14.3 Inventory & COGS
Key Takeaways
- Inventory required if merchandise is a material income-producing factor.
- Small Business Taxpayer (Tax Year 2025: $31M average gross receipts): exempt from §471 inventory rules and from §263A UNICAP.
- §471(c) election: treat inventory as non-incidental materials/supplies OR follow book method.
- LIFO Conformity Rule: must use LIFO for financial reports if used for tax.
- LIFO: lower income in inflation. FIFO: higher income in inflation.
- LCM prohibited with LIFO.
- UNICAP (§263A): capitalize direct and indirect costs into inventory; small business ($31M, 2025) exempt.
Why This Matters for the Exam
Inventory rules are tested extensively. Know LIFO vs. FIFO effects, the LIFO Conformity Rule, and the UNICAP/§471(c) small-business exceptions — both keyed to the same $31M (2025) threshold under §448(c).
Expect at least 3-4 questions on inventory.
Who Must Use Inventory?
| Rule | Description |
|---|---|
| General | If merchandise is material income factor |
| Exception | Small Business Taxpayer exempt under §471(c) |
Small Business Taxpayer Inventory Exception (§471(c))
| Tax Year | Threshold | Treatment |
|---|---|---|
| 2024 | $30M | Treat as non-incidental materials/supplies OR follow book |
| Tax Year 2025 | $31M | Treat as non-incidental materials/supplies OR follow book |
Under the §471(c) non-incidental-materials method, items are deductible when paid or when used/consumed in the business, whichever is later. Alternatively, the taxpayer may follow the inventory method used on the books (the "book conformity" option).
Inventory Valuation Methods
| Method | Description |
|---|---|
| Cost | Invoice price + freight, less discounts |
| Lower of Cost or Market (LCM) | Compare cost to replacement cost |
| Retail Method | Estimate based on selling price |
LIFO vs. FIFO (Inflation)
| Method | Ending Inventory | COGS | Taxable Income |
|---|---|---|---|
| FIFO | Higher | Lower | Higher |
| LIFO | Lower | Higher | Lower |
LIFO Conformity Rule
| Rule | Requirement |
|---|---|
| If LIFO for tax | Must use LIFO for financial statements |
| Applies to | Reports to shareholders, creditors |
| No exceptions | Cannot use FIFO for bank, LIFO for IRS |
LCM Prohibition with LIFO
| Rule | Description |
|---|---|
| LCM | Prohibited with LIFO |
| Reason | Prevents "double benefit" |
UNICAP (§263A)
| Rule | Description |
|---|---|
| Requires | Capitalize direct + indirect costs |
| Applies to | Production, resale activities |
| Exempt | Small Business Taxpayer — $31M for 2025 (§263A(i)) |
UNICAP Costs to Capitalize
| Include | Exclude |
|---|---|
| Direct materials | Marketing |
| Direct labor | R&D (§174 — see 14.8) |
| Utilities (production) | Selling expenses |
| Indirect labor | Distribution |
| Insurance (production) |
Real-World Scenario (2025)
Scenario: Hardware store with $25M average gross receipts wants LIFO for tax. Bank requires FIFO statements.
- LIFO Conformity: If using LIFO for tax, must also use LIFO for the bank-required statements.
- Result: Cannot use LIFO for tax if the bank requires FIFO. (Note: with only $25M receipts, the store is also a small business taxpayer under §471(c) and could elect non-incidental materials treatment for 2025.)
On the Exam
Expect 3-4 questions on inventory, typically:
- LIFO/FIFO Questions: "Which method = lower tax in inflation?"
- Conformity Questions: "What is the LIFO Conformity Rule?"
- UNICAP Questions: "Which costs are capitalized?"
The key is to remember: LIFO = lower tax in inflation. LIFO Conformity = must match financial reports. LCM prohibited with LIFO. Small Business ($31M for 2025) exempt from §471 inventory rules AND from §263A UNICAP.
LIFO for tax—what is required for financial statements?
Rising prices (inflation). Which method = lowest taxable income?
$50M manufacturer (2025). Which UNICAP cost must be capitalized?