Businesses that rely on carrying inventory face a number of risks. One of the most serious risks is that the goods will lose their appeal to customers before being sold. Inventory that’s gone bad, such as spoiled produce or obsolete consumer electronics, is known as distressed inventory. Distressed inventory depresses a business’s earnings, but when properly accounted for, the expense can at least provide a tax deduction to offset the loss.

Treasury Regulations

Treasury regulation 1.471-2 allows businesses to deduct the drop in their inventories’ value if the inventory can't be sold at normal prices or can't be used "in the normal way.” Inventory is normally recorded at cost, but when it becomes distressed, the business can revalue it at its selling price minus the direct costs of disposal. The deduction is equal to the difference between the inventory’s historical cost and its distressed valuation.

Bona Fide Sale

Businesses must establish the selling price for distressed inventory in a realistic manner and can’t simply set an arbitrary price. Finding a willing buyer, who is under no compulsion to buy and doesn’t reserve any rights to return the inventory, is a solid way of establishing the selling price of the inventory. Additionally, the transaction must take place at arm’s length, which specifies that if the buyer and seller are related, the transaction price would have been agreeable to unrelated buyers and sellers.

Destroyed Inventory

When your inventory is destroyed, as is the case with spoiled groceries, you effectively disposed of it for a selling price of $0. You can deduct your basis in the destroyed inventory, because it has no salvage value. It’s up to the business to substantiate deductions for destroyed inventory, and insufficient documentation could result in the Internal Revenue Service disallowing part or all of your deduction. Keeping records, even photographs, of the inventory before and after destruction can protect your tax write-off.

Donation to Charity

Sometimes you can get a larger deduction from distressed inventory by donating it to a tax-exempt charity. If a charity puts the distressed inventory to its intended use or to care for the ill, the needy or infants, the donating business might be able to deduct the fair market value of the inventory as a charitable donation. The deduction is limited to the lesser of the fair market value reduced by half the gain that would be recognized if it were sold or twice the tax basis in the inventory.