Last-In, First-Out (LIFO) inventory deductions allow companies to deduct the cost of inventory at the price of the most recently acquired items and assumes that the last inventory purchased is the first to be sold. LIFO limits the impacts of volatile prices or inflation and lowers the tax cost of new inventory.
How Does Last-In, First-Out (LIFO) Work?
Under current law, businesses generally cannot deduct the cost of capital investments when they purchase them. Similarly, businesses cannot deduct the cost of inventories when they first produce or purchase them. Instead, businesses must deduct the cost of inventories when they are sold. Sometimes, however, different units of inventory cost different amounts than when they were produced or purchased, so the correct value of the deduction is not immediately obvious.
Businesses are generally allowed to choose among three methods when calculating their cost in a given year: First-in, First-out (FIFO); Last-in, First-out (LIFO); and Weighted-Average Cost.
In general, prices in the economy rise over time. By reducing the time between when a unit of inventory is acquired and when its costs are deducted, LIFO prevents inflation from reducing the real value of the deductions for the costs of goods sold.
A business normally maintains or increases its level of inventory, continuously replacing inventory as it is sold. If it uses LIFO, it continues to deduct the cost of the last inventory purchased, and it appears to never sell the earliest inventory purchased (at least on paper). Economically speaking, LIFO comes closest to deducting the full real value of inventory acquisition.
According to the Tax Foundation’s General Equilibrium Model, the elimination of Last-in, First-out accounting for write-offs of future inventory would raise the cost of capital and reduce economic growth, for a relatively small increase in revenue.
Unless a special provision were made, LIFO repeal would also retroactively tax a company’s “LIFO reserve.” This additional tax could hit cash-strapped companies particularly hard and could result in tens of thousands of additional job losses in the short run.
An Example of Last-In, First-Out (LIFO)
Suppose a business purchases three units of inventory throughout the year at three different prices ($30, $31, and $32). The company sells one unit of its inventory at $40.
Under LIFO, a business assumes that the last inventory purchased is the first to be sold. In this case, the business is assumed to have sold the last unit purchased for $32, so the amount the business can deduct against taxable income is $32. This results in $8 of additional taxable income.
When the business sells the next unit of inventory, it would then deduct the cost of the second unit for $31; and on the third sale, it would deduct the first unit purchased for $30.
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