Yes. A qualifying small business can sometimes deduct merchandise purchase costs before the goods are sold. For a business without an applicable financial statement, section 471(c) provides a route based on how its actual books and records treat inventory.
That can matter when cash has gone out to suppliers but products are still on the shelf. The answer depends on eligibility, payment timing, the records used to run the business, and the method already used for tax. Start there before changing the year-end inventory number.
First, check whether the business qualifies
The small-business inventory exception generally requires average annual gross receipts for the preceding three tax years at or below the applicable limit. For tax years beginning in 2025, the limit is $31 million; for years beginning in 2026, it is $32 million. These are gross receipts, not profit. Related-business aggregation, predecessor and short-year rules can affect the calculation. IRS 2025 threshold, section 2.31; 2026 threshold, section 4.30.
The business also cannot be a tax shelter under the applicable rules. Being closely held or having modest receipts does not settle that test.
Next, check for an applicable financial statement, or AFS. Certain audited statements and government-filed statements can qualify. An ordinary compilation or review does not automatically establish AFS status. A qualifying business with an AFS follows a different conformity branch; this article focuses on businesses without one. Section 471(c) sets out the alternatives.
Separate payment timing from the date of sale
Under the non-AFS books-and-records method, merchandise costs can be recovered when the qualifying records expense them, but no earlier than payment for a cash-method taxpayer or incurrence for an accrual-method taxpayer.
For a cash-method business, an unpaid supplier invoice is not deductible just because someone entered it as an expense. For an accrual-method business, “incurred” has tax meaning: the liability, amount and applicable economic-performance requirements must be satisfied. A book entry alone does not meet those requirements. Advance payments and deposits also need their own analysis; this is not blanket permission to deduct every supplier payment.
There is a separate small-business option called nonincidental materials and supplies, often shortened to NIMS. For inventory under that method, recovery generally waits until the goods are provided to the customer and the costs are paid or incurred, whichever happens later. Choosing NIMS is different from choosing purchase-cost expensing through book conformity. Treasury Regulation 1.471-1(b)(4), (6) and (7).
Use the records that actually run the business
The key is the business’s real accounting practice. The non-AFS method follows books and records prepared under its accounting procedures that properly reflect its activities for non-tax business purposes.
Those records may include the ledger, purchasing records, point-of-sale reports, spreadsheets and financial reports used by owners or lenders. A purchases account showing expenses is only part of the picture if year-end entries or other regular reports allocate costs to unsold inventory.
Consider two illustrative setups:
- Quantity tracking: A qualifying reseller pays for merchandise and consistently expenses those purchases in its regular business records. Staff count items to decide what to reorder, without using those counts to capitalize or allocate costs. Paid merchandise can remain unsold at year-end without necessarily delaying the deduction.
- Cost allocation: A reseller’s regular, reconciled point-of-sale ledger tracks both quantities and acquisition costs and allocates costs to goods still on hand. An expense entry in the general ledger does not make those cost records disappear. The tax treatment must account for the actual capitalization practice.
These are the distinctions illustrated by the regulation’s Examples 6 and 7. Quantity counts alone are not the problem. Using records to carry and allocate inventory costs changes the analysis. Treasury’s final-rule explanation, section 3.C.
Can tax-basis records—or the tax return itself—qualify?
You do not need a separate GAAP accounting system merely to use this route. Tax-basis records can also be the records used to manage the business. A simple cashbook or spreadsheet may be relevant if it is maintained and used as the business’s actual accounting record, subject to the regulation’s requirements.
The distinction is between the accounting basis and how the records are used. Preparing records on a tax basis does not mean their only purpose is filing a tax return.
But claiming the deduction on the return does not, by itself, prove that the books-and-records requirement is satisfied. The statute’s books-and-records clause does not itself use the phrase “for non-tax purposes”; that language appears in the final regulation. Treasury rejected an unrestricted definition chosen by the taxpayer and accountant in favor of examining the totality of the records.
If the return and its schedules are the reports the owner actually uses, document that use and examine the underlying records. There is no express return-alone safe harbor in the authorities reviewed here. A written policy or tax-return label cannot override contrary regular cost allocation. Final regulation and Treasury explanation.
A separate rule, Regulation 1.446-1(b)(2), discusses a taxpayer whose sole income is wages. Its statement about returns establishing an accounting method does not establish a reseller’s eligibility for this inventory method.
Establish the method before changing the deduction
A first adoption of a permissible method differs from changing an established method. Proper treatment on the first return reflecting the item can establish the method. Later changes generally require IRS consent through the applicable procedure.
For qualifying changes into AFS or non-AFS inventory conformity, the automatic-change category is generally DCN 261. A taxpayer already using conformity that changes its underlying book inventory treatment may instead fall under DCN 262. That latter category provides no audit protection. Automatic consent still requires eligibility and the proper filing; updating an accounting policy is not enough. Rev. Proc. 2025-23, sections 22.18–22.19.
A transition may also require a section 481(a) adjustment to prevent costs from being omitted or deducted twice. Our Form 3115 explanation covers the procedural questions.
Reconcile the history and gather the support
An old inventory balance needs separate attention. Current purchase deductions do not establish whether historical costs were recovered. Our inventory-expensing case study explains why ongoing treatment and an old-balance correction are separate decisions.
Before applying the method, gather the receipts calculation, entity and AFS information, purchase and payment records, final adjusted ledger, inventory reports used in the business, and prior tax treatment. Have the owner and accountant reconcile what those records actually do. That is useful bookkeeping and reconciliation work, followed by the appropriate tax-planning review.
Keep the scope clear: merchandise held for resale is different from land, builder-owned homes and equipment used in the business. Those assets—and goods allocated to construction contracts—require separate analysis. A permissible deduction follows the facts and method; the account name does not decide it.
General federal tax information, updated September 11, 2026. Applying these rules requires review of the business’s records, eligibility and method history.
Joe Gallegos, CPA/CVA
Partner-in-Charge · JAG CPA & Co.
Author of The Ultimate Guide to Choosing a CPA
THE HOUSTON CPA
Let’s work through your next business decision.
Start with what you want to accomplish. We’ll look at the facts, talk through the tradeoffs, and identify a practical next step.
Public accounting since 2012 · Big Four background
Business tax planning · Cash flow · Business valuation · Advisory
Request a time, then complete the questionnaire our team emails you. Joe reviews the fit before our team confirms your phone consultation.
Read Joe’s story: the purpose and principles behind JAG