How Does Unsold Inventory Affect Your Taxes?

Unsold inventory raises your taxable income because its cost stays parked on your balance sheet as an asset instead of becoming a deductible expense. So how does unsold inventory affect your taxes in practical terms? Every dollar of goods you still hold at year-end is a dollar of cost you cannot deduct yet, which pushes your reported profit up and your tax bill with it. The cost only converts into a deduction, through Cost of Goods Sold, when a customer actually buys the item.

The arithmetic is direct. Beginning inventory, plus purchases and production during the year, minus ending inventory, equals COGS. Revenue minus COGS is gross profit. A higher ending inventory number means less cost flowing into COGS, which means more taxable profit. Overstate ending inventory by $100,000 and you overstate taxable income by the same $100,000. Understate it, and you have hidden real profit from tax, which the IRS treats as a problem of its own.

Because inventory sits at the center of that calculation, federal rules require most businesses that carry it to use the accrual method for purchases and sales, so costs get matched to the revenue they produce rather than deducted the moment a check clears.¹ Once you adopt a method for valuing inventory, you have to apply it consistently year to year; consistency matters more to the IRS than which reasonable method you pick.² Changing later means filing Form 3115.³

The Small Business Exemption Most Owners Should Check First

Before you spend hours on inventory accounting, find out whether you even have to. Section 471(c) of the Internal Revenue Code exempts businesses that pass the gross receipts test from the standard inventory rules. For tax years beginning in 2026, you qualify if your average annual gross receipts over the prior three years do not exceed $32 million.⁴

Qualifying businesses have two simplified options. You can treat inventory as non-incidental materials and supplies, deducting the cost when items are used or sold rather than running a formal beginning-and-ending inventory calculation. Or you can follow whatever inventory method appears on your applicable financial statement, or on your own books and records if you have no audited financials.

The same exemption frees you from the UNICAP capitalization rules covered further down. For most small retailers, contractors, and manufacturers, that means simpler bookkeeping and, often, an earlier deduction for inventory-related costs. Tax shelters are excluded from the exemption regardless of size.⁴

How Your Valuation Method Changes the Tax Bill

If you do not qualify for the exemption, the method you use to assign costs to unsold goods will move your taxable income. The choice determines which purchase prices attach to the stock still sitting on your shelves at year-end.

FIFO

First-In, First-Out assumes the oldest units sell first, so the most recent (and, in an inflationary period, most expensive) purchases stay in ending inventory. That produces a higher ending inventory value, a lower COGS, and a higher current-year taxable income. You pay more tax now but carry a balance sheet closer to current replacement cost.

LIFO

Last-In, First-Out reverses that. It assumes the newest purchases sell first, leaving the oldest and cheapest costs in ending inventory. In an inflationary environment, LIFO pushes higher costs into COGS and defers tax. Electing it requires filing Form 970 with the return for the first year of use.⁵ LIFO inventory must be valued at cost, with no market write-downs allowed.⁶

LIFO also carries a conformity requirement. If you use it on your tax return, you must use it in financial reports to shareholders, partners, and creditors as well. Showing outside parties a FIFO profit while filing a LIFO-based return is not permitted, and violating the rule can force you off the method entirely.⁷⁸

Weighted Average Cost

Weighted average takes the cost of all goods available for sale during the period and averages it out per unit, applying that average to ending inventory. It smooths out price swings and fits businesses selling fungible goods, like bulk chemicals, commodities, or grain, where one unit is indistinguishable from another.

Specific Identification

When items can actually be traced to individual purchase invoices, you can match each unit’s real cost to itself. The IRS allows this when goods are distinguishable.⁹ It suits art galleries, car dealerships, jewelers, and custom manufacturers. If your goods are interchangeable, you need one of the other methods.

Writing Down Damaged, Obsolete, or Unsalable Stock

Inventory that has lost value before it sells can be written down, which raises COGS and lowers taxable income. The rules, though, are stricter than most owners expect.

The main mechanism is valuing inventory at cost or market, whichever is lower, applied item by item. Federal regulations define “market” for normal goods as the current bid price of the cost elements in the inventory: direct materials, direct labor, and required indirect costs.¹⁰

Goods that cannot be sold at normal prices because of damage, defects, style changes, or broken lots follow a separate track. They are valued at their actual offering price minus the direct cost of disposing of them. A bona fide selling price, in the IRS’s terms, is an actual offering made within 30 days after the inventory date.² Raw materials or work in process are valued on a reasonable basis considering usability and condition, but never below scrap value.

Where most write-down claims fall apart: the IRS wants verifiable action, not an internal journal entry. You need to actually offer the goods at the reduced price or physically scrap them. Booking an obsolescence reserve and taking a deduction against it will not survive audit. The burden is on you to keep records showing how the goods were disposed of and why the reduced value was justified.²

One important boundary: if you use LIFO, the lower-of-cost-or-market method is not available to you. LIFO inventory must stay valued at cost regardless of what the market is doing.⁸ That trade-off is worth understanding before electing LIFO.

Inventory Lost to Theft or Shrinkage

Missing inventory is different from devalued inventory. When goods are gone rather than just worth less, the loss reduces your ending inventory count, which automatically raises COGS and lowers taxable income. The IRS still expects specific documentation.

For theft, the taking must be illegal under the law where it happened and must have been done with criminal intent.¹¹ The deductible amount equals the adjusted basis of the stolen inventory minus any insurance reimbursement or salvage value received or expected. For business inventory, adjusted basis is typically cost, with UNICAP adjustments if applicable. Business theft and casualty losses go on Section B of Form 4684. Keep police reports, incident records, insurance correspondence, and physical count records.

Routine shrinkage from spoilage or counting errors is handled through your regular inventory process. The IRS allows businesses to use shrinkage estimates confirmed by a physical count after year-end, so long as the counts are done regularly and consistently and estimating methods are adjusted when estimates diverge from actual results.¹²

UNICAP for Larger Businesses

The Uniform Capitalization rules under Section 263A require certain manufacturers and resellers to fold indirect overhead into the value of their inventory rather than deducting those costs immediately.¹³ The statute requires capitalizing both direct costs and a proper share of allocable indirect costs on property produced or acquired for resale.

Typical UNICAP additions include storage and warehousing, purchasing department expenses, handling and processing labor, and portions of administrative overhead tied to production or acquisition. Those costs sit locked inside ending inventory value until the associated goods sell, at which point they finally flow through COGS. For slow-moving inventory, the gap between paying overhead and deducting it can run into years.

Small businesses that pass the Section 448(c) gross receipts test are fully exempt from UNICAP, the same $32 million threshold that exempts them from the standard inventory accounting rules for 2026.¹⁴ Under the threshold, indirect costs are deductible as incurred.

Donating Unsold Inventory Instead of Scrapping It

Donating obsolete or excess inventory to a qualified charity can produce a deduction that scrap value cannot match. C corporations get the strongest treatment under Section 170(e)(3). When a C corporation donates inventory to a 501(c)(3) that uses the goods in furtherance of its exempt purpose, the deduction equals cost basis plus half the difference between cost basis and fair market value, capped at twice the cost basis. Inventory that cost $10,000 and is now worth $20,000 would generate a $15,000 deduction rather than $10,000.

S corporations, partnerships, and sole proprietorships generally deduct only cost basis on donated inventory. Their total charitable contribution deduction for inventory donations is also limited to 10 percent of aggregate net income from the trades or businesses that made the contributions.

Any donation valued above $5,000 requires a qualified appraisal and Section B of Form 8283. The charity must give you a written acknowledgment describing the property and confirming that no goods or services were received in return. Donated items must be in usable condition and meet applicable quality or safety standards.

State Personal Property Tax on Inventory

Federal income tax is not the only exposure. Roughly a dozen states treat business inventory as taxable personal property and impose an annual tax based on the value of goods on hand. Others exempt inventory fully or partially. Where inventory tax applies, you pay it every year on unsold stock, on top of the federal consequences already described. Businesses with large seasonal inventory or slow turnover feel it most. Multi-state operations should check each location’s rules, since treatment varies significantly.

What It Costs to Get Inventory Valuation Wrong

Inventory errors do more than distort a return. They trigger the accuracy-related penalty under Section 6662, which adds 20% to any tax underpayment caused by negligence, disregard of rules, or a substantial understatement of income. For most taxpayers, a substantial understatement means the understatement exceeds the greater of 10% of the tax that should have been shown or $5,000.¹⁵

Inventory manipulation is one of the most common triggers, because inflating or deflating ending inventory changes taxable income dollar for dollar. Understate ending inventory by $200,000 and you have hidden $200,000 of profit. The IRS treats any failure to make a reasonable attempt to comply as negligence, and reckless disregard of the inventory regulations qualifies without difficulty.

The penalty can be reduced or eliminated if you had substantial authority for the position or adequately disclosed the relevant facts on your return with a reasonable basis. Those defenses are worth knowing about, but leaning on them after the fact is far less reliable than valuing the inventory correctly the first time.

1
eCFR. 26 CFR 1.446-1 – General Rule for Methods of Accounting
2
eCFR. 26 CFR 1.471-2 – Valuation of Inventories
3
Internal Revenue Service. About Form 3115, Application for Change in Accounting Method
4
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
5
Internal Revenue Service. About Form 970, Application to Use LIFO Inventory Method
6
Office of the Law Revision Counsel. 26 USC 472 – Last-In, First-Out Inventories
7
Internal Revenue Service. LIFO Conformity Requirement
8
eCFR. 26 CFR 1.472-2 – Requirements Incident to Adoption and Use of LIFO Inventory Method
9
Internal Revenue Service. Publication 538 – Accounting Periods and Methods
10
GovInfo. 26 CFR 1.471-4 – Inventories at Cost or Market, Whichever Is Lower
11
Internal Revenue Service. Topic No. 515, Casualty, Disaster, and Theft Losses
12
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
13
Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
14
GovInfo. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
15
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty