max of 29.6% when you factor in QBI. Unfortunately, the income pickup in 2026 will be taxed at 39.6% (max rate goes up – no more QBI). What could be looming is a permanent tax cost of 10 percentage points.

That’s a lot of information to unpack. No one is telling you not to go on LIFO. If it makes sense, do it. We just want to make sure that everyone has all of the information to make an informed decision, and understands that LIFO is not necessarily the solution, but more of a tool in the toolbox.

If you have questions about any of the information outlined above, McKonly & Asbury’s experienced professionals are here to help. Please contact us  or visit our website to find out more about our Manufacturing and Tax Services.

About the Author

Mark Heath

Mark is a Partner with McKonly & Asbury. Serving as Director of Tax Services, he brings a wealth of experience in federal, state, and international income as well as franchise tax issues for both publicly and privately held corporatio… Read more

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