Inventory Requirements for Small Business: What the IRS Says and How to Track It

Last updated: March 2026 to reflect IRS Publication 334 (2025) guidance.

Here’s a question almost every new maker asks at some point: “Do I really need to bother tracking inventory? I’m tiny.”

The answer from the IRS is pretty clear — and it’s not the one most people hope for.

It doesn’t matter if you sold $8,000 last year or $800,000. If you manufacture products from raw materials, the IRS expects you to track what those materials cost and when they were used. Not because they’re out to get small sellers. But because without that tracking, you can’t accurately calculate what it actually cost to run your business — and that number matters for your taxes.

The good news: doing this correctly is a lot simpler than it sounds.

What IRS Publication 334 Actually Says About Inventory

Let’s go straight to the source. IRS Publication 334 (2025), Tax Guide for Small Business covers accounting rules for sole proprietors filing on Schedule C. Under the Inventories section, it states:

Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, the following [small business taxpayer] taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers can also account for inventoriable items as materials and supplies that are not incidental.

A lot of makers read this and breathe a sigh of relief — “I’m small, so I don’t need to track inventory.” That’s a misreading. Let’s go through it carefully.

What it actually says: If you qualify as a small business taxpayer (more on that threshold in a moment), you don’t have to use the accrual accounting method. You can use the simpler cash method instead. That’s the good news.

But the inventory tracking requirement is separate from the accounting method question. Keep reading.

The “Not Incidental” Rule

The second sentence is the one that trips people up: “These taxpayers can also account for inventoriable items as materials and supplies that are not incidental.”

“Not incidental” materials are the ones you actually use to make your products. Fabric, resin, wax, soap base, essential oils, yarn — whatever goes into your finished goods. Without those materials, there’s no product. Those are “not incidental.”

“Incidental” materials, by contrast, are things you buy that don’t end up in your products: printer paper, packing tape, cleaning supplies.

Under IRS Reg. Section 1.162-3, “not incidental” materials and supplies are deductible in the year they are used or paid — whichever is later.

For most makers, that means the year you sold a finished product, not the year you bought the raw material. And to know which year you used which materials, you need to track them.

What This Means in Practice

If you buy a batch of candle wax in November and sell the finished candles in January, those material costs belong to January’s deductions — not November’s. The only way to match costs to sales correctly is to track what went into each product. This tracking is your cost of goods sold (COGS).

To summarize where we are: the IRS says it doesn’t matter how small your business is. If you make products from raw materials, you need to track your inventory in some form.

Wait — Hasn’t the Threshold Changed?

Yes, and this is worth clarifying because the original version of this post mentioned a $1 million gross receipts threshold. That rule changed significantly with the Tax Cuts and Jobs Act of 2018.

Under current law (reflected in Publication 334 for 2025), you qualify as a small business taxpayer if your average annual gross receipts for the prior three tax years are $31 million or less (this figure is inflation-adjusted from the $30M baseline). If you’re under that threshold, you can use the cash method of accounting and account for inventoriable items as materials and supplies.

For virtually every Etsy seller, Shopify maker, or craft business reading this: you’re well under $31M. So the cash method flexibility applies to you.

But — and this is the key point — the cash vs. accrual question only affects how you record transactions. It doesn’t eliminate the need to track what materials you used, when, and at what cost. Your COGS calculation still requires inventory records. That obligation doesn’t go away.

Additional Tracking Requirements for Certain Product Categories

If you make consumable products — soap, candles, cosmetics, food, or supplements — there’s a second layer of record-keeping that goes beyond the IRS.

The FDA’s Modernization of Cosmetics Regulation Act (MoCRA), which took full effect in 2024, requires cosmetics manufacturers to maintain records of the facilities and products they manufacture, including ingredient traceability. Our post on MoCRA requirements for handmade cosmetics makers covers this in detail.

Soap and candle makers selling consumable products also benefit from lot number tracking — it’s how you trace a specific batch of materials back to a specific production run. If a supplier issues a recall, lot numbers let you know exactly which products are affected. See our guide to lot number tracking for small makers.

And if you sell anything that could harm a child — toys, certain apparel, candles — the CPSC has its own compliance requirements. The short version: the same inventory records the IRS wants are also the records that protect you in a product safety situation.

How to Keep Track of Inventory for a Small Business

There’s no prescribed format from the IRS. What matters is that you can account for which materials went into which products and when those products were sold.

The best way to keep track of inventory for a small business comes down to three things you need to record:

1. What materials you have on hand — a starting count, updated every time you buy more stock
2. What goes into each product — a recipe or bill of materials that links raw materials to finished goods
3. When finished products sell — so you can match material costs to the right tax year

Those three data points are all the IRS needs you to reconstruct. Everything else — COGS summaries, reorder alerts, year-end reports — flows from getting these basics right.

Spreadsheet vs. Software: Which Fits Your Stage?

Spreadsheets work fine when you’re making a handful of products and your material list is short. Many makers start there — perfectly valid. The cracks show when your product range grows, when you’re buying from multiple suppliers, or when you sit down in January and try to reconstruct what you spent all year.

A handmade inventory spreadsheet can get you through early stages. But if tax time feels like a guessing game, that’s usually the sign it’s time to move on. When you do file, our Schedule C guide for handmade sellers walks through exactly how to report your inventory values and COGS on your tax return.

FAQ

What if my revenue is under $31 million — do I still need to track inventory?

Yes. The $31M threshold only determines your accounting method (cash vs. accrual). The requirement to track materials used in production — and match them to the products you sold — applies regardless of your revenue. Every maker who manufactures from raw materials needs some form of inventory records.

Do I need to track inventory from day one, even as a brand new business?

Honestly, yes — and starting early is much easier than catching up later. You don’t need elaborate systems on day one, but a basic record of what you buy and what goes into each product saves you real pain at tax time. The makers who scramble in February are almost always the ones who skipped this at the start.

What’s the easiest way to start if I’ve never tracked inventory before?

Pick a starting date — ideally the beginning of your tax year — and do a physical count of everything you have on hand. That’s your opening inventory. From there, record each material purchase as it happens and note which materials go into each product you make. Even a simple spreadsheet with those three things puts you ahead of most new sellers.

What counts as “inventory” for a handmade business?

Both your raw materials (the supplies you buy to make products) and your finished goods (the products ready to sell). If you have work-in-progress — partially made items — that technically counts too, though it’s rarely significant for most small makers.

Does the IRS audit small handmade businesses over inventory?

Audit rates for sole proprietors are low, but inaccurate COGS is a known flag. If your reported COGS doesn’t align with your revenue and expense patterns, it can attract attention. More practically: inaccurate COGS means you’re either overpaying or underpaying taxes. Getting it right protects you either way.

The Bottom Line

The IRS doesn’t make exceptions for small makers when it comes to tracking production materials. The good news is that the obligation isn’t as complicated as it sounds — you’re essentially recording what you buy, what goes into each product, and when those products sell. That’s it.

Craftybase handles all of that automatically. Enter your material purchases, build your product recipes, and it calculates COGS and generates year-end reports without a formula in sight. If you’d rather be at the workbench than in a spreadsheet, that’s the trade-off worth making.