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How Does Inventory Affect Corporate Tax?

The amount of corporate tax your retail or manufacturing business pays is directly related to your inventory costs. The Internal Revenue Service considers the expenses of purchasing and storing inventory part of your cost of doing business. You must account for these costs and disclose them on your income statement. Under IRS and generally accepted accounting principals, or GAAP, you can decide which method you want to use to account for your inventory. The method you select determines how your inventory costs affect your corporation’s tax liability.

Inventory and Taxable Income

Your inventory costs are the original purchase price, any freight charges and the sales tax you paid. As such, you include all these expenses with the cost of goods sold calculation shown on your income statement. Your cost of goods sold directly reduces your gross income dollar for dollar. This, in turn, reduces your taxable income. The greater your cost of goods sold, the less income you have available that might be subject to taxation.

Increased Corporate Tax

The first-in, first-out, or FIFO, inventory method increases your corporate tax liability. With FIFO, inventory rotates in and out of storage chronologically. The first inventory you buy is the first inventory you sell or use. Since inventory costs rise with inflation, you are using the cheaper inventory units first. The remaining unsold inventory consists of the higher-cost units. This decreases your cost of goods sold and increases your taxable income. When you use FIFO, you report a larger profit and pay more in corporate income tax.

Decreased Corporate Tax

The last-in, first-out, or LIFO, inventory method decreases your corporate taxes. With LIFO, you use the newest inventory first and hold the older inventory in storage. The most recent inventory, which typically consists of the more expensive units, is what you use first. The remaining inventory consists of lower-cost units. This increases your cost of goods sold and decreases your taxable income. With LIFO, you report less in profits and pay less in taxes.


Using LIFO allows you to defer paying your corporate income taxes. While the IRS still recognizes LIFO, you must complete and file Form 970, Application to Use LIFO Inventory Method, before you can use it. Another concern with using LIFO is the potential tax liability if you change your business organization from a C corporation to an S corporation. In that case, you must recapture the valuation difference between the LIFO and FIFO inventory methods. The IRS classifies this difference as income, and you must pay taxes on the amount when you file your final C corporation tax return.