Inventory is required when the production, purchase, or sale of merchandise is a key income‑producing factor. When inventory is required, the business must use the accrual method for purchases and sales and must value inventory at the beginning and end of each tax year. The method must follow GAAP for similar businesses and clearly reflect income.
The small business taxpayer exception allows taxpayers who meet the §448(c) gross receipts test (≤ $31 million average for 2025) to avoid Section 471 inventory rules. They may instead treat inventory as non‑incidental materials and supplies or follow their financial accounting treatment.
What Counts as Inventory
Inventory includes:
- Merchandise or stock in trade
- Purchased goods when title has passed, even if in transit
- Goods under contract not yet segregated
- Goods out on consignment
- Goods held in display rooms or booths
- Raw materials, WIP, finished goods
- Supplies that become part of the final product
- COD sales: title passes when buyer pays
- Containers (kegs, bottles, cases) if title has not passed
Inventory does not include:
- Goods sold when title has passed
- Goods consigned to the taxpayer
- Goods ordered but not yet owned
- Land, buildings, equipment
- Notes and receivables
- Real estate held for sale by dealers
- Supplies not part of the final product
Identifying Inventory Cost
Acceptable methods:
- Specific identification
- FIFO
- LIFO — requires Form 970; complex rules
FIFO assumes earliest items are sold first. LIFO assumes latest items are sold first.
Inventory Valuation (Cost Method)
Cost includes all direct and indirect costs:
- Beginning inventory = prior year ending cost
- Purchases = invoice price − discounts + freight‑in
- Produced goods = direct + indirect costs required under UNICAP
Example: Cost of Goods Sold (COGS)
Using the provided manufacturing data (and ignoring UNICAP), COGS is calculated as:
- Beginning inventory: $134,000
- Purchases: $2,000,000
- Factory salaries: $200,000
- Chemicals: $10,000
- Freight‑in: $3,000
- Ending inventory: $137,000
COGS = $2,210,000