When Congress passed the Economic Recovery Tax Act of 1981, one of the things it intended to do was help small companies reduce their tax burden by switching to the LIFO method of inventory accounting, which eliminates "phantom" profits. But as with any major legislation that comes from Capitol Hill, the new revisions need to be evaluated by each small business from the perspective of its own circumstances. Indeed, the changes in LIFO rules will be of little consequence to many types of firms.

LIFO is shorthand for "last in, first out" -- an accounting method that permits companies to value their inventories on the basis of the cost of the last item placed in stock. With inflation, the last inventory item is apt to be more costly than the first. The higher cost inventory reflected under LIFO significantly reduces the phantom profits created by inflation, hence reducing taxable income, cutting corporate income taxes, and increasing cash flow.

Given these positive attributes, it should not be surprising that increasing numbers of companies have considered converting from the more conventional FIFO -- "first in, first out" -- accounting method, which fails to reflect the more recent higher costs and thus catches businesses in the inflation trap. But there have been notable obstacles to making the shift to LIFO. Chief among them is cost: The Internal Revenue Service calls back -- or recaptures -- certain tax breaks a company has taken under FIFO accounting.

Fashionable items such as designer dresses or seasonal merchandise such as patio furniture, for example, can be restated under FIFO to reflect their lower market value, which may be even lower than initial costs. LIFO rules, however, require that inventory be stated at cost. Accordingly, write-downs must be restored and reported as income. This income has traditionally been reported by amending the prior year's tax return -- often resulting in a sizable tax increment.

In addition to the cost problem, critics have long complained that LIFO procedures are too complex and cumbersome for most small businesses. Responding to these complaints, Congress last summer simplified some of the LIFO rules and eased the immediate cash burden on a company making the switch. These changes, along with some simplifications initiated by the IRS itself earlier last year (see INC., May 1981, page 164), plainly make LIFO more appealing to small businesses.

The new LIFO provisions affected three fundamental areas:

Prior-Year Inventory Write-downs. When switching from FIFO to LIFO accounting, you must restate your inventory to reflect prior-year write-downs of inventory items you scrapped as obsolete or otherwise worthless. The result is that you increase your taxable income and get socked for an additional tax bill. Under the old LIFO rules, this potentially huge new tax liability was due immediately; for many companies the prospect of a major extra tax payment was a persuasive deterrent to making the conversion. The new law reduces the immediate financial hurdle by giving you three years to pay and additional tax bill that stems from the prior-year write-down.

Pooling. LIFO rules have stipulated that a business must maintain distinct inventory categories, or pools, to assure that different types of items whose costs fluctuate separately from one another are not lumped together. For many small businesses, however, attempting to make sense out of the rules for pooling has been a nightmare. IRS requirements have been notoriously inconsistent and fuzzy. Under the old rules, for instance, a frozen-pizza processor with $360,000 worth of ingredients in inventory was instructed by the IRS to maintain eight different pools so that his green peppers were kept separate from his cheese and pepperoni, on the grounds that each has a different rate of inflation, depending on the weather and other factors.

These rules have been most troublesome for small businesses, which are least able to pay an accountant to help them meet all the complex requirements. Under the 1981 tax act, however, businesses with gross receipts averaging less than $2 million for the previous three years get special treatment: For tax years after 1981, smaller companies meeting this description will be allowed to adopt LIFO, with only one inventory pool required. The time-consuming paperwork associated with multiple pools should be reduced, and the initial accountant's bill for switching to LIFO should be lower for firms qualifying for one pool.

A growing company, of course, has a potential problem. What if it elects LIFO under the rules for businesses with revenues less than $2 million and sees its gross receipts break through the $2-million level? If the resulting three-year average exceeds $2 million, the company must give up the special exemption permitting a single pool and adjust its LIFO procedures accordingly. Depending on the nature of the business, the firm may be required to set up multiple pools. If so, it would have to obtain the consent of the IRS for its method of establishing the pools.

Should you stay away from LIFO if you think you'll soon outgrow the $2-million limit? Most accountants say no. Many experts on Capitol Hill indicate that there are mounting pressures on Congress to raise the threshold to account for inflation. On balance, therefore, it probably doesn't make a lot of sense to forgo the short-term advantages of LIFO in the meantime.

Indexing. Many companies have steered away from LIFO accounting because of the cost and complexity of creating an internal price index for each LIFO pool. These indexes are established by calculating the dollar value of each pool in a base year so subsequent year increases can be determined. Smaller firms, especially those that now qualify to use a single pool, usually don't have the in-house professionals or the money to hire outside consultants to develop these internal indexes.

But help is on the way. Last year's tax law instructed the secretary of the Treasury to issue regulations simplifying index requirements by making available the use of published government indexes. There is some precedent for this action -- department stores are already allowed to base their LIFO inventories on indexes developed by the U.S. Bureau of Labor Statistics. It is expected that the Treasury will recalculate these inflation breakdowns for other types of businesses as well.

Preparation of external indexes will obviously make life easier for small firms, but there are hints coming out of Treasury that new regulations may allow companies to use the government index to compute only a portion -- perhaps 80% -- of the increased inventory valuation. Business groups are objecting to the less-than-full calculation, however, on the grounds that the Treasury would be violating the spirit of the Reagan Administration's tax bill.

Such uncertainties aside, it's clear that the new law simplifies LIFO procedures to a degree that should encourage small companies to make the switch. To know whether LIFO is for you, however, you will have to take a hard look at your own business and the external forces it is subjected to. If you run a company with low profitability -- and hence little tax liability -- you may find LIFO isn't worth the remaining complications. There is an exception. You might want to elect LIFO for the purpose of triggering a loss for the year which may be carried back to prior years and result in a potential refund.

Another test is what kind of impact inflation has on the products you deal with. If you're in the petroleum-products business, for example, skyrocketing oil prices over the past decade probably justified a switch to LIFO.Now that many experts forecast declining oil prices for perhaps the next few years, today's argument for converting to LIFO probably wouldn't be as strong. Other volatile businesses, such as jewelry manufacturing and lumber wholesaling, would be similarly tricky since inventory costs on materials and merchandise don't always rise -- they can decline. If this happens, deductions on higher-value inventory don't amount to very much. So your taxable income, as well as your tax bill, will rise.