No, inventory is not an expense when you buy it. Under federal tax law and standard accounting rules, goods you purchase for resale or manufacture sit on your balance sheet as a current asset, and the cost only becomes an expense (called cost of goods sold) in the period the item actually sells to a customer. Treating a purchase as an immediate deduction overstates your expenses, understates your income, and is exactly the kind of mismatch the IRS looks for.
Why Inventory Sits on the Balance Sheet
When your business buys goods to resell, you are swapping one asset (cash) for another (inventory). Nothing has been consumed, so nothing gets expensed. The products in your warehouse still represent future revenue, and accounting standards treat them that way. Booking the whole purchase as an expense would make your financials look terrible in months you stock up and artificially strong in months you sell through that stock.
The tax code cares for a related reason. If businesses could deduct inventory the moment they bought it, they could time large purchases to wipe out taxable income in any given year. Federal law requires any business where producing or selling goods is a significant income source to account for inventory in a way that clearly reflects income.1Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories
When Inventory Becomes an Expense
The cost of an item hits your income statement in the same period the sale is recognized. Accountants call this the matching principle. A retailer who buys winter coats in August does not expense those coats until customers buy them in November and December.
The expense line is cost of goods sold, or COGS. The formula is straightforward: beginning inventory, plus purchases and production costs during the year, minus ending inventory. If you started the year with $10,000 in goods, bought $50,000 more, and had $20,000 on the shelf at December 31, your COGS is $40,000. That $40,000 is the portion that reduces your taxable income; the remaining $20,000 stays on your balance sheet as an asset and rolls into next year’s beginning inventory.
Because prices change over time, you also have to pick a consistent method for deciding which units are treated as sold: FIFO (oldest first), LIFO (newest first), or average cost. The IRS gives greater weight to consistent application than to any particular method, as long as your approach conforms to acceptable practices and clearly reflects income.2eCFR. 26 CFR Part 1 – Inventories – Section: 1.471-2 Valuation of Inventories Bouncing between methods to chase a lower tax bill is not allowed.
Costs That Have to Be Capitalized Into Inventory
The invoice from your supplier is not always the full cost that belongs in inventory. Section 263A, commonly called the uniform capitalization or UNICAP rules, requires businesses that produce property or buy it for resale to fold certain indirect costs into inventory value rather than deducting them right away.3Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses For manufacturers, that means direct labor and a share of overhead like storage, handling, and factory utilities. For retailers and wholesalers, it covers a portion of purchasing, warehousing, and related costs.
These costs stay locked inside the inventory asset until the goods sell, then flow through COGS. Deducting them upfront overstates expenses and understates income, and it is a frequent audit finding. Smaller businesses are exempt, as explained below.
When Inventory Loses Value Before It Sells
Not everything you buy makes it to a paying customer. Theft, damage, expiration, and shifting demand can leave you holding stock that is no longer worth what you paid.
For tax purposes, you can value inventory at the lower of cost or market under Treasury Regulation 1.471-4. You compare each item’s original cost to its current market value and use whichever is lower.4eCFR. 26 CFR 1.471-4 – Inventories at Cost or Market, Whichever Is Lower The drop becomes an immediate expense in the period you record it. Goods that are damaged, shopworn, or obsolete must be valued at their realistic selling price minus disposal costs.2eCFR. 26 CFR Part 1 – Inventories – Section: 1.471-2 Valuation of Inventories
Documentation is where most businesses trip up. If you write off or write down inventory, you need proof the goods were not quietly sold: photos before and after destruction, receipts from a liquidator or salvage buyer, or acknowledgment letters from a charity. The burden of proof is on you.
The Small-Business Shortcut
Not every business has to run full inventory accounting. If your average annual gross receipts over the prior three tax years are $32 million or less, you may qualify for a significant simplification.5IRS. Rev. Proc. 2025-32 Section 471(c) lets qualifying small businesses skip traditional inventory accounting and instead treat inventory as non-incidental materials and supplies.1Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories Under that treatment, the cost is deductible when the item is sold to a customer or when it is paid, whichever is later.6eCFR. 26 CFR 1.471-1 – Need for Inventories
The exemption also releases you from UNICAP, so you do not have to capitalize indirect costs. Some limits apply: you cannot use LIFO under this method, you must apply your chosen tracking approach (specific identification, FIFO, or average cost) consistently, and tax shelters are excluded regardless of receipts.6eCFR. 26 CFR 1.471-1 – Need for Inventories The $32 million threshold is inflation-adjusted annually, so check the current revenue procedure each year.
How to Report COGS on Your Return
Where you calculate cost of goods sold depends on your business structure. Sole proprietors handle it in Part III of Schedule C.7IRS. Schedule C (Form 1040) – Profit or Loss From Business C corporations (Form 1120), partnerships (Form 1065), and S corporations (Form 1120S) attach Form 1125-A.8IRS. Form 1125-A – Cost of Goods Sold
Both forms walk through the same beginning-plus-purchases-minus-ending calculation, and both ask you to identify your valuation method and flag any change in method during the year. The IRS uses those entries to check whether your COGS aligns with the inventory method you elected. Inconsistencies are a common audit trigger.
Changing Your Inventory Method
Once you have chosen an inventory method, you cannot simply switch. Section 446(e) requires the Secretary’s consent before changing the method of accounting you use to compute income.9Office of the Law Revision Counsel. 26 USC 446 – General Rule for Methods of Accounting In practice that means filing Form 3115 (Application for Change in Accounting Method). Many inventory-related changes qualify for automatic consent, which means no user fee and no individual IRS review at the time of filing, though the IRS can still examine the change later.10IRS. Instructions for Form 3115
Changing methods without filing Form 3115 is a common and expensive mistake. The IRS can adjust reported income for every year you used an unauthorized method, with interest on any resulting underpayment, and your inventory valuations remain subject to examination at any time.