I certainly hope Ways and Means Committee Chairman Dave Camp had some idea what he was getting into when he wrote a plan to reform our tax system. Even though both parties claim to agree to tax reform, actually writing something down is like painting a political target on your back. After Dave Camp initial release the reform idea back in February, he was punched in the gut (figuratively, of course) by his fellow politicians, then kicked while we was down by every single special interest group in the US (still figuratively to my knowledge).
It’s been a few months now, but the blows keep coming. Last week, a group of 115 House legislatures (which is a good quarter of the House), sent a letter to Dave Camp requesting that the reform removes the LIFO repeal provision. Like everything related to taxes, they claimed that a LIFO repeal would cause serious harm to many American businesses.
They are, of course, right. LIFO, or last-in, first-out, is an inventory accounting method that values the inventory a company sells and has on hand. Most companies can’t track each individual inventory item to an individual sale, so instead they track it by groups of items. When the sale occurs, they have to come up with a system to decide which processor was just sold. The most common options are LIFO or FIFO (which is first-in, first-out)
Let’s say Microcenter buys 3 processors over a month for $35, $40, and $45. They then sell one of the processors for $50. If they use the FIFO method, they would calculate profit by taking the sale price less the first processor they bought, or $50 – $35 = $15. LIFO method would use the most recently purchased processor, or $50 – $45 = $5.
So which one puts Microcenter in a better position? From a cash standpoint, neither. Either way they paid out $120 for processors and only made $50 back. However, under the LIFO method, they would owe less in taxes. Since prices are generally increasing, it is almost always true that LIFO will lead to a better tax consequence that FIFO.
One thing that must be pointed out is that, in the long run, theoretically it should all reverse out when the company clears out its inventory. For large companies that plan on being in business forever, though, chances of it clearing out are low.
If the government were implement a LIFO repeal, most companies that use LIFO would face a stiff and unexpected tax bill. Dave Camp’s proposal would be to pay the tax difference over a four year period. But that could still hurt.
Here’s the most extreme example. Exxon has the largest known LIFO reserve (fancy phrase for difference between LIFO and FIFO) in the US, which, last I checked, is close to $16 billion. Changing methods would mean about $5.6 billion in additional taxes. While it’s unlikely it would put Exxon out of business, paying out almost $6 billion in cold, hard cash would seriously hurt (no matter what people think about Exxon).
Smaller companies will not have reserves that big. But they might have less means to pay for the sudden tax increase.
So yes, the legislators are right that it will hurt some companies. And they’re correct that there’s nothing evil or wrong about the LIFO method. It’s not a loophole or some special interest treatment. It’s a perfectly acceptable and, at least at times, reasonable method to calculate inventory.
BUT! Our tax code is complex, with it’s tentacles reaching into some pretty obscure industries. It’s impossible to make a change without someone hurting. Not everyone can get their way. And while I wouldn’t have including a LIFO repeal as the first choice to the chopping block, we’re going to have to slaughter a few sacred tax cows along the way.
Maybe LIFO will avoid the BBQ pit, but if we keep adding in these one off complaints to the tax reform proposals, the proposal will quickly look exactly like the original tax code.
I’d love to start seeing comprehensive alternative suggestions instead of these Disney’s Pocahontas type saves for their particular interest. If nothing else, it’ll give the critics a thicker binder to use when they hit Dave Camp.
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Picture by Jason Rogers