Walk through almost any stockroom in late October and you will find it: the product line that stopped selling two years ago, the boxes damaged in a leak, the seasonal goods nobody wanted, the vaccines and injectables that expire next month. On your balance sheet, all of it is still carried at full cost. On your tax return, that inflated inventory means a smaller cost of goods sold and a higher tax bill than you actually owe.
The fix is a disciplined year-end inventory count followed by proper write-downs. But the IRS does not let you simply decide your inventory is worth less. You need the right method, the right timing, and the right paperwork. Here is how to clean up obsolete and damaged stock before December 31, 2026—and make the deduction stick.
Key Takeaways
- Overstated inventory understates cost of goods sold and overstates taxable income.
- The IRS allows write-downs for damaged, obsolete, or out-of-style goods, but generally only when they are offered for sale at a reduced price, scrapped, or donated.
- A bookkeeping “reserve” for slow-moving stock is not deductible on its own.
- Plan the count, disposals, and donations now so they happen before year-end.
Why Inventory Accuracy Drives Your Tax Bill
Cost of goods sold is calculated as beginning inventory, plus purchases, minus ending inventory. Every dollar of worthless stock left in ending inventory is a dollar of expense you are not deducting. For a business with $400,000 of inventory that includes $40,000 of unsellable goods, failing to write it down can mean paying tax on $40,000 of phantom profit—roughly $10,000 or more at typical combined federal and state rates.
The error also distorts your financial statements. Inflated inventory overstates assets and gross margin, which can mislead lenders, buyers, and your own pricing decisions. Our guide to improving profit margins starts with exactly this kind of clean, accurate cost data.
Step 1: Run a Real Physical Count
Your inventory software is only as accurate as the last time someone checked it. A year-end physical count catches shrinkage, miscounts, and items that exist in the system but not on the shelf.
- Set a cutoff date and time. Freeze receiving and shipping, or carefully log anything that moves during the count.
- Use two-person count teams. One counts, one records. Separate counters from the people who manage the stock.
- Tag and flag condition. Record damaged, expired, and slow-moving items separately as you count.
- Check goods in transit and on consignment. Include what you own even if it is not on site; exclude what belongs to someone else.
- Reconcile to the books. Investigate large variances and adjust the general ledger before closing the year.
A count works best when it is built into a reliable month-end close process, so year-end is a confirmation rather than a surprise. Count controls also double as fraud controls; unexplained shrinkage is a classic warning sign covered in our post on internal controls.
Step 2: Know What the IRS Lets You Write Down
Subnormal Goods
Under Treasury Regulation 1.471-2(c), goods that are damaged, imperfect, shop-worn, out of style, or in odd or broken lots can be valued at their bona fide selling price minus direct disposal costs. The catch: the reduced price must be supported by an actual offer to sell, generally made within 30 days after your inventory date. Price lists, marked-down listings, and liquidator quotes are your evidence.
Lower of Cost or Market
If you use FIFO or specific identification, you may be able to value inventory at the lower of cost or market, where market is generally the current replacement cost. This method is not available to LIFO users, and switching methods may require filing Form 3115.
What Does Not Work
In Thor Power Tool Co. v. Commissioner, the Supreme Court held that a company could not deduct a write-down of excess inventory it continued to hold and offer at full price. A general “obsolescence reserve” on your books may be appropriate for financial reporting, but for taxes you generally need to sell it, scrap it, donate it, or offer it at a lower price.
Step 3: Choose the Right Exit for Dead Stock
| Option | Tax Result | Documentation Needed |
|---|---|---|
| Mark down and offer for sale | Value at reduced selling price | Dated price lists, listings, sales records |
| Sell to a liquidator | Loss flows through cost of goods sold | Invoice and proof of payment |
| Scrap or destroy | Remove full cost from inventory | Photos, disposal receipts, signed destruction log |
| Donate to charity | Cost removed from inventory; C corporations may qualify for an enhanced deduction | Written acknowledgment from the charity |
C corporations donating inventory used for the care of the ill, the needy, or infants may deduct more than cost under Section 170(e)(3)—up to the lesser of cost plus half the built-in gain, or twice the cost. Keep in mind the new 1% floor on corporate charitable deductions starting in 2026, explained in our post on the new charitable giving rules.
Inventory you cannot sell is not an asset. It is a tax deduction waiting for the right paperwork.
Small Businesses Have Simpler Options
Businesses that meet the small business gross receipts test (about $31 million of average annual receipts in 2025, indexed for inflation) may use the simplified inventory methods of Section 471(c). You can treat inventory as non-incidental materials and supplies, or follow the method used in your books and records. These options can reduce compliance work, but they require care to adopt correctly. Our tax preparation and strategy team can tell you whether a method change makes sense before year-end.
Special Notes for Medical Practices
Practices carry more inventory than most realize: vaccines, injectable drugs, implants, retail skincare, optical frames, and supplies. Expired drugs and vaccines should be removed from inventory and disposed of through approved channels with records kept. Practices that buy and bill drugs should also reconcile purchase records against billed units, a common source of lost revenue. Our medical practice finance specialists include supply and drug inventory in every year-end review.
Your Year-End Inventory Checklist
- Schedule the physical count and assign independent count teams.
- Pull an aging report and flag items with no sales in 12 months or more.
- Mark down, liquidate, scrap, or donate dead stock before December 31.
- Keep photos, receipts, destruction logs, and price evidence in one file.
- Post adjustments through your bookkeeping so the books and tax return match.
- Review whether a different inventory method would lower your taxes going forward.
The Bottom Line
Obsolete and damaged inventory quietly inflates your taxable income every year it sits on the books. A careful count, a clear disposal plan, and solid documentation can turn dead stock into a legitimate deduction while giving you financial statements you can trust. The key is acting before the year closes.
Numbers Right helps businesses and medical practices plan year-end counts, document write-downs, and choose the best inventory method through our CFO and advisory services. Schedule a free consultation to clean up your inventory before December 31.
