Inventory Write-Off Tax Deductions: Methods, Records, and Penalties

An inventory write-off is tax deductible when the loss in value is real, documented, and flowed through your Cost of Goods Sold on the correct return. The IRS lets you take an inventory write-off tax deduction either by writing goods down to a lower value on the books or by deducting their full cost once they’ve been physically disposed of. Which path you use depends on what happened to the goods, and a few specific rules decide whether the deduction survives an audit.

Two Ways Inventory Comes Off Your Return

There is no separate “write-off” line on a business tax return. Inventory losses reduce your ending inventory figure, which increases Cost of Goods Sold, which lowers taxable income. A $10,000 write-off cuts ending inventory by $10,000 and adds $10,000 to COGS.

You get there one of two ways. You can write goods down to a lower value while they’re still on hand, using the lower of cost or market method for normal goods or the subnormal goods rule for damaged and obsolete items. Or you can write goods off entirely once they’ve been destroyed, scrapped, donated, or otherwise removed from your assets. The rules are different for each, and the documentation the IRS expects is different too.

Writing Down Normal Goods That Lost Market Value

The main tool for writing inventory down is the lower of cost or market method (LCM). You compare each item’s original cost to its current market value and use whichever is lower. If market has dropped below what you paid, the difference reduces ending inventory and flows into COGS.¹

For normal goods, “market” means current replacement cost: what you would pay to buy or reproduce the item on the inventory date. The IRS looks at current bid prices for the basic cost elements — direct materials, direct labor, and any indirect costs you’re required to capitalize — based on the volume you typically purchase.²

One rule catches people out: you compare cost and market item by item, not in aggregate. You can’t total the cost column, total the market column, and use the lower total. Each item gets its own comparison, and the sum of those individual lower values becomes your ending inventory.¹

To support an LCM write-down, keep independent evidence of the lower price: vendor quotes, published price indexes, supplier catalogs, or documentation of replacement purchases at the reduced cost.

Writing Down Damaged, Obsolete, or Unsalable Goods

A stricter rule applies to goods that can’t be sold at normal prices because of damage, imperfections, style changes, odd lots, or similar problems. The IRS calls these “subnormal” goods, and they have their own valuation method regardless of whether you use cost or LCM for everything else.

For finished goods that are subnormal, you value them at the price you’re actually offering them for sale, minus the direct cost of disposal. The offering price has to be real. A “bona fide selling price” is an actual offering of the goods during a period ending no later than 30 days after your inventory date. Marking something down on paper is not enough; you have to offer it to buyers at the reduced price within that window.³

For subnormal raw materials or partially finished goods, the value is a reasonable assessment of condition and usability rather than a selling price. But there is a floor: you can never write below scrap value. If damaged steel is worth $200 as scrap, you cannot carry it at zero.³

The burden of proof is on you. You need to show the goods genuinely qualify as subnormal and keep records of how they were ultimately sold or disposed of so the IRS can verify your inventory figures.³ Save price lists, advertisements, liquidation offers, or communications with buyers that prove the offering was genuine.

The LIFO Restriction

If you use LIFO (last-in, first-out) to cost your inventory, you cannot use the lower of cost or market method at all. IRS Publication 538 is explicit that LCM does not apply to goods accounted for under LIFO.¹ A LIFO taxpayer who adopts that method cannot write inventory down to market value using LCM.⁴

The subnormal goods rule still applies for damaged or obsolete items on LIFO. But for normal goods whose market value has just declined, LIFO businesses stay at cost.

Deducting Inventory That’s Been Destroyed, Scrapped, or Lost

Writing down is not the same as writing off. To deduct the full cost of an item, the inventory has to be physically disposed of and no longer part of your assets. Disposal can mean physically destroying the goods, selling them to a liquidator for a nominal amount, sending them to a scrap dealer, or donating them. Inventory sitting in a back warehouse that you have mentally written off but never removed does not qualify.

The deduction belongs in the tax year the goods actually leave your books. If you destroy inventory in January 2026, the loss goes on the 2026 return even if you decided in late 2025 that the goods were worthless.

For a full write-off, keep internal work orders authorizing the destruction, receipts from scrap dealers or recyclers, bills of lading showing removal, or documentation of a sale to a liquidator. Photographs and witness statements help when the disposal involves large quantities.

Inventory Lost to Fire, Flood, or Theft

Inventory destroyed by a casualty is deductible under the general rule allowing businesses to deduct losses sustained during the tax year to the extent not covered by insurance.⁵ For business inventory, the loss typically reduces ending inventory (and therefore increases COGS) for the year the casualty occurred. If you receive insurance proceeds, you deduct only the uncompensated portion. File any insurance claims before finalizing the deduction amount.

The Small Business Shortcut Under Section 471(c)

Not every business has to run these rules. Section 471(c) of the Internal Revenue Code exempts businesses that meet the gross receipts test under Section 448(c). For tax years beginning in 2026, you qualify if your average annual gross receipts over the prior three years do not exceed $32 million.⁶

If you qualify, the normal inventory accounting requirements don’t apply. You can treat inventory as non-incidental materials and supplies, deducting costs when the items are used or consumed rather than when sold, or follow whatever method your financial statements use.⁷ Many small businesses can deduct inventory costs more flexibly this way, without navigating LCM or the 30-day subnormal rule.

Where the Deduction Shows Up on Your Return

The write-off itself is invisible on the return. What shows up is a lower ending inventory number, which produces a higher COGS through the standard formula: beginning inventory plus purchases, minus ending inventory, equals COGS.⁸

Where you report depends on your entity:

Sole proprietors report COGS in Part III of Schedule C (Form 1040). Line 33 identifies your inventory valuation method, and closing inventory on line 41 reflects any write-downs.⁹
Corporations, S corporations, and partnerships complete Form 1125-A (Cost of Goods Sold) and attach it to the return. Line 7 carries ending inventory, line 9a indicates the valuation method, and line 9b is checked if you wrote down subnormal goods.¹⁰

Form 1125-A is required for filers of Form 1120, 1120-C, 1120-F, 1120-S, or 1065 that claim a COGS deduction.¹¹ If you changed your inventory valuation method during the year, line 9f asks you to disclose it and attach an explanation.

Records You Need to Keep

The IRS does not take your word for a lost inventory value. What you keep depends on why you wrote the goods down.

For subnormal goods, your file should establish the date you determined the goods were subnormal and show that you offered them for sale at the reduced price within 30 days of the inventory date. Advertisements, price lists, liquidation offers, and buyer correspondence all work.³

For scrapped or destroyed goods, keep the destruction authorization, scrap dealer receipts, removal documentation, or liquidator sale records. For LCM write-downs, keep the vendor quotes, price indexes, catalogs, or invoices that prove the lower replacement cost.

Penalties If You Overstate the Write-Off

Inflating an inventory write-off can trigger the accuracy-related penalty. Where the IRS determines you substantially understated your income tax, the penalty is 20% of the resulting underpayment.¹²

For individuals, a substantial understatement exists when you understate liability by the greater of 10% of the correct tax or $5,000. If you claim the Section 199A qualified business income deduction, the threshold drops to the greater of 5% of the correct tax or $5,000. For corporations other than S corporations, it’s the lesser of 10% of the correct tax (or $10,000, if greater) and $10 million.¹²

Auditors who examine inventory deductions look for the same patterns: write-offs that spike in unusually profitable years, goods supposedly scrapped without any third-party confirmation, and subnormal goods where no real sales effort happened inside the 30-day window. Document the loss, size it to what your records support, and take a full write-off only after the goods have physically left.

1
Internal Revenue Service. Publication 538 – Accounting Periods and Methods
2
eCFR. 26 CFR 1.471-4 – Inventories at Cost or Market, Whichever Is Lower
3
eCFR. 26 CFR 1.471-2 – Valuation of Inventories
4
Internal Revenue Service. LB&I Concept Unit – Adopting LIFO
5
Office of the Law Revision Counsel. 26 USC 165 – Losses
6
Internal Revenue Service. Rev. Proc. 2025-32
7
GovInfo. 26 USC 471 – General Rule for Inventories
8
eCFR. 26 CFR 1.199A-10 – Allocation of Cost of Goods Sold
9
Internal Revenue Service. 2025 Instructions for Schedule C (Form 1040)
10
Internal Revenue Service. Form 1125-A – Cost of Goods Sold
11
Internal Revenue Service. About Form 1125-A, Cost of Goods Sold
12
Internal Revenue Service. Accuracy-Related Penalty