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.

However, if your average annual gross receipts for the 3 prior tax years are $1 million or less and you are an eligible taxpayer who adopts or changes to the cash method of accounting, you will not be required to account for inventories.

If your business has been in existence for less than three years, average gross receipts are determined over the tax years it has been in existence (including annualized amounts for short years). For this purpose, gross receipts are defined as all amounts from the trade or business required to be recognized under your current method of accounting.  These amounts include total sales (net of returns and allowances), all amounts received from services, interest, dividends, and rents. You do not have to include taxes that are legally imposed on the purchaser and are merely collected and remitted on their behalf.

If you are not required to account for inventories and do not want to do so, you must treat inventory in the same manner as cost of materials and supplies that are not incidental. Under this rule, inventory costs for raw materials purchased for resale are deductible in the year the finished goods or merchandise are sold (or, if later, the year you paid for the raw materials or merchandise).

If you want to change to the cash method of accounting, you must file Form 3115, Application for Change in Accounting Method.  You may also have to make an adjustment to prevent the amounts of income or expense from being duplicated or omitted.  This is called a section 481(a) adjustment, which is taken into account over a period not to exceed 4 years.