Recordkeeping is often essential to business operations and automobile dealerships are no exception.
Case in point: Many auto dealerships use the Last-In, First-Out (LIFO) method of inventory accounting. Although the LIFO method can provide significant tax benefits, you must be careful to meet certain tax law requirements. One such requirement that is often overlooked is the need to maintain comprehensive records.
There are different LIFO methods for new and used vehicle inventories. For new vehicle inventories, dealerships electing to use the alternative LIFO method are required to follow IRS Revenue Procedure 97-36. (This IRS guidance superseded and amplified IRS Revenue Procedure 92-79.)
The Last In, First Out (LIFO) method assumes the items of inventory your dealership purchased or produced last are sold or removed from inventory first. Items included in closing inventory are considered to be from the opening inventory in the order of acquisition and acquired in that tax year.
The rules for using the LIFO method are very complex. According to the IRS, two common methods are used to price LIFO inventories are:
1. The dollar-value method. Under the dollar-value method of pricing LIFO inventories, goods and products must be grouped into one or more pools (classes of items), depending on the kinds of goods or products in the inventories.
2. Simplified dollar-value method. Under this method, you establish multiple inventory pools in general categories from appropriate government price indexes. You then use changes in the price index to estimate the annual change in price for inventory items in the pools. An eligible small business (average annual gross receipts of $5 million dollars or less for the three preceding tax years) can elect this method.
Under this pronouncement, an automobile dealer must maintain and retain “complete records” of the computations utilizing the alternative LIFO method. In addition, the dealership must maintain actual purchase invoices for every new vehicle.
This requirement has been generally interpreted to mean that the dealership should retain all invoices and related LIFO computations dating back to the first year for which the alternative LIFO method was elected.
If your dealership made the election to use alternative LIFO years ago, the records should be permanently stored in a secure location. Do not make the common mistake of keeping the records on the business premises. You don’t want to run the risk that the records may be destroyed by a natural disaster or otherwise ruined or stolen.
What is the potential downside? If you don’t keep adequate records, it could lead to expensive tax complications. For instance, good records may help you withstand challenges from the IRS and avoid tax penalties. Also, if you put your dealership up for sale, the buyer may ask you to reduce the price by the amount of the LIFO taxes deferred.
A business using the alternative LIFO method should also:
- Ensure that it permanently maintains copies of the IRS Form 970 originally used for the LIFO election.
- Maintain copies of any IRS Form 3115 requests to change accounting methods.
Practical suggestion: Have the required LIFO records held by your CPA firm, which specializes in automobile dealerships. Don’t assume the firm has the records if you used a different practitioner years ago.