Expensing Inventory Under the Small Business Exception: NIMS and Form 3115

A qualifying small business can deduct inventory costs in the year it pays for them instead of capitalizing those costs and waiting to recover them through cost of goods sold. The rule lives in Section 471(c) of the Internal Revenue Code, and it’s the cleanest path to expense inventory under the small business exception: pass the gross receipts test, avoid the tax shelter disqualification, elect a permitted method, and file Form 3115 to make the change official. For tax years beginning in 2026, the gross receipts ceiling is $32 million.¹

Who Qualifies

Eligibility runs through the Section 448(c) gross receipts test. Average annual gross receipts for the three tax years before the current one must not exceed the inflation-adjusted threshold, which the statute sets at a $25 million base and rounds to the nearest $1 million each year.² For 2026 that’s $32 million.

Gross receipts is a wide net. It covers sales, services, interest, rents, royalties, and annuities. Loan proceeds and capital contributions generally don’t count because they aren’t income.

A business that hasn’t existed for the full three years averages only the years it has operated, and any short year gets annualized by multiplying the receipts by 12 and dividing by the number of months.²

Related Entities Combine

Owners of multiple businesses can’t test each one in isolation. Entities treated as a single employer under Sections 52(a), 52(b), 414(m), or 414(o) must combine their receipts.² In practice, that means corporations in the same controlled group (more-than-50-percent ownership) and trades or businesses under common control aggregate.³ Two commonly owned businesses with $20 million each hit $40 million combined and lose the exception even though neither crosses the line alone.

The Tax Shelter Trap

Section 471(c) bars any tax shelter from using the exception, and the Section 448(d)(3) definition reaches further than owners usually expect.⁴ It pulls in enterprises other than C corporations whose interests must be registered with a securities regulator, syndicates, and arrangements that meet the accuracy-related-penalty definition of a tax shelter.²

The syndicate rule is the one that catches ordinary partnerships. A flow-through entity is a syndicate for the year if more than 35% of its losses are allocated to limited partners or owners who aren’t active in management. The test runs year by year, so a loss year can take the exception away even after good years with it. If the entity has net income for the year, the syndicate rule doesn’t apply. An S corporation isn’t a tax shelter just because it filed a notice of exemption from registration with a state securities agency.

Pick a Method: NIMS or Financial Statement Conformity

Qualifying businesses have two paths under Section 471(c).

The non-incidental materials and supplies (NIMS) method treats inventory the way a business treats supplies it uses up in operations. Costs are deducted when paid or incurred, or when the items are consumed or provided to a customer.⁴

The financial statement conformity method matches the tax treatment of inventory to the method used in the taxpayer’s applicable financial statement (AFS), generally an audited GAAP statement or one filed with a federal agency. A business without an AFS uses the method shown in its own books and records.⁵

Most small businesses chasing immediate deductions pick NIMS, because it writes inventory off the fastest. Conformity fits a business whose financial statements already use an inventory method it wants mirrored on the tax return, and the mirror cuts both ways: if the books capitalize inventory and recover it through cost of goods sold, the tax return does too. A hard limit sits on top of the conformity method regardless of what the books show: no cost can be deducted earlier than the year it’s actually paid or incurred under the overall accounting method.⁵

How the NIMS Deduction Actually Works

Under NIMS, inventory costs are deductible when paid or incurred rather than when the goods ship out the door. For a cash-basis business, the deduction generally hits in the year the money is spent. There’s no requirement to track unsold goods for tax or run a physical count just to satisfy the IRS.

The costs that count as NIMS inventory are direct material costs only: raw materials for property the business produces and the purchase price of property acquired for resale.⁵ Indirect costs like warehouse rent, utilities, and factory overhead aren’t capitalized into inventory. They’re deducted under the ordinary rules for business expenses.

That’s where the real simplification lives. The Uniform Capitalization (UNICAP) rules of Section 263A normally force businesses to allocate a share of indirect costs to inventory and release them only as goods are sold. Qualifying small businesses are fully exempt from UNICAP.⁶ The overhead allocation math disappears.

One consistency rule applies. The NIMS deduction timing must line up with how the business treats inventory in its own books. Expensing for tax while capitalizing for the internal books is the kind of inconsistency that invites audit scrutiny.

Filing Form 3115 to Make the Switch

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

The change qualifies for automatic consent, so the business doesn’t need individual IRS approval. For tax years beginning on or after January 5, 2021, two designated change numbers apply:

DCN 260 for changing to the NIMS inventory method under the final regulations.
DCN 261 for changing to the AFS conformity method (if the business has an AFS) or the non-AFS books-and-records method (if it doesn’t).⁷

An older DCN 235 covers the same election but only for tax years beginning before January 5, 2021. The wrong DCN can get the filing rejected. A business that also wants to drop UNICAP should file a separate change under DCN 234 for the Section 263A exemption.

The One-Time Deduction for Prior Capitalized Inventory

Changing methods triggers a Section 481(a) adjustment, the mechanism the IRS uses to keep income and deductions from being counted twice or skipped entirely as the rules change.⁸ For a business switching from capitalizing inventory to NIMS, the adjustment is almost always negative. The capitalized costs sitting on the balance sheet, costs the business hasn’t yet recovered through cost of goods sold, become deductible through the adjustment.

The timing is where this gets powerful. A negative Section 481(a) adjustment is taken entirely in the year of change, not spread.⁹ Positive adjustments that increase income get a four-year spread; the IRS doesn’t apply the same cushion in reverse. A business sitting on $200,000 of capitalized inventory when it switches to NIMS gets the full $200,000 deduction in year one.

One restriction attaches to any loss the adjustment creates. No portion of a net operating loss attributable to a negative Section 481(a) adjustment can be carried back to a year before the change.⁹ It only moves forward.

The De Minimis Safe Harbor Won’t Do This For You

Some owners try to shortcut the process by using the de minimis safe harbor under the tangible property regulations to expense low-cost inventory items without electing Section 471(c). The regulations block it. The de minimis safe harbor doesn’t apply to amounts paid for property that is or is intended to be included in inventory.¹⁰ A $50 widget bought for resale is still inventory. Section 471(c) is the correct path, and trying to force inventory through the de minimis safe harbor invites an audit adjustment.

Staying Eligible Year to Year

The gross receipts test runs every year, not just at adoption. If average annual gross receipts cross the inflation-adjusted threshold in a later year, the business loses the exception and reverts to traditional inventory capitalization under Section 471(a), with UNICAP back in play if applicable.

Reverting is itself a change in accounting method requiring IRS consent under Section 446(e), which means another Form 3115.¹¹ The Section 481(a) adjustment on the way back out will likely be positive, because previously expensed inventory still on hand has to be added back. Positive adjustments get the four-year spread, which softens the hit. A business whose receipts are trending toward the ceiling should plan for the reversion rather than be surprised by it.

Documentation keeps the exception defensible. Hold on to the gross receipts calculations for the three-year lookback, purchase invoices showing when inventory was acquired and what it cost, and records confirming that the book treatment of inventory matches the tax treatment. In an audit, the burden is on the taxpayer, and the IRS wants a clean paper trail from the deduction on the return back to the amounts paid and the method on 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