How Does Inventory Affect Taxes: Valuation, Write-Offs, and UNICAP

Inventory affects your taxes through one central mechanism: the value you place on goods sitting unsold at year-end sets your Cost of Goods Sold, and COGS is the largest deduction most product businesses take against sales revenue. Push ending inventory down and COGS goes up, which shrinks taxable income. Push ending inventory up and you report more profit. Everything else in the inventory tax rules — which valuation method you use, whether you have to capitalize indirect costs, how you handle damaged or donated stock — is a variation on that single lever.

How Inventory Converts Into Tax

The formula is short: beginning inventory, plus purchases during the year, minus ending inventory, equals COGS. Gross profit is sales revenue minus COGS. Taxable business income flows from there.

That makes the year-end inventory count the pressure point. A dollar of cost that stays in ending inventory is a dollar you cannot deduct this year. A dollar that moves into COGS reduces the current year’s tax. The IRS pays close attention to inventory valuation for exactly this reason.

Federal tax law generally requires any business where selling merchandise is an income-producing factor to maintain inventories and use the accrual method for purchases and sales.¹ There is a small business carve-out, discussed below, but the default rule catches most businesses that carry stock.

Valuation Methods and What They Do to Your Bill

Because prices change over the year, you need a cost-flow assumption to decide which purchase costs get expensed and which stay on the balance sheet. The assumption is an accounting choice, not a description of which physical units left the warehouse first. Once chosen, it has to be applied consistently; switching requires filing Form 3115.²

First-In, First-Out

FIFO treats the oldest costs in your inventory as the first ones sold. During inflation, that leaves the newer, higher costs in ending inventory, which produces a lower COGS and a higher taxable profit than the alternatives.³ Your balance sheet looks strong, but you pay more tax this year.

Last-In, First-Out

LIFO reverses the assumption. The most recent purchases are treated as sold first, so during inflation the highest costs land in COGS and taxable income drops.³

There is a catch. The LIFO conformity rule requires that if you use LIFO on your tax return, you must also use it in the financial statements you show shareholders, partners, and creditors.⁴ You cannot report a higher FIFO profit to investors and lower LIFO income to the IRS. If the IRS finds a different method was used in reports to outside parties, it can revoke the LIFO election.⁵ LIFO users also cannot write inventory down to the lower of cost or market; LIFO inventory must be carried at cost.³

Average Cost

The average cost method blends all purchase costs into a weighted average and applies that average to every unit sold. It tends to produce results between FIFO and LIFO and is common for businesses that move large volumes of interchangeable goods where tracking individual lots would be impractical.

Small Business Simplifications

Not every product business has to run full inventory accounting. If your average annual gross receipts over the prior three tax years fall at or below the Section 448(c) threshold, you qualify as a small business taxpayer. For tax years beginning in 2026, the threshold sits at approximately $32 million.⁶ Tax shelters are excluded regardless of size, and related entities you control have to be aggregated when you test whether you qualify.

Two significant breaks come with that status. First, you can skip formal FIFO/LIFO/average-cost accounting and instead treat inventory as non-incidental materials and supplies, deducting costs as items are used or consumed rather than when sold; alternatively, you can use whatever method appears on your audited financial statements, or on your internal books if you have no audited financials.⁶ Second, you are exempt from the Uniform Capitalization rules described in the next section.⁷

Together, those exemptions can accelerate deductions and cut bookkeeping work substantially. If you are near the threshold, running the aggregation math each year matters.

UNICAP for Larger Businesses

Businesses above the small business threshold have to apply Section 263A, commonly called the UNICAP rules. UNICAP blocks you from deducting many indirect costs as current operating expenses. Instead, those costs get added to inventory value and only reach your return through COGS when the inventory sells.⁷

The rules apply to manufacturers and to resellers. Indirect costs that get capitalized include warehouse rent, depreciation on production equipment, utilities for manufacturing facilities, quality control labor, insurance on inventory, and purchasing department overhead. For resellers, receiving, handling, and storage costs are pulled in as well.

The net effect is timing. You still deduct these costs eventually, but not until the associated inventory turns into revenue. For businesses carrying slow-moving stock, UNICAP can defer sizeable deductions and raise your current tax bill.

Writing Down and Writing Off Inventory

When goods lose value before you sell them, tax law lets you recognize the loss early. The main tool is the lower of cost or market (LCM) rule, which compares each item’s original cost to its current market value and lets you use the lower figure.⁸ Market value here means the current bid price for the goods in the quantities you normally buy.⁹ Writing inventory down increases current-year COGS and reduces taxable income. LIFO users cannot use LCM.

Goods that are completely worthless — severely damaged, obsolete, or expired — can be written off in full, but the IRS wants to see that the inventory has actually been removed from your usable assets. Scrap, destroy, or donate the goods and document what happened. Subnormal goods that still have some value can be written down to their actual selling price minus the direct cost of disposal, but not below scrap value.⁹ Without documentation of the disposition, the deduction is generally disallowed until the goods are actually sold or disposed of.

Donation as an Alternative to Disposal

Donating inventory to charity can produce a deduction larger than your cost basis. Under Section 170(e)(3), C corporations that donate inventory to a qualified 501(c)(3) can claim an enhanced deduction if the charity uses the property solely for the care of the ill, the needy, or infants and does not resell it.¹⁰ The deduction equals cost basis plus half the difference between cost and fair market value, capped at twice basis.

Food inventory gets more generous treatment. The PATH Act of 2015 permanently extended the enhanced food-donation deduction to all business types, including S corporations, partnerships, and sole proprietors.¹¹ For a business that routinely dumps unsold food, donation can be a materially better outcome than the trash. You need a written acknowledgment from the charity, and donations over $5,000 in fair market value generally require a qualified appraisal and a completed Section B of Form 8283.

Estimating Shrinkage

Retail and wholesale businesses lose inventory to theft, spoilage, miscounting, and damage. Federal law lets you estimate that shrinkage at year-end instead of requiring a count on the exact last day of the tax year, but only if you conduct physical counts at each location on a regular and consistent basis and adjust your estimates when actual counts show they were off.⁶ Shrinkage reduces ending inventory, increases COGS, and lowers taxable income. Aggressive estimates that are never reconciled to real counts are a familiar audit target.

Reporting and Penalties

Corporations, S corporations, and partnerships claiming a COGS deduction complete Form 1125-A and attach it to the return. The form asks for beginning and ending inventory, purchases, labor, other costs, and your valuation method.¹² Sole proprietors report COGS directly on Schedule C.

Inventory errors that produce a substantial understatement of tax can trigger an accuracy-related penalty of 20% of the underpayment.¹³ The IRS puts the burden of substantiation on the taxpayer, and reconstructing inventory records after the fact rarely works. Keep physical count records, purchase invoices, allocation workpapers if UNICAP applies, and disposition records for anything written down or written off.

State Inventory Taxes Are Separate

Federal income tax is not the only inventory-driven tax. Roughly a dozen states impose personal property tax on business inventory as part of their tangible personal property regime. Those taxes are based on inventory value at an assessment date and are owed regardless of whether the business earned a profit. Most states have fully or partially repealed inventory taxes, but in the states that still impose them, holding excess stock creates a carrying cost that sits on top of the federal timing issues covered here.

1
eCFR. 26 CFR 1.471-1 – Need for Inventories
2
Internal Revenue Service. About Form 3115, Application for Change in Accounting Method
3
Internal Revenue Service. IRS Publication 538 – Accounting Periods and Methods
4
Office of the Law Revision Counsel. 26 USC 472 – Last-In, First-Out Inventories
5
Internal Revenue Service. LIFO Conformity Requirement
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Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
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Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
8
eCFR. 26 CFR 1.471-4 – Inventories at Cost or Market, Whichever Is Lower
9
Internal Revenue Service. Form 1125-A, Cost of Goods Sold
10
Office of the Law Revision Counsel. 26 USC 170 – Charitable, Etc., Contributions and Gifts
11
United States Department of Agriculture. Federal Incentives for Businesses to Donate Food
12
Internal Revenue Service. About Form 1125-A, Cost of Goods Sold
13
Internal Revenue Service. Accuracy-Related Penalty