Do I Have to Report Inventory on My Taxes?

If your business buys or produces goods for resale, you generally have to account for inventory when reporting on your taxes, because the value of what you have on hand at year-end drives your Cost of Goods Sold and therefore your taxable income.¹ There is a large exception. Businesses with average annual gross receipts of $31 million or less (for 2025, adjusted annually for inflation) can skip traditional inventory accounting and use a simplified method instead.²

Who Actually Has to Track Inventory

The rule from the regulations is simple. If buying, producing, or selling merchandise is a factor in generating your income, you need inventories at the beginning and end of each tax year.¹ Retailers, wholesalers, and manufacturers all sit squarely inside this rule because their revenue comes from selling tangible products.

Service businesses generally do not maintain inventory. A consulting firm or a law practice earns from labor and expertise, not merchandise. The gray zone is a service business that also sells some products, like a salon retailing shampoo. If the merchandise is a material income-producing factor, inventory accounting applies. Where product sales are incidental, it usually doesn’t.

One arrangement catches sellers off guard: consignment. The supplier who places goods with a retailer on consignment still owns those goods until they sell. The supplier carries the consignment inventory, not the retailer. The retailer only records commission income when the goods actually move.

The Small Business Exception Most Sellers Qualify For

Most small businesses never need to wrestle with formal inventory accounting. Under IRC Section 471(c), any business that meets the gross receipts test in Section 448(c) can opt out of traditional inventory rules.² You qualify if your average annual gross receipts over the prior three tax years do not exceed $31 million (for 2025; the IRS adjusts this annually).³ The statutory base is $25 million, indexed from 2018.⁴ Tax shelters do not qualify regardless of size.

Qualifying businesses get two simplified options. The first is the non-incidental materials and supplies method: you treat inventory as materials and supplies and deduct the cost when the items are sold, or when you pay for them, whichever is later. The second is financial statement conformity: you follow whatever inventory method appears on your audited financial statements, or on your internal books and records if you don’t have audited financials.

The materials and supplies approach is the more common choice for small retailers and online sellers because it effectively lets you handle inventory on a cash basis. You adopt it by using it on your timely filed return. If you’re switching from a traditional inventory method, the IRS treats the change as one made with its consent, so you don’t have to go through the usual approval process for the initial switch.²

The same gross receipts threshold also exempts qualifying businesses from the Uniform Capitalization (UNICAP) rules under Section 263A, which otherwise require you to capitalize certain indirect costs into inventory.⁵ Between these two exemptions, most of the complexity around inventory reporting drops away for a small business.

How Cost of Goods Sold Works

When you do use traditional inventory accounting, Cost of Goods Sold is the number that matters. COGS is what you spent to acquire or produce the goods you sold during the year, and it gets subtracted from gross receipts to determine gross profit. The formula is: beginning inventory, plus the cost of goods purchased or produced during the year, minus ending inventory.

The costs that go into inventory are broader than just the invoice price. You include everything needed to get the goods to a saleable condition and location: direct materials, direct labor, and inbound shipping (often called freight-in). Shipping goods out to a customer is a separate selling expense, not an inventory cost.

For businesses above the $31 million threshold, UNICAP requires capitalizing a share of indirect costs into inventory rather than deducting them currently.⁵ Those costs sit on the balance sheet as part of inventory value until the goods are sold, then flow through as COGS. Costs unrelated to production or acquisition, such as advertising, sales commissions, and outbound shipping, stay deductible in the year incurred.

Accuracy carries into the next year. Your ending inventory becomes next year’s beginning inventory, so an error in one year distorts the following year’s COGS in the opposite direction. Overstating ending inventory understates COGS and inflates taxable income now. Understating does the reverse. If your beginning inventory differs from last year’s reported ending inventory, Schedule C requires you to attach an explanation.⁶ A mismatch without a credible explanation is a red flag, and if the prior year was genuinely wrong, amending that earlier return is the cleanest fix.

Valuation Methods You Can Use

Two questions drive valuation: what basis do you use for each item, and what cost-flow assumption applies when identical items were bought at different prices?

The IRS accepts two valuation bases. The cost method uses the actual price you paid. The lower of cost or market method compares that cost against current replacement cost and uses whichever is lower, which lets you recognize a drop in value before you sell. Whichever you pick, you must apply it consistently year to year; the IRS weighs consistency more heavily than any particular method.⁷ Businesses using the simplified small-business method under Section 471(c) cannot use LIFO or LCM.

For cost-flow, the accepted approaches are:

First-In, First-Out (FIFO), which assumes the oldest inventory sells first. In a rising-price environment, FIFO produces lower COGS and higher taxable income.
Last-In, First-Out (LIFO), which assumes the newest inventory sells first. When prices are rising, LIFO produces higher COGS and lower taxable income.
Specific identification, which tracks each item’s actual cost. It suits high-value, one-of-a-kind goods like custom furniture, and is impractical for commodities.

LIFO carries a conformity requirement. If you use it on your tax return, you must also use it on your financial statements and in reports to shareholders or creditors.⁸ You can’t claim the LIFO tax benefit while showing lenders more favorable FIFO numbers.

Once you’ve adopted a method, switching requires IRS consent through Form 3115, Application for Change in Accounting Method.⁹ Changing without filing Form 3115 is one of the fastest ways to trigger an IRS-imposed adjustment.

Where Inventory Goes on Your Return

Where you report COGS depends on your business structure. The idea is the same across forms: show how you got from gross receipts to gross profit.

Sole Proprietors and Single-Member LLCs

If you’re a sole proprietor or a single-member LLC filing as a disregarded entity, you report COGS in Part III of Schedule C (Form 1040).¹⁰ The walkthrough:⁶

Line 35: beginning inventory, which must match last year’s ending inventory.
Line 36: purchases, minus any items withdrawn for personal use.
Lines 37–39: cost of labor, materials and supplies, and other costs.
Line 40: total of lines 35 through 39, the goods available for sale.
Line 41: ending inventory, valued using your chosen method.
Line 42: COGS (line 40 minus line 41), which carries to line 4 of Schedule C.

Line 33 also asks which valuation method you used for ending inventory: cost, lower of cost or market, or another method.

Corporations, S-Corps, and Partnerships

C corporations filing Form 1120, S corporations filing Form 1120-S, and partnerships filing Form 1065 all report COGS on Form 1125-A, Cost of Goods Sold.¹¹ Form 1125-A requires a detailed breakdown, including beginning inventory, purchases, labor, additional Section 263A costs where applicable, and ending inventory. The resulting figure transfers to line 2 of the main return.¹²

What Happens If You Get It Wrong

Errors on inventory can cost more than the tax you should have paid. If the IRS determines your accounting method doesn’t clearly reflect income, it has authority under Section 446(b) to recompute your taxable income using whatever method it considers appropriate.¹³ That recomputation usually means a higher bill plus interest from the original due date.

Substantial inventory valuation errors that lead to a significant underpayment can trigger an accuracy-related penalty of 20 percent of the underpaid amount under Section 6662.¹⁴ The penalty covers underpayments from valuation misstatements, negligence, or substantial understatement of income tax.

Changing methods without filing Form 3115 is treated as an unauthorized change. When the IRS catches this in an examination, it imposes the change on its own terms and the taxpayer has no right to a retroactive correction.¹⁵ Not asking permission also doesn’t shield you from penalties. Section 446(f) explicitly blocks taxpayers from using the lack of IRS consent as a defense against penalty assessments.¹³

Records You Need to Keep

The IRS requires records that substantiate the income and expenses on your return, and inventory is no exception. Keep inventory-related records for at least three years from the date you filed, which matches the standard audit window. If you underreport income by more than 25 percent of the gross income shown on the return, the assessment window extends to six years.¹⁶

For inventory, records mean more than a year-end number. Keep purchase invoices, production cost records, physical count worksheets, and documentation of whichever valuation method you used. Because ending inventory rolls into next year’s beginning inventory, a gap in one year’s records can cascade into audit problems for several years. Holding inventory records for at least six years is a sensible baseline for any business where inventory is a significant asset.

1
eCFR. 26 CFR 1.471-1 – Need for Inventories
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Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
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Internal Revenue Service. Revenue Procedure 2024-40
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Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting
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Office of the Law Revision Counsel. 26 US Code 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
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Internal Revenue Service. Schedule C (Form 1040) – Profit or Loss From Business
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eCFR. 26 CFR 1.471-2 – Valuation of Inventories
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Office of the Law Revision Counsel. 26 US Code 472 – Last-In, First-Out Inventories
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Internal Revenue Service. About Form 3115, Application for Change in Accounting Method
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Internal Revenue Service. About Schedule C (Form 1040), Profit or Loss From Business
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Internal Revenue Service. About Form 1125-A, Cost of Goods Sold
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Internal Revenue Service. Instructions for Form 1120
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Office of the Law Revision Counsel. 26 US Code 446 – General Rule for Methods of Accounting
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Office of the Law Revision Counsel. 26 US Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments
15
Internal Revenue Service. 4.11.6 Changes in Accounting Methods
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Internal Revenue Service. Topic No. 305, Recordkeeping