How to account for inventory and cost of goods sold as a small business

Inventory is an asset until it sells. When you buy goods to resell, record them as inventory at cost. Cost means the invoice price less trade discounts, plus freight-in, duties and other charges to get the goods (Treas. Reg. § 1.471-3). For the import side, see tariffs, landed cost and COGS.

When a unit sells, its cost moves from inventory to cost of goods sold. For a period, the formula is:

COGS = beginning inventory + purchases − ending inventory

You also need a cost flow method to decide which units sold. IRS Publication 538 describes specific identification, FIFO (first in, first out) and LIFO (last in, first out). Most small online sellers use FIFO or a weighted average in their inventory software. Pick one and use it consistently.

Valuation is generally at cost, or at the lower of cost or market. Under lower of cost or market, you compare each item separately, not the whole inventory at once.

Section 471(c) exempts a business from the formal inventory rules for any year it meets the Section 448(c) gross receipts test. For tax years beginning in 2026, an entity meets the test if its average annual gross receipts for the prior three tax years do not exceed $32,000,000 (Rev. Proc. 2025-32, section .30). Certain tax shelters are excluded. Sole proprietors apply the test to each trade or business.

A qualifying business can:

• Treat inventory as non-incidental materials and supplies. Cost is generally deducted when items are sold to customers, not when bought.
• Follow its books. Use the method in its applicable financial statement (such as audited statements), or if it has none, the method in its books and records kept under its own procedures.

The same test also exempts you from the uniform capitalization (UNICAP) rules under Section 263A(i).

Neither 471(c) option is a license to deduct a big December inventory buy. If your books track inventory on hand, a books-and-records method generally follows that tracking. Plan purchases with that in mind. See year-end tax planning.

Count. Publication 538 says you must take a physical inventory at reasonable intervals, and the book amount must be adjusted to agree with the actual inventory. Count at year end at least. For FBA or 3PL stock, reconcile the platform’s inventory reports to your records.

Shrinkage. Missing units found in a count reduce inventory and increase COGS. If you claim a loss through COGS, you cannot claim it again as a casualty or theft loss (Pub. 538).

Damaged or slow goods. Under Treas. Reg. § 1.471-2(c), goods that cannot be sold at normal prices because of damage, imperfections, style changes, odd lots or similar causes are valued at bona fide selling price less direct cost of disposition, and never below scrap value. Bona fide selling price means an actual offering of the goods within 30 days after the inventory date. You carry the burden of proof.

Destroyed or donated goods. When goods are destroyed, scrapped or donated, they leave inventory and their cost flows out. Keep disposal records, such as destruction reports from Amazon or your 3PL, photos and donation receipts.

Platform reimbursements for lost or damaged FBA units are recoveries, not sales. Record them against the loss.

If you have been expensing purchases, or used a method you do not qualify for, the fix is usually a change in accounting method on Form 3115. The Form 3115 instructions list automatic change procedures for many small-business inventory changes.

A method change usually comes with a Section 481(a) adjustment that catches up the difference. Depending on whether it increases or decreases income, the IRS rules generally spread it over time or take it in one year.

Catching up the books first helps. See catch-up bookkeeping.

Best for: Online and product sellers whose books expense inventory on purchase, who have never done a year-end count, or who are unsure which inventory method they use for tax.

1. Free initial consultation. Tell us your channels, inventory software and how your books handle purchases today.
2. Fees quoted upfront, in writing. Transparent, fair fees in an engagement letter before work starts.
3. Method review. We confirm whether you meet the § 448(c) test and which method fits.
4. Cleanup. We rebuild inventory and COGS, and prepare Form 3115 if a method change is needed.
5. Ongoing. Monthly e-commerce accounting with count reconciliations and SKU margins.