Generally, if you engaged in a trade or business in which the production, purchase, or sale of merchandise was an income-producing factor, you must take inventories into account at the beginning and end of your tax year.
As a general rule, businesses that make or buy goods to sell may deduct the cost of goods sold from their gross receipts in computing business income. This information applies if the business is a manufacturer, wholesaler or retailer, or if engaged in any business that makes, buys or sells goods to produce income.
Exception for certain taxpayers. If you are a qualifying taxpayer or a qualifying small business taxpayer, you can account for inventoriable items in the same manner as materials and supplies that are not incidental. Under this accounting method, inventory costs for raw materials purchased for use in producing finished goods and merchandise are sold (but not before the year you paid for the raw materials or merchandise, if you are also using the cash method).
A qualifying taxpayer is a taxpayer who:
A qualifying small business taxpayer is a taxpayer:
whose average annual gross receipts for the 3 prior tax years are $10 million or less,
whose business is not a tax shelter (as defined in section 448(d)(3)), and
whose principal business activity is not an ineligible activity as explained in Rev. Proc. 2002-28, 2002-18 I.R.B. 815. You can find Rev. Proc. 2002-28 on page 815 of Internal Revenue Bulletin 2002-18.
Changing accounting methods. File Form 3115 if you are a qualifying taxpayer or qualifying small business taxpayer and want to change to the cash method or to account for inventoriable items as non-incidental materials and supplies.