Inventory at the Beginning of the Year for Tax Returns

Beginning inventory for tax returns is last year’s ending inventory carried forward without change. The dollar value of every salable good your business held when the prior year’s books closed becomes the opening figure on this year’s return. For a calendar-year business, the number locked in on December 31 rolls straight into January 1. It matters because it is the first line of your Cost of Goods Sold calculation, and COGS drives your gross profit and your tax.

How It Flows Into Cost of Goods Sold

Every merchandising and manufacturing business builds COGS from the same formula: beginning inventory plus net purchases minus ending inventory. Net purchases means everything you spent acquiring goods for resale during the year, including freight and handling, less any returns or allowances. Add that to beginning inventory and you have the total cost of goods available for sale. Subtract what is still on the shelves at year-end, and the remainder is the cost of the inventory that actually went out to customers.

Because beginning inventory is the first input, an error there cascades. Overstate it by $10,000 and COGS is overstated by the same $10,000, which understates gross profit and taxable income. Understate it and the reverse happens. The IRS pays attention to this figure because it directly controls how much income the business reports.

Where Beginning Inventory Goes on the Return

The form depends on your entity type. Corporations filing Form 1120 and partnerships filing Form 1065 report COGS on Form 1125-A, and beginning inventory is Line 1.¹ The form walks through the full calculation: beginning inventory on Line 1, purchases on Line 2, labor costs on Line 3, Section 263A costs on Line 4, other costs on Line 5, ending inventory on Line 7, and final COGS on Line 8.

Sole proprietors report COGS in Part III of Schedule C (Form 1040), with beginning inventory as the starting point of the calculation.² Both forms also ask you to identify your inventory valuation method and to disclose any changes during the year.

It Must Match Last Year’s Ending Inventory

Your beginning inventory this year has to equal your ending inventory from last year’s return. If the numbers do not match, attach an explanation. The only legitimate reason for a difference is a change in accounting method, which triggers a Section 481(a) adjustment and requires you to refigure the prior year’s closing inventory under the new method.¹

The consistency principle sits behind this. The IRS gives greater weight to consistency than to any particular valuation method, so whatever approach you used last year is the approach you use now.³ Switching methods without approval is one of the fastest ways to trigger an audit adjustment, because a gap between last year’s ending inventory and this year’s beginning inventory is immediately visible.

Do You Even Have to Track Inventory?

Before working through valuation, check whether traditional inventory accounting applies to you at all. Under IRC Section 471(c), businesses that meet the gross receipts test are exempt from the standard inventory requirements. For tax years beginning in 2026, you qualify if your average annual gross receipts over the prior three tax years do not exceed $32 million.⁴

If you qualify, you have two options. You can treat inventory as non-incidental materials and supplies, deducting cost when you use or sell the goods rather than tracking cost layers. Or you can follow whatever inventory method you use on your financial statements or internal books.⁵

The exception, introduced by the Tax Cuts and Jobs Act, removes a substantial compliance burden for smaller businesses. If your receipts are well under the threshold, the detailed valuation methods below are optional rather than required. Many businesses still track inventory formally because lenders and investors expect it and because it improves purchasing decisions.

Valuation Methods That Determine the Number

The dollar amount you carry into beginning inventory depends on the costing method your business adopted. The IRS requires consistency: whatever method produced last year’s ending inventory automatically produces this year’s beginning figure.³

First-In, First-Out (FIFO)

FIFO assumes the oldest units purchased are the first sold. What sits on the shelves at year-end is the most recently purchased stock. When prices are rising, FIFO produces a higher ending inventory value because recent purchases cost more, and that higher value rolls forward as a higher beginning inventory. The trade-off is a lower COGS during inflationary periods, meaning higher reported profit and a bigger tax bill.

Last-In, First-Out (LIFO)

LIFO assumes the most recently purchased units are sold first, leaving the oldest, cheapest inventory on the books. A LIFO beginning inventory can reflect costs from years or even decades ago. During periods of rising costs, LIFO pushes the expensive recent purchases into COGS and reduces taxable income. The catch is the LIFO conformity rule: any business using LIFO for taxes must also use it in financial reports to shareholders and creditors.⁶ You cannot show investors a FIFO income statement while filing a LIFO return.

Weighted Average Cost

Weighted average blends all costs together. After each purchase, divide the total cost of goods available by the total number of units to get a single average cost per unit. Every item in inventory carries that blended cost. Businesses dealing with interchangeable goods like fuel, grain, or chemicals often prefer it because tracking individual lots would be impractical. The beginning inventory value sits between what FIFO and LIFO would produce.

Lower of Cost or Market

The IRS lets businesses value inventory at cost or the lower of cost or market. Under LCM, you compare each item’s historical cost to its current market replacement price and use whichever is lower. “Market” here means the current bid price you would pay to buy or reproduce the item on the inventory date.⁷

LCM matters most when prices drop. Widgets bought at $15 that now cost $10 to replace can be written down under LCM, which lowers ending inventory and rolls forward as a lower beginning inventory for the following year. Subnormal goods (damaged, obsolete, or out-of-season) must be valued at actual selling price minus the direct cost of selling them, and the business must have offered them at that price within 30 days of the inventory date.⁸

The Physical Count Behind the Number

The physical count is what anchors beginning inventory to reality. Most calendar-year businesses count during the last days of December or the first days of January. The IRS states that businesses must take a physical inventory at reasonable intervals and adjust their book amounts to match the actual count.⁹

You can estimate shrinkage and confirm those estimates with a count conducted after year-end, as long as you count inventory at each location on a regular and consistent basis and adjust both the figures and the estimating methods when actual shrinkage differs from your estimates.⁵ You can close the books using an estimate and true it up when the count is finished, but you cannot skip the count. Discrepancies found during reconciliation directly affect the ending inventory value that becomes next year’s opening figure.

Two Situations That Trip Up Beginning Inventory

Consigned Goods

Consignment creates a common error. If another company’s merchandise sits in your warehouse under a consignment arrangement, it does not belong in your inventory. The consignor keeps ownership until sale, so only the consignor counts the goods. As consignee, you record commission income when the goods sell, but the inventory itself never touches your balance sheet. If you send your own goods out on consignment, the reverse applies: they remain your inventory until the consignee sells them to an end customer.

Goods in Transit

Shipments moving between your supplier and your warehouse on the count date depend on shipping terms. Under FOB shipping point, ownership transfers when goods leave the supplier’s dock, so you include them in inventory even though they have not arrived. Under FOB destination, the supplier owns them until they reach you, so you exclude them. Missing this distinction can overstate or understate the number that rolls into the new year.

UNICAP for Larger Businesses

Businesses that produce goods or acquire them for resale may need to capitalize certain indirect costs into inventory rather than deduct them right away. Under IRC Section 263A, you include not only the direct costs (what you paid the supplier, direct labor) but also a proper share of indirect costs like warehouse rent, utilities, insurance, and management overhead that relate to producing or acquiring the goods.¹⁰

Those capitalized costs become part of inventory value, so they flow into beginning inventory and are not deducted until the goods sell. The same small business exception applies: if average annual gross receipts over the prior three years do not exceed $32 million for tax years beginning in 2026, you are exempt from UNICAP.⁴ Larger businesses subject to UNICAP carry a higher beginning inventory than a purchase-cost-only approach would produce.

Changing Your Inventory Method

Switching from FIFO to weighted average, adopting LIFO, or moving to LCM cannot be done by simply using the new method on next year’s return. File Form 3115, Application for Change in Accounting Method, during the tax year in which you want the change to take effect.¹¹

When the change is approved, the IRS computes a Section 481(a) adjustment to prevent income from being counted twice or skipped entirely. The adjustment is the cumulative difference between what income would have been under the old method and the new one, going all the way back. A negative adjustment (decrease in income) is typically deducted in full in the year of the change. A positive adjustment (increase in income) is spread over four tax years.¹¹

The practical effect on beginning inventory: when you change methods, recalculate last year’s ending inventory as if the new method had always applied. That recalculated figure is your beginning inventory for the year of the change, and the difference from the originally reported ending inventory is the basis for the 481(a) adjustment.

1
Internal Revenue Service. Form 1125-A – Cost of Goods Sold
2
Internal Revenue Service. 2025 Instructions for Schedule C (Form 1040)
3
eCFR. 26 CFR 1.471-2 – Valuation of Inventories
4
Internal Revenue Service. Rev. Proc. 2025-32
5
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
6
Internal Revenue Service. LIFO Conformity
7
Internal Revenue Service. LB&I Concept Unit – Lower of Cost or Market
8
eCFR. 26 CFR 1.471-4 – Inventories at Cost or Market, Whichever Is Lower
9
Internal Revenue Service. Publication 538 – Accounting Periods and Methods
10
Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
11
Internal Revenue Service. 4.11.6 Changes in Accounting Methods