Lower inventory could mean higher taxes for dealers

Industry expertise

Joe Magyar, CPA is Managing Partner of the Retail Dealer Services Group for Crowe LLP and provides tax and consulting services to the dealership industry, especially large multi-point dealership groups.  

While dealers may be struggling to find enough vehicles to satisfy customers, those they do sell may be generating higher tax bills than they would like. Depending on your inventory accounting method, shrinking inventories and inflated prices could push profits and taxes higher, at a much faster pace than you might expect.

LIFO and taxes in a shrinking inventory environment

Most dealerships rely on the last-in, first-out (LIFO) accounting method for inventory. When inventories are stable and auto prices are rising, LIFO keeps taxes low by using the most recent additions to inventory—generally higher priced vehicles—in cost of goods sold so that taxable profits stay low. But when inventory levels drop, cost of goods sold draws from older, lower cost inventory—also called the LIFO reserve—that can create a jump in tax liability. Worse yet, LIFO accounting rules could mean that the hike in taxable income persists into future years.

Some dealerships have already seen this effect on their 2020 tax returns. The hit could be much harder in later years.

Relief could be on the way.

The good news is that potential action by Treasury may deliver meaningful relief for dealers. Section 473 of the Internal Revenue Code permits a three-year inventory replacement window under certain conditions which is meant to mitigate the negative tax impact of inventory reductions.

Specified conditions include a major interruption to foreign trade that makes replacing the class of covered products difficult or impossible. That’s exactly what’s happening to automotive dealerships, according to the National Automobile Dealers Association (NADA). The organization has petitioned the Treasury for relief under Section 473, as has the American Institute of CPAs (AICPA) and others, including bipartisan groups from the House and the Senate.

If Treasury fails to provide relief, NADA has stated that it will urge Congress to enact new legislation that would provide similar relief to dealers and launch a major dealer grassroots initiative in support of the legislation.

Strategies to minimize the hit

Even without regulatory or legislative relief, there are a few ways to limit the damage. While most new-vehicle dealers use the alternative LIFO method (ALM), the inventory price index computation method (IPIC) is also allowable. IPIC historically has delivered fewer tax benefits but has one key advantage—dealers can pool new-vehicle inventory with inventories that may be more stable, such as automotive parts or used car inventory, to dampen the impact of falling new car inventories. Making the switch from ALM to IPIC could soften the tax blow now, but it may limit future benefits and prevents a switch back to ALM for five years.

Revenue Procedure 2008-31 is another pooling strategy for automobiles and light-duty trucks that allows limited inventory changes in one category to offset sharp reductions in another—lessening the impact of deep LIFO reserve reductions that results in higher taxes. There’s also the option to abandon LIFO entirely, triggering full LIFO reserve capture and spreading the recapture over four years. This strategy has considerable tax implications in future years but can deliver net short-term benefits in certain situations.

Any change in inventory accounting must typically occur before filing your tax return for that year. With auto inventories reaching historic lows, dealers should estimate the tax implication of changing inventory levels and seek expert advice on the best options for their situation.

Have you prepared for the tax implications of lower inventory levels?

Talk to you tax advisors about taking steps to minimize the tax effects of shrinking inventory levels.