Schedule C: Lower of Cost or Market Explained for Inventory Adjustments

Small business owners who sell physical products must track inventory costs accurately for tax reporting. The IRS requires businesses to report inventory value on Schedule C, using the “Lower of Cost or Market” (LCM) method. This rule prevents overstating inventory value by requiring businesses to record it at either its original cost or current market value—whichever is lower. Applying LCM affects taxable income, making it essential to understand how it works and how to adjust inventory values properly.

Distinguishing Cost from Market

Determining whether to use cost or market value requires understanding each term. Cost refers to the purchase price, including expenses like shipping and handling. This figure remains fixed unless adjustments are needed due to obsolescence, damage, or other factors that reduce value. Market value represents the price at which inventory could be replaced under normal business conditions, subject to IRS limitations.

For LCM purposes, market value is the current replacement cost—the amount needed to purchase the same item today. However, this value cannot exceed net realizable value, which is the estimated selling price minus reasonable costs of completion and disposal. It also cannot be lower than net realizable value reduced by a normal profit margin. These restrictions prevent businesses from manipulating inventory values to lower taxable income artificially.

Applying these definitions can be challenging for products with frequent price fluctuations, such as perishable goods or technology items. For example, a retailer selling smartphones may find that a model’s price drops significantly after a newer version is released. If the replacement cost falls below the original purchase price but remains within the IRS-defined range, the business must use the lower amount when valuing inventory.

Calculating Inventory Adjustments

To apply LCM correctly, businesses must assess inventory value at year-end, identifying losses due to market downturns, obsolescence, or damage. They then compare the recorded cost of each item to its current replacement cost. If the replacement cost is lower, the item’s value must be adjusted downward within IRS-defined limits.

For example, if a retailer purchased seasonal clothing for $50 per unit but the replacement cost has dropped to $30, the inventory must be recorded at the lower amount—unless the net realizable value is $35, in which case that amount must be used instead.

Accounting for these adjustments requires a general ledger entry reflecting the reduced inventory value. This typically involves debiting an expense account, such as “Inventory Write-Down,” and crediting the inventory asset account. This recognizes the decline in value as an expense, reducing taxable income. Proper documentation, including invoices, market price data, and valuation calculations, is necessary to substantiate these adjustments in case of an IRS audit.

Reporting Adjustments on Schedule C

Sole proprietors and single-member LLCs must report inventory adjustments on Schedule C (Form 1040) in Part III, which covers Cost of Goods Sold (COGS). Accurately reflecting inventory reductions ensures taxable income is not overstated, reducing compliance risks.

The process begins by entering the beginning inventory amount on Line 35, which should match the previous year’s ending inventory. Purchases during the tax year, excluding personal-use items or those withdrawn for non-business purposes, are recorded on Line 36. If an inventory adjustment is necessary due to LCM, the reduced valuation is reflected in the ending inventory amount on Line 41. This adjustment directly impacts the COGS calculation on Line 42, as a lower ending inventory increases the deductible cost and reduces taxable profit.

The IRS may scrutinize inventory reductions to ensure they are justified. Unsubstantiated write-downs can be disallowed, leading to penalties or additional tax liability. Businesses should be prepared to explain why inventory values were lowered, referencing industry pricing trends, supplier cost changes, or documented product obsolescence. The IRS may also compare reported inventory changes against broader economic data to assess whether adjustments align with market conditions.

Recordkeeping for LCM

Maintaining thorough records is essential for businesses applying LCM. Proper documentation supports valuation decisions and ensures adjustments can withstand IRS scrutiny. A well-organized system should include historical purchase records, supplier invoices, and documentation related to markdowns or inventory reductions.

Beyond purchase records, businesses should retain evidence of market conditions that justify lower valuations. Industry price indices, competitor pricing data, and supplier cost trends can serve as supporting documentation. For example, if a business lowers inventory value due to a widespread decline in wholesale prices, retaining market research reports or correspondence with suppliers confirming cost reductions strengthens the case for the adjustment. Photographic evidence or condition reports may also be necessary when inventory is written down due to physical deterioration or obsolescence.