Can I Deduct Inventory When I Purchase It? + FAQs

No, you generally cannot deduct inventory when you purchase it; under IRS rules, inventory is a business asset that you deduct only when it’s sold (as part of Cost of Goods Sold), not at the moment of purchase.

According to a 2024 inventory management study, 43% of small businesses do not even monitor their inventory levels, leading to widespread confusion about what can be written off and when. Many entrepreneurs mistakenly try to reduce taxes by stocking up on inventory, only to learn the hard way that unsold merchandise usually does not count as a tax deduction. This comprehensive guide will clarify the inventory deduction rules and cover every angle – from accounting methods and key IRS regulations to real-world scenarios for retail, manufacturing, and service businesses.

🛒 No Instant Write-Off: Understand why unsold stock isn’t immediately deductible and how the cost of goods sold rule means you only get to write off inventory when you sell it.
💡 Key Tax Rules (IRC 471 & 263A): Learn about the IRS regulations that require capitalizing inventory costs and the special exceptions that simplify accounting for small businesses.
💰 Cash vs Accrual & TCJA: See how choosing cash vs accrual accounting – and the Tax Cuts and Jobs Act’s $25 million gross receipts exception – changes when you can deduct inventory purchases.
⚖️ GAAP vs Tax Treatment: Discover how financial accounting (GAAP) rules differ from tax rules for inventory, and what that means for your bookkeeping vs. tax filings.
🏭 Real Scenarios & State Nuances: Walk through examples for retail, manufacturing, and service businesses, and learn about state-specific inventory tax pitfalls (and strategies to navigate them).

Immediate Answer: Inventory Purchases Are Not Immediately Deductible

Under standard tax rules, buying inventory does not create an immediate deduction. You generally cannot write off the cost of inventory at the time of purchase. Instead, the cost of inventory is added to your balance sheet as an asset. It only becomes a tax deduction later, when you sell the inventory and record its cost as Cost of Goods Sold (COGS) on your income statement or tax return.

For example, if you purchase $10,000 of goods for resale in December but sell only $2,000 worth by year-end, only $2,000 is deductible as that year’s COGS. The remaining $8,000 stays on your books as inventory (asset) to be deducted in a future year when those items are actually sold.

The rationale is that expenses should be matched to the revenue they generate. Inventory is essentially a prepaid expense for future sales, so the IRS wants you to deduct it later – in the year you actually make the sale.

This matching principle prevents businesses from wiping out profits by buying a ton of stock they haven’t sold. Simply put, purchasing inventory is not a tax write-off until those items contribute to your gross income – with only a few narrow exceptions for certain small businesses (as discussed later).

Avoid These Costly Inventory Deduction Mistakes

Even savvy business owners slip up when it comes to inventory and taxes. Avoid these common pitfalls:

Counting unsold stock as a deductible expense: Don’t list unsold inventory as a direct expense on your tax return. For example, do not put inventory purchases under “Supplies” or “Expenses” hoping to get an immediate deduction. If the goods are still on hand (not sold), they should remain on the balance sheet, not reduce taxable income yet.
Ignoring your year-end inventory count: Failing to tally up unsold inventory at year-end leads to an overstated COGS deduction. This mistake can trigger IRS audits or adjustments. Always perform an accurate physical inventory count and carry over the correct ending inventory value – it ensures you only deduct what was actually sold.
Deducting the same cost twice: Be careful not to “double-dip.” If you include a cost in COGS, don’t also claim it elsewhere. For instance, if you allocate certain labor or overhead to inventory, those costs should be part of inventory/cost of goods sold, not claimed again as a separate business expense.
Switching accounting methods incorrectly: If you decide to change from accrual to cash accounting (or vice versa) for handling inventory, get IRS approval (usually by filing Form 3115). An improper switch – like suddenly expensing all inventory on hand without permission – is a big no-no. The IRS expects consistency (or an approved method change) in how you report inventory.
Misclassifying assets as inventory: Inventory is for items held for sale (or used in production). Don’t confuse it with other assets. For example, equipment and tools are not inventory – they may be depreciated or expensed under other rules, but they are not COGS. Similarly, consumable supplies used in providing services (like office supplies or cleaning materials) might be immediately deductible, whereas inventory for sale is not.

Key Terms and Concepts (Inventory Accounting 101)

Understanding these fundamental terms will help clarify how inventory is treated:

Inventory: Items held for sale (or used in producing goods for sale) in the ordinary course of business. Inventory can be merchandise a retailer buys for resale, or raw materials, work-in-process, and finished goods for a manufacturer.

Cost of Goods Sold (COGS): The direct cost of products you sold during the period. It’s calculated as Beginning Inventory + Purchases – Ending Inventory. COGS is the portion of your inventory costs that becomes a deductible expense once the goods are sold.

Capitalize vs. Expense: To capitalize an expenditure means to record it as an asset (to be expensed over time or when used), whereas to expense means to deduct it immediately. Inventory costs are capitalized when incurred (added to the asset) and expensed later through COGS. This contrasts with regular business expenses (like rent or utilities) which are expensed right away.

Accrual Method Accounting: An accounting method where income is reported when earned and expenses are reported when incurred, regardless of cash flow. Under accrual, inventory must be accounted for: you record sales when made (even if not paid yet) and you match the cost of inventory to those sales (COGS) when the sale happens.

Cash Method Accounting: An accounting method where income is reported when cash is received and expenses when cash is paid. Traditionally, businesses using the cash method still had to follow special rules for inventory (treating it similarly to accrual). However, new tax law changes (for small businesses) allow some to treat inventory more like materials and supplies under the cash method (discussed later).

Materials and Supplies: Tangible items used in the business that are not inventory for sale – for example, office supplies or repair parts used in a service business. Incidental supplies (small items you don’t track, like office pens or nails) can be deducted when purchased. Non-incidental supplies (items you do track or that are significant, like spare parts) are deducted when first used or consumed. The tax rules now allow qualifying small businesses to treat inventory as non-incidental materials and supplies, meaning deduct when used (i.e. when sold in the case of goods for sale).

IRC Section 471: The section of the Internal Revenue Code that governs inventory accounting. It essentially requires that inventory be accounted for in a way that clearly reflects income – generally meaning you must capitalize inventory costs and cannot deduct them until sold. (Section 471 has special subsections now that give exceptions to small businesses.)

IRC Section 263A (UNICAP): The “Uniform Capitalization” rules which mandate capitalizing not just the direct cost of inventory, but also certain indirect costs (like factory overhead, storage, handling, and some administrative costs). Large and medium businesses must allocate these costs into inventory, preventing immediate deduction of those expenses. Small businesses under a gross receipts threshold are now exempt from 263A, so they can expense those indirect costs each year instead of tying them up in inventory.

Gross Receipts Test (Small Business Taxpayer): A provision that allows businesses with average annual gross receipts under a certain threshold ($25 million, adjusted for inflation – around $27–$30 million in recent years) to qualify as “small business taxpayers”. If you qualify, you are exempt from some of the strict inventory rules (Sec. 471 and 263A requirements), and you can opt for simplified methods like the cash method for inventory.

Section 179 Deduction: A tax rule that lets businesses immediately deduct the cost of certain tangible assets (like equipment) instead of depreciating over years. Important: Section 179 does not apply to inventory. Inventory is not a depreciable business asset – it’s intended for sale, not for use in the business’s operations – so you cannot use Section 179 or bonus depreciation on inventory purchases.

Lower of Cost or Market (LCM): An inventory valuation method where you write down unsellable or obsolete inventory if its market value drops below cost. For tax purposes, write-downs are allowed only if goods are unsellable or have actual reduced value. (A tax write-down must follow IRS rules; you can’t just devalue inventory to get a deduction unless there’s a real impairment or loss.)

FIFO vs. LIFO: These are cost-flow assumptions for inventory. FIFO (First-In, First-Out) assumes the oldest items are sold first, while LIFO (Last-In, First-Out) assumes the newest items are sold first. Companies choose one for financial and tax reporting. This choice affects which costs become COGS first (important during inflation/deflation) but does not change the overall rule that unsold inventory remains on the balance sheet. (Note: LIFO is permitted for tax only if elected and used in financial books; it can provide tax deferral in inflationary times by expensing newer, higher costs first.)

Examples: Inventory Deductions in 3 Business Scenarios

To illustrate the rules in action, let’s look at three different types of businesses and how each handles inventory for tax purposes.

Scenario 1: Retail Business (Reseller of Products)

Imagine a small retail shop – say, a bookstore. The owner buys $20,000 of books during the year. By December 31, $15,000 worth of those books have been sold to customers, and $5,000 of books remain unsold on the shelves (ending inventory at cost). For tax purposes, the bookstore’s COGS for the year is $15,000 (the cost of the books sold). The remaining $5,000 is not deducted this year; it stays on the balance sheet as inventory. In the next year, when those remaining books are sold, that $5,000 will become part of COGS (reducing next year’s taxable income). The key point: the retailer cannot deduct the cost of the unsold books now, even though the cash was spent – the deduction is deferred until sale.

Note: If the bookstore qualifies as a small business under the $25 million gross receipts test and uses the simplified cash method for inventory, it might not separately report inventory on tax forms. However, even under those simplified methods, unsold stock isn’t immediately expensed. The cash-method bookstore could choose to treat inventory as “non-incidental materials and supplies,” but that still means the cost comes off when the book is sold or used (not before). So our retailer’s outcome (no deduction for $5k unsold stock) remains the same.

Scenario 2: Manufacturing Business (Producer of Goods)

Now consider a manufacturer, for example a furniture maker. This company buys $50,000 of raw materials (wood, hardware, fabric) and incurs another $30,000 in factory labor and overhead to build furniture. By year-end, some of the furniture is completed and sold for $60,000 revenue, and some is still in production or finished awaiting sale. Let’s say out of the $80,000 total production cost ($50k materials + $30k labor/overhead), $45,000 worth of goods were sold by year-end. That $45,000 becomes the Cost of Goods Sold deduction for the year. The remaining $35,000 of production cost is tied up in ending inventory (some as finished products in the warehouse, some as work-in-process). That $35,000 is not deducted this year – it’s carried on the balance sheet as inventory asset going into next year.

For manufacturers, inventory accounting can be even more complex. They must capitalize all the production costs into inventory. Only when a product is sold do those capitalized costs flow to COGS. If the furniture maker is a larger business, it also has to apply UNICAP (Section 263A), meaning even indirect costs (factory utilities, quality control, etc.) get rolled into inventory value rather than expensed immediately. (If it’s a small manufacturer under the TCJA threshold, it can opt out of UNICAP – a relief that lets it deduct those indirect costs each year – but direct material and labor still stick with the inventory until sale.) The bottom line: a manufacturer cannot deduct the costs of producing inventory until that inventory is sold, which may span across tax years.

Scenario 3: Service Business (Minimal or No Inventory)

Finally, consider a service-based business – for example, a plumbing repair sole proprietor. Generally, service companies don’t have merchandise inventory for sale, but they might have materials and supplies used in providing their service. Our plumber, Alice, buys $2,000 worth of pipes, valves, and fittings to use on various jobs this month. If she uses $1,600 worth of those parts on client projects by the end of the year, that $1,600 is deductible (it’s part of her cost of providing services). The remaining $400 of unused plumbing supplies will be treated as inventory or materials on hand – not deducted until she uses those parts on a future job.

In practice, very small service businesses often expense supplies immediately if the amounts are minor (incidental). For instance, Alice might not bother tracking every washer or screw, and the IRS allows deduction of incidental supplies when purchased. However, for significant materials (like water heaters, expensive fixtures, or a bulk stock of pipes), she must follow the inventory rules. If it’s on the shelf at year-end and still unused, its cost should stay on her books (asset) rather than being written off. The good news for Alice is that as a qualifying small business, she can use cash accounting and treat supplies similarly to inventory under the new rules – but this doesn’t magically create a deduction for unused items. It mainly simplifies her recordkeeping. In short, service businesses get to deduct materials when used (installed in a job), not simply when bought (unless the items are so minor that they fall under incidental expenses).

IRS Rules and Regulations for Inventory Deductions

The U.S. tax code has specific provisions that govern how inventory is treated. The goal is to ensure taxpayers clearly reflect income and don’t take deductions too early. Here are the key rules:

“Clearly Reflect Income” – The General Rule (IRC §471)

Internal Revenue Code Section 471 and related regulations lay out the baseline: if you have inventory, you must account for it in a way that clearly reflects income. In plain terms, this means you capitalize inventory costs and defer deductions until the inventory is sold. Historically, the IRS required businesses with inventory to use the accrual method for purchases and sales – treating inventory as an asset, not an immediate expense. The tax regulations long stated that when inventory is a “income-producing factor” in a business, the accrual method is needed to clearly reflect income. Thus, under Section 471, you cannot just deduct inventory when bought, because doing so would distort your true profits for the period.

(Implication: If a taxpayer tried to expense all inventory purchases, the IRS could deem their method improper under §471 and require an adjustment. In practice, most businesses follow the rules by computing COGS and carrying unsold inventory over to the next year.)

Uniform Capitalization (UNICAP) – Adding Overhead Costs (IRC §263A)

IRC Section 263A – the Uniform Capitalization rules – is another layer of inventory tax law. Under §263A, medium and large businesses must capitalize certain indirect costs into their inventory, not just the direct cost of goods. This means costs like warehouse rent, production equipment depreciation, quality control, and even officer salaries related to production can’t be deducted immediately; they must be added to inventory value. The effect is to further delay those deductions until the inventory is sold as COGS. UNICAP was intended to prevent big companies from currently expensing a bunch of indirect production or storage costs to reduce taxable income – instead, a portion of those costs sticks on the balance sheet as part of inventory.

For example, if a factory incurs $1 million in overhead, a portion gets allocated into the products made and will only be deducted through COGS when those products are sold. This rule can be quite complex, requiring detailed calculations each year. However, small businesses are exempt: If your average gross receipts are under the threshold (currently around $27 million), §263A does not apply to you after the Tax Cuts and Jobs Act. You can elect to opt-out of UNICAP, reducing capitalized expenses and eliminating the burdensome UNICAP calculation. Importantly, even with UNICAP relief, the direct costs of inventory (materials, labor) still remain capitalized until sale – only the extra burden of indirect cost allocation is lifted.

Small Business Taxpayer Exception (TCJA and IRC §471(c))

In 2017, the Tax Cuts and Jobs Act introduced major simplification for small businesses regarding inventory. Under new IRC §471(c), if a business meets the “small business taxpayer” gross receipts test (<= $25 million average receipts, adjusted for inflation), it is no longer bound by the strict accrual rules of §471 for inventories. These taxpayers have two main options:

Treat inventory as non-incidental materials & supplies. This means rather than maintaining formal inventory on the books, you expense the inventory items when they are “used or consumed” in the business. For a reseller, “used or consumed” effectively means sold to a customer; for a manufacturer, it means used in producing a product that is sold. (As we saw, the IRS clarified that even under this method, you can’t deduct raw materials until the finished product is sold – you must wait until consumption is complete.)
Conform to the company’s financial accounting treatment. If you don’t want to use the special supplies method, a small business can simply follow its book accounting for inventory on the tax return. If your books (or financial statements) don’t bother recording inventory and just expense costs, the IRS will allow the same for tax up to a point. Essentially, if you have no inventory on your balance sheet, you may deduct purchases – but caution: you must be consistent and your books must “clearly reflect income” even without formal inventory. Many small businesses still track inventory for their own management or lending requirements. In those cases, they would generally mirror that tracking for tax.

These TCJA provisions do not force small businesses to change; they only provide flexibility. A qualifying business can stick with accrual inventory if preferred, or adopt one of the above simplified methods. To change methods, filing a Form 3115 (Change in Accounting Method) is generally required, but the IRS made it automatic and user-friendly to switch to these small-business-friendly methods after TCJA.

Important: The small business exception does not mean you get to deduct unsold inventory immediately in any practical sense. It mainly frees you from some complexity. If a small retailer uses the book-conformity method and their books simply expense inventory purchases (with no tracking), then yes, in that scenario the purchases are deducted – but that’s because by year-end essentially they’re treating everything not on hand as sold or used. Any significant unsold inventory would presumably show up on their books (if they do a count for their own profit calculation), and would still not be deducted. The IRS’s final regulations confirmed that you can’t just ignore large amounts of inventory on hand. In short, the TCJA gave small businesses the option to use cash-style accounting for inventory, but it didn’t create a loophole to write off inventory en masse before it’s used or sold.

(Side note: Certain businesses, like tax shelters or farming corporations, may not qualify for the small-business exception even if their revenue is low. But for the majority of typical small businesses, the $25M/inflation-adjusted threshold applies.)

GAAP vs. Tax: Different Inventory Accounting Rules

It’s worth noting that financial accounting (GAAP) rules and tax rules on inventory, while similar in core principle, do diverge in some areas. Generally Accepted Accounting Principles (and IFRS internationally) require that inventory be treated as an asset on the balance sheet and expensed through COGS when sold – just like tax. So the basic idea that you don’t immediately expense inventory is true in both GAAP and tax. However, recent tax law changes (like the small-business exceptions) have no equivalent in GAAP. GAAP doesn’t say “if you’re under $25M revenue you can just expense your inventory.” Even a small company’s audited financial statements must follow the accrual method for inventory if inventory is significant.

Write-downs and valuation: GAAP is often more aggressive in requiring inventory write-downs for impairment. If inventory becomes obsolete or unsellable, GAAP says you should mark it down to its net realizable value (and record a loss). Tax law, on the other hand, is more conservative – you can only write down or deduct inventory losses when you can prove the goods are actually worthless or unsellable (or under specific IRS-approved valuation methods like Lower of Cost or Market). For example, if you have outdated stock that might still sell at a deep discount, GAAP might have you recognize a loss reserve, but tax law might not allow a deduction until you actually scrap or dispose of those items.

Cost allocation differences: Both GAAP and tax require that product costs (direct materials, direct labor, and a share of overhead) attach to inventory. GAAP mandates absorption costing for inventory (similar to the IRS’s 263A UNICAP rules). A difference is that GAAP doesn’t provide a small-business exemption – even if you’re a tiny manufacturer, GAAP would say all relevant overhead should be factored into inventory cost on the financial statements. In contrast, as we discussed, tax law now lets small manufacturers opt out of capitalizing some overhead. This means a company’s financial books might show a higher inventory asset (with overhead included) while the tax books might have slightly lower inventory (if certain costs were deducted immediately for tax). Companies that utilize the tax simplifications will have a book-tax difference to reconcile. (This is handled via schedules on the tax return so the IRS sees why your tax COGS might differ from your accounting records.)

LIFO and other methods: Another quirk – if a company uses LIFO (Last-In, First-Out) for tax (a method beneficial in inflationary times), it is required by tax law to use LIFO for its financial reporting as well (the LIFO conformity rule). GAAP permits LIFO or FIFO, but IFRS (international standards) do not allow LIFO at all. Some firms therefore stick to FIFO on both books and tax to avoid complexity. The key point is that any method that accelerates or defers inventory costs for tax might not be reflected the same way in the GAAP financials, and vice versa, so keeping dual records or adjustments is often necessary.

In summary, tax rules and GAAP both uphold the matching principle for inventory, but tax rules have special exceptions and elections (based on policy goals like small business relief) that don’t exist in GAAP. If you’re a small business owner who took advantage of cash-method inventory for tax purposes, you may still maintain traditional accrual accounting for your internal or lender-required financial statements. Always be mindful of which set of rules you are following in a given context, because methods allowed in tax might not be acceptable in financial reporting (and vice versa).

Cash vs. Accrual Accounting (Impact on Inventory)

Your overall accounting method – cash or accrual – plays a major role in when deductions are taken, but inventory historically has been a special case. Under the pure cash method, you normally deduct expenses when you pay them and report income when you receive it. However, for many years the IRS didn’t let cash-basis businesses simply deduct inventory purchases when paid – inventory had to be handled essentially on an accrual basis (because of the clear-reflection-of-income rule).

Accrual method with inventory: If you use accrual accounting, you’re automatically following the standard inventory rules. You record sales when earned (even if not paid yet), and you record COGS for the inventory sold. Unsold inventory sits on the balance sheet. This method matches income and expenses well, but it can cause cash flow strain – you might be paying for inventory (cash out) but not deducting it until later.

Cash method with inventory (old rules vs new): Traditionally, a strictly cash-basis business would still have to compute COGS and track inventory if inventory was a big part of the business. The Tax Cuts and Jobs Act changed this by allowing eligible small businesses to use the cash method and simplify inventory accounting. Now, if you qualify as a small taxpayer, you can choose not to track inventory in the traditional way. In practice, as we described in the TCJA section, you might treat inventory as materials and supplies or use your book method. If you literally expense all inventory as it’s purchased (cash out the door), that implies you are not counting any inventory left on hand. This is only permissible if doing so aligns with your actual books and the inventory on hand is minimal or turns over very fast. Generally, cash-method taxpayers still can’t deduct inventory that remains unused at year-end – the cash method flexibility mainly means you don’t have to adhere to the formal accrual tracking, but you can’t blatantly deduct items still sitting on your shelf.

Cash vs accrual timing differences: Cash accounting can offer some tax deferral advantages – for example, you don’t count a sale as income until the customer pays, and you don’t deduct expenses until you pay them. For inventory-heavy businesses, being on cash method might defer income (if you have large accounts receivable) and let you time payments for supplies. But inventory itself often neutralizes some benefits: whether cash or accrual, you end up deferring the deduction until sale in most cases. One potential benefit for those switching from accrual to cash is a one-time deduction boost: when you switch, you may deduct existing inventory that was on the books (via a “§481 adjustment”). Essentially, you’re catching up on deductions for inventory costs that were capitalized under accrual. This can produce a significant tax savings in the year of change. (The IRS allows this adjustment when you file Form 3115 to change methods.)

In summary, accrual method is required for proper inventory accounting except for those who qualify for and elect the new simplified cash method exceptions. Many small businesses love the cash method for its simplicity and potential deferral of income, but even they must respect the basic principle that unsold inventory isn’t immediately expensed. Always weigh the pros and cons of cash vs accrual in light of your inventory levels and business needs – and consult a tax professional if considering a method change.

Inventory Capitalization vs. Inventory Write-Offs

When you capitalize inventory costs, you are essentially postponing the deduction. The value sits on your balance sheet as an asset (inventory) until some triggering event – usually a sale – lets you expense it via COGS. However, what if the inventory is never sold? Businesses sometimes end up with spoiled, damaged, or obsolete inventory. In such cases, tax rules do allow you to write off inventory and claim a deduction, but you must follow proper procedures:

Damaged or unsellable goods: If items become worthless (e.g. expired perishable goods or damaged beyond sale), you can remove them from inventory and charge their cost to COGS or a loss account. This effectively deducts the cost. It’s wise to document the disposal (e.g. throw them away, donate, or otherwise dispose) to support the deduction.

Inventory shrinkage or theft: If your inventory count finds less inventory than your books show (due to theft or error), you can write down the inventory and increase COGS for the missing amount. Again, keep records of such adjustments in case of audit.

Obsolete inventory: For items that have dropped in value (outdated stock), tax law doesn’t let you freely mark them down unless you actually scrap them or their market value is verifiably lower than cost. If you can show an item’s market value is below cost (and you use an authorized lower-of-cost-or-market method), you may write it down. Otherwise, many businesses choose to deeply discount or liquidate old inventory – the loss will then show up as lower revenue or as COGS when sold at a loss.

Donating inventory: If you donate inventory to a charity, you generally can deduct the cost of those goods (as a charitable contribution or as COGS). You cannot deduct the full retail value. (C Corporations donating inventory for certain causes can get an enhanced deduction – usually cost plus half the markup, subject to limits – but small businesses typically just deduct their cost).

The key point is that inventory write-offs become deductions at the point the inventory leaves your possession (or is no longer economically valuable). Until then, its cost must remain capitalized. Keeping good records of inventory write-offs (physical destruction, donation receipts, etc.) is crucial to substantiate the deduction if the IRS asks.

Notable Court Rulings on Inventory Accounting

Court decisions over the years have reinforced the IRS’s strict stance on inventory deductions:

Thor Power Tool Co. v. Commissioner (1979): In this famous U.S. Supreme Court case, a company had written down the value of slow-moving inventory on its financial books (because it likely wouldn’t sell at full price). They wanted to deduct that write-down for tax. The Supreme Court sided with the IRS, ruling that tax law does not permit an inventory write-down simply for slow-moving stock unless you can show the goods are actually obsolete or unsellable. This case underscored that tax accounting can be less flexible than GAAP – you can’t take a deduction just because you think inventory’s value dropped.

Knight-Ridder v. United States (2001): This case involved a newspaper publisher that treated newsprint and ink as supplies rather than inventory. The court allowed it, given that the taxpayer consistently treated those consumables as supplies used up in producing the newspaper (and not as inventory held for sale). The takeaway here was that certain items closely tied to a service/product and consumed quickly might not be considered inventory for tax purposes. However, the facts must support that treatment (and now the §471(c) rules explicitly allow treating materials as non-incidental supplies in some cases).

Overall, courts have consistently upheld the principle that you cannot currently deduct inventory costs unless and until the requirements are met (sale, worthlessness, etc.). If you ever have a gray area (like an item that could be inventory or a supply), consistent treatment and strong justification are key – and even then, the IRS or courts may scrutinize aggressive tax positions on inventory.

Tax Forms and Schedules Involved

When dealing with inventory on your taxes, be aware of these important forms and schedules:

Schedule C (Form 1040): This is the form sole proprietors and single-member LLCs file with their individual tax return. Part III of Schedule C is specifically for “Cost of Goods Sold.” You’ll report your beginning inventory, purchases, ending inventory, and compute COGS on this schedule. (For a service business with no inventory, this part may be left blank.)

Form 1125-A (Cost of Goods Sold): Corporations (Form 1120) and many pass-through entities (Form 1120-S for S-corps, Form 1065 for partnerships) use Form 1125-A to detail their COGS calculation. It’s essentially the same information: beginning inventory, purchases, cost of labor, materials, other costs, and ending inventory. The totals from Form 1125-A flow into the main tax return to adjust gross income.

Balance Sheets (Schedule L): On business tax returns (Form 1120, 1120S, 1065), if you’re required to provide a balance sheet, the Inventory asset will appear there (end of year inventory equal to what you reported as ending inventory in COGS). Consistency between your COGS calculation and balance sheet inventory is important.

Form 3115 (Application for Change in Accounting Method): If you decide to change how you account for inventory (for example, switching to the cash method & §471(c) small-business method, or adopting LIFO), you generally need to file Form 3115 to get IRS approval (often automatic for these changes). This form outlines the nature of the change and calculates any §481(a) adjustment (like adding income or deducting previously capitalized costs) due to the switch. In recent years, the IRS has made it easier for small businesses to file this when implementing the TCJA inventory simplifications.

Form 970 (Application to Use LIFO): If you want to use the LIFO inventory method for tax, you must file Form 970 in the first year you adopt LIFO. This isn’t about immediate deduction, but it’s a form related to inventory that’s worth noting – LIFO can affect the timing of inventory cost deductions.

State Tax Forms: If your state has an inventory tax (property tax), there may be a separate form or section on the business personal property tax return where you report inventory value. For example, some local jurisdictions require an annual business property report listing inventory value on hand. This is separate from your income tax filing but important for compliance.

Pros and Cons of Expensing Inventory Immediately

Many business owners wish they could deduct inventory as soon as they buy it. While generally not allowed (except in limited cases for small businesses), it’s useful to understand the potential advantages and drawbacks of immediate expensing versus the normal capitalization method:

Pros of Immediate Expensing	Cons of Immediate Expensing
Immediate tax relief and cash flow – Reduces current taxable income, which can free up cash (through tax savings) to reinvest in the business sooner.	Mismatch with actual profit – Expenses would be recorded before the revenue is earned, making financial statements less reflective of true performance; you might show a tax loss despite having unsold goods of value.
Simpler accounting (in theory) – No need to track inventory levels each year or perform complex closing inventory counts for tax purposes if everything is expensed.	Taxable income volatility – Deducting large purchases one year and having no COGS in the next (because you expensed it already) can cause big swings in taxable income between years, complicating planning and potentially pushing you into higher tax brackets in later years.
Avoids capitalizing overhead – For small producers, being able to expense costs (materials, labor, overhead) now means not tying up money in inventory on the books. (TCJA effectively allows this for indirect costs by opting out of UNICAP.)	Audit risk if done improperly – Immediately expensing inventory without proper eligibility or method change can draw IRS scrutiny. The IRS could disallow the deduction, leading to back taxes and penalties.
One-time boost when switching methods – If allowed to switch to expensing (e.g. via a §481 adjustment), you get a big deduction for existing inventory. This can provide a significant one-time tax benefit.	Not allowed for most – Bottom line: except for specific small-business situations, you legally cannot expense inventory at purchase. Trying to do so (outside the rules) can put you in non-compliance with tax law. Plus, even when allowed, you still need to track inventory for management purposes (to avoid stockouts and to measure profit margins).

State Law Nuances (Inventory Tax by State)

Inventory isn’t just a federal income tax issue – some states have their own quirks. A number of states impose a property tax on business inventory (usually at the county/local level), which is separate from income tax. Meanwhile, state income tax codes usually start with federal taxable income, but not all states conform to the latest federal rules on inventory expensing. Here’s a brief look at some state differences:

State	Inventory Tax & Treatment
California	No property tax on inventory. California’s income tax largely conforms to federal rules, meaning inventory is treated the same as under IRS rules (no immediate deduction for unsold inventory).
Texas	Yes – Texas businesses pay a local property tax on inventory (rates ~0.37–2.5% of inventory value). There is no state income tax, so businesses don’t get an income tax deduction for inventory until federal COGS applies, but the property tax on holding inventory increases the cost of carrying unsold stock.
Georgia	Partial – Georgia allows local counties to tax inventory, but offers Freeport Exemptions that can exempt certain inventory (like goods in warehouses destined to be shipped out of state) from property tax. Georgia’s state income tax conforms to federal law, so small businesses follow the same inventory deduction rules as IRS.
Louisiana	Yes – Louisiana parishes levy property tax on inventory. However, Louisiana provides a state income (or franchise) tax credit to businesses for the local inventory taxes paid, softening the blow. For income tax, Louisiana conforms to federal treatment of inventory (with state-specific adjustments being rare).
Maryland	Yes (local) – Maryland has no state-level inventory tax, but some local jurisdictions tax business inventory as part of personal property. Rates vary by county. For state income tax, Maryland uses federal taxable income as a starting point, so it generally follows the IRS inventory rules (small federal exceptions, like the TCJA small-business inventory provisions, typically flow through to Maryland’s tax unless the state legislature decouples).

FAQ (Frequently Asked Questions)

Q: Can I deduct inventory I haven’t sold yet on my taxes?
A: No. Unsold inventory is not deductible. You must carry it into the next year as an asset. You only get a deduction once the inventory is sold (via COGS).

Q: If I use the cash method of accounting, can I expense inventory when purchased?
A: Generally no. Even cash-basis businesses must follow inventory rules. Only if you qualify for the IRS small-business exception can you simplify inventory, and even then unsold items aren’t immediately expensed.

Q: Is inventory considered a business expense?
A: Yes, but not upfront. Inventory costs become a business expense through Cost of Goods Sold when you sell the product. Until then, they’re treated as an asset, not a current expense.

Q: Can I use Section 179 or bonus depreciation to write off inventory?
A: No. Section 179 and bonus depreciation apply to long-term assets like equipment. Inventory is not depreciable – it’s intended for sale, so its cost is deducted only as COGS when sold.

Q: Do I need to count my inventory at year-end for tax purposes?
A: Yes. An accurate year-end inventory count (or valuation) is necessary to calculate COGS correctly. Knowing beginning and ending inventory values ensures you deduct the right amount and stay compliant.

Q: Do any states tax your inventory just for holding it?
A: Yes. About a dozen U.S. states impose a property tax on business inventory value (usually at the local level). Most states, however, do not – it depends on your location.

Q: If my inventory loses value or becomes worthless, can I write it off?
A: Yes, in most cases. If goods are unsellable (damaged, expired, obsolete), you can remove them from inventory and claim a deduction for their cost. Document the loss or disposal for your records.

Q: Will buying a lot of inventory before year-end reduce my taxes for this year?
A: No. Simply purchasing inventory doesn’t lower your taxable income unless you sell or use those items. Unsold inventory at year-end isn’t deducted, so year-end stockpiling won’t generate an immediate tax break.