How to Minimize the S Corporation LIFO Recapture Tax

• Learn the difference in reporting inventory with LIFO vs FIFO.
• Find ways to soften the blow of the recapture tax triggered by converting your C corporation to an S corporation.

Considering converting your C corporation to an S corporation? Be aware that there may be tax implications if you’ve been using the last in, first out (LIFO) inventory method. Why? Because of the LIFO recapture income triggered by converting to S corporation status. Your Fiducial representative can compute what the tax on this recapture would be. They can also help you plan steps to minimize it.

Inventory reporting in LIFO vs FIFO

Your corporation has likely been reporting a lower amount of taxable income under LIFO than it would have under the first in, first out (FIFO) method. The reason? The inventory taken into account in calculating the cost of goods sold under LIFO reflects current costs, which are usually higher.

This benefit of LIFO over FIFO equals the difference between the LIFO value of inventory and the higher value it would have had if you had used the FIFO method. In effect, the tax law treats this difference as though it were profit earned while the corporation was a C corporation. To make sure there’s a corporate-level tax on this amount, it must be “recaptured” into income when the corporation converts from a C corporation to an S corporation. Also, the recapture amount will increase the corporation’s earnings and profits, which can have adverse tax consequences down the road.

Soften the blow

There are a couple of rules that soften the blow of this recapture tax to some degree.

1. You may pay the increase in tax imposed on the C corporation in its final tax year because of the LIFO recapture over a four-year period.
2. The basis of the corporation’s inventory will increase by the amount of income recognized. So, the net effect may be one primarily of timing. Because of the basis increase, the corporation may realize less income in later years. This is only true if there are decrements in the adjusted LIFO layer.

We can help you gauge your exposure to the LIFO recapture tax. We can also suggest strategies for reducing it. There are also other considerations beyond LIFO recapture in converting a C corporation to an S corporation, such as exposure to the Built-in Gain tax. Want to discuss these issues in detail? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.

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