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Treating inventories as non-incidental materials & supplies: an exception worth understanding

Generally, if you produce, purchase, or sell merchandise in connection with your trade or business, you are required to keep an inventory of the merchandise and use an accrual method of accounting for all merchandise purchased or sold. For example, let’s say you own a lemonade stand and purchased $5 of lemons from the grocery store to make a batch of lemonade that you end up selling for $20. Normally, you would be required to account for the $5 purchase of lemons (i.e., raw materials) in your books and records as a cost of goods sold (COGS), and log the $20 as gross sales. Then, at tax time, you would report the $20 in gross sales on your return and deduct the $5 for COGS to arrive at a net profit of $15, the amount subject to tax. As an aside, you would also factor in the COGS for all the other components connected with selling a cup of lemonade (e.g., the paper cups, ice, water, etc.). Now this is an overly simplistic example, but one can imagine how burdensome the inventory accounting process can be for a small business owner with several different inventories or a large volume of inventory.

Electing to Treat Inventory as Non-incidental Materials or Supplies

Fortunately, a qualified small business taxpayer may elect to deduct the costs to acquire or produce an inventory item rather than keeping an inventory of the item and tracking its value. The deduction is taken in the year in which the inventory item is first used or consumed in your trade or business. Importantly, the election generally requires the small business taxpayer to change its method of accounting for inventory, as further explained below.


If a small business taxpayer makes the election to not keep an inventory, then they must account for inventory items as non-incidental materials and supplies on their applicable financial statements (or on the books and records for small business owners without applicable financial statements).

Qualified Small Business Taxpayers

You qualify as a small business taxpayer for purposes of the election if you:

  1. Have average annual gross receipts of $26 million or less for the 3 prior tax years, and

  2. Are not a tax shelter (as defined in I.R.C. section 448(d)(3)).

Note, if your business has not been in existence for all of the 3-tax-year period used in calculating average gross receipts, base your average on the period it has existed. If your business has a predecessor entity, include the gross receipts of the predecessor entity from the 3-tax-year period when calculating average gross receipts.

Financial Accounting Treatment of Inventories

Your financial accounting treatment of inventories is determined with regard to the method of accounting you use in your applicable financial statement (as defined in I.R.C. section 451(b)(3)). If, however, you do not have an applicable financial statement, your treatment of inventories is determined with regard to the method of accounting you use in your books and records that have been prepared in accordance with your accounting procedures.


Changing Your Method of Accounting for Inventory

Remember, if you were previously keeping an inventory but would like to take advantage of the no inventory exception, you are required to file IRS Form 3115 to change your method of accounting for inventory.


Key take-away: Making the election to not keep an inventory can significantly save small business taxpayers time that would otherwise be spend on tracking and managing inventory items for tax accounting purposes.


For more information, see the Exception for small business taxpayers section in IRS Publication 334 (Tax Guide for Small Business).


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