How to Write Off Inventory: Documentation, Entries, and Penalties

To write off inventory, you reduce the value of your ending inventory to reflect goods that are damaged, obsolete, stolen, or otherwise worth less than you paid for them. That reduction flows automatically into a larger cost of goods sold figure, which lowers your taxable income. The deduction itself is mechanical. The work is in proving the loss: you need documentation showing what the goods cost, what they are now worth, and why. Sloppy support here is what triggers the 20% accuracy-related penalty under Section 6662.¹

When a Write-Off Is Allowed

Federal rules let you recognize a loss before you sell the goods when their market value drops below cost. Treasury Regulation Section 1.471-4 sets up the “lower of cost or market” framework: compare each item’s cost to its current market value and carry it at whichever is lower.²

The situations that typically justify a write-down fall into a few buckets:

Obsolescence. Technology shifts or changing consumer taste leave goods unsalable at the original price, like last year’s phone cases after a new model launches.
Physical damage or spoilage. Perishables that expire, water damage in a warehouse, freight damage.
Shrinkage. Inventory confirmed missing through a physical count.
Subnormal goods. Items unsalable at normal prices because of imperfections, shop wear, style changes, or odd and broken lots. These are valued at their actual selling price minus the direct cost of selling them, but never below scrap value.³

For subnormal goods, the “actual selling price” is the price you offered the goods for during a window ending no later than 30 days after your inventory date. The IRS places the burden of proof on you to show the goods genuinely belong in one of these categories and to keep records of how you disposed of them.⁴ Form 1125-A has a specific checkbox at line 9b for reporting a writedown of subnormal goods.⁵

Stolen inventory is worth flagging separately, because instinct sends people to the casualty and theft loss rules. It does not go there. Regulations under Section 165 explicitly carve inventory theft out of the general theft-loss regime, and the loss flows through inventory and COGS under Section 471 instead.⁶ Practically: you handle stolen goods the same way as obsolete or damaged goods, by reducing ending inventory.

Check the Small Business Exemption First

Before working through formal write-off procedures, confirm whether you need to track inventory for tax purposes at all. Section 471(c) exempts businesses that meet the gross receipts test under Section 448(c). For tax years beginning in 2026, that threshold is average annual gross receipts of $32 million or less over the prior three years.⁷ Most small and mid-sized businesses qualify.

If you do, you have two simplified options. Treat inventory as non-incidental materials and supplies, deducting the cost when items are used or sold rather than tracking formal balances. Or use whichever inventory method matches your financial statements, or if you don’t have audited financials, your internal books.⁸ Either approach removes the need for year-end lower-of-cost-or-market calculations and formal write-off entries on your return. Qualifying businesses are also exempt from the uniform capitalization rules under Section 263A.

Documentation the IRS Expects

A write-off that survives audit depends on three layers of records: what you paid, what the goods are now worth, and what happened to them.

Original Cost

Start with purchase invoices or historical ledger entries showing exactly what you paid. If you manufactured the goods, records need to capture direct materials, direct labor, and any indirect costs capitalized into inventory. The cost basis is the starting point for computing the loss.

Evidence That Market Value Dropped

This is where most claims fall apart. A judgment call is not enough. The IRS expects actual offerings, actual sales, or contract cancellations that show the lower price.⁴ When there’s no active market, you can rely on specific purchases or sales by you or other businesses at reasonable volume, made in good faith, near the inventory date.

For subnormal goods sold at a discount, the price must be supported by actual sales within a reasonable period before, and no later than 30 days after, the inventory date.⁴ Holding damaged goods for months without attempting to sell them undercuts the valuation.

A Disposal Log

Compile the details into an inventory disposal log. Each entry should include the specific items or SKUs, quantity, original cost, current market value with supporting evidence, calculated loss, date the loss was identified, and reason for the write-off. If goods were physically destroyed, a certificate of destruction from the disposal vendor strengthens the audit trail, especially for regulated goods or electronics with sensitive data.

How Long to Keep the Records

The standard period is three years from the date you filed the return claiming the write-off. If you underreport gross income by more than 25%, the IRS has six years to assess. Claims tied to worthless securities or bad debt stretch to seven years.⁹ Given cheap storage, keeping inventory write-off documentation for at least seven years is the safer approach.

Journal Entries: Direct Write-Off vs. Allowance

Two methods cover almost every situation. Choose based on how frequent and how large your losses are.

Direct write-off. When you identify a loss, debit Cost of Goods Sold and credit the Inventory account for the loss amount. Inventory drops, COGS rises, and the deduction hits in the period you discovered the problem. Most small businesses use this method because it’s straightforward and matches each loss to the period it’s found. It works best when write-offs are small or infrequent.

Allowance method. Larger businesses that expect ongoing losses set up a contra-asset account, typically called Allowance for Obsolete Inventory. Rather than hitting COGS directly, you debit an inventory write-down expense and credit the allowance. The allowance reduces inventory’s carrying value on the balance sheet without pulling specific items out of your tracking system. When you eventually dispose of the goods, debit the allowance and credit Inventory to clear both entries.

The allowance method smooths earnings across periods, but it requires you to estimate future losses, and those estimates need to be reasonable and documented. Auditors will test whether the allowance balance tracks your actual disposal history.

How the Write-Off Appears on Your Tax Return

Inventory write-offs are not a standalone line item on any federal return. They reduce ending inventory, and that reduction mechanically increases cost of goods sold. Where you report depends on entity type.

Corporations, S corporations, and partnerships report COGS on Form 1125-A, attached to Form 1120, 1120-S, or 1065. The write-off shows up as a lower ending inventory on line 7, which increases COGS on line 8.⁵ Check the box on line 9b if you wrote down subnormal goods.

Sole proprietors put the same information on Schedule C (Form 1040), Part III. Adjust ending inventory to reflect the write-off, and it flows through to total cost of goods sold.¹⁰

One point people miss: insurance proceeds received or expected for damaged or destroyed inventory reduce the deductible loss. You cannot claim the full write-off and keep the insurance check on top. Subtract the reimbursement before adjusting ending inventory.

Donating Inventory as an Alternative

If the goods still have some value but you can’t sell them at full price, donating them may produce a bigger benefit than writing them off, especially for C corporations.

An ordinary inventory donation gets you a deduction equal to your cost basis, which is the same benefit as a write-off. But Section 170(e)(3) offers an enhanced deduction for C corporations that donate inventory to qualified 501(c)(3) organizations (not private foundations) for the care of the ill, the needy, or infants. The enhanced deduction is the lesser of cost basis plus half the built-in appreciation, or twice the cost basis.¹¹ For appreciated inventory, that can be up to double what you paid.

The charity must provide a written statement confirming the donation will be used solely for the care of the ill, needy, or infants, that the use relates to the charity’s exempt purpose, and that no money or services were exchanged for the goods.¹¹

Food donations follow a parallel rule that’s open to any business, not just C corporations. Contributions of apparently wholesome food from a trade or business qualify for the same enhanced deduction formula, capped at 15% of net income from the trades or businesses that made the contributions, with excess carrying forward.¹¹ For restaurants, grocers, and food manufacturers sitting on expiring inventory, donation often beats writing off at cost.

Changing Your Inventory Valuation Method

If you’ve been valuing inventory at cost and want to switch to lower of cost or market so you can start recognizing write-downs, you need IRS consent. File Form 3115, Application for Change in Accounting Method.¹²

Many inventory method changes qualify for automatic consent, meaning no advance approval and no user fee. You attach Form 3115 to your timely filed return for the year of the change and send a copy to the IRS National Office. Non-automatic changes require filing the form separately with the National Office and paying a user fee.¹²

The same process covers a small business newly opting into the Section 471(c) simplified method. Section 471(c)(4) treats the change as initiated by the taxpayer with the Secretary’s consent, so you still file Form 3115.⁸ When switching methods, you’ll recalculate the prior year’s closing inventory under the new method and account for the difference as a Section 481(a) adjustment, which keeps amounts from being duplicated or omitted in the transition.¹⁰

Penalty Exposure for Inaccurate Write-Offs

Inventory errors cut both ways. Overstate inventory and you understate COGS, inflate taxable income, and overpay. Understate inventory and you overstate COGS, and underpay. The IRS cares about the second scenario.

Section 6662 imposes accuracy-related penalties on underpayments caused by negligence, substantial understatement of income, or valuation misstatements. The penalty is 20% of the underpayment attributable to the error.¹ Aggressive write-downs without adequate support are exactly the kind of position that attracts it. The subnormal goods rules, the 30-day offering window, and the lower-of-cost-or-market comparisons exist so the IRS can test whether a write-off is legitimate.

The best protection is the paperwork already described. Purchase invoices establishing cost, market evidence establishing the decline, and a disposal log showing when and why each loss was identified: that combination makes an auditor’s job easy and keeps penalties off the table.

1
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
2
eCFR. 26 CFR Part 1 – Inventories
3
eCFR. 26 CFR 1.471-2 – Valuation of Inventories
4
Internal Revenue Service. Lower of Cost or Market (LCM)
5
Internal Revenue Service. Form 1125-A Cost of Goods Sold
6
eCFR. 26 CFR 1.165-8 – Theft Losses
7
Internal Revenue Service. Revenue Procedure 2025-32
8
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
9
Internal Revenue Service. How Long Should I Keep Records?
10
Internal Revenue Service. Instructions for Schedule C (Form 1040)
11
Office of the Law Revision Counsel. 26 USC 170 – Charitable, Etc., Contributions and Gifts
12
Internal Revenue Service. Instructions for Form 3115