The Internal Revenue Service has simplified regulations covering the last in, first out inventory accounting method, known as LIFO. Among the changes are new provisions eliminating requirements that large businesses reduce the inventory price index, or IPI, by 20 percent when using the inventory price index computation method, or IPIC.

The new rules, effective for taxable years ending on or after December 31, 2001, permit all businesses electing IPIC to use 100 percent of the IPI to compute the LIFO value of a dollar-value pool. The IPI is based on consumer or producer price indexes published by the U.S. Bureau of Labor Statistics.

LIFO’s Attractions
LIFO, matching recent expenses against current revenues, is often an attractive option for manufacturers in accounting for the value of their inventories for tax purposes, although in the current deflationary environment faced by many manufacturers it may be less attractive than FIFO, the first in, first out method. FIFO establishes the value for current inventory by matching older expenses against current revenue.

Many manufacturers use FIFO to monitor profit trends during interim periods. Another factor to consider is the potential requirement that C corporations electing S corporation status pay a LIFO recapture tax.  

Record-Keeping Burden
Until now, LIFO’s tax advantages have carried a heavy burden in costly and time-consuming record keeping to convert current year inventory costs to base dollars. Earlier efforts to simplify the process led to IPIC, which carried its own problems, including a limitation to 80 percent of index-based inflation calculations for larger companies.

Unpredictable Variations
Companies with high and variable gross margins found it difficult to calculate accurate, interim gross margin percentages as the heavy fixed costs associated with inventory and swings in production volume produced significant variations in average unit costs. Unable to determine true gross margin for the year without a physical inventory timed to a cutoff in sales and accounts payable operations, these companies faced unpredictable variations in taxable income.

Elimination of Surprises
The new LIFO regulations are designed to eliminate just such surprises by allowing taxpayers to use public price indexes without having to convert them to cost indexes. By improving a company’s ability to predict its year-end LIFO adjustment, high-margin businesses can reduce the volatility in LIFO expense created from even slight changes in gross margin percentage.

Category Choices
New regulations allow taxpayers to limit IPIC election to one or more specific trades or businesses and provide a category for work-in-process. They provide methods for computing the category inflation rate based on indexes for either an appropriate month of the year before the LIFO election or for the preceding year.