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).
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
Question types to practice on inventory:
- 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?
Can use any method
Must use LIFO
Must use FIFO
LIFO for <$10M only
Rising prices (inflation). Which method = lowest taxable income?
FIFO
LIFO
Average Cost
Specific Identification
$50M manufacturer (2025). Which UNICAP cost must be capitalized?
Marketing
R&D
Indirect labor for storage
Selling expenses
Sections you finish are checked off in the contents.