How Does Inventory Affect Taxes: COGS, Valuation, and Write-Downs

Inventory affects your taxes because the value you assign to unsold goods at the end of the year sets your Cost of Goods Sold, and Cost of Goods Sold is the largest deduction most product businesses take against sales revenue. A lower ending inventory pushes more cost into COGS and shrinks taxable income; a higher ending inventory holds cost back on the balance sheet and raises the tax bill. Which valuation method you use, whether you qualify for small business simplifications, and how you treat damaged or donated stock all move that number.

The COGS Math

Cost of Goods Sold has a simple formula: beginning inventory, plus purchases during the year, minus ending inventory. Whatever you don’t count as ending inventory has been “sold” for tax purposes and reduces revenue.

That makes ending inventory the pressure point. Assign a lower value to what’s on the shelves December 31, and COGS goes up, gross profit goes down, and so does the tax owed. Assign a higher value and the opposite happens. The IRS pays close attention to this number because small changes in valuation move real money.

Federal tax law generally requires any business where selling merchandise is an income-producing factor to keep inventories and use the accrual method for purchases and sales.¹ Smaller businesses get an exception, covered below.

How Valuation Methods Change the Tax Bill

You can’t just pick a number for ending inventory. You have to apply a cost-flow assumption — a consistent rule for deciding which of the costs sitting in inventory get expensed first. The assumption doesn’t have to match how goods physically move. It’s an accounting choice with tax consequences, and once you pick it, you’re expected to stick with it.

First-In, First-Out (FIFO)

FIFO treats your oldest purchases as the first ones sold. The costs from your earliest buys flow into COGS, and the newest costs stay in ending inventory.²

When prices are rising, that means a lower COGS deduction and a higher taxable profit than you’d get under other methods. The balance sheet looks strong, because ending inventory reflects near-current costs, but you pay more tax in the current year.

Last-In, First-Out (LIFO)

LIFO flips it. The most recent purchases are treated as sold first, so during inflation the highest costs land in COGS and taxable income drops.²

The catch is the LIFO conformity rule. If you use LIFO on your federal return, you must also use it in the financial statements you give to shareholders, partners, and creditors.³ You can’t show investors a healthier FIFO profit and tell the IRS the LIFO story. If the IRS finds a different method in reports to outside parties, it can revoke your LIFO election.⁴

LIFO users also can’t write inventory down to the lower of cost or market. LIFO inventory must be carried at cost.² When market prices drop, that removes a tool other businesses have for accelerating deductions.

Average Cost

The average cost method blends every purchase into a single weighted average and applies it to every unit sold. It smooths out price spikes and lands somewhere between FIFO and LIFO on the tax scale. Businesses that move large volumes of interchangeable goods often prefer it because tracking individual purchase lots isn’t practical.

When You Qualify as a Small Business Taxpayer

Not every business selling goods has to follow the full inventory regime. If your average annual gross receipts for the prior three tax years are at or below the Section 448(c) threshold, you’re a small business taxpayer with access to simplified methods. For tax years beginning in 2026, that threshold is approximately $32 million.⁵ Tax shelters don’t qualify regardless of size.

Two significant breaks come with that status:

You can skip formal inventory accounting. Instead of applying FIFO, LIFO, or average cost, you can treat inventory as non-incidental materials and supplies and deduct the cost when items are used or consumed. Or you can follow whatever inventory method your audited financial statements use, or if you don’t have audited financials, whatever your internal books use.⁵
You’re exempt from the Uniform Capitalization rules described below, so indirect production and acquisition costs don’t have to be pushed into inventory value.⁶

If your receipts sit near the threshold, remember to aggregate the gross receipts of all related entities under common control when you test whether you qualify.

UNICAP: When the Rules Get Harder

Businesses above the small-business threshold have to apply Section 263A, known as UNICAP. The rule prevents you from immediately deducting many indirect costs as operating expenses. Those costs instead get added to inventory value and only reach COGS when the inventory sells.⁶

UNICAP applies to manufacturers and to resellers. The indirect costs that must be capitalized reach well past purchase price and direct labor: warehouse rent, depreciation on production equipment, factory utilities, quality control labor, insurance on inventory, purchasing department overhead. For resellers, receiving, handling, and storage costs also fold into inventory value.

The effect is timing. You still deduct these costs eventually, but not until the inventory they attach to produces revenue. Businesses holding large amounts of slow-moving stock feel the deferral in higher current-year tax.

Writing Down Damaged or Obsolete Inventory

When inventory loses value from damage, obsolescence, or a market price drop, you don’t have to wait until the goods sell to recognize the loss. The main tool is the lower of cost or market (LCM) rule.⁷

Under LCM, you compare each item’s original cost to current market value and carry it at whichever is lower. Market value here means the current bid price for the goods in the quantities you normally purchase.⁸ The write-down flows into higher COGS and lowers taxable income for the year. LIFO users can’t use LCM.

For inventory that’s genuinely worthless — severely damaged goods, dead SKUs, expired product — you can take a full write-off. The IRS wants proof the goods have been permanently removed from your usable assets, which usually means scrapping, destroying, or donating them and keeping records of what happened. Subnormal goods that still have some value can be written down to their actual selling price minus the direct cost of selling them, but not below scrap value.⁸ Without documentation, the IRS will generally disallow the deduction until the goods are actually sold or disposed of.

Donating Inventory for a Larger Deduction

Donating inventory to charity can produce a deduction that exceeds your cost basis. Under Section 170(e)(3), a C corporation that donates inventory to a qualified 501(c)(3) can take an enhanced deduction, provided the charity uses the property solely for the care of the ill, the needy, or infants and doesn’t resell it.⁹

The enhanced amount is your cost basis plus half the difference between cost basis and fair market value, capped at twice cost basis. Goods that cost $10,000 and are worth $20,000 at fair market value would produce a $15,000 deduction: the $10,000 cost plus half the $10,000 spread.

Food inventory follows more generous rules. The PATH Act of 2015 permanently extended the enhanced food-donation deduction to all business types, including S corporations, partnerships, and sole proprietors.¹⁰ For a business that routinely disposes of unsold food, donating it rather than throwing it out produces a materially better tax result.

Either way, you need a written acknowledgment from the charity confirming the donation and that no goods or services were given in return. Donations over $5,000 in fair market value generally require a qualified appraisal and Section B of Form 8283.

Estimating Shrinkage

Retail and wholesale businesses lose inventory to theft, spoilage, miscounting, and damage. You can estimate that shrinkage at year-end instead of doing a physical count on the last day of the tax year, but only if you meet two conditions: you conduct physical counts at each location on a regular and consistent basis, and you adjust your estimates when actual counts show they were off.⁵

Estimated shrinkage reduces ending inventory, increases COGS, and lowers tax. Where businesses get into trouble is estimating aggressively without ever reconciling to a real count, which is an easy audit target.

State Inventory Taxes

Federal income tax is not the only way inventory hits your bill. Roughly a dozen states impose personal property taxes on business inventory as part of their tangible personal property tax, levied on the value of inventory you hold as of a specific assessment date and owed whether or not the business turned a profit. Most states have fully or partially repealed inventory taxes, but if you operate in one that hasn’t, holding extra stock in that jurisdiction adds a tax cost on top of the federal timing effects above.

Reporting and Penalties

Corporations, S corporations, and partnerships that claim COGS complete Form 1125-A and attach it to their return, reporting beginning and ending inventory, purchases, labor, other costs, and the valuation method used.¹¹ Sole proprietors report COGS directly on Schedule C.

Switching valuation methods requires filing Form 3115 with the IRS; you can’t just start calculating differently.¹²

Inventory errors that understate tax can trigger the accuracy-related penalty of 20% of the underpaid amount. For individuals, a substantial understatement exists when the understated tax exceeds the greater of 10% of the correct tax or $5,000. For corporations other than S corporations, the threshold is the lesser of 10% of the correct tax (or $10,000 if greater) and $10 million.¹³

Documentation is what protects the deduction: physical count records, purchase invoices, your allocation method for indirect costs if UNICAP applies, and evidence of any write-downs or dispositions. The IRS puts the burden of substantiation on the taxpayer, and reconstructing inventory records after the fact rarely holds up.

1
eCFR. 26 CFR 1.471-1 – Need for Inventories
2
Internal Revenue Service. IRS Publication 538 – Accounting Periods and Methods
3
Office of the Law Revision Counsel. 26 USC 472 – Last-In, First-Out Inventories
4
Internal Revenue Service. LIFO Conformity Requirement
5
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
6
Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
7
eCFR. 26 CFR 1.471-4 – Inventories at Cost or Market, Whichever Is Lower
8
Internal Revenue Service. Form 1125-A, Cost of Goods Sold
9
Office of the Law Revision Counsel. 26 USC 170 – Charitable, Etc., Contributions and Gifts
10
United States Department of Agriculture. Federal Incentives for Businesses to Donate Food
11
Internal Revenue Service. About Form 1125-A, Cost of Goods Sold
12
Internal Revenue Service. About Form 3115, Application for Change in Accounting Method
13
Internal Revenue Service. Accuracy-Related Penalty