Inventory for Tax: FIFO, LIFO, and the Small Business Rule
How inventory changes the timing of deductions, the cost-flow methods the IRS allows, and the simplified rules for businesses under the gross receipts threshold.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
For tax, inventory is deducted when goods are sold, not when they are bought. The cost-flow method — FIFO (first in, first out), LIFO (last in, first out), or specific identification — decides which purchase costs count as sold. Businesses under the gross receipts threshold may use simplified rules that follow their own books.
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Which cost-flow methods are allowed?
| Method | How it works | Effect when prices rise |
|---|---|---|
| FIFO | Oldest costs are treated as sold first | Lower cost of goods sold, higher taxable income |
| LIFO | Newest costs are treated as sold first | Higher cost of goods sold, lower taxable income |
| Specific identification | Each item's actual cost is tracked | Exact; used for vehicles, jewelry, large equipment |
| Average cost | Costs averaged across units | Between FIFO and LIFO |
LIFO requires filing Form 970 and the "conformity rule": a business using LIFO for tax must also use it for financial statements given to owners, lenders, and creditors.
How is ending inventory valued?
Unless it uses LIFO, a business can value inventory at cost or at the lower of cost or market, which lets it deduct declines in replacement value. Under LIFO, inventory must be valued at cost. Damaged, shop-worn, or out-of-style goods that cannot be sold at normal prices are valued at their bona fide selling price minus direct cost of disposition — which requires an actual offering for sale within 30 days after the inventory date — but never below scrap value, with records to prove it.
What is the small business rule?
A business that is not a tax shelter and meets the Section 448(c) gross receipts test — average annual gross receipts for the three prior tax years of no more than $31 million for tax years beginning in 2025 and $32 million for tax years beginning in 2026 — is not required to keep inventory under the general rules. Under Section 471(c) it may instead:
- treat inventory as non-incidental materials and supplies, deducted in the year the items are provided to customers (or, if later, the year they are paid for), or
- follow the method used in its applicable financial statements or, without audited statements, its books and records.
The same businesses are exempt from uniform capitalization, which otherwise requires adding a share of storage, purchasing, and overhead costs to inventory.
What do larger businesses have to capitalize?
Under uniform capitalization (Section 263A), producers and larger resellers add direct costs and an allocable share of indirect costs — warehousing, purchasing, handling, and part of administration — to inventory. Those costs are deducted only as goods are sold.
Do you need a physical count?
Generally yes — the IRS requires a physical inventory at reasonable intervals, with the book amount adjusted to agree with the actual count. Shrinkage — theft, spoilage, damage — is reflected through the count. Some businesses use estimates between counts if they are consistent and adjusted to actual counts.
Frequently asked questions
Can I deduct inventory when I buy it?
Generally no, even on the cash method. Purchases flow into cost of goods sold only as items are sold. Under the small business rule, inventory treated as non-incidental materials and supplies is likewise deducted when provided to customers, and the books-and-records option follows how your books, including any year-end counts, treat inventory.
Is switching from FIFO to LIFO allowed?
Yes, by filing Form 970 (or a statement with the same information) with your timely filed return for the first LIFO year. Switching away from LIFO requires Form 3115.
Do service businesses have inventory?
Usually not. Materials consumed in a service, like a plumber's parts, may be treated as supplies or inventory depending on the facts.
Does donating inventory produce a deduction?
Usually the deduction is limited to the lesser of cost or fair market value. Enhanced deductions apply to food inventory donated by any business and to certain inventory C corporations donate for the care of the ill, the needy, or infants.
Official sources
The IRS explains: “If you are a small business taxpayer (defined below), you can choose not to keep an inventory, but you must still use a method of accounting for inventory that clearly reflects income.” — Internal Revenue Service, Publication 538 (01/2022), Accounting Periods and Methods, https://www.irs.gov/publications/p538
The IRS explains: “File this form with your income tax return to elect to use the last-in, first-out (LIFO) inventory method described in the Internal Revenue Code section 472.” — Internal Revenue Service, About Form 970, Application to Use LIFO Inventory Method, https://www.irs.gov/forms-pubs/about-form-970
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk sets up inventory tracking that matches the method on your return. See pricing or book a free fit call.
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