What Is LIFO?
LIFO, which stands for “last in, first out,” is an inventory accounting method used by many companies across multiple industries in the U.S. to determine both book income and tax liability. Primarily, LIFO is used to manage the cost of inflation. If inventory costs are rising, LIFO is a more accurate way of measuring financial performance and calculating tax. LIFO takes into account greater costs of replacing inventory, thereby giving a more conservative measure of the financial condition of the business and the economic income to which tax should apply.
It has been accepted as a legitimate tax accounting method by accountants, tax lawyers, the IRS, the SEC, and Congress since the 1930s.
LIFO is NOT a tax loophole, as some have claimed – it is an accounting method. If the business utilizes inventory that can go up and down in price on a consistent basis, LIFO accounting helps balance out that dynamic to ensure the business is getting an accurate measure of performance. If inventory costs are rising, using the LIFO method may mean less tax liability in a given year than under the FIFO (“first in, first out”) method. However, if inventory prices fall, the taxpayer would repay the LIFO benefit through greater tax liability.
Once a company elects to use the LIFO method, it requires IRS approval to change its accounting method. Taxpayers may not pick and choose between LIFO and FIFO at a moment’s notice in order to get the best tax outcome. So, once a business decides to use the LIFO method, that business also assumes the ongoing risk of increased tax costs if fluctuating inventory costs go down.
The Administration and some in Congress have suggested repealing LIFO as a way of reducing the federal deficit and increasing revenue without increasing taxes. However, abolishing LIFO as an accounting method would discriminatorily and retroactively increase taxes for hundreds of thousands of American businesses that have fluctuating inventory costs. The detrimental impact of LIFO repeal would reverberate across the economy as small businesses would be forced to take yet another blow from the government.