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Supply Chain Woes Put Businesses in Path of Tax ‘Time Bomb’

Dec. 16, 2021, 9:45 AM

The global supply chain disruptions that have limited the availability of everything from new cars to the latest video game consoles are about to cause a tax headache for a wide swath of businesses.

Businesses that sink large amounts of cash into inventory, such as car dealers, equipment rental companies, and grocers, are seen as particularly vulnerable because many use an accounting method known as “last-in, first out,” or LIFO, for valuing their inventory. Normally, that method helps businesses lower their reported income and associated tax bill when prices rise.

Under LIFO rules, a decline in inventory value can trigger a recapture tax, so businesses typically aim to keep their inventories consistent at the beginning and end of the year. But this year, jammed-up supply chains, caused by the economic shock of Covid-19 followed by a surge in demand as vaccinations increase and the economy lurches back to normal, have left many businesses short of inventory and set them up for a much larger than expected tax bill.

Dan Chodan, a partner at Trout CPA in Lancaster, Pa., said one of his clients—a local auto dealer—typically ends the year with $15 million in inventory. This year, they forecast ending the year with roughly $4 million in inventory, if vehicles currently en route arrive in the next two weeks.

“They just can’t get their hands on enough inventory and that’s the driver of a pretty tremendous amount of income that’s going to be realized,” Chodan said. “The industry is probably the strongest it’s ever been in terms of profit margins, but the time bomb that everyone’s worried about is, what do you do when you have nothing to sell?”

The IRS doesn’t have publicly available, current statistics on use of the LIFO method, but the National Automobile Dealers Association estimates approximately 50% of dealerships use the accounting method. The trade group projects that supply chain disruptions will lead to an additional $1.7 billion in taxes for the industry next year.

Valuable Tax Write-Off Impacted

The supply chain crunch is also causing issues for businesses that use the 100% accelerated depreciation tax break created by the 2017 tax law, allowing businesses to quickly write-off long-term assets faster than their value declines.

James River Equipment, a Virginia-based John Deere equipment rental and sales dealer with locations in four states, is one business that has been relying on that tax break to deduct the cost of equipment it rents out. Mark Romer, the company’s president, said delays in the shipment of sales inventory led James River to start selling off the equipment it typically rented, which will force the company to lose out on the valuable depreciation tax break.

“When you can’t get the inventory and you’re still selling, you end up with unusually high taxable profit, because the benefit you had of being able to have accelerated depreciation in your rental fleet evaporates to the extent that your rental fleet shrinks,” Romer said in an interview. “We’ll replace that as soon as we can, but that probably will be later next year.”

The delay in replacing that rental inventory will likely lead to higher than normal taxable income for the company, Romer said.

The looming tax bills will challenge smaller businesses that can’t issue bonds and have less access to easy credit, making it harder for them to cost-effectively borrow if they don’t have enough cash on hand.

“This sort of issue is very acute for small and medium-sized businesses where cash flow matters quite a deal,” said Kyle Pomerleau, senior fellow specializing in federal tax policy at the American Enterprise Institute. “This is another unnoticed impact of the supply chain disruption, on top of the other issues that people are worried about.”

Push for Treasury Action

A coalition of lawmakers and trade groups are pushing the Treasury Department to step in and protect businesses that use LIFO accounting from the brewing tax bill sticker shock.

They point to a provision within the U.S. tax code that grants the Treasury secretary unilateral authority to grant temporary tax relief to LIFO businesses if a “major trade interruption” occurs.

A bipartisan group of 92 members of Congress last month asked Treasury Secretary Janet Yellen to establish a temporary safe harbor for businesses that use the accounting method and face inventory shortages. The requested relief would give businesses three years to restock their inventories to avoid the tax hit.

That safe harbor could give auto dealers enough time to restock their inventory. Paul Walser, chairman of the National Automobile Dealers Association, said people expect the vehicle shortage to ease, but estimated that supplies are roughly “six-to-12 months behind.”

“This inventory shortage is going to be around at least through 2022, and hopefully we’ll be back to normal in 2023,” he said.

No Help Yet

But Treasury has remained noncommittal about using its power to provide the requested relief.

Rep. Dan Kildee (D-Mich.), a member of the House Ways and Means Committee, said Treasury officials have argued that Yellen’s ability to offer the safe harbor is unclear because it would apply to cars produced domestically, but delayed due to a global computer chip shortage.

“I disagree with their assessment,” Kildee said, noting that a shortage in overseas computer chips has been blamed for much of the disruption. “There’s no reason that this can’t be viewed as a pandemic-related emergency.”

A spokesperson for the Treasury Department declined multiple requests for comment.

Chodan, the Pennsylvania accountant, said he understood why Treasury might be reluctant to provide tax relief to auto dealers because most did extremely well in the past year as a more limited supply allowed them to increase their profit margin on the vehicles they did have.

“I’m sure there are already some dealerships who are already at that point, where they were raking in money but now they can’t get product,” said Chodan.

But, Chodan said of Treasury’s lack of action,"I definitely don’t understand the argument that there is no trade disruption.”

To contact the reporter on this story: Colin Wilhelm in Washington at cwilhelm@bloombergtax.com

To contact the editors responsible for this story: Patrick Ambrosio at pambrosio@bloombergtax.com; Cheryl Saenz at csaenz@bloombergindustry.com