Section 471 Inventory Rules: Costs, Valuation, and LIFO

If your business produces, buys, or sells merchandise, the Section 471 inventory rules require you to track inventory and match its cost to the year the goods are sold, using a valuation method the IRS accepts. There is one large escape hatch: for the 2026 tax year, businesses whose average annual gross receipts over the prior three years do not exceed $32 million can skip the full framework and use one of two simplified alternatives.¹ Everyone above that line has to comply in full, and the penalties for getting it wrong run to 20% of any resulting underpayment.

Who Has To Keep Inventory

The rules kick in whenever producing, purchasing, or selling merchandise is a factor in generating your income.² That sweeps in manufacturers, wholesalers, distributors, and retailers. If your business holds goods for sale to customers, you are almost certainly inside the rules.

The $32 Million Small Business Exception

Section 471(c) exempts businesses that meet the Section 448(c) gross receipts test from the full inventory framework.³ For 2026, that means three-year average annual gross receipts of $32 million or less.¹ Tax shelters barred from the cash method under Section 448(a)(3) cannot use the exception no matter how small they are.

Qualifying businesses pick between two simplified methods:

Non-incidental materials and supplies (NIMS). You deduct the cost of inventory in the year you provide it to the customer, or the year you pay for it, whichever comes later.⁴
Applicable Financial Statement (AFS) method. You match your tax treatment to the method used on your audited financial statements, or, if you don’t have an AFS, to the method reflected in your own books and records.³

Two things follow from qualifying. Businesses that meet the Section 448(c) threshold are also exempt from the Uniform Capitalization rules of Section 263A, which is where most of the cost-capitalization burden lives.⁵ And if your receipts eventually grow past the threshold, you lose the exception and have to adopt full Section 471 accounting, which counts as an accounting method change requiring IRS consent.

What Costs Go Into Inventory

For businesses subject to the full rules, inventory cost includes every expenditure needed to bring goods to their present condition and location. Section 263A widens that considerably by requiring you to capitalize direct costs and an allocable share of indirect costs into inventory rather than deducting them right away.⁵ The result is a higher inventory balance and a deduction that waits until the goods sell.

If you manufacture, capitalized costs include direct materials, wages for production workers, factory utilities, depreciation on manufacturing equipment, and rent for production facilities. Less obvious items like purchasing department expenses, materials handling, and warehouse storage also get allocated into inventory. If you buy finished goods for resale, you capitalize the purchase price plus indirect costs such as processing, repackaging, and warehousing.

Not everything gets capitalized. Selling and distribution expenses, advertising, research costs, and general administrative overhead unrelated to inventory production stay deductible in the year incurred.

Valuation Methods You Can Use

Once you know which costs belong in inventory, you need a method to value the ending balance. Section 471 accepts several, and whichever you pick has to be applied consistently across similar goods.³

Cost With a Flow Assumption

For fungible inventory, two cost-flow assumptions dominate:

First-In, First-Out (FIFO) assumes the oldest inventory sells first. Ending inventory reflects your most recent purchase prices.
Last-In, First-Out (LIFO) assumes the newest inventory sells first. Ending inventory reflects older, often lower, costs.

In an inflationary period, FIFO produces higher taxable income because expensive recent costs stay on the balance sheet. LIFO does the reverse, pushing higher recent costs into cost of goods sold and reducing current tax. That is why LIFO is attractive when prices are rising, but it comes with extra rules.

Lower of Cost or Market

The lower of cost or market (LCM) method lets you write inventory down to current replacement cost when that cost has dropped below what you paid. LCM pairs with FIFO or average cost. It is not available for LIFO, which must be carried at cost.⁶

Specific Identification

For unique or high-value items such as custom machinery or individual art pieces, you can track the exact cost of each unit and match it to revenue when that unit sells. It is the most precise method and only practical when the item count is manageable.

The Extra Rules That Come With LIFO

LIFO’s tax benefits are large enough that the IRS layers on requirements to keep it honest.

You elect LIFO by filing Form 970 with the return for the first year you want to use it, and once elected the method continues in every subsequent year unless the IRS approves a change.⁶

The LIFO conformity rule is the trap. If you use LIFO on your tax return, you also have to use it on any financial statements provided to shareholders, partners, creditors, or beneficiaries, including consolidated statements that include a LIFO subsidiary. Violating conformity gives the IRS grounds to revoke your LIFO election entirely.⁷

Most LIFO users don’t track individual items. They use dollar-value LIFO, which pools inventory and measures changes in total dollar terms so that new products replacing discontinued ones inside a pool don’t trigger the accidental liquidation of old, low-cost layers.⁸

Damaged, Obsolete, and Subnormal Goods

Inventory that can’t be sold at normal prices because of damage, style changes, odd lots, or defects gets valued at its actual selling price less the direct cost of disposal, regardless of your overall method.⁹ The selling price has to be a real offering price within 30 days after the inventory date, not an estimate. Raw materials or partially finished goods that are damaged or obsolete get valued on a reasonable basis considering usability and condition, but never below scrap value. The burden is on you to prove the goods qualify and to keep records showing how you eventually disposed of them. Aggressive write-downs of “obsolete” inventory draw IRS attention.

Physical Counts and Shrinkage

You can use estimates of shrinkage from theft, breakage, or spoilage, but only if you back them up. Section 471 requires that you conduct physical counts at each location on a regular and consistent basis, and that you adjust both your inventory figures and your estimating method when the count differs from the estimate.³ Even businesses using the small business books-and-records option are expected to reconcile physical counts against book records; sloppy documentation invites problems on audit.⁴

Changing Inventory Methods

Switching methods, whether between FIFO and LIFO, adding LCM, or moving from a small business method to full Section 471, is a change in accounting method that needs IRS consent. The primary vehicle is Form 3115.¹⁰

Many common inventory changes, including those tied to the Section 471(c) small business rules, qualify for the automatic consent procedure. Automatic changes are made by filing Form 3115 with a timely filed return for the year of change.¹¹ Non-automatic changes require advance IRS approval and a user fee.

Any change triggers a Section 481(a) adjustment, which captures the total difference between the old and new methods as of the start of the year of change so income is neither doubled nor skipped. A positive adjustment (more income) is generally spread over four years, starting with the year of change; if it is less than $50,000 you can elect to take it all in year one. A negative adjustment (less income) is always taken entirely in the year of change.¹²

What Getting It Wrong Costs

Inventory errors compound quickly. An overstated ending inventory understates cost of goods sold and overstates income; understating inventory does the reverse. Either can produce an underpayment, and if the understatement of tax is substantial, the accuracy-related penalty is 20% of the underpayment. For most taxpayers, an understatement is substantial when it exceeds the greater of 10% of the tax that should have been shown on the return or $5,000. For corporations other than S corporations, the test is the lesser of 10% of the correct tax (or $10,000 if greater) and $10 million.¹³

Changing methods without IRS consent creates a separate problem. The IRS can force you back to your old method even when the new one was technically correct, and if the year of the unauthorized switch is closed by the statute of limitations, the correction lands in the earliest open year. The Section 481(a) adjustment on an involuntary change hits in a single year rather than being spread over four.¹² Filing Form 3115 before an audit begins is always the better path.

1
Internal Revenue Service. Rev. Proc. 2025-32
2
eCFR. 26 CFR 1.471-1 – Need for Inventories
3
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
4
eCFR. 26 CFR 1.471-1 – Need for Inventories
5
Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
6
Office of the Law Revision Counsel. 26 USC 472 – Last-In, First-Out Inventories
7
Internal Revenue Service. Practice Unit – LIFO Conformity
8
Internal Revenue Service. Introduction to Dollar Value LIFO
9
eCFR. 26 CFR 1.471-2 – Valuation of Inventories
10
Internal Revenue Service. About Form 3115, Application for Change in Accounting Method
11
Internal Revenue Service. Instructions for Form 3115 – Application for Change in Accounting Method
12
Internal Revenue Service. 4.11.6 Changes in Accounting Methods
13
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments