How to Account for Inventory on Taxes

This guide explains how to report inventory on your business tax return, covering the two main methods (cash and accrual), how to value inventory (FIFO, LIFO, and lower of cost or market), and how to handle the IRS requirements for businesses that hold stock in trade. By the end, you’ll know what records to keep, how to calculate cost of goods sold, and how to avoid common filing errors.

What You’ll Need

Your business tax return forms (Schedule C for sole proprietors, Form 1125-A for most other businesses)
Inventory records: beginning inventory count and value, purchases during the year, and ending inventory count and value
Receipts, invoices, and shipping documents for all inventory purchases
Records of any inventory write-offs, shrinkage, or damage
Your chosen inventory valuation method (FIFO, LIFO, or weighted average) from previous years
Accounting software or spreadsheet to track inventory quantities and costs

Step-by-Step

Determine if you must account for inventory. If your business buys or produces goods to sell to customers, you must report inventory. The IRS requires inventory accounting for businesses that have stock in trade, even if you use the cash method of accounting. However, small businesses with average annual gross receipts of $25 million or less (in 2024) may be eligible to treat inventory as non-incidental materials and supplies, which simplifies the process.
Choose your accounting method. Most small businesses use either the cash method or the accrual method. Under the cash method, you report income when cash is received and expenses when paid. Under the accrual method, you report income when earned and expenses when incurred. Inventory must be accounted for under the accrual method, unless you qualify for the small business exception. If you use the cash method, you can deduct inventory costs when you pay for them, but you still need to track inventory for tax purposes.
Select an inventory valuation method. The most common methods are:
- FIFO (First-In, First-Out): Assumes the oldest items are sold first. Ending inventory is valued at the most recent costs.
- LIFO (Last-In, First-Out): Assumes the newest items are sold first. Ending inventory is valued at the oldest costs. LIFO can lower taxable income during inflation, but requires IRS approval (Form 970) and may result in lower book income.
- Weighted Average: Averages the cost of all items available for sale during the year. Ending inventory is valued at the average cost per unit.
Choose a method that best reflects your business operations and stick with it. Changing methods requires IRS approval (Form 3115).
Calculate your beginning inventory. This is the value of inventory you had at the start of the tax year. It should match the ending inventory from your previous year’s tax return. If this is your first year, your beginning inventory is zero.
Add purchases during the year. Include the cost of all inventory bought during the year, including freight, shipping, and handling charges. Do not include sales tax you paid if you later collect it from customers; that is a liability, not an expense.
Calculate cost of goods available for sale. This is beginning inventory plus purchases. For example, if you started with $10,000 of inventory and bought $50,000 more, your cost of goods available is $60,000.
Conduct a physical inventory count at year-end. Count everything you have on hand, including raw materials, work-in-progress, and finished goods. For each item, record the quantity and cost. Use your valuation method to assign a dollar value to your ending inventory.
Calculate cost of goods sold (COGS). The formula is: Beginning Inventory + Purchases – Ending Inventory = COGS. This is the amount you deduct on your tax return. For example, if your beginning inventory was $10,000, purchases were $50,000, and ending inventory is $12,000, your COGS is $48,000.
Report inventory on your tax return. For sole proprietors, report inventory on Schedule C, Part III (Cost of Goods Sold). For partnerships, S corporations, and C corporations, use Form 1125-A. You’ll need to enter your beginning inventory, purchases, ending inventory, and COGS.
Keep detailed records. Retain all invoices, receipts, and inventory counts for at least three years (or longer if you have large deductions). If you use LIFO, keep records for the entire time you use the method, plus three years after you stop.

Common Mistakes

Using the wrong valuation method. Switching between FIFO and LIFO without IRS approval can trigger penalties. Pick one method and use it consistently.
Ignoring shrinkage. If you count less inventory than your records show, you must adjust your ending inventory down. Failing to do so overstates assets and understates COGS, leading to higher taxes.
Mixing cash and accrual incorrectly. Even if you use the cash method for income, you may still need to account for inventory using accrual rules. The small business exception is available, but it requires a formal election.
Forgetting to include freight-in. Shipping costs to get inventory to your business are part of the inventory cost, not a separate expense. Excluding them understates COGS and overstates profit.
Not adjusting for obsolete or damaged inventory. If you can’t sell an item at its normal price, you may need to write it down to its market value (lower of cost or market rule). Ignoring this can inflate your taxable income.

Tips

Use accounting software to track inventory in real-time. This reduces errors and makes year-end counting easier.
If you use LIFO, consider the impact on your financial statements. LIFO may reduce taxable income but can also make your inventory value look outdated on your balance sheet.
For small businesses, the simplified method of treating inventory as non-incidental materials and supplies can save time. Under this method, you deduct the cost of inventory when you pay for it, regardless of when you sell it. This is available if your average annual gross receipts are $25 million or less (in 2024).
If you have inventory in multiple locations, make sure to count all locations at year-end. Missing a warehouse can cause a significant error.
Consider using a periodic inventory system (count at year-end) versus a perpetual system (continuous tracking). Perpetual systems are more accurate but require more setup.

Troubleshooting

What if my ending inventory count is lower than expected? This could be due to theft, damage, or administrative errors. Adjust your ending inventory to reflect the actual count. If the loss is due to theft, you may be able to deduct it as a casualty loss, but you need to document the cause.

What if I forgot to include a purchase in my records? If you have the invoice, you can amend your tax return. If the purchase was made in the current year, simply include it in your current year’s purchases. If it was from a prior year, file an amended return (Form 1040-X for individuals) to correct the error.

What if I changed my inventory valuation method without IRS approval? You may need to file Form 3115 to request a change in accounting method. The IRS may require you to adjust your income for the difference (a Section 481(a) adjustment). It’s best to consult a tax professional in this situation.

What if I don’t have records for beginning inventory? Reconstruct it using your prior year’s tax return or purchase records. If you can’t determine it, you may need to estimate based on reasonable assumptions, but be prepared to defend your estimate to the IRS.

Frequently Asked Questions

Q: Do I need to account for inventory if I’m a freelancer or service provider?
A: No, if you don’t sell physical goods, you don’t have inventory. But if you buy supplies that you use in providing services, those are typically supplies expense, not inventory.

Q: Can I use the cash method if I have inventory?
A: Yes, if your average annual gross receipts are $25 million or less (in 2024), you can use the cash method and treat inventory as non-incidental materials and supplies. This simplifies reporting.

Q: What is the lower of cost or market rule?
A: This rule requires you to value inventory at the lower of its original cost or its current market value (replacement cost). If market value has declined, you must write down the inventory, which reduces your ending inventory and increases COGS, lowering taxable income.

Q: How do I value inventory if I make products?
A: For manufacturers, inventory includes raw materials, work-in-progress, and finished goods. You must allocate costs such as direct materials, direct labor, and manufacturing overhead to each unit. This is complex; consider using standard costing or consult a tax professional.

Q: What is the difference between periodic and perpetual inventory systems?
A: Periodic inventory requires a physical count at year-end to determine ending inventory. Perpetual inventory tracks each sale and purchase in real-time, so you always know your inventory balance. For tax purposes, both are acceptable, but perpetual systems are more accurate.

Q: Can I deduct inventory that is damaged or spoiled?
A: Yes, you can write down damaged inventory to its salvage value. You must document the damage and the reason it can’t be sold at full price. The write-down increases COGS and reduces taxable income.

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