 FIFO / LIFOFirst In, First Out (FIFO)The First In, First Out method assumes the items you have purchased or produced first are the first items you sold, consumed, or otherwise disposed of. The items in inventory at the end of the tax year are matched with the costs of items of the same type that you most recently purchased or produced. Last In, First Out (LIFO)The Last In, First Out method assumes the items you have most recently purchased or produced are the first items you sold, consumed, or otherwise disposed of. Under LIFO inventory items which are sold are assumed to be the items most recently purchased or produced. This is the opposite of FIFO where the items sold are assumed to be the items first purchased or produced. In a period of rising prices (inflation) LIFO will result in a larger cost of sales deduction which reduces taxable income and taxes paid. However, if prices decline (which can occur with certain types of raw materials, increases in manufacturing efficiencies, etc.) LIFO will produce a lower cost of sales which increases taxable income. The difference between inventories computed under the FIFO and LIFO methods is referred to as the LIFO reserve. Differences Between FIFO and LIFO
Who Can Use LIFO?Any taxpayer permitted or required to take inventories pursuant to the provisions of section 471 can use the LIFO method. While LIFO is a cost flow assumption, a taxpayer can use the LIFO method even if they know exactly which item is being sold. How to Elect LIFOLIFO must be elected by completing and filing Form 970 (PDF), Application To Use LIFO Inventory Method, or a similar statement. This form or similar statement must be attached to your timely filed (including extensions) tax return for the year you wish to start using the LIFO method. In addition to filing the above form or statement, taxpayers must comply with other provisions of section 1.472-2 of the regulations. These include:
Which LIFO Methods to UseFor manufacturers the permitted LIFO methods include specific goods and dollar-value. While these methods have their differences, their overall purpose is the same: to permit the deduction, through cost of goods sold, of inflation. Manufacturers can elect to inventory raw materials, including the raw material content of in-process and finished goods, under the LIFO method while retaining the FIFO method for labor and overhead costs. It is also permissible to inventory all manufacturing costs including labor and overhead costs under the LIFO method. What to Expect if LIFO is AuditedRegardless of which LIFO methods you use the following items are likely to be requested during an examination of your return:
After examining the above records you may be requested to provide the detail workpapers for prior years, back to the inception of the LIFO election, and other records supporting your determination of pools and computation of cost increase indexes. All of these records must be maintained under sections 1.472-3(d) and 1.472-8(d) of the regulations. Issues in LIFOThere are many areas of issue in the computation of LIFO inventories. There are presently two coordinated issues that the IRS has released in-depth positions on. There is also a non-inclusive list of other potential issues involving LIFO. Coordinated Issues Proposed LIFO Issues Other Tax ConsiderationsAlternative minimum tax under section 56(g)(4)(D)(iii). For corporations (other than S corporations) the increase or decrease in the annual LIFO reserve is included in Adjusted Current Earnings, which is a component of the alternative minimum tax computation. This may increase your tax liability if you are subject to the alternative minimum tax. An existing corporation that elects S corporation status will be required to report as income their entire LIFO reserve. A special tax under section 1363(d) is paid, in four annual installments, if the S corporation election is made. The new S corporation can continue using the LIFO method. For additional information see section 1.1363-2 of the regulations and Revenue Procedure 94-61, 1994-2 C.B. 775. Section 263A costs are capitalized only in years where there are increments to LIFO inventory. When LIFO inventories decline (decrement occurs) no section 263A computation is required for the pool with the decrement. While the LIFO method will reduce taxes during inflationary periods, it will produce higher taxable income in years of declining prices. All or part of the LIFO reserve must be reported as income in the future if inventories are significantly liquidated or sold entirely, the election is terminated (by you or the IRS), or your entire business is disposed in a taxable transaction.
APPENDIXTermination of LIFOOnce adopted LIFO must be used unless permission is obtained from the IRS to change to another method. Changes from LIFO to another inventory method can be made voluntarily by the taxpayer or involuntarily by the IRS. Voluntary termination If a taxpayer chooses to voluntarily terminate their LIFO election they must file a Form 3115. If eligible for the provisions of Revenue Procedure 99-49, I.R.B. 1999-52 the consent of the IRS will be automatic and no filing fee is due. However, if the taxpayer is not eligible for this procedure, they must file the Form 3115 under the conditions of Revenue Procedure 97-27, 1997-1 C.B. 680. Under this procedure the taxpayer must wait for written permission to change their method. In addition a filing fee is required. Involuntary termination In certain circumstances the IRS may terminate the LIFO election of a taxpayer. If this were to occur the entire LIFO reserve would be brought back into income. Four conditions where the IRS may terminate a LIFO election are outlined in Revenue Procedure 79-23, 1979-1 C.B. 564. These four conditions are:
Specific goods methodUnder the specific goods LIFO method inventory quantities are measured in physical units such as pounds, kilograms, pieces, etc. This method is not as widely used in the manufacturing industry as is the dollar-value method. Dollar-value methodMany taxpayers choose the dollar-value method to compute their LIFO inventories. Under this method inventories are measured in base year (the year prior to your LIFO election) dollars instead of physical units. Dollar-value pools ease the computation where many items are contained in one pool. This will generally retain the benefits of LIFO longer than under specific unit pools. Under the dollar-value method a manufacturer first determines the number of pools and then, for each pool, computes the annual cost increases to the items in those pools. The number and composition of pools is based on section 1.472-8(b) of the regulations and is a factual determination based on the characteristics of the manufacturing operations. It is possible, based on the facts in each case, to have a single manufacturing pool. Under section 1.472-8(d) of the regulations the appropriateness of the pools as well as the propriety of all computations incidental to the use of such pools will be determined in connection with the examination of the taxpayer's income tax returns. Once the pools are determined a manufacturer has two general methods to compute the cost increases for the pools:
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