FIFO tax deductions work on a simple assumption: the first items you bought are the first ones you sold. For a business, that means your Cost of Goods Sold deduction pulls from your oldest purchase prices, which usually produces a smaller deduction and higher taxable income when supplier costs are rising. For an investor selling stock or cryptocurrency, FIFO is the IRS default rule for identifying which shares or units you sold, and it typically assigns your lowest cost basis to the sale, producing the largest taxable gain.
What FIFO Does to Your Cost of Goods Sold
Every business that sells physical products needs a way to figure out how much those products cost. That cost becomes a deduction against gross receipts, and the result is your gross profit. Under FIFO, when you calculate Cost of Goods Sold you pull from the oldest purchase prices in your records before touching newer ones.1Internal Revenue Service. Publication 538, Accounting Periods and Methods
The practical effect flows in two directions. Your ending inventory on the balance sheet reflects your most recent, higher purchase prices. Your deduction reflects older, lower prices. In an inflationary economy, that means a smaller COGS deduction and more taxable income. When replacement prices fall, the reverse happens: the older, higher costs flow into your deduction and shrink your tax bill.
The Tax Bill Difference Between FIFO and LIFO
The main alternative for business inventory is LIFO (Last-In, First-Out), which deducts the newest, most expensive costs first. The choice can produce dramatically different tax bills, especially when inflation is running hot.
Take a simple case. A retailer buys 100 units at $10 each in January and another 100 units at $12 each in June, then sells 100 units during the year. Under FIFO, the deduction uses the $10 cost, producing $1,000 in COGS. Under LIFO, the deduction uses the $12 cost, producing $1,200 in COGS. That $200 difference flows straight to taxable income. At a 21% corporate rate, FIFO generates $42 more in federal tax on those 100 units alone. Scale that across thousands of units and years of compounding inflation, and the gap becomes substantial.
In a deflationary environment where replacement costs are dropping, FIFO flips to the taxpayer’s advantage. The older, higher costs flow to the deduction first, cutting taxable income more than LIFO would. That is uncommon in the broader economy but does happen in specific industries such as consumer electronics, where component prices can fall sharply.
Despite the tax disadvantage during inflation, many businesses still choose FIFO because it mirrors the actual physical flow of goods (a grocer sells the oldest milk first), produces financial statements that look better to lenders and investors, and avoids the LIFO conformity requirement, which forces LIFO users to depress their reported earnings too.2Office of the Law Revision Counsel. 26 U.S. Code 472 – Last-in, First-out Inventories
Whether You Have to Track Inventory at All
The Tax Cuts and Jobs Act created an exemption that spares many smaller businesses from formal inventory accounting. For the 2026 tax year, a business qualifies as a small business taxpayer if its average annual gross receipts over the prior three tax years don’t exceed $32 million. The base threshold was $25 million when the law passed in 2017, and it adjusts annually for inflation.3Internal Revenue Service. Tax Cuts and Jobs Act Inventory and Accounting Method Changes
Qualifying businesses can treat inventory as non-incidental materials and supplies, deducting costs when items are used or consumed rather than tracking them through a formal FIFO or LIFO system. They can also follow whatever method they use on their financial statements or books and records. The business cannot be classified as a tax shelter to claim this exemption.
If you sit under that $32 million line, FIFO becomes optional rather than a matter of tax compliance. Above it, the IRS expects a defined method, applied consistently year to year.
Costs That Get Loaded Into Inventory Before FIFO Touches Them
The purchase price on an invoice is only the starting point. Under the Uniform Capitalization rules in Section 263A, businesses must add certain indirect costs to their inventory values. These capitalized costs include indirect labor, a share of officers’ compensation allocable to production, pension contributions, rent and depreciation on production facilities, and interest on debt used to finance production.4eCFR. 26 CFR 1.263A-1 – Uniform Capitalization of Costs Inbound freight, customs duties, and handling charges to get goods into your warehouse also get folded into inventory cost rather than expensed immediately.
The logic is straightforward. If a cost was necessary to get inventory into sellable condition, it’s part of the inventory’s value and gets deducted only when the item sells. Outbound shipping to customers, by contrast, is a selling expense you deduct in the year you incur it.
The same $32 million gross receipts threshold that exempts small businesses from formal inventory accounting also exempts them from Section 263A capitalization.5Office of the Law Revision Counsel. 26 U.S. Code 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
Writing Inventory Down With Lower of Cost or Market
If the replacement cost of your inventory drops below what you originally paid, FIFO users can write the value down using the Lower of Cost or Market method. You compare each item’s historical cost to its current replacement cost (what you’d pay to buy the same item today on the open market) and use whichever figure is lower.6Internal Revenue Service. Lower of Cost or Market (LCM)
Replacement cost means the current bid price at the inventory date, not what you’d sell the item for. If no active market exists for the goods, you need to demonstrate a fair market price through recent purchases, sales by comparable businesses, or similar evidence. The IRS won’t accept prices that differ materially from actual transaction prices.
A write-down increases your COGS deduction for the year because you’re assigning a lower value to ending inventory. LIFO users cannot use this method; it’s available only to businesses valuing inventory at cost, including FIFO cost. That makes it one of the few tax levers where FIFO holds an edge over LIFO.
Calculating Cost of Goods Sold Step by Step
The COGS formula is short, but the FIFO logic sits inside one specific piece of it.
- Start with beginning inventory. This is the ending inventory value from last year’s return. The two numbers must match; any discrepancy requires an explanation attached to your return.
- Add total purchases during the year, plus capitalized costs like inbound freight and any indirect costs required under Section 263A.
- Beginning inventory plus purchases equals goods available for sale, the full pool of costs that could flow to either COGS or ending inventory.
- Value ending inventory using FIFO. Count what’s physically on hand at year-end, then assign costs starting from the most recent purchases and working backward. If 100 units remain and your last purchase was 60 units at $15, those 60 units are valued at $15 each. The remaining 40 units pull from the next most recent purchase price.
- Subtract ending inventory from goods available for sale. The result is your Cost of Goods Sold deduction.
The FIFO assumption does all its work in the ending inventory step. By assigning the newest costs to what remains on the shelf, the oldest costs automatically flow into the deduction. A physical inventory count on the last day of your fiscal year anchors the entire calculation, so accuracy there ripples through everything else.
Where to Report FIFO on Your Return
Where you report Cost of Goods Sold depends on your business structure. Sole proprietors use Part III of Schedule C (Form 1040), which walks through beginning inventory, purchases, labor, materials, and ending inventory on lines 35 through 42. Line 33 asks which valuation method you used, including cost, lower of cost or market, or another method.7Internal Revenue Service. Schedule C (Form 1040) – Profit or Loss From Business
Corporations filing Form 1120 or 1120-S, and partnerships filing Form 1065, report COGS on Form 1125-A instead. The form requires the same basic information: beginning inventory, purchases, ending inventory, and the resulting COGS figure. Any entity claiming a cost of goods sold deduction on those returns must complete and attach Form 1125-A.8Internal Revenue Service. About Form 1125-A, Cost of Goods Sold
The COGS total flows to the main return and reduces gross income before other deductions apply. Line 34 on Schedule C (and the equivalent on Form 1125-A) also asks whether you changed how you determined quantities, costs, or valuations between opening and closing inventory. Answering “yes” without filing the proper change request is a red flag for the IRS.
FIFO on Stock and Cryptocurrency Sales
FIFO is not just an inventory concept. It’s also the IRS default for determining which shares of stock or units of cryptocurrency you sold, and it directly affects your capital gains tax.
Stocks and Mutual Funds
When you sell shares you purchased on different dates at different prices, the IRS needs to know which specific shares you sold to calculate gain or loss. If you don’t identify the specific lot, Treasury regulations treat the sale as coming from the earliest shares you purchased.9eCFR. 26 CFR 1.1012-1 – Basis of Property That’s FIFO by default.
Your oldest shares often have the lowest cost basis, so FIFO usually produces the largest taxable gain. Say you bought 100 shares at $20 five years ago and another 100 shares at $45 last month, then sell 100 shares at $50. FIFO assigns the $20 basis and you report a $3,000 gain. Had you identified the $45 shares instead, your gain would be only $500. To avoid the FIFO default, you must adequately identify the specific shares before the sale settles, typically by instructing your broker which lot to sell.
For mutual fund shares, you may also use the average cost method, which divides the total cost of all shares by the number of shares owned. This is available only for shares in regulated investment companies and certain dividend reinvestment plans.
Cryptocurrency and Digital Assets
The IRS applies the same FIFO logic to virtual currency. If you don’t identify specific units when you sell or exchange cryptocurrency, the units are treated as sold in chronological order, starting with the earliest ones you acquired.10Internal Revenue Service. Frequently Asked Questions on Virtual Currency Transactions
Starting January 1, 2025, formal regulations under Treasury Regulation 1.1012-1(j) codified this FIFO default for digital assets held by brokers. When a broker custodies your crypto and you don’t make an adequate identification of which units to sell, the broker must apply FIFO ordering.11Internal Revenue Service. Extension of Temporary Relief Under Section 1.1012-1 For anyone who accumulated crypto over several years at widely varying prices, that can create a significantly higher tax bill than selling higher-cost lots first. If your exchange supports specific identification, using it gives you control over which cost basis applies to each sale.
How Long to Keep Your Records
The IRS requires you to keep records that support any item on your return for as long as they may be relevant, which generally means at least three years from the filing date.12Internal Revenue Service. How Long Should I Keep Records For inventory, that includes purchase invoices showing dates and unit prices, physical count sheets, freight bills, and any worksheets used to calculate ending inventory values. FIFO in particular relies on knowing purchase dates and prices in order, so losing early-year invoices can make the method impossible to defend.
The three-year period covers the standard statute of limitations for assessments. If the IRS believes you understated income by more than 25%, the limitations period extends to six years. For inventory-heavy businesses where valuation judgments swing taxable income by tens or hundreds of thousands of dollars, keeping records for six years is the safer practice.13Internal Revenue Service. Topic No. 305, Recordkeeping
Switching Away From FIFO
If FIFO isn’t working for your business and you want to move to LIFO or another method, you need IRS approval through Form 3115, Application for Change in Accounting Method.14Internal Revenue Service. About Form 3115, Application for Change in Accounting Method Many inventory method changes qualify for automatic consent, which means you file the form with your return and don’t wait for a ruling. There’s no user fee for automatic changes; non-automatic changes require a user fee and produce a letter ruling from the IRS National Office.
Either way, you’ll likely calculate a Section 481(a) adjustment, a one-time income adjustment that prevents costs from being deducted twice or skipped entirely during the transition.15Internal Revenue Service. Instructions for Form 3115 – Application for Change in Accounting Method Small businesses that newly qualify for the gross receipts exemption and want to stop maintaining formal inventories also use Form 3115 to make the switch.