Published: December 8, 2025 Tax Year: 2026
When I advised e-commerce sellers at Anna Money, I saw countless business owners overpaying taxes because they didn't understand inventory deductions. One client was sitting on $2.3M in unsold inventory and using the wrong accounting method—costing them $85,000 in unnecessary taxes every year.
The inventory tax rules changed dramatically in 2018 with the Tax Cuts and Jobs Act. If your business has gross receipts under $30 million, you now have powerful new options that can immediately deduct inventory costs instead of waiting until items sell. Yet most business owners don't know these rules exist.
This guide will show you exactly how to maximize your inventory deductions in 2026, choose the optimal accounting method, and potentially save tens of thousands of dollars in taxes.
Three Ways to Deduct Inventory in 2026:
Key Threshold for 2026:
Inventory (merchandise) includes goods and products that a business owns to sell to customers in the ordinary course of business.
What counts as inventory:
What is NOT inventory:
Legal Citation: IRS Publication 334, Chapter 7 - Inventory
Not counted as inventory:
Tax Treatment:
Examples:
Tax Treatment:
Before 2018:
After 2018 (Tax Cuts and Jobs Act):
Legal Citation: IRC § 471(c) - Simplified dollar-value LIFO method for certain small businesses
Formula:
Average Annual Gross Receipts =
(Year 1 Receipts + Year 2 Receipts + Year 3 Receipts) ÷ 3
Example:
2024 gross receipts: $22,000,000
2025 gross receipts: $28,000,000
2026 gross receipts: $31,000,000
Average: ($22M + $28M + $31M) ÷ 3 = $27,000,000
Result: UNDER $30M threshold ✅
→ Eligible for simplified inventory methods
Important: You use the average over 3 years, not just the current year. So even if 2026 exceeds $30M, you still qualify if the 3-year average is under $30M.
If your business has gross receipts under $30M and uses the cash method of accounting, you can immediately deduct inventory when purchased—as long as you don't maintain inventory records for cost allocation or creditor reporting.
Requirements:
What you CAN do:
What you CANNOT do (if you want immediate deduction):
Legal Citation: IRS Reg. 1.471-1(b)(6) - Inventory rules for small business taxpayers
Scenario:
Business: Small online clothing retailer
Gross receipts: $18M (3-year average)
Accounting: Cash method
Inventory tracking: Point-of-sale for reordering only
Tax Treatment:
December 2026: Purchases $500,000 in inventory
Books: Expense $500,000 when purchased
Tax return: Deduct $500,000 in 2026
✅ Full immediate deduction
Why it qualifies:
Scenario:
Business: Liquor store chain
Gross receipts: $25M (3-year average)
Accounting: Cash method
Inventory tracking: Physical counts on Dec 31
Bank reporting: Provides inventory valuations to lender
Tax Treatment:
December 2026: Purchases $500,000 in inventory
Year-end physical count: $200,000 unsold inventory
Deduction 2026: $300,000 (COGS only)
✅ Can only deduct what was SOLD
Why it doesn't qualify:
Businesses under $30M can treat inventory as nonincidental materials and supplies and deduct costs when the materials are first used or consumed in business operations.
Key Advantage: For manufacturers, "used or consumed" means when materials move from raw material storage into work-in-process—NOT when the finished product is sold.
Who benefits most:
Who doesn't benefit:
Legal Citation: IRC § 471(c)(1)(A) - Materials and supplies
Scenario:
Business: Custom furniture manufacturer
Gross receipts: $22M
Purchases: $800,000 in lumber and hardware (December 2026)
Traditional method (COGS):
December 2026: Purchase $800,000 lumber
January 2027: Use lumber in production
March 2027: Sell finished furniture
Deduction: March 2027 (when sold) ❌
Materials & supplies method:
December 2026: Purchase $800,000 lumber
January 2027: Move lumber into production
Deduction: January 2027 (when consumed) ✅
Savings: 2-3 month earlier deduction
Additional Benefits:
Required if:
Standard COGS calculation:
Beginning Inventory (Jan 1)
+ Purchases during the year
+ Cost of labor (if manufacturing)
+ Materials and supplies
+ Other costs (freight, storage)
- Ending Inventory (Dec 31)
= Cost of Goods Sold (COGS)
Example:
Beginning inventory (Jan 1, 2026): $500,000
Purchases during 2026: $2,000,000
Ending inventory (Dec 31, 2026): $400,000
COGS = $500,000 + $2,000,000 - $400,000
COGS = $2,100,000 ← Deductible in 2026
Tax Treatment:
When you maintain traditional inventory, you must choose an accounting method to value your ending inventory. This choice affects your COGS and taxable income.
Assumption: The first items purchased are the first items sold
How it works:
January: Purchase 100 units @ $10 each = $1,000
June: Purchase 100 units @ $12 each = $1,200
December: Sell 150 units
FIFO assumes you sold:
- 100 units from January @ $10 = $1,000
- 50 units from June @ $12 = $600
COGS = $1,600
Ending inventory:
- 50 units from June @ $12 = $600
Advantages:
Disadvantages:
Best for:
Assumption: The last items purchased are the first items sold
How it works:
January: Purchase 100 units @ $10 each = $1,000
June: Purchase 100 units @ $12 each = $1,200
December: Sell 150 units
LIFO assumes you sold:
- 100 units from June @ $12 = $1,200
- 50 units from January @ $10 = $500
COGS = $1,700
Ending inventory:
- 50 units from January @ $10 = $500
Advantages:
Disadvantages:
Legal Citation: IRC § 472 - Last-in, first-out inventories
Best for:
Assumption: All units have the same average cost
How it works:
January: Purchase 100 units @ $10 each = $1,000
June: Purchase 100 units @ $12 each = $1,200
Total: 200 units for $2,200
Average cost = $2,200 ÷ 200 = $11 per unit
December: Sell 150 units
COGS = 150 × $11 = $1,650
Ending inventory:
- 50 units × $11 = $550
Advantages:
Disadvantages:
Best for:
Assumption: Track the actual cost of each specific item sold
How it works:
Purchase Item #1: $100
Purchase Item #2: $150
Purchase Item #3: $120
Sell Item #2:
COGS = $150 (the actual cost of that specific item)
Advantages:
Disadvantages:
Best for:
Business: Electronics retailer
Annual sales: $5,000,000
Beginning inventory: $400,000
Purchases during year:
- Q1: 500 units @ $200 = $100,000
- Q2: 500 units @ $220 = $110,000
- Q3: 500 units @ $240 = $120,000
- Q4: 500 units @ $260 = $130,000
Total purchases: 2,000 units for $460,000
Total goods available for sale: $860,000
Units sold: 1,800
Sales revenue: $5,000,000
COGS (first 1,800 units):
- Beginning inventory: $400,000 (800 units)
- Q1 purchase: $100,000 (500 units)
- Q2 purchase: $110,000 (500 units)
COGS = $610,000
Ending inventory (200 units from Q4):
200 units × $260 = $52,000
Gross profit: $5,000,000 - $610,000 = $4,390,000
COGS (last 1,800 units):
- Q4 purchase: $130,000 (500 units)
- Q3 purchase: $120,000 (500 units)
- Q2 purchase: $110,000 (500 units)
- Q1 purchase: $60,000 (300 units @ $200)
COGS = $420,000 + $400,000 (from beginning inventory)
COGS = $820,000
Ending inventory (200 units from Q1):
200 units × $200 = $40,000
Gross profit: $5,000,000 - $820,000 = $4,180,000
| Metric | FIFO | LIFO | Difference |
|---|---|---|---|
| COGS | $610,000 | $820,000 | $210,000 more COGS |
| Gross Profit | $4,390,000 | $4,180,000 | $210,000 less profit |
| Taxable Income | Higher | Lower | - |
| Taxes (35% rate) | $1,536,500 | $1,463,000 | $73,500 savings |
Conclusion: LIFO saves $73,500 in taxes during inflationary periods by matching higher recent costs against current revenue.
Even if you use computerized tracking, the IRS requires periodic physical inventory verification to ensure accuracy.
When physical counts are required:
Step 1: Plan the count
Step 2: Perform the count
Step 3: Value the inventory
Step 4: Adjust your books
| Adjustment Type | Example | Tax Treatment |
|---|---|---|
| Shrinkage | Shoplifting, employee theft | Increase COGS (deductible loss) |
| Obsolete goods | Outdated technology | Write down to fair market value or zero |
| Damaged goods | Broken/unsellable items | Write down to salvage value |
| Spoiled goods | Expired food/medicine | Write off completely (deductible loss) |
Legal Citation: IRS Publication 538 - Accounting Periods and Methods
IRS Form 3115 required when:
When no permission needed:
Key Information Required:
Section 481(a) Adjustment:
Example:
You switch from accrual to cash method
Accrual method: $800,000 in unsold inventory (not yet deducted)
Cash method: Deduct when purchased
Section 481(a) adjustment: +$800,000 (deduction)
Spread over 4 years: $200,000 per year additional deduction
Legal Citation: Rev. Proc. 2018-40 - Simplified procedures for changing accounting methods
Important: Form 3115 is complex. Strongly recommend working with a tax professional.
Who it applies to:
What it requires:
Who is EXEMPT:
Legal Citation: IRC § 263A - Capitalization and inclusion in inventory costs of certain expenses
When can you write off inventory?
Obsolete inventory:
Damaged inventory:
Spoiled/expired inventory:
Example:
Original cost: $50,000 (500 units @ $100 each)
Problem: Technology obsolete, unsellable
Salvage value: $5,000 (parts/scrap)
Deductible loss: $45,000
Documentation required:
Goods you own but are held by others:
Goods you hold for others (consignment sales):
Determining ownership:
FOB (Free on Board) Shipping Point:
FOB Destination:
Example:
You purchase $100,000 in inventory on December 28, 2026
Terms: FOB Shipping Point
Goods arrive January 3, 2027
✅ Include in YOUR December 31, 2026 inventory
(You owned the goods on Dec 31)
Cost of Goods Sold section (Part III):
Inventory method question:
Cost of Goods Sold form:
What to report:
❌ Problem: Business with $15M in receipts continues using accrual method and traditional COGS
Consequences:
✅ Solution:
Potential savings: $50,000+ in accelerated deductions for businesses with substantial inventory
❌ Problem: Using cash method in QuickBooks but taking physical inventory counts for bank reports
Consequences:
✅ Solution:
❌ Problem: No documentation of which method you're using (FIFO vs LIFO)
Consequences:
✅ Solution:
❌ Problem: Switching from accrual to cash method without Section 481(a) adjustment
Consequences:
✅ Solution:
❌ Problem: Keeping unsellable inventory on books at original cost
Consequences:
✅ Solution:
Tracking inventory, calculating COGS, choosing the right accounting method, and managing physical counts shouldn't consume weeks of your time every year. At Jupid, our AI-powered platform automates the entire inventory management process.
What makes Jupid different for inventory management:
✅ Automatic inventory tracking - Sync with your e-commerce platform, point-of-sale, or accounting system
✅ Smart method selection - We analyze your business and recommend the optimal inventory method (cash, materials & supplies, or COGS)
✅ Real-time COGS calculation - See your cost of goods sold update in real-time with every sale
✅ Multi-method comparison - Calculate your taxes using FIFO, LIFO, and Average Cost to see which saves most
✅ Obsolescence detection - AI flags slow-moving or obsolete inventory for potential write-offs
✅ Physical count management - Mobile app for easy physical inventory counts with auto-reconciliation
✅ Form 3115 assistance - Guided wizard for changing inventory methods with automatic Section 481(a) calculations
✅ Chat with your AI accountant - Ask questions like "Should I use FIFO or LIFO for my inventory?" and get instant, personalized answers
Example conversation:
Annual value: Product sellers using Jupid save an average of $34,000 more on inventory deductions compared to manual tracking, simply by:
Learn more about how Jupid can optimize your inventory tax strategy →
Inventory tax deductions are one of the most overlooked opportunities for product-based businesses. With the 2018 tax law changes, businesses under $30M in gross receipts can now deduct inventory immediately when purchased—potentially freeing up hundreds of thousands of dollars in cash flow that was previously tied up in unsold inventory.
The key is understanding your options:
Your choice depends on:
Remember: If you're under $30M and still using the old accrual method with traditional COGS, you're likely paying taxes on inventory you haven't even sold yet. Consider switching to the cash method and immediately deducting inventory purchases—it could be one of the most valuable tax planning moves you make this year.
Disclaimer
This article provides general information about tax deductions and should not be considered tax advice. Tax laws change frequently, and individual circumstances vary significantly. Inventory accounting method changes require careful analysis and IRS Form 3115 filing. For advice specific to your situation, consult with a qualified tax professional.
Tax Year: 2026 Last Updated: May 30, 2026
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