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Here's some good news about inventory methods and their potential tax impact. The IRS issued new regulations that make the LIFO (last-in, first-out) method of accounting for inventory far more attractive than it used to be. In fact, says Brian Lucas, federal tax partner in the Chicago office of accounting firm Grant Thornton, "the IRS has cleared up a lot of the ambiguity with these new regulations."
As you know, LIFO and FIFO (first-in, first-out) are two inventory identification methods. FIFO assumes that sales are made from items that have been sitting in inventory the longest. LIFO assumes that the most recently purchased items are the first ones sold.
With the FIFO method, if prices are increasing, your gross income will be matched against the lowest-priced items in your inventory, which means higher net profits. LIFO, on the other hand, matches your gross income against the most expensive items in your inventory, resulting in lower net profits and lower taxes.
The LIFO calculation has always been considered more complex than FIFO. As a result, many business owners have shied away from LIFO, even though it could prove to be beneficial, says Lucas. The new regulations, which are now effective for taxable years ending on or after December 31, 2001, simplify what is known as the inventory price index computation (IPIC) method used in calculating LIFO.
The simplified IPIC method uses a Bureau of Labor Statistics index so you don't have to spend extra time calculating and maintaining your own internally developed indices. The new rules also eliminate the 20 percent reduction in the price index that affects some business owners. "Now every business can get 100 percent of the calculated inflation based on the published indices," says Lucas.
The change is expected to have an impact on many businesses, including manufacturers, distributors and retailers. In addition, it could create potential tax savings opportunities. Such an outcome, however, depends on your own particular business situation, so talk to your tax advisor first.
Great Falls, Virginia, writer Joan Szabo has reported on tax issues for more than 15 years.
(312) 856-0200, www.grantthornton.com