LIFO in the Oil Patch

The Wall Street Journal had a really nice piece about how it’s a well known “secret” that the oil industry uses LIFO accounting rules to reduce their tax bill.   (this strategy only works when oil prices are going up.) LIFO stands for “last-in first-out” which means you value the inventory based on the cost of the most recent oil purchase.  The Journal article explains,

“Oil inventories are typically valued each year using prices at the start of the year, said Les Schneider, partner at the Washington, D.C., law firm Ivins, Phillips & Barker and an expert on inventory taxation. If a refiner builds up one million barrels of oil inventories over the course of 2009, it could value that crude at the January 2009 price of roughly $40 a barrel. But if the refiner ends 2010 with 1.5 million barrels in storage, the additional 500,000 barrels would be valued at around $80 a barrel, the January 2010 price.”

 The cost of that sold inventory reduces the company income, which in turn reduces the amount of income tax paid.  The article points out that this practice is so widespread that even as supply levels go down at the end of the year, prices don’t follow at the same rate.  Investors not in the know (like me) can be fooled into thinking there’s a price spike coming, when in fact inventories will make their way back at the start of the year because actual demand hasn’t changed.

Speaking of demand, the Journal had another tidbit on this topic in Heard on the Street this week.  Apparently the President’s deficit commission decided this earnings management tool is an area where the Treasury department might pick up some bucks.  Among their recommendations was a proposal to disallow LIFO for anyone.  The report focused on the oil companies’ current LIFO reserves, which are estimated to be worth about $10 billion in additional tax dollars if this accounting principle were to be eliminated. 

Of course oil companies aren’t the only people to use LIFO.  The article goes on to say the AICPA estimates about 36% of companies value their inventory that way.  Tax issues aside, LIFO is considered by many astute financial types to be the most accurate form of reporting inventory value.  The logic is that bias toward the current price of whatever the company sells is a more realistic snapshot of the company’s  current financial prospects. 

While there may be a tax advantage to LIFO in an inflationary period, or when the price of your inventory is rising, the opposite is also true.  Presumably whoever wrote the report must have heard that the big fear these days is actually deflation, so eliminating LIFO in that scenario won’t help the deficit at all.  What happened to all the talk about reducing the deficit by cutting complexity in the tax code?



Tips on Tipping

I’m not a US News & World Report subscriber, though I admit they’re often a first choice when I’m at the airport news stand.  I stumbled on their piece about appropriate amounts to tip at year end, and thought I would pass along the key points.  This is always a “nail-biter” for me.  I want to show my appreciation.  I value courtesy and think it’s important to extend it whenever possible.  However, it’s not obvious to me how one determines where the number is between doing a Scrooge imitation or acting like Daddy Warbucks. 

 So here’s the scoop according the US News:

• The postman can get up to $20, but it’s OK to leave cookies or a little gift instead.  Newspaper delivery came in a little understand the postman with a $10 to $20 recommendation.  For the garbage truck they recommended $20 for each person on the truck.  (Oops, I’ve definitely under done that one for years.) 
• They suggest collaborating with other parents to come up with between $100 to $300 for daycare.  (I always did cookies for that!) 
• For your cleaning lady or any other personal service provider you see at least once a month (massage, personal trainer, etc.) they recommend the value of one visit.

 

Of course, the minute someone puts a number on something I have this uncontrollable impulse to benchmark.  Kiplinger recommendations run along the same lines as US News, though they did suggest just $25 to $75 for the day care provider.  (I still think a personal gift is a better bet for that one.)  Another area of difference from US News was a flat rate of $50 for a personal trainer and the cost of one visit for your hairstylist.  Interestingly the Kiplinger folks opine that if the provider of personal services acts as a confidant as well as their official job title, you should throw in a little extra. 

 Martha Stewart had a few ideas surprised me.  She frowns on giving home-made gifts in lieu of a holiday tip, which she suggests should be only for friends and family.  OK, so not everyone can be Martha Stewart, but if you take the time to make something, I think it sends a nice message.  Oh well, one of us is famous for our social suggestions, and it’s not me.  So I guess I’ll hang up my glue gun.   I will agree with Martha on another topic.  She said no need to send some cash back to your accountant if you appreciate the job done on the tax return.  Just a thank you card and repeat business will do. 

The final note in the US News article is one I have argued for years – the standard tip now is 20%.  15% is archaic.  I joined the 20% club after finding the right answer to the New York Times crossword puzzle clue on standard tip amount was – 20%.

Going Where the Money Is

Even if you’ve not been impacted by Justice Department’s investigation of insider trading, here’s a new potential notice to worry about.  The IRS is in the process of launching it’s Employment Tax National Research Project.   The research plan is to audit 6,000 companies selected at random on the general topic of the compliance characteristics of employment tax filers.  In case you’re wondering why this is a priority, the taxes collected through employers come to $1.7 trillion a year.  This is almost 72% of the annual revenue of the US treasury.   So yes,  it appears the study is worth doing “because that’s where the money is” .

The first 2,000 “lucky” companies have gotten their audit notices already.   This will be an annual event for the next two years, so you still may be selected.  The stated goal of the study sound reasonable.  The IRS estimates a “tax gap”, which they define as the difference between the amounts taxpayers should pay and what they actually send in as payment.  The IRS typically targets audits hoping to reduce this tax gap.  There is a concern that in the 25 years since the IRS last looked at likely causes of “tax gap” associated with employment taxes much has changed in how companies process these payments.  So the first goal is to determine if current estimates of this tax gap on target, and then, perhaps more importantly to figure out what areas of employment tax lead to the most compliance problems. 

While the agency indicates that the audits are going to be comprehensive, there are apparently four areas that will be targeted for scrutiny:  worker classification (this goes to the question of whether you’re an employee or contractor), executive compensation, fringe benefits and payroll taxes.  According to the Thompson Bulletin, law-abiding companies who are included in these random samples will have to provide significant amounts of information and will need to allocate specific resources to meet the IRS requirements for data.   Compliance Week  passes on the following:

  In its alert to employers the IRS advises companies to plan their response carefully should they receive a letter initiating an audit under the research program. The IRS says companies should form an internal team consisting of representatives from payroll, accounts payable, accounting, human resources, internal auditing, general counsel, and outside tax professionals.

If you’re not getting scrutiny on this topic now, it’s worthwhile to add doing some internal due diligence on the area of employment tax compliance as a New Year’s resolution.   Better to catch your issues yourself rather than have the IRS do it for you. 

What is Appropriate Compensation?

Although the future of the tax code is all the talk these days, an article that appears in this month’s The Tax Adviser turned my attention to a different topic.  It’s a discussion of a recent Tax Court ruling about what constitutes reasonable compensation for employees of a closely held corporation.  I may not know what marginal tax rate will be associated with said compensation, but at least this a topic accountants can discuss with clients today without waiting for an act of Congress before expressing an opinion.

According to the article there are five factors that have emerged from Tax Court rulings that form the basis of current thinking about what the IRS will look at in assessing whether compensation is “in the money” or not.  The five factors are:

-       What the employee actually does in the company

-      A comparison with similar positions at similar firms

-      The character and condition of the company

-      Potential conflicts of interest, and

-      Internal consistency of compensation. 

Looking at the first two seems the most objective and therefore what I think most accountants would gravitate toward in terms of emphasis.  (It may be a misplaced stereotype, but I do think accountants tend to be objective.)  In this case though (Multi-Pak Corp., T.C. Memo. 2010-139) the case turned on the interpretation of the potential conflict of interest. 



The test used to assess if there is a conflict of interest is, would a “hypothetical independent investor” think the compensation was reasonable.  The alternative would be our friend H.I. Investor thinking that management is siphoning money out of the company disguised as salary. In this particular case in one year the compensation met the criteria, but in the year the salary payments would have resulted in an almost 16 percent negative return on equity, the court said it agreed with the IRS that the company’s amount of deductible compensation to the CEO had to be reduced. 

Now if we can just here from H.I. on the topic of S-Corporation owners taking too little compensation….

It's Patch Time for AMT

It was both good news and contributed to my apprehension to see the bi-partisan pledge to pass the AMT patch.  This patch is designed to adjust for inflation an essentially incomprehensible tax that is supposed to prevent millionaires from sheltering too much income.  It became law in 1969 without any adjustment feature, and that creates the need to repeatedly do something in Congress or create a situation where people who are far from millionaires end up paying extra taxes.  So far this year there's no legislation that addresses this issue, and since we're running out of days left in the year, the  Congressional leadership decided to issue this pledge.

The pledge is better than nothing, but it seems like it would have been easier to just pass the legislation in a timely manner.  Of course if there is a problem with getting the legislation passed, then this pledge looks like nothing more than good intentions.  And we know what road is paved with those.

The issue is not a small one.  A report released last week by the Congressional Research Service quotes the Tax Policy Center as projecting that without the patch, the number of taxpayers with small business income who fall into AMT will be higher than those who don’t.  This same report shows that sans patch the amount of small business income (this is the dollars not the people) that is taxed will be 4 times the amount that is taxed at the 36% bracket.  I don’t want to dismiss the Bush tax cut discussion around small business, but in terms of impact the AMT patch issue seems more important to business owners.  (Presumably people who sit on the tax related committees of Congress are thinking along the same lines, which prompted the “pledge”). 



If the proposed legislation passes, it would allow for personal credits against the AMT and the exemption amounts for 2010 to be set at $72,450 for those married filing jointly and $47,450 for individuals.  Without the patch legislation the exemption falls to $45,000 for joint filers and $33,750 for single filers.   

The Tax Policy Center blog points out that this waiting until the last minute is not new behavior. In fairness making the decision to add the patch will cost the government serious money. No patch and the result should be about $90 billion in total taxes. The Tax Policy Center estimates that about $70 billion of that goes away if the patch is in place. So you can see where there some natural foot dragging associated with passage. Still for those of us paying the tax (if there no patch the Congressional Budget Office estimates that 20 percent of all taxpayers and 40 percent of married couples will fall into AMT) the idea that this tax only impact millionaires makes this more of a foot stomping exercise.