How to Value Inventory for Taxes: Methods, Rules and COGS

For US federal taxes, most businesses value inventory at cost or at the lower of cost or market, using a cost-flow assumption of FIFO, LIFO or specific identification. Inventory value drives cost of goods sold, which is beginning inventory plus purchases minus ending inventory. Small businesses under the Section 471(c) gross receipts threshold, $32 million for tax years beginning in 2026, can skip formal inventory accounting entirely.

That last point matters more than most owners realize. The Tax Cuts and Jobs Act created a genuine escape hatch, and a lot of small retailers and ecommerce sellers are still doing inventory accounting they are not required to do. Here is how valuation actually works, which method fits which business, and where people get into trouble. This is general information, not tax advice; your CPA should sign off on any method change.

Why inventory valuation changes your tax bill

Inventory is not deductible when you buy it. It sits on the balance sheet as an asset and only becomes a deduction when it sells, through cost of goods sold. The formula is:

COGS = Beginning inventory + Purchases (plus labor and other costs) − Ending inventory

Read that formula again and the tax lever is obvious. A higher ending inventory value means a lower COGS, which means higher taxable income. A lower ending inventory value means a bigger deduction this year. That is why the IRS cares which valuation method you use and why you cannot switch methods casually to chase a result. Sole proprietors report this in Part III of Schedule C; corporations and partnerships use Form 1125-A.

The small business exemption most sellers miss

Under Section 471(c), a taxpayer that meets the Section 448(c) gross receipts test and is not a tax shelter is exempt from the general inventory rules. The test looks at average annual gross receipts over the prior three years. The base figure of $25 million is inflation-adjusted each year: it was $31 million for tax years beginning in 2025 and $32 million for tax years beginning in 2026. Gross receipts means gross, so cost of goods sold does not reduce it. Those figures come from the annual IRS revenue procedures (Rev. Proc. 2024-40 for 2025 and Rev. Proc. 2025-32 for 2026), which is where to look rather than Publication 538, whose dollar figures are out of date.

If you qualify, you get two choices. You can treat inventory as non-incidental materials and supplies, deducting the cost when the item is sold or used rather than maintaining a formal inventory. Or you can simply follow the method of accounting for inventory reflected in your applicable financial statement, or in your books and records if you have no such statement. Both are dramatically simpler than the standard regime, and qualifying businesses are also exempt from UNICAP, because Section 263A(i) uses the same gross receipts test. One test, two pieces of relief. Corporations and partnerships tick which of these they used on Form 1125-A line 9a, where boxes (iv) through (vi) cover the non-incidental materials and supplies method, the applicable financial statement method and the non-AFS books method.

The valuation methods you can use

If you are not exempt, the regulations give you two ways to state inventory value. Cost means what you paid, including freight in and other acquisition costs, which is why your landed cost figure matters here and not just for pricing. Lower of cost or market lets you carry goods at market value when market has fallen below cost, recognizing the loss earlier. Retailers can also use the retail method, which works backward from selling prices using a cost-to-retail percentage, and is standard practice in stores with large mixed catalogs.

One rule trips people up constantly: if you elect LIFO, you cannot use lower of cost or market. LIFO taxpayers must value at cost. LIFO also carries a conformity requirement, meaning you generally have to use it in your financial statements too, not just your tax return.

FIFO vs LIFO vs specific identification

The cost-flow assumption decides which units are treated as sold when your purchase costs vary over time.

LIFO is not automatic. You adopt it by filing Form 970 with the return for the year you first use it, and once adopted you cannot simply drop it without IRS consent. In practice most small and mid-size US businesses use FIFO, because the recordkeeping is straightforward and it matches how goods physically move in almost every warehouse. If you are weighing the switch, model it on your own numbers first: LIFO only helps while costs are genuinely rising, and it costs you the option of lower of cost or market.

What about average cost, the method most inventory systems calculate by default? It is not one of the methods the Section 471 regulations enumerate, and for years the IRS treated it as failing to clearly reflect income. Rev. Proc. 2008-43 softened that: the Service generally accepts a rolling-average method for tax where the taxpayer already uses rolling average for financial accounting and meets the safe harbors, with more scrutiny when inventory is held for years or costs swing hard. A small business using the Section 471(c) books method effectively gets average cost anyway, since it simply follows its own books.

Can you write off obsolete or slow-moving inventory?

This is the most common misconception in the whole topic. You cannot simply decide that stock is not worth what you paid and write it down for tax purposes. The regulations require evidence. Under the standard rules you may value unsalable or damaged goods at a bona fide selling price less the cost of disposition, but that generally requires the goods to actually be offered for sale at that reduced price within a short window after the inventory date. The regulation is specific: a bona fide selling price means the goods were actually offered during a period ending no later than 30 days after the inventory date, the burden of proof sits with you, and raw or partly finished goods cannot be written below scrap value. The other clean route is actual disposal: scrap it, donate it, or sell it off, and document what happened.

The Supreme Court settled this in Thor Power Tool Co. v. Commissioner (1979). Thor wrote its excess spare parts down to net realizable value under GAAP while continuing to hold them and offer them at the old prices. The write-down was disallowed. Conforming to GAAP is not enough for tax: you need an actual price cut and offer, an actual disposal, or genuinely subnormal goods. Note too that because LIFO inventories are valued at cost regardless of market, LIFO taxpayers generally cannot take these write-downs at all.

Slow-moving is not the same as obsolete. A product that is still sellable at full price, just sitting, stays on the books at cost no matter how much cash it is tying up. That is a business problem long before it is a tax one, which is why dead stock is worth attacking during the year rather than hoping for a deduction at year end. The carrying cost of holding it is real money you are already spending.

Getting the numbers right before you file

Whichever method you use, the return is only as good as the count behind it. Ending inventory is a physical fact, and the fastest way to create an audit problem is to plug a number that your records cannot support. Do a real physical inventory count at year end, reconcile it against your system, and document the variances rather than quietly adjusting to match.

Cost records matter just as much as counts. Freight, duty and handling belong in the cost of the goods, and those charges are usually scattered across supplier invoices and card statements rather than sitting in one tidy report. Pulling them together is much easier when you can turn those statements into a clean spreadsheet instead of retyping a year of transactions in April.

Changing methods

Inventory valuation is a method of accounting, so switching, including moving onto or off the Section 471(c) treatment, generally requires filing Form 3115 for a change in accounting method. Many of these changes are automatic, meaning no advance IRS consent is needed, but the form still has to be filed and there may be a Section 481(a) adjustment to spread the catch-up difference. Do not change methods mid-stream on your own; this is exactly the point where a CPA earns their fee. Worth knowing as well: several states decouple from the federal small business provisions, so qualifying for Section 471(c) federally does not automatically settle how you report inventory on a state return.

What actually saves you money

Method selection moves your tax bill at the margin. Buying accuracy moves it much more. Every dollar sitting in stock you did not need is a dollar you already spent, and no valuation method gives it back. Getting the order quantities right in the first place, through honest demand forecasting and live reorder points, is worth more than any election on the return.

Want to see how much of your ending inventory is money that should not be there? Paste your stock and sales history into the live stock scan at the top of the site. It flags the items holding cash that is not earning, which is the same list you should be working before year end. For the software side of the decision, our inventory management software for small business page covers the practical options.