The FIFO inventory method, short for first in, first out, assigns the cost of your oldest inventory to each sale, so the items you bought earliest are the first ones expensed when you calculate taxable income.1Federal tax regulations require any inventory method to clearly reflect income and match standard accounting practices in your industry, and once you adopt FIFO you must apply it consistently from year to year. For securities, FIFO is the IRS default when you sell shares without specifying which lot to use. The method has real tax consequences, especially during inflation, because expensing older, cheaper costs first produces higher reported profits and a larger tax bill than alternatives like LIFO.
How the FIFO Cost Flow Works
FIFO is a cost flow assumption, not a rule about how you physically move products. A warehouse worker might grab the nearest pallet off the shelf regardless of when it arrived, but the accounting department records the sale as if the oldest unit left. That separation is what makes FIFO practical for businesses that don’t track every individual item.
The payoff shows up on the balance sheet. Because older costs flow out through cost of goods sold, the inventory that remains reflects your most recent purchase prices, giving a more realistic picture of what it would cost to replace your stock today. Treasury Regulation 1.471-2 reinforces this approach: intermingled goods that can’t be traced to specific invoices are deemed to be the most recently purchased items, which effectively treats the oldest costs as the ones already sold.
Calculating Cost of Goods Sold and Ending Inventory
To calculate cost of goods sold under FIFO, you peel costs off in the order you incurred them. Suppose a retailer buys ten units at $50 each in January and ten more at $60 each in February. If 12 units sell during the period, the first ten come from the January layer at $50 and the next two come from the February layer at $60. Cost of goods sold works out to $620. The eight unsold February units stay on the balance sheet at $60 each, giving an ending inventory of $480.
Each purchase creates a separate cost layer with its own date, quantity, and unit price. As sales happen, you deplete the oldest layer first, then move to the next. The math is straightforward once the layers are organized, but it depends on recording every purchase batch with its exact cost and date. Skip a layer or mix up the order and the entire chain of calculations shifts.
How FIFO Affects Your Tax Bill
FIFO’s tax impact depends on whether your prices are rising or falling. When costs climb over time, FIFO expenses the older, cheaper inventory first and leaves newer, higher-cost inventory on the books. That produces a lower cost of goods sold, higher gross profit, and a bigger tax bill than the LIFO method, which would expense the newest, most expensive costs first.
The difference is not trivial. In a model with a 10% cost increase and a 30% tax rate, a business using FIFO paid roughly 45% more in tax on the same sales than one using LIFO. The gap narrows at lower tax rates, and the 2017 reduction of the corporate rate from 35% to 21% has reduced the incentive to switch to LIFO. For businesses with thin margins and steadily rising input costs, the FIFO tax penalty during inflation is worth understanding before you lock in a method.
When prices fall, the dynamic reverses. FIFO expenses the older, more expensive inventory first, which increases cost of goods sold and lowers taxable income. In deflationary periods, FIFO actually produces a smaller tax bill than LIFO.
IRS Rules for Using FIFO
IRC Section 471 imposes two requirements on any inventory method: it must conform to the best accounting practice in your trade, and it must clearly reflect your income. Treasury Regulation 1.471-2 adds that consistency matters more than the particular method you pick, as long as the approach falls within acceptable bounds. The two valuation bases that satisfy Section 471 are cost, and cost or market whichever is lower.
FIFO falls under the cost basis. When you report inventory at cost using FIFO, you are telling the IRS that the remaining stock is valued at the prices you most recently paid. FIFO does not require a special election form the way LIFO requires Form 970. You simply report your valuation method on your return and apply it consistently going forward. Because greater weight is given to consistency than to the specific method chosen, switching methods later triggers a formal process.
Businesses that report inventory values inaccurately face penalties tied to the size and cause of the understatement. A 20% penalty applies to underpayments caused by negligence or a substantial valuation misstatement. Gross valuation misstatements carry a 40% penalty. If the IRS finds fraud, the penalty jumps to 75% of the underpaid amount.
Reporting FIFO on Federal Tax Returns
Where you report inventory depends on your business structure. Sole proprietors use Schedule C (Form 1040), where line 33 asks you to identify your valuation method (cost, lower of cost or market, or other) and lines 35 through 42 track beginning inventory, purchases, and ending inventory to arrive at cost of goods sold on line 42.
Corporations report cost of goods sold on Form 1120, line 2, with the detailed calculation on Form 1125-A. Line 9a of Form 1125-A asks you to check the applicable valuation method. The options include cost, lower of cost or market, and alternative methods for qualifying small businesses. If you adopted LIFO during the year, a separate checkbox on line 9c requires attaching Form 970. FIFO users checking “Cost” on line 9a need no additional election form.
One continuity rule catches businesses off guard: the ending inventory reported on last year’s return must exactly match the beginning inventory on this year’s return. If the numbers differ, you need to attach an explanation. Mismatches without explanation are an audit flag.
FIFO for Stocks, Mutual Funds, and Other Securities
FIFO applies to investment portfolios as well as physical inventory. When you sell shares of a stock or mutual fund that you bought at different times and prices, the IRS treats the oldest shares as the ones sold first unless you specifically identify different shares at the time of the sale. This default determines your cost basis and, by extension, your capital gain or loss.
The holding period follows the same logic. Because FIFO assigns the oldest purchase date to the shares sold, those shares are more likely to qualify as long-term holdings, meaning held more than one year. Long-term capital gains receive preferential rates: 0% for taxable income up to $49,450 for single filers in 2026, 15% up to $545,500, and 20% above that. Short-term gains are taxed as ordinary income, which can be significantly higher.
Brokerage firms report your cost basis on Form 1099-B using FIFO as the default when you haven’t specified a method. If no identification is provided, the broker reports the sale starting with shares whose acquisition date is unknown, followed by the shares purchased or acquired first.
How to Override the FIFO Default
You can avoid FIFO for securities by using the specific identification method, which lets you choose exactly which shares to sell. To qualify, you must adequately identify the shares at the time of the sale. In practice, that means telling your broker which lot to sell before or at the time the trade executes. Call after the fact or don’t specify at all, and FIFO applies automatically.
Specific identification gives you control over the tax outcome. In a rising market, selling your highest-cost shares first minimizes the capital gain. In a falling market, selling your lowest-cost shares can generate a larger loss to offset other gains. The tradeoff is administrative: you need to track every lot and communicate clearly with your broker each time you trade.
Changing To or From FIFO
Switching from FIFO to another method, or from another method to FIFO, requires IRS consent through Form 3115, Application for Change in Accounting Method. The form captures what you’re changing, why, and how the transition affects previously reported income.
The core issue with any method change is the Section 481(a) adjustment, which prevents items of income or expense from being duplicated or omitted during the switch. If the change produces a positive adjustment (meaning you owe more tax), you generally spread that adjustment over four years. A negative adjustment is taken entirely in the year of change. Getting the 481(a) calculation wrong can create the exact reporting problems the IRS designed the form to prevent, so this is where most businesses bring in professional help.
The Small Business Exemption
Not every business needs to maintain formal FIFO cost layers. For tax years beginning in 2026, businesses with average annual gross receipts of $32 million or less over the prior three years qualify as small business taxpayers under Section 448(c). These businesses can skip traditional inventory accounting entirely and instead treat inventory as non-incidental materials and supplies.
Under this approach, you deduct inventory costs in the year you sell the goods to a customer (or the year you pay for them, whichever is later) rather than tracking cost layers. You can use any reasonable method to estimate raw materials in year-end work-in-process and finished goods, as long as you apply it consistently. This exemption also removes the requirement to capitalize overhead costs under Section 263A, which simplifies bookkeeping considerably for smaller operations. If you currently use FIFO and want to switch to this method, the change requires Form 3115 and a Section 481(a) adjustment.
Records You Need to Keep
FIFO reporting depends on a complete paper trail for every purchase batch: the date of acquisition, quantity received, and unit cost. Each batch forms a cost layer that must be tracked until depleted. A missing invoice can throw off the entire layer sequence, and reconstructing cost layers after the fact is far harder than maintaining them as you go.
The IRS requires you to keep supporting records for at least three years from the date you filed the return or two years from the date you paid the tax, whichever is later. That baseline extends to six years if you fail to report more than 25% of your gross income, and to seven years if you claim a loss from worthless securities or a bad debt deduction. For inventory-heavy businesses, the practical advice is to retain purchase records, cost layer worksheets, and inventory count documentation for at least seven years, because you won’t always know in advance which retention period applies.