The COVID-19 pandemic caused significant supply chain disruptions, and recovery is not keeping pace with demand. Auto dealers are continuing to project record low year-end inventory levels due to an inability to replenish their stock.
Because of this, dealers using the last-in, first-out inventory (LIFO) method of accounting could face a substantial jump in their federal tax bills. Under LIFO rules, declines in the LIFO value could trigger a recapture tax. What’s more, even when a dealer restores future inventory to normal levels, the liquidated LIFO layers will be replaced with an increment valued at current-year costs. That means the income that came from the involuntary liquidation will not reverse, creating what amounts to a long-term increase in taxable income.
As a result of this possible disruption in the industry, the American Institute of CPAs (AICPA) and the National Automobile Dealers Association (NADA), along with others, have reached out to the IRS for change.
In April, the AICPA called on the Treasury Department and the IRS to provide relief to taxpayers who find themselves with an artificial increase in taxable income created by inventory replacement challenges. In the letter issued to the IRS, AICPA argues that, absent this relief, many taxpayers will realize significant and unexpected tax liabilities. This may also cause underpayment penalties for large corporations if this additional income is not taken into consideration during the year.
NADA also presented the Treasury Department with a similar request in fall of 2020. Now, going into the last two months of the 2021 tax year, no relief has been addressed or proposed. I inquired with NADA CEO Mike Stanton on where the organization stands on the current relief request. He stated, “We’ve put out the letters, we have relationships with Treasury, we’re advocating for dealers. Treasury has the ability to make things right, but we are taking a different approach. We have partnered with an outside consultant, and we are using our contacts and taking a legislative approach to this, too.”
Section 473 relief
AICPA states in their letter, “Congress enacted section 473 to provide relief to taxpayers in circumstances such as these.” Section 473 allows for qualified liquidations of LIFO inventories. Under the provision, if a taxpayer replaces inventory within three years, they can reduce gross income in the year of liquidation. To define what constitutes a qualified liquidation, Section 473 includes major foreign trade interruption that “has made difficult or impossible the replacement during the liquidation year of any class of goods for any class of taxpayers.”
AICPA believes the COVID-19 pandemic qualifies. The letter says, “The government actions and restrictions implemented in 2020 to mitigate the global health crisis and curtail the COVID-19 pandemic caused major disruptions to foreign trade, affecting the integrated supply chains upon which our global economy relies. These disruptions made it difficult, and in some cases impossible, for taxpayers to maintain inventories at normal levels, resulting in an involuntary liquidation of LIFO layers.”
AICPA is requesting that:
- Taxpayers may elect section 473 relief if they experienced a qualified liquidation.
- A qualified liquidation year includes taxable years ended March 31, 2020, through taxable years ending June 30, 2021.
- The applicable replacement period is the three taxable years following the liquidation year.
- Taxpayers be provided a safe harbor method to replace inventory during the replacement period.
How Wipfli can help
We advise dealers using the LIFO method to talk with their accounting team and tax advisors to review year-end inventory levels, the impact on taxable income and possible options should the Treasury Department fail to act on the requests.