Why Lifo's The Only Way To Fly

It's a legal way to reduce taxes, stresses 'last-in, first-out' expert Dan Fensin.

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What's happening with LIFO, the "little giant" of tax deferrals? In light of last year's tax act, is LIFO (a method for valuing inventory on a last-in, firstout basis) fulfilling its potential as small business's greatest opportunity to save on taxes?

A rapidly growing number of smaller companies are adopting it, reports Dan Fensin, partner and director of LIFO services for Blackman, Kallick & Co., a Chicago accounting firm. "As a cure for phantom profits caused by inflation, the lure of LIFO has become almost impossible to ignore or disavow," he says. As testimony to the accelerated interest in LIFO, Fensin cites the experience of his own firm. "Five years ago, only about 10% of our clients who maintained inventories were on LIFO. But as inflation rates mushroomed to double digits, more and more got into it. Now, at least 65% of those clients are on LIFO."

In an interview with INC., Fensin reviewed the benefits of LIFO, itemized changes in LIFO procedures caused by the 1981 Economic Recovery Tax Act (ERTA), and described several recent experiences with LIFO conversion.

Although LIFO first emerged in 1939, when it was written into the tax codes, it was little used and relatively unappreciated until inflation rates began their steady rise. Basically, LIFO removes the latest and highest priced items from inventory, charges them to the cost of goods sold, and leaves the earliest and lowest priced items in inventory. In effect, for tax purposes, the latest items purchased -- at presumably higher prices because of inflation -- are assumed to be the first items sold, thus removing the inflation rate from inventory value. Even at currently lower inflation rates, this results in reduced taxable income, lower taxes, and increased cash flow (see box).

"Even if inflation were to drop to, say, 3%," Fensin points out, "LIFO would still give you the opportunity to shelter 3% of your total inventory value from taxes."

Since 1973, when he handled his first LIFO conversion, Fensin has witnessed continual misunderstanding about the time and effort involved in converting. "Unfortunately, exaggeration and misinformation about problems with LIFO conversion have caused many business owners to put it off. Yet, it's not that difficult to make the switch," he says. "Whatever effort is expended is returned many times, because LIFO is a building process -- the benefits keep accumulating each succeeding year."

As an example, Fensin cites the case of a $14 million plastics distributor that converted to LIFO eight years ago. The company's inventory, for tax purposes, is now running at 50% of its actual value.

"On FIFO [first-in, first-out], at cost, it's a $4 million inventory," notes Fensin. "Using LIFO, it's valued at $2 million." Equally dramatic on a slightly smaller scale, is the experience of a $6 million manufacturer of check protectors. With an inventory of $1.5 million, the company converted to LIFO in 1977 -- a move that has since enabled it to eliminate some $600,000 in "inventory profits."

Fensin has worked with many companies whose inventories and sales are in the area of $50,000 and $500,000, respectively. "Businesses with inventories as low as $25,000 are candidates for LIFO," he emphasizes. "The same techniques apply, regardless of sales volume or inventory size."

Type of business is more important than size, Fensin points out. Conversion to LIFO is easier for manufacturers than for distribution companies, because regulations allow all manufacturers' products to be classified in a single pool for valuing "Putting all items into one pool, called a natural business unit, makes the conversion process less time-consuming, less complicated, and easier to understand," he says.

Once the value of a pool is established for the base year (the beginning of the first year a company elects LIFO), that year becomes "memorialized," because every succeeding year's values are indexed to it. Quantity of items is not the key factor. Instead, the pool's dollar value is extended, using the base-year cost, the end-of-year cost, and the earliest acquisition price.

Most of the time required for LIFO conversion is spent gathering information about the purchase history for the sample items in each pool. Although three methods are available -- using the earliest, latest, or average prices during the year -- most companies opt to use the earliest acquisition price because it is the lowest.

For nonmanufacturers or those engaged in manufacturing plus other businesses, Fensin concedes that working with a number of pools is more complex. But he still characterizes the conversion process as not nearly the oniinous task many business owners and accountants fear it will be.

"Regardless of type of business, it's not necessary to analyze every inventory item individually," he explains. "Streamlining is part of the conversion process. Statistically sound samples and representative product groups can be used to create indexes. They, in turn, can be used to compute the value of inventory -- or LIFO adjustment -- each year compared to the base year."

Because the base year for each company electing LIFO is so strategic, at least as long as inflation exists, Fensin bemoans the loss of benefits because of hesitation. The extension option for filing tax returns up to six months after the due date has allowed many companies to take advantage of LIFO for fiscal years long ended. Fensin is quick to add that shifting to LIFO requires no permission from the Internal Revenue Service. "All you have to do to initiate LIFO is file a Form 970 with your tax return," he says. However, the completion of that form and the filing of financial statements are crucial, he warns. "Many people don't believe that an entire LIFO election can be disallowed just because the forms are filed incorrectly. Uncle Sam doesn't monkey around. Everything has to be filed properly. Every company should look at LIFO as a gift. It helps defer taxes. And those who want to use it must do what's required to take advantage of that gift."

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