Inflation hits manufacturers tax benefits could help
As the end of the year approaches, it’s time to start thinking about one of the largest expenses a business faces: income taxes. This year, manufacturers and other businesses that maintain large inventories are likely feeling pain as a result of price increases. Proactive planning and addressing inventory issues now could provide significant tax benefits.
According to the Bureau of Labor Statistics data, although the prices of consumer goods, year over year through August, are up 3.8 percent, price increases in many commodities are far more expansive. If your manufacturing business has not experienced price increases in inventories, you are in exclusive company.
Samplings of some inputs that have been particularly hard hit by inflation include the following:
- Ferrous metals (hot rolled and cold rolled steel and bars), up 20 percent
- Non-ferrous metals (copper, nickel, stainless, etc.), up 21 percent
- Yarn and thread, up 22 percent
- Plastic resins, up 13 percent
- Synthetic rubber, up 37 percent
If your business is part of the large group of manufacturers hit hard by inflation, there are action steps that can be taken to better manage price increases and realize potential tax benefits. Some action steps include:
- Investigating segments of inventories experiencing particularly high price increases. A review of price increases and competitor responses could provide valuable information regarding pricing decisions. Price elasticity may be low on slow-moving products, so determination should be made as to whether more aggressive pricing on those products should be pursued.
- Determining if strategies exist to decrease quantities on hand. Inventories should be reviewed to ensure appropriate profit margins by product line. Inventories with low turnover and low margins should be properly addressed to ensure excessive inventories are not maintained.
- Determining if inventories include subnormal goods. In certain circumstances, inventories may be written down to net realizable value for subnormal goods. Additionally, obsolete items disposed of by year-end may result in additional tax deductions for the current year.
- Reviewing the manner in which lower of cost or market write-downs are being handled. Many companies that indicate they are on the LCM method may not systematically be marking goods down to market. Review processes for making market write-downs and ensure appropriate adjustments are made for 2011. Care should be taken to ensure the determination of “market” is reasonable. In light of inflationary pressures, markdowns might be a bit more limited this year.
- Determining if LIFO/IPIC LIFO should be considered. In light of price increases, significant benefits may be derived from LIFO. For example, a manufacturer that maintains $3 million of inventory and experiences 10 percent average price increases in 2011 may derive a tax benefit of over $100,000 by switching to LIFO. It should be noted, however, that IPIC LIFO provides a simplified means of deriving LIFO benefits without the complications associated with traditional LIFO calculations. Although LIFO may be elected after year-end, certain conformity with financial reporting is required.
A word of caution: President Obama’s jobs creation bill includes provisions that could affect inventory valuations after 2012. Specifically, he proposes provisions that would eliminate both LIFO and LCM after 2012. Under his plan, LIFO would be recaptured over 10 years, while LCM adjustments would be included in income over four years. It should also be noted that LIFO does not conform to International Financial Reporting Standards. Any eventual adoption of IFRS (the eventuality and timing of which is uncertain for closely held companies) will prompt a change to an inventory valuation regime in conformity with IFRS.
Observation: Although there has been talk from some legislators about LIFO repeal over the past several years, LIFO repeal provisions have not gained traction. Furthermore, all talk of repeal has included recapture over periods of 10 to 15 years, which could result in significant tax deferral even for late adopters.
Although continued price increases may be part of the new status quo, aggressively addressing them and carefully managing inventories may provide benefits that help mitigate the effects. Particularly, specific steps prior to year-end may provide significant tax savings.
Daniel Lynn, CPA, is a tax partner with Beene Garter specializing in transactional tax consulting and planning. Carol Hubbard, CPA, is the partner-in-charge of Beene Garter’s assurance department.