How to Expense Inventory Under the Small Business Exception

If your business carries inventory and your average annual gross receipts stay under the inflation-adjusted threshold, you can expense inventory under the small business exception in Section 471(c) of the Internal Revenue Code, deducting those costs when you pay or incur them instead of capitalizing them and recovering them later through cost of goods sold. For tax years beginning in 2026, the receipts ceiling is $32 million.¹ The election gets you faster deductions, simpler books, and an exemption from the Uniform Capitalization rules that normally force overhead into inventory.

Do You Qualify

Eligibility runs on two gates. Clear both, and the election is available.

The Gross Receipts Test

Your average annual gross receipts for the three tax years immediately before the current year must not exceed the threshold under Section 448(c). The statute sets the base at $25 million and adjusts it each year for inflation, rounded to the nearest million.² For 2026, that’s $32 million.¹

Gross receipts covers more than sales. It includes amounts from sales, services, interest, rents, royalties, and annuities. Non-income items like loan proceeds and capital contributions generally don’t count.

If you own more than one business, you can’t test each one on its own. Entities treated as a single employer under Sections 52(a), 52(b), 414(m), or 414(o) — including corporations in the same controlled group and trades or businesses under common control — combine their receipts for the test.²³ Two related businesses at $20 million each become $40 million together and blow the 2026 ceiling.

The Tax Shelter Bar

Section 471(c) locks out any tax shelter regardless of size.⁴ The definition in Section 448(d)(3) is wider than most owners assume. It reaches any non-C-corporation enterprise whose interests must be registered with a securities regulator, any syndicate, and any arrangement that meets the tax shelter definition used for accuracy-related penalties.²

The syndicate rule is what usually trips people up. A partnership or other flow-through entity becomes a syndicate for the year if more than 35% of its losses are allocated to limited partners or others not active in management. It’s an annual test. A partnership can qualify in a profitable year and lose eligibility the next year if it runs a loss with the wrong allocation profile. If the entity has net income for the year, the syndicate rule doesn’t apply. And an S corporation isn’t treated as a tax shelter just because it filed a notice of exemption from registration with a state securities agency.

Pick a Method: NIMS or Conformity

Section 471(c) gives qualifying businesses two ways to handle inventory.

The first is to treat inventory as non-incidental materials and supplies, or NIMS. Costs are deducted when you pay or incur them, or when the items are consumed or provided to a customer — whichever is later under your overall accounting method.⁴

The second is financial statement conformity. Your tax treatment matches the method used in your applicable financial statement (an audited GAAP statement, or one filed with the SEC or another federal agency). If you don’t have an AFS, you follow the method reflected in your internal books and records.⁵

Most owners aiming for the fastest write-off pick NIMS. Conformity makes more sense when your audited financials already reflect an inventory method you want your tax return to mirror. The tradeoff with conformity cuts both ways: if the financials capitalize inventory and recover costs through cost of goods sold, the tax return has to do the same.

How NIMS Actually Deducts the Cost

Under NIMS, inventory costs are deductible when paid or incurred rather than when the goods sell. For a cash-basis business, that generally means the deduction lands in the year cash leaves the account. You aren’t required to track unsold goods for tax purposes or run a physical count just to satisfy the IRS.

What counts as NIMS inventory cost is narrow: direct material costs only. That means raw materials for property you produce and the purchase price of property you acquire for resale.⁵ Indirect costs — warehouse rent, utilities, factory overhead — aren’t capitalized into inventory. They’re deducted as ordinary business expenses under the usual rules.

This is the real simplification. Under the standard rules, the Uniform Capitalization (UNICAP) provisions of Section 263A force businesses to allocate a share of indirect costs to inventory and recover them only as goods are sold. Qualifying small businesses are fully exempt from UNICAP.⁶ The overhead allocations disappear.

One consistency rule matters: your NIMS deductions have to line up with how you treat inventory in your books and records. You can’t expense inventory on the tax return while capitalizing it internally. An inconsistency between the two is the kind of thing that draws scrutiny on audit.

How Conformity Works Without an AFS

If you don’t have an applicable financial statement, the conformity method looks to the books and records you keep under your own accounting procedures. An inventory cost under this method is any production or resale cost you capitalize to inventory in those books. Costs you don’t capitalize on the books don’t have to be capitalized for tax either.⁵

One outer limit holds regardless of your books: a cost cannot be deducted any earlier than the year it’s actually paid or incurred under your overall accounting method.

Making the Change on Form 3115

Moving to a Section 471(c) method from traditional inventory capitalization is a change in accounting method that needs IRS consent. That means filing Form 3115 (Application for Change in Accounting Method) with your timely filed return, extensions included, for the year of change.⁷

The change qualifies for automatic consent, so you don’t need individual IRS approval. For tax years beginning on or after January 5, 2021, there are two designated change numbers to know:

DCN 260 covers a change to the NIMS inventory method under the final regulations.
DCN 261 covers a change to the AFS conformity method, or the non-AFS books-and-records method if you don’t have an AFS.⁷

Using the wrong DCN is a common rejection trigger. If you also want to stop capitalizing indirect costs under UNICAP, that’s a separate change filed under DCN 234 for the Section 263A exemption.

The Section 481(a) Catch-Up Deduction

Any change in accounting method requires a Section 481(a) adjustment so that income or deductions aren’t double-counted or skipped in the transition.⁸ Switching from capitalizing inventory to NIMS almost always produces a negative adjustment: you have inventory sitting on the balance sheet with capitalized costs that haven’t been run through cost of goods sold yet. Those previously capitalized costs come out as a deduction through the adjustment.

The math favors the taxpayer here. A negative Section 481(a) adjustment is taken entirely in the year of change, not spread out.⁹ Positive adjustments get a four-year spread to soften the income hit; the IRS doesn’t run that cushion in reverse. A business carrying $200,000 of capitalized inventory when it switches to NIMS deducts the full $200,000 in year one.

One limit on the resulting loss: no portion of a net operating loss attributable to a negative Section 481(a) adjustment can be carried back to a tax year before the year of change.⁹ It can only move forward.

What This Election Doesn’t Cover

Owners sometimes try to expense low-cost inventory items using the de minimis safe harbor in the tangible property regulations. The regulations block that route. The de minimis safe harbor does not apply to amounts paid for property that is or is intended to be included in inventory.¹⁰ A $50 item bought for resale is inventory regardless of its unit cost. The Section 471(c) election is the correct path; running inventory through the de minimis safe harbor invites an audit adjustment.

Keeping the Election Year After Year

The gross receipts test resets each year. If your average annual receipts cross the inflation-adjusted threshold, you lose the Section 471(c) exception and have to go back to traditional inventory capitalization under Section 471(a), including UNICAP if it applies.

Reverting is itself a change in accounting method under Section 446(e), which means another Form 3115.¹¹ The Section 481(a) adjustment on the way back will likely be positive, because you have to add back previously expensed inventory still on hand. Positive adjustments spread over four years, which softens the income spike. If your receipts are trending up toward the threshold, plan for the reversion rather than getting forced into it.

Documentation matters throughout. Keep gross receipts calculations for the three-year lookback, purchase invoices showing when inventory was acquired and at what cost, and evidence that your book treatment of inventory matches your tax treatment. The burden of proof sits with the taxpayer in an audit, and the IRS expects a clean paper trail from the deductions on the return back to the amounts actually paid and the method actually used in the books.

1
IRS. Rev. Proc. 2025-32
2
Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting
3
Office of the Law Revision Counsel. 26 US Code 52 – Special Rules
4
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
5
eCFR. 26 CFR 1.471-1 – Need for Inventories
6
Office of the Law Revision Counsel. 26 US Code 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
7
Internal Revenue Service. Instructions for Form 3115
8
Office of the Law Revision Counsel. 26 USC 481 – Adjustments Required by Changes in Method of Accounting
9
IRS. Revenue Procedure 2015-13
10
eCFR. 26 CFR 1.263(a)-1 – Capital Expenditures; In General
11
eCFR. 26 CFR 1.481-1 – Adjustments in General