Is Inventory Tax Deductible?

Quick Answer: ⚠️ Yes, but not directly — inventory isn't deducted when purchased. It's deducted as Cost of Goods Sold (COGS) when the inventory is sold. The timing matters.

The Short Answer

Inventory is one of the most misunderstood tax topics for small businesses. You can't deduct inventory when you buy it — you deduct it when you sell it, through Cost of Goods Sold (COGS). This means if you buy $50,000 in inventory but only sell $30,000 worth this year, your COGS deduction is $30,000. The remaining $20,000 sits on your balance sheet as an asset until it's sold (or written off as obsolete).

Exception: If your average annual gross receipts are $29 million or less (for 2025), you may qualify to use the cash method and treat inventory as non-incidental materials and supplies — deducting it when purchased or when it's used/consumed.

IRS Rules for Deducting Inventory

The IRS has specific rules for how inventory is accounted for:

1. Accrual method (most businesses with inventory) — You track inventory as an asset when purchased. It becomes an expense (COGS) only when sold. COGS = Beginning Inventory + Purchases − Ending Inventory.
2. Small business exception (cash method) — Businesses with $29M or less in average gross receipts can treat inventory as "materials and supplies" and deduct it when purchased, used, or consumed — not when sold.
3. Inventory valuation — You must value inventory consistently using cost, lower of cost or market, or other IRS-approved methods. You can't switch methods without IRS permission.
4. Write-offs for obsolete inventory — If inventory becomes unsellable (damaged, expired, obsolete), you can write it off as a loss.

Source: IRS Publication 334 — Tax Guide for Small Business; IRC Section 471; IRC Section 263A

What Inventory Costs Are Included in COGS?

✅ Included in COGS:

• Purchase price of goods
• Freight and shipping to receive inventory
• Direct labor to produce goods (for manufacturers)
• Materials used in production
• Factory/warehouse overhead (for manufacturers — under Section 263A uniform capitalization rules)
• Import duties and tariffs

⚠️ Not COGS (but still deductible as business expenses):

• Sales commissions
• Marketing and advertising
• Office rent (unless it's a production facility)
• Administrative salaries
• Shipping to customers (this is a selling expense)

How Much Can You Deduct?

You deduct the cost of inventory sold during the year.

Example: You run an e-commerce business.

Your COGS deduction is $75,000 — regardless of how much you actually collected from customers (if on accrual method).

Small business cash method example: Same business, qualifies for cash method. You bought $80,000 in inventory and it all arrived. You can deduct $80,000 as materials and supplies in the year purchased (regardless of what sold).

How to Categorize in QuickBooks

• QBO Category: "Cost of Goods Sold" (not regular Expenses)
• Schedule C Line: Line 42 — Cost of Goods Sold (Part III of Schedule C)
• Inventory Asset Account: Track unsold inventory as "Inventory Asset" on your balance sheet
• Tip: Turn on inventory tracking in QBO: Gear → Account and Settings → Expenses → Track inventory. QBO will automatically calculate COGS when you record sales of inventory items.

Common Mistakes to Avoid

1. Deducting inventory as an expense when purchased — Unless you qualify for the small business cash method exception, inventory must be tracked as an asset and deducted through COGS when sold. This is the biggest mistake small business owners make.
2. Not doing a year-end inventory count — Your COGS calculation depends on accurate ending inventory. If you don't count your inventory at year-end, your COGS (and your taxes) will be wrong.
3. Ignoring obsolete inventory — If you have dead stock that will never sell, write it off. Don't let it sit on your books at full value forever.
4. Not qualifying for the small business exception — If your average gross receipts are under $29M, you may be able to simplify everything by using the cash method. Talk to your CPA — it could save you significant bookkeeping time.
5. Forgetting Section 263A (UNICAP) rules — If you manufacture goods or are a large reseller, you may need to capitalize certain indirect costs into inventory. This is complex — get a CPA involved.

Record-Keeping Requirements

• Purchase invoices for all inventory bought
• Year-end physical inventory count or perpetual inventory records
• Inventory valuation method documentation (cost, FIFO, LIFO, etc.)
• Records of inventory written off as damaged, expired, or obsolete
• Freight and shipping receipts for inbound goods
• For manufacturers: direct labor records and overhead allocation

Who Can Deduct Inventory (via COGS)?

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