Follow the advice of the Boy Scouts and “be prepared.” Now is the time to help clients prepare to take advantage of rising inflation. While most view inflation by its clear downsides, LIFO accounting is a tool that CPAs can use to turn this negative into a positive.

Why should businesses already on LIFO take another look at this accounting method? In addition to relieving pressure in inflationary times, IRS LIFO regulations issued in 2002 enable both LIFO and non-LIFO taxpayers to significantly reduce federal income taxes.

Prior to tax returns being filed for 2004 (as well as before 2004 annual financial statements are due), more and more CPAs are turning to LIFO specialists to identify clients who might benefit from a LIFO implementation for 2004. An expert team of inventory categorization specialists can quickly and accurately determine the potential LIFO benefit for any business type.

Who can benefit from LIFO?
Good candidates for LIFO include manufacturers, wholesalers and retailers that are experiencing inflation and carry a minimum year-end inventory of $500,000 or more. Those who fit the criteria may use potentially substantial 2004 inflation to significantly reduce federal income taxes with LIFO.

What is LIFO?
LIFO enables a business, on a once-a-year basis, to defer income based on inventory inflation. There are many different LIFO methods, but in January of 2002 the IRS issued updated regulations for a method that has been available for more than twenty years. Inventory Price Index Computation (IPIC) LIFO is a specific method using government-published (Bureau of Labor Statistics) indexes to measure domestic inflation.

The new regulations issued in 2002 made the IPIC method much more taxpayer-favorable by allowing businesses to use 100 percent of the inflation measured by the government published indexes. Prior to these new regulations, taxpayers could only use 80 percent of the inflation, which was known as the “20 percent haircut.”

What kind of tax benefit is available?
If a company has a scrap metal inventory of only $3.5 million at year-end 2004, the first-year LIFO reserve could be $1.75 million (based on the August, 2004 PPI index for “iron and steel scrap”). At a 40 percent tax rate, this could reduce this company’s 2004 federal tax obligation by approximately $700,000. (This is just one example, and there are many variables that would impact the actual benefit.)

The bottom line about LIFO: Even when annual indexes are volatile, the LIFO inventory method can still yield significant tax benefits over time. During inflationary periods, the immediate tax benefits could be substantial.

What other considerations are important with LIFO?
For clients with a December year-end, NOW is the time to explore the potential benefits specific to the company. Time is of the essence because a client using LIFO for tax purposes must also have a LIFO provision on its financial statements. This “conformity requirement” is strictly enforced by the IRS.

The LIFO impact on financial statements must be discussed with any company shareholders and/or debt holders. To the extent that LIFO reduces taxes, it also reduces book income. But financial stakeholders normally approve the LIFO election when they understand the tremendous cash flow benefits.

It’s not too late to explore the potential tax benefits of implementing the IPIC LIFO method for your clients. This article used an iron and steel scrap business example; however, the variety of inventory types potentially exposed to inflation in 2004 is vast. Inventory categorization specialists can assist a firm by quickly and accurately estimating the potential benefit available for any current or prospective clients.

About the Author
Stanton Williams is president of SOURCECORP Tax Benefits Group. SOURCECORP Tax Benefits Group makes otherwise time consuming, complicated and highly specialized tax benefit opportunities readily available to businesses and CPAs across the nation.

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