The federal income tax general rule is that an entity in the business of producing, buying, or selling merchandise must maintain inventories.

Under this general rule, the business must treat the goods it produces or buys for resale as inventory assets on its books and deduct their cost only in the year they are sold.

But in 2018, the Tax Cuts and Jobs Act changed this long-standing rule for small businesses. Small businesses have three optional alternative ways to treat inventory. They can treat it.

1. as non-incidental materials and supplies, 

2. the same way it is treated in their applicable financial statements, or 

3. the same way it is treated in their books and records. 

Small businesses that elect to use one of the alternative methods are also allowed to use the overall cash method of accounting instead of the more complex accrual method normally required for businesses that maintain inventories.

Key point. Using the cash method and immediately expensing inventory gives the business great control over its taxes. 

What Is a Small Business? 

For these purposes, a small business is one whose gross receipts for the previous three tax years do not exceed an inflation-adjusted threshold. For 2026, the threshold is $32 million ($31 million for 2025). Gross receipts include

• • • total sales after reductions for returns and allowances; 

    • all amounts received for services; and 

    • interest, dividends, rents, royalties, and annuities from business investments. 

    • The cost of goods sold does not reduce gross receipts. But the adjusted basis reduction from the sale of a capital asset does reduce the gross receipts amount. In other words, only the recognized gain or loss counts. 

All trades and businesses owned by a single individual are aggregated for these purposes. 

If the taxpayer was not in existence for the three preceding years, the test is based on the years the taxpayer was in existence. 

Non-incidental Materials and Supplies Deduction 

Small businesses with less than $32 million in gross receipts can use the cash method of accounting (although it is not required) and treat inventory as non-incidental materials and supplies (NIMS). A business deducts the cost of inventory treated as NIMS in the later of

• the year the NIMS are used or consumed in the business, or 

• the year the business pays for them. 

• A reseller that buys and pays for finished merchandise gets no deduction until the merchandise is sold—the same timing as under the regular inventory rules. The NIMS method’s one real advantage for such businesses is that it lets them use the cash method of accounting. 

Similarly, the NIMS method does not let manufacturers deduct raw materials as soon as they enter production. But this method does have advantages for small manufacturers. Under normal inventory accounting, direct labor usually gets built into the cost of finished goods and deducted only when the goods are sold. Under the NIMS method, direct labor is not included in inventory costs.

So a small manufacturer may deduct production wages currently, instead of waiting until the finished product is sold. 

Moreover, the uniform capitalization rules, which require that a portion of overhead and other indirect costs be allocated to inventory, do not apply.As a result, overhead costs for producing the goods can be deducted as incurred. 

Applicable Financial Statement Inventory Method 

The second alternative method is available only to small businesses with an applicable financial statement (AFS). Such businesses can recover their inventory costs in accordance with the inventory method used in their AFS. 

But what about a cost that is neither deductible nor otherwise recoverable under the Internal Revenue Code? It cannot be deducted as an inventory cost. For example, a business with an AFS cannot deduct illegal bribes, penalties and fines, or non-deductible lobbying costs or entertainment expenses. 

An AFS is either

• • a certified financial statement prepared in accordance with U.S. generally accepted accounting principles (GAAP) that is (1) a Form 10-K or annual shareholder statement filed with the Securities and Exchange Commission (SEC); (2) an audited financial statement used for credit purposes, owner/beneficiary reporting, or another substantial non-tax purpose; or (3) a non-tax-return financial statement filed with the federal government or a federal agency other than the SEC or IRS; or 

  • a non-tax-return financial statement filed with the federal government, a federal agency, a state government, a state agency, or a self-regulatory organization—for example, a statement filed with a state insurance regulator or FINRA. 

  • A certified financial statement prepared under international financial reporting standards (IFRS) and foreign audited financial statements can also qualify as an AFS. 

Financial statements prepared in accordance with GAAP take priority over regulatory financial statements in the order listed above. The same is true for IFRS statements. 

If the AFS is an audited GAAP financial statement, material inventory held for sale ordinarily remains an asset until sold or impaired. However, GAAP does allow some inventory-related costs to be expensed currently—for example, ordinary general and administrative expenses that are not clearly production-related, abnormal spoilage, abnormal freight/handling, and unallocated fixed overhead from abnormally low production.

Books and Records Inventory Method 

If a business doesn’t have an applicable financial statement, it can deduct its inventory costs in conformance with its books and records, as long as they’re prepared in accordance with the business’s accounting procedures.

All businesses with less than $32 million in gross receipts are allowed to use the overall cash method of accounting for tax purposes and book purposes. With the overall cash method of accounting, income is reported when cash is received, and expenses are reported when cash is paid. So, inventory is expensed on a business’s books when it is purchased. A sale (income) is shown on the books when purchased inventory is sold and cash received. 

There is no need to calculate cost of goods sold at the end of the year, and the uniform capitalization rules (requiring indirect costs be apportioned to inventory) do not apply. 

A small-business cash-basis taxpayer without an AFS can currently deduct inventory the year it is purchased so long as it is not capitalized to inventory in any of its books and records. However, as with the AFS method, it can’t deduct as an inventory cost an expense that is neither deductible nor otherwise recoverable under the Internal Revenue Code. 

Here is an example based on IRS regulations.

Example 1. Gilbert operates a baking business as a sole proprietor and reports income and expenses on IRS Schedule C. Gilbert’s business qualifies as a small business, does not have AFS for 2026, uses the cash method of accounting, and applies the non-AFS inventory method for federal income tax purposes. 

Under Gilbert’s books and records, the cost of cookie ingredients is capitalized to inventory, while wages paid to employees who bake the cookies are expensed as incurred. Although direct labor costs are generally required to be capitalized as part of inventory, the non-AFS inventory method allows Gilbert to follow the treatment used in his books and records. Therefore, because direct labor costs are expensed rather than capitalized in his books, Gilbert is not required to capitalize those costs for tax purposes. 

As a result, Gilbert may deduct the employee labor costs in the year they are paid, rather than including them in inventory and recovering them when the cookies are sold. 

All the business’s books and records must expense the business’s inventory costs. The IRS takes an expansive view of what constitutes business “books and records.” 

Books and records include physical counts of inventory and electronic point-of-sale systems that track acquisition costs and inventory levels. If such physical or electronic records are used to allocate costs to inventory or make reports to banks or other creditors about the value of unsold inventory, the taxpayer can deduct only the cost of goods sold during the year.

Here is another example based on IRS regulations.

Example 2. Hellfire Spirits, Ltd., is a partnership engaged in the retail sale of beer, wine, and liquor. It has no applicable financial statement and uses the cash method of accounting because its gross receipts are under $32 million. In its electronic bookkeeping software, Hellfire treats all costs paid during the year as currently deductible. 

But Hellfire’s employees take a physical count of inventory on its selling floor and warehouse on December 31 of each year. 

Hellfire uses this physical count as part of its books and records to capitalize and allocate costs to inventory. Hellfire also periodically lets its lender know the cost of inventory on hand for specific categories of products it sells. 

Hellfire can’t currently deduct all of its costs paid during the year because its electronic records do not accurately reflect the inventory records used for non-tax purposes. Instead, Hellfire can deduct only the cost of goods sold during the year in accordance with the physical inventory count taken on December 31. 

On the other hand, inventory can be currently deducted if physical counts or electronic records are used only for reordering purposes and not to capitalize and allocate costs to inventory. 

Here is yet another example from IRS regulations.

Example 3. Assume the same facts as the prior example, except that Hellfire uses the electronic ledger and physical counts only for reordering purposes, not to allocate costs between ending inventory and cost of goods sold or to make reports to creditors. Instead, in its records, the company expenses the cost of the inventory in the year it is paid for. On December 20, 2026, Hellfire pays for $500,000 of beer, wine, and liquor. Hellfire can deduct the full amount in 2026. 

Thus, a business can currently deduct inventory costs if all the following are true: 

• It is a small-business taxpayer with gross receipts for the three preceding years of less than $32 million. 

• It does not have an AFS for the year.  

• It uses the overall cash method of accounting for federal tax purposes and the overall cash method for book purposes. 

• Its books and records prepared under its accounting procedures treat inventory costs as currently expensed rather than capitalized. 

• It does not allocate inventory costs to its inventory counts in any of its books and records, including a point-of-sale system. 

• It is not a tax shelter (defined below). 

Change in Accounting Method 

An existing small business must obtain IRS permission to change to the cash method of accounting and NIMS, AFS, or non-AFS method. To do this, file IRS Form 3115, Application for Change in Accounting Method. The change is automatically accepted by the IRS. The form must be filed by the due date of the business’s tax return for the year of change (plus extensions). 

In addition, to claim a deduction for unsold inventory from past years before you used the cash method, you’ll need to make a Section 481(a) adjustment when you file Form 3115. This enables you to deduct the entire cost of unsold inventory from past years in a single year. 

Tax Shelters Don’t Qualify for Small Business Treatment 

Tax shelters are prohibited from using the small-business inventory exceptions, regardless of the amount of their gross receipts. Tax shelters include the following: 

• • An enterprise, other than a C corporation, whose interests have been offered for sale in an offering required to be registered with a federal or state securities regulator 

  • A syndicate under IRC Section 1256(e)(3)(B), which is a partnership or another entity, other than a C corporation, of which more than 35 percent of its losses for the taxable year are allocated to limited partners or limited entrepreneurs 

  • An entity, investment plan, or arrangement with a significant purpose of avoiding or evading federal income tax—in other words, a classic tax shelter 

  • The syndicate rule is the biggest trap. It can catch an ordinary LLC, partnership, or S corporation that has passive owners. Such an entity will be considered a syndicate in any year in which more than 35 percent of its losses are allocated to passive investors who are limited partners or “limited entrepreneurs.” A limited entrepreneur is someone who has an interest in the enterprise other than as a limited partner and does not actively participate in management. 

Syndicate status is tested year by year. A business can be classified as a syndicate in one year and then avoid the status the next profitable year. To avoid being disqualified from using the small-business inventory exception, a business may make an irrevocable election to use the prior profitable year’s allocation instead of the current losing year for the syndicate determination.

Takeaways 

Here are four takeaways from this article: 

1. Businesses with gross receipts below $32 million qualify to use the small-business exceptions to the traditional inventory rules that require inventory to be deducted only as sold. Such businesses can also use the overall cash method of accounting. 

2. Small businesses may use NIMS. With this method, a business deducts the cost of inventory in the later of (1) the year it is used or consumed in the business, or (2) the year the business pays for it. 

3. Small businesses may also choose to deduct inventory in conformance with their AFS. This is a certified financial statement prepared under GAAP or a regulatory financial statement. Statements prepared under GAAP do not permit expensing of inventory.

4. Small businesses without an AFS may deduct inventory in conformance with their books and records, which can allow them to currently deduct inventory the year it is purchased so long as it is not capitalized to inventory in their books and records.