Inventory has a direct impact on both a company’s balance sheet and taxable income. For businesses that sell physical goods, accurate accounting for inventory is essential for meeting IRS requirements and producing reliable financial statements.
When Inventory Reporting Is Required
Businesses with average annual gross receipts exceeding $30 million for taxable years beginning in 2024 or $31 million for taxable years beginning in 2025 must account for their inventory. These thresholds are based on the average of the prior three years and are adjusted annually for inflation. Smaller businesses may treat inventory as non-incidental materials and supplies instead. Whatever method is selected—First-In, First-Out (FIFO), Last-In, First-Out (LIFO), or weighted average—it must be applied consistently.
Inventory Classification
Inventory is generally categorized as:
- Raw Materials – Purchased components recorded at cost, including freight, import duties, and related fees.
- Work in Progress (WIP) – Items in production but not completed, valued using raw material, labor, and allocated overhead costs.
- Finished Goods – Completed items ready for sale, recorded at the lower of cost or net realizable value.
Inventory Valuation Methods
FIFO sells the oldest stock first. During inflation, it generally results in lower COGS and higher taxable income. It works well for perishable goods, keeping inventory turnover high, reducing waste, simplifying record-keeping, and aligning closely with actual product flow.
LIFO sells the newest stock first. In inflationary periods, it increases COGS and reduces taxable income, which can improve cash flow. It is common in industries with rapidly changing prices, such as retail and supermarkets, but it may lower inventory values on financial statements. Businesses using LIFO must file IRS Form 970 and maintain detailed inventory layer records.
Weighted Average Cost (WAC) averages the total cost of goods available for sale over the total units available for sale, applying that average to both COGS and ending inventory.
Balance Sheet and Compliance
FIFO often results in higher ending inventory values, strengthening financial statements. LIFO values inventory at older, lower costs, which can reduce the value of reported assets. FIFO is permitted under both IRS rules and GAAP; LIFO remains permitted under U.S. GAAP.
Record Retention
The IRS generally requires the retention of inventory records for at least three years; however, in cases of fraud or unreported income, the retention period may be extended indefinitely. Records should include invoices, production costs, inventory counts, and adjustments. Retention rules vary by state, often ranging from three to seven years.
Exceptions
Service businesses generally do not report inventory. Smaller companies under the $27 million threshold may expense items at purchase. Agriculture and construction industries may use specialized methods such as the cash basis or percentage-of-completion.
State Inventory Taxes
Businesses must follow state filing requirements and deadlines, which can vary. For example, some states, such as Texas, impose a property tax on inventory that assesses value as of January 1. States also use different methods to assess inventory value, and some allow businesses to choose between approaches, such as the cost method or the retail method, each of which affects tax liability. Selecting the appropriate method is critical, as it can significantly impact the amount of tax owed.
Valuation Approaches and Liability
Beyond FIFO, LIFO, and WAC, other valuation options include market value, replacement cost, and lower of cost or market (LCM). Calculating inventory tax liability involves determining the taxable value, applying the applicable rate, and accounting for any available exemptions or credits.
Selecting the right inventory method is critical for accurate tax reporting, compliance, and strong financial management. Consistent classification, valuation, and documentation practices help avoid penalties and ensure reliable COGS calculations. Understanding federal, state, and industry-specific requirements allows businesses to manage inventory efficiently and remain compliant. Contact your Stephano Slack tax manager or partner at 610-687-1600 or taxinfo@StephanoSlack.com to determine the most effective approach for your business.
Author John J. Loughlin, Jr., CPA, Partner, leads the Tax & Advisory Services Department at Stephano Slack. He specializes in tax compliance, planning, and projections. His expertise and personalized approach enable clients to navigate complex tax matters with confidence, ensuring peace of mind and optimal outcomes. John can be contacted at 610-710-4045 or jloughlin@stephanoslack.com.
Disclaimer: This content is for informational purposes only and doesn’t constitute professional advice.
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