The selection by an entity of its company structure, its fiscal year and its method of accounting are the three main mechanisms that a company can employ in performing substantial tax planning, according to Nicholas Crocetti, CPA, a partner in CBiz Accounting Tax & Advisory."The concept of an accounting method is much broader than what many people believe," he said. "Most companies employ a number of accounting methods. First, they have an overall method of accounting - for example, the cash method, accrual or some form of hybrid method. Additionally, companies need accounting methods for every timing item they encounter in their business, such as how to account for inventory, bad debts, vacation pay and self-insured medical expenses."
"Depending on the company, we usually recommend the last-in-first-out method of accounting for inventory, but for non-publicly held companies that depend on suppliers' credit, a switch to first-in-first-out might make sense," he said.
"Formerly, accountants would present accounting statements using the FIFO method, since that's what people are comfortable in seeing, and for tax purposes we would use LIFO. In a period of rising prices, with LIFO you're taking a deduction for more current costs versus more historical, lower-cost items," he said.
"If you bought something three months ago for a dollar and now it's $1.20, then bought another today for $1.20 and sell one, you would write off the $1.20 and leave the dollar item in inventory, so you're taking more current costs as a reduction of a cost against the revenue of the company, thus reducing income," he said. "In that scenario, the historical financial statement would use FIFO, and they would continue to report 20 cents more in income than they would have had they used the FIFO method."
"But 20 years ago, the IRS decided they didn't like this," he explained, "so they came up with a uniformity requirement - if you use LIFO for tax, you have to use the same method for your financial statement. So today, any time you use LIFO, you must present your financial statements in the same vein."
The pros and cons
"The use of LIFO for tax purposes has been very good," according to Crocetti, because "effectively it has reduced taxable income for most companies due to rising prices. The problem we now have is the uniformity issue, so when you present your financial statements using LIFO, the readers - banks, creditors and suppliers - see depressed earnings and a reduced balance sheet, because it doesn't reflect historical cost."
"The company appears weaker than its competitors that don't use the LIFO method," he went on. "In dealing with a bank, you may be giving supplemental schedules so that the bank can take the differences in method into account, but your suppliers and your Dun & Bradstreet report won't have that."
The LIFO method has additional disadvantages, according to Crocetti. "It's more work to maintain LIFO records than FIFO," he explained. "There are different levels of inventory calculations associated with the index used to measure that level, so it requires much more work just to maintain the system. It also requires annual calculations. If the company is growing, you're adding new layers when you do your inventory calculation at the end of the year. It requires a detailed and complex computation, so you need an accountant who understands the company's activities."
A problem arises when the company produces less units and inventory goes down, according to Crocetti.
"You start eliminating the upper layers of inventory. They go away, but in the process you have created phantom income through dipping into the layers of inventory. In essence, you're recapturing the deferred income," he said.
This gives you an opportunity for substantial planning, Crocetti noted. "If the numbers are significant enough, you may want to consider switching from LIFO to FIFO," he said. "For example, assume inventory for FIFO purposes is $16 million dollars, and the LIFO valuation is only $6 million. Because of activity during the year, the inventory was reduced, and physically there are only a few units left. At the end of the year, there's a potential of $10 million in phantom income. If we switch, that $10 million can be spread over a four-year period. For financial statement purposes, you have increased the net worth and inventory value of the company by $10 million, while postponing the income."
It's so easy!
The mechanics are simple, according to Crocetti. Simply file Form 3115 with the IRS, attach it to the filed return and send a separate copy to the IRS under separate cover.
"It's a huge opportunity," he said, "because when you file the Form 3115 during the tax year of the company, you have until the due date of the return. The IRS likes you to change from LIFO to FIFO, so you can do this without a user fee, and it's deemed to be an automatic change. Since most clients are on extension, you have eight-and-a-half months after the due date of the return to make the change."
There is a potential trap, according to Crocetti, when an advisor suggests that a C corporation make an S corporation election.
"The differential between FIFO and LIFO is picked up as additional income in the last year of the C corporation," he said. "Even though the S corporation can continue to use LIFO, it's kicked the LIFO base up to the FIFO inventory base at the time the corporation makes the S election."
Last May, when Senate leaders proposed a $100 gas-tax rebate for every American family, they intended to pay for it by repealing LIFO for oil companies. While the rebate idea has been scrapped, the talk of eliminating LIFO has not, noted Crocetti. In Senate Finance Committee hearings on corporate tax reform in July, LIFO was again on the table, he said.
Any kind of broad tax reform would likely do away with the LIFO method, according to Crocetti. "The Treasury would like to see it gone," he said. "Oil companies have benefited tremendously through huge tax deferrals using this method. So, if and when tax reform becomes a reality, LIFO may very well be gone."
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