Supply chain problems linked to the COVID-19 pandemic are depleting last-in, first-out inventories and forcing some car dealerships to use purchase prices from the 1980s for cost offsets of current sales.
Franchise car dealers saw their inventories fall 63 percent from the beginning of 2021 through the end of October, Paul D. Metrey of the National Automobile Dealers Association (NADA) told Tax Notes December 1.
Those inventory levels aren’t expected to recover substantially before the end of 2021, so dealers face the prospects of paying more in taxes because they have to reach back in their books and find only lower-priced purchases, which offset less of the cost of their sales than would current inventory purchases.
"The ratio between inventory and sales is at its lowest point since at least 1985, [and] in some cases, the ratio between inventory and sales has dropped below 1 to 1, which is really quite extraordinary,” Metrey said, adding that it will take a long time for dealers to return to pre-pandemic inventory levels.
The problem for car dealers and other taxpayers with section 471 inventory affected by pandemic-induced supply chain problems is that they can’t replace their LIFO inventories while making sales. In other words, they’re working their way into older and older bases for their inventories to apply against current sales rather than using recent purchases for their cost recovery under LIFO.
Metrey noted that NADA and the American Institute of CPAs have been writing letters to Treasury and the IRS since November 2020 pointing to a provision created for when taxpayers can’t replace their LIFO inventories. Section 473 allows regulatory relief from involuntary LIFO layer liquidations when events like a “major foreign trade disruption” make replacement difficult or impossible.
Not only have NADA and the AICPA followed up on their requests in a November 29 letter asking for a meeting with Lily Batchelder, the newly confirmed Treasury assistant secretary for tax policy, but members of Congress have also joined in with their own letters to Treasury. Ivette Rivera of NADA noted that the congressional requests for section 473 relief have been bipartisan, which she hopes will convince Treasury to act.
Back to the ‘80s
Joseph A. Magyar of Crowe LLP said LIFO reserves come from the benefit built up over years of using LIFO. That benefit for a specific year will be at most the inflation rate multiplied by inventory, but the various years over time become LIFO layers, he explained.
That history — and thus, the LIFO layers — will be unique to each taxpayer, according to Magyar. The 63 percent reduction in inventory doesn’t necessarily correspond to a 63 percent reduction in the LIFO reserve; it could be more or less, he said. Looking at NADA and client data, that sort of inventory reduction generally halves a taxpayer’s LIFO reserve in the current year, he added.
“We have clients who’ve been on LIFO for a few years; we have clients who have been on LIFO back into the ‘70s,” Magyar said. While the pandemic may not have taken the latter group of taxpayers back into the early 1970s, some are using LIFO layers generated in the 1980s, he added.
To illustrate, a car dealer could be using a 1980 Ford Escort as the basis for cost recovery when selling an F-150 sold in 2021, according to Magyar.
While inflation rates may have been low for a long time — even at 2 to 3 percent — over the course of 20 years or more, the effect on how much cost of goods sold a dealer can deduct when deep in the LIFO layers, compared with being able to use current purchases, can build up, Magyar said.
NADA and the AICPA have asked for three years to refill LIFO layers without having to dig into older ones — relief that section 473 was written to provide, Metrey noted.
Magyar said that even if a taxpayer’s inventory falls from 40 million to 5 million and then bounces back up to 40 million, it will take many more years for the new LIFO layers to accumulate the same value as the old reserves.
Time to Act
According to Metrey, dealer taxpayers need help from Treasury and the IRS as soon as possible. NADA and the AICPA aren’t asking for permanent tax relief but rather timing help, he noted. Still, the cash flow hit of greater income tax realizations based on the LIFO rules is a critical and immediate problem for car dealers and other LIFO taxpayers, he said.
There are approximately 18,200 franchise car and truck dealers in the country; car dealerships average 64 employees, and commercial truck dealerships average 55, Metrey said. All told, that’s just over 1.2 million employees, he said.
Most of those businesses operate as passthrough entities, meaning their initial tax return due date will be March 15, Metrey noted. Even if they get filing extensions, they’ll still have to make estimated payments by that date, he added.
The IRS and Treasury need to not only decide to grant section 473 relief but also publish that guidance in the Federal Register and issue procedures for taxpayers to take advantage of it, Metrey said. With just three and a half months, NADA and the AICPA want to urge the government to act with all possible speed, he said.
Magyar noted that in 2020, auto dealers saw their inventories fall by only around 20 percent, causing just five or six years of LIFO layer lookback. Especially with current low inflation, that hit was much smaller than the larger reductions and decadeslong lookbacks dealers are facing for tax year 2021, he said.
Metrey noted that the AICPA raised the question of distinguishing foreign from domestic supply chain disruptions in recent discussions with the IRS and Treasury. No vehicle built today is made with only domestically sourced parts, and the modern economy has foreign and domestic supply chains of all sorts intricately intertwined, he said. The IRS and Treasury should be further allayed on that front by the bipartisan letters from legislators asserting that the pandemic supply chain snarls fit the conditions for section 473, he said.