How to Write Off Inventory: Journal Entries and Tax Rules

To write off inventory, you remove worthless or damaged goods from your records with a journal entry that debits Cost of Goods Sold (or an inventory loss account) and credits Inventory, then let the higher COGS flow through to your tax return and reduce taxable income for the year. The rules that govern how most businesses value and adjust inventory sit in Internal Revenue Code Section 471.¹ Getting the entry, the documentation, and the return line right is what makes the deduction stick if the IRS asks.

Write-Off or Write-Down: Pick the Right One First

A write-off is for goods with zero remaining value. Physical damage from accidents, fires, or natural disasters, theft and counting shrinkage, expired food or pharmaceuticals, and products killed off by a technology shift or a change in consumer taste all fit here.

A write-down is for goods that are still worth something, just less than you paid. Federal rules ask you to compare each item’s cost to its current market value and carry it at the lower of the two — the “lower of cost or market” method.¹ Under Treasury Regulation 1.471-2, “market” generally means current replacement cost, meaning what you would pay today to buy or reproduce the item, not what you could sell it for.²

Damaged or outdated goods that can’t sell at normal prices sit in a separate “subnormal” category. Value them at your actual offering price minus the direct costs of selling, and be prepared to show the goods were offered at that reduced price within 30 days of the inventory date.² Subnormal raw materials or partially finished goods are valued by their condition and usability, but never below scrap value.

Gather Your Documentation Before You Touch the Books

The write-off is only as strong as the paper trail behind it. For every item you plan to write off or write down, pull together:

Cost basis for each item, determined under your established valuation method — typically FIFO or LIFO.³
Item identification: SKU numbers, lot numbers, and product descriptions so each affected unit can be traced.
Quantity verification from a physical count or warehouse audit.
The date the damage, theft, or obsolescence was identified.

Back the paperwork with physical evidence. Police reports for stolen goods. Dated photographs of damaged products. Disposal logs signed by a supervisor, waste hauler receipts, or certificates of destruction to prove the items left your possession. For hazardous materials, keep the required waste manifests; federal rules require generators to retain those records for at least three years.

Recording the Write-Off in Your Books

Two approaches are standard.

Direct Write-Off

Record the loss in the period you discover it. The journal entry debits an expense account — Cost of Goods Sold or a dedicated inventory loss account — and credits Inventory for the same amount. This fits businesses whose losses are infrequent and hard to predict, because the expense lands in the period the loss actually happened.

Allowance Method

Set up a reserve based on your historical loss patterns. You estimate expected losses for a period and record that estimate as an expense before the loss occurs. When goods do go bad, you charge them against the reserve instead of booking a fresh expense. Perishable, fragile, and trend-sensitive inventory usually suits this approach because it smooths the financial impact across reporting periods.

Whichever method you use, update your inventory management system to match the general ledger. Adjust quantities for each affected SKU so the system stops suggesting reorders for items that no longer exist. Mismatches between inventory software and financial records surface as problems at year-end reconciliation.

How the Write-Off Reaches Your Tax Return

The write-off flows through cost of goods sold for the year, reducing gross profit and the income subject to federal tax.¹ The IRS allows estimates of inventory shrinkage that are later confirmed by a physical count, provided the count happens after the close of the tax year.

Which form carries the numbers depends on how your business is organized:

Sole proprietorships report COGS and inventory adjustments on Schedule C (Form 1040).⁴
C corporations, S corporations, and partnerships attach Form 1125-A (Cost of Goods Sold) to Form 1120, 1120S, or 1065. Form 1125-A asks whether inventory quantities, costs, or valuations changed between opening and closing inventory; if a write-off changed your method, answer “Yes” and attach an explanation.⁵⁶

To change your inventory valuation method — for instance, moving from FIFO to LIFO or adopting lower of cost or market — you generally file Form 3115 (Application for Change in Accounting Method) with your return. Some changes qualify for automatic IRS consent, meaning you file the form but don’t have to wait for approval to apply the new method.

Inaccurate reporting invites penalties. The failure-to-pay penalty runs 0.5 percent of the unpaid tax for each month the balance is outstanding, up to 25 percent.⁷ Interest accrues on top until the balance is paid.⁸

Simplified Rules for Small Business Taxpayers

Not every business has to run the full Section 471 machinery. Under Section 471(c), if your average annual gross receipts for the prior three tax years do not exceed $32 million (the inflation-adjusted threshold for tax years beginning in 2026), you qualify as a small business taxpayer and can use a simplified approach.⁹

Qualifying small businesses have two options. Treat inventory as non-incidental materials and supplies, deducting the cost when the items are used or sold rather than maintaining a formal inventory account. Or follow whatever method your financial statements already use.¹ Either way, you’re exempt from the uniform capitalization rules that otherwise pull indirect costs into inventory.¹⁰

Switching to the simplified method from a traditional inventory method requires filing Form 3115 with your return for the year of the change. Automatic consent applies to this switch, so no advance approval is needed, but the form still has to be filed.

Casualty, Theft, and Disaster Losses

Inventory lost to a casualty event or theft follows a different tax path than routine shrinkage or obsolescence. You have two options, and the one you pick controls how any insurance recovery gets handled.¹¹

Through cost of goods sold: reflect the loss in your opening and closing inventory figures, which automatically increases COGS. If you go this route, include any insurance reimbursement in gross income, and don’t also claim the loss as a separate casualty deduction.
As a separate casualty deduction: remove the affected inventory from COGS by adjusting opening inventory or purchases downward, then deduct the loss separately (typically on Form 4684). Reduce the loss by any insurance reimbursement, and don’t include that reimbursement in gross income.

You can’t use both methods for the same loss. Pick one and apply it consistently.

Insurance Reimbursement

Federal law only allows a deduction to the extent the loss isn’t compensated by insurance or other reimbursement.¹² If you haven’t received the payment by year-end but reasonably expect a recovery, you can’t deduct the portion you expect to recover. If a later reimbursement exceeds what you deducted, the excess goes into income for the year you receive it.¹¹

Federally Declared Disaster Areas

If the loss comes from a federally declared disaster in a FEMA-designated area, you can elect to deduct it on your return for the immediately preceding tax year rather than the current year. The election accelerates the tax benefit and can bring cash flow relief sooner. If you make it, reduce your opening inventory for the disaster year so the same loss isn’t counted twice.¹¹

Donating Inventory Instead of Writing It Off

Some inventory still has value but no market — overstocked seasonal goods are a common example. Donating those goods to a qualified charity can produce a better tax result than a straight write-off. C corporations that donate inventory for the care of the ill, the needy, or infants can claim an enhanced deduction that exceeds the normal cost basis.¹³

Four conditions have to be met:

The recipient must be a 501(c)(3) organization, and the goods must be used solely for the care of the ill, needy, or infants.
The charity cannot sell the donated goods for money, other property, or services.
You must receive a written acknowledgment from the charity confirming it will use and dispose of the property in accordance with these rules.
If the goods are FDA-regulated (food, drugs, cosmetics), they must fully comply with all applicable requirements on the date of transfer and for the 180 days before.

The enhanced deduction equals the item’s cost basis plus half the difference between fair market value and basis, capped at twice the basis.¹³ A corporation’s total charitable deductions are capped at 25 percent of taxable income for the year, with excess carrying forward.¹⁴ S corporations and unincorporated businesses don’t get the enhanced deduction, though they can still claim a standard charitable contribution for donated inventory.

Don’t Forget the Disposal Cost

Writing off inventory on paper doesn’t make the goods disappear. Standard commercial landfill tipping fees run roughly $50 to $70 or more per ton on average, with private landfills generally charging more than public ones and regional variation on top. Hazardous materials cost significantly more: professional disposal of regulated waste — chemicals, certain electronics, batteries, and similar items — can run several hundred dollars per drum. Federal manifest rules track hazardous waste from your facility to its final destination, and completed manifests have to be kept for at least three years.

These disposal costs are themselves deductible as ordinary business expenses in the year you pay them. Build them into the overall calculation so the tax benefit of clearing worthless inventory isn’t wiped out by the bill to get rid of it.

1
Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
2
GovInfo. 26 CFR 1.471-2 – Valuation of Inventories
3
Internal Revenue Service. Publication 538 – Accounting Periods and Methods
4
Internal Revenue Service. About Schedule C (Form 1040) – Profit or Loss From Business (Sole Proprietorship)
5
Internal Revenue Service. About Form 1125-A – Cost of Goods Sold
6
Internal Revenue Service. Form 1125-A (Rev. November 2024) – Cost of Goods Sold
7
Office of the Law Revision Counsel. 26 USC 6651 – Failure to File Tax Return or to Pay Tax
8
Internal Revenue Service. Topic No. 653 – IRS Notices and Bills, Penalties and Interest Charges
9
Internal Revenue Service. Rev. Proc. 2025-32 – 2026 Adjusted Items
10
Internal Revenue Service. Publication 334 (2025) – Tax Guide for Small Business
11
Internal Revenue Service. Publication 547 (2025) – Casualties, Disasters, and Thefts
12
Office of the Law Revision Counsel. 26 USC 165 – Losses
13
Office of the Law Revision Counsel. 26 USC 170 – Charitable Contributions and Gifts
14
Internal Revenue Service. Charitable Contribution Deductions