If your business makes or sells products, the tax law does not let you deduct the cost of what you buy to resell when you buy it. Instead, those costs become inventory, and you deduct them as cost of goods sold (COGS) when the goods are sold. Getting this right affects your profit, your tax, and often the method of accounting you are allowed to use. This guide explains how inventory and COGS work for 2025 returns and 2026 planning.
What counts as inventory
Inventory includes merchandise you hold for sale, raw materials, work in process, finished goods, and supplies that physically become part of the item you sell. It is different from supplies you use to run the business, and different from equipment, which is depreciated. See depreciation.
Service businesses generally do not have COGS. A restaurant, a retailer, an online seller and a manufacturer usually do.
The COGS formula
Schedule C, Part III, builds the figure from these parts:
| Line item | What it includes |
|---|---|
| Beginning inventory | The value of goods on hand at the start of the year, equal to last year's ending figure |
| Plus purchases | Merchandise or materials bought, less items withdrawn for personal use |
| Plus labor | Generally only for manufacturers and miners |
| Plus materials and supplies | Items that become part of the product |
| Plus other costs | Freight-in, containers that are integral to the product, and manufacturing overhead such as rent, utilities, insurance and depreciation for the production area |
| Minus ending inventory | The value of goods on hand at year-end |
Overstating ending inventory understates COGS and overstates profit, and understating it does the opposite. The ending inventory of one year becomes the beginning inventory of the next, so errors carry over.
Valuing inventory
Inventory must be valued at the beginning and end of each year using a method that follows accepted practice in your industry and clearly reflects income. Common approaches under the rules in IRS Publication 538 include:
- Cost. What you paid, including freight in.
- Lower of cost or market. Valuing each item at the lower of its cost or its current market price.
- Retail method. Used by many retailers, which works back from selling prices.
- Unsalable or damaged goods. Goods that cannot be sold at normal prices can be valued at a bona fide selling price less the cost of disposing of them.
To decide which unit's cost to match with a sale, you may use specific identification when costs can be tied to particular items. When you cannot, you use first-in, first-out (FIFO) or last-in, first-out (LIFO). LIFO is adopted by filing Form 970 with a timely filed return for the first LIFO year, and it is a significant choice that should be discussed in advance.
A physical count at year-end, with records that tie to the books, is the foundation of a defensible figure. Adjust for shrinkage, damage and obsolescence.
Small business exceptions
A small business taxpayer has average annual gross receipts of $31 million or less over the three prior tax years for 2025 (indexed for inflation each year, and $32 million for tax years beginning in 2026) and is not a tax shelter. Small business taxpayers are not required to keep inventory in the usual way. Their method must still clearly reflect income, and they can treat inventory as non-incidental materials and supplies, or follow the treatment in their financial statements or books. In practice, many small retailers and restaurants take this approach, deducting items when used or sold. This is also the basis on which a small business may use the cash method even though it sells goods. See cash vs. accrual accounting.
Changing how you account for inventory is an accounting method change, generally requiring Form 3115.
Uniform capitalization (UNICAP)
The uniform capitalization rules require producers and resellers to include certain direct and indirect costs in inventory rather than deducting them right away, such as part of storage, handling, purchasing and administrative costs. Small business taxpayers under the gross receipts test are exempt. Other exceptions exist, including for certain property produced with low indirect costs. If your business crosses the threshold, plan ahead.
Common mistakes
- Deducting purchases and also claiming the same costs in COGS.
- Failing to count inventory at year-end, or estimating the number.
- Valuing slow-moving goods at full cost without a basis.
- Carrying last year's ending inventory figure incorrectly into the new year.
- Mixing personal use of merchandise into business purchases.
- Not recording freight and other costs of getting goods ready for sale.
How we can help
We help product-based businesses set up inventory tracking that supports the tax return, calculate COGS, review the small business exception, and handle accounting method changes. See our bookkeeping and accounting and financial statements services, or contact us.
Frequently asked questions
Do I need to count inventory if I am a small business?
A small business taxpayer may choose not to keep formal inventory for tax purposes, but you still need records that clearly reflect income, and lenders often want counts anyway.
Is inventory the same as supplies?
No. Inventory physically becomes part of what you sell or is held for sale. Supplies used to run the business are deducted separately.
Can a service business claim cost of goods sold?
Generally no. COGS is for businesses that make or sell products. Service businesses deduct their costs as expenses.
What if my ending inventory is zero?
A zero figure is acceptable only if it is accurate. Beginning and ending values should reflect what is actually on hand.
Where do I report COGS?
Sole proprietors use Schedule C, Part III. Corporations and partnerships report it on their own returns.
Official sources
- IRS: Publication 334, Tax Guide for Small Business
- IRS: Publication 538, Accounting Periods and Methods
- IRS: Instructions for Schedule C (Form 1040)
- IRS: Rev. Proc. 2025-32 (2026 inflation adjustments), in Internal Revenue Bulletin 2025-45
This page is a plain-language summary. The official source controls if there is any difference.
General information only, not tax, legal or accounting advice for your situation. Rules, limits and deadlines change; confirm the current rules with the official source or a qualified professional before you act. Reading this page does not create a professional relationship with CPA Tax Payroll and Accounting Corp.