Inventory Tax Laws for the Cannabis Industry

Inventory Tax Laws for the Cannabis Industry

Facts / Summary / Overview:

Internal Revenue Code (IRC) section 280E unfortunately still limits the deduction of expense other than Cost of Goods Sold (COGS) for the Cannabis industry. This is true even if the state has legalized Cannabis. It does not seem fair, but currently under Federal laws, Cannabis is still an illegal business. Hemp is NOT considered Cannabis. Accordingly, Federal income tax law does not allow deductions for expenses other than costs of goods sold (COGS) and according to IRC section 280E, that is the law that subjects the limitations. Many professionals and business operators have tried to argue around IRC section 280E and unfortunately, they have been unsuccessful. .Recently, Harborside Health Center try to argue that IRC section 280E did not apply based on a fairly new IRC section 471(c), and they lost in the 9th Circuit court of appeals. So, there is guidance on IRC section 471(c) and unfortunately it is not good news.

Questions / Issues:

Question: Does IRC section 471(c), allow a business to disregard the IRC section 280E limitations?
Answer: No, Based on the opinion of USTC Case, Patient’s Mutual Assistance Collective Corporation, DBA Harborside Health Center, Petitioner – Appelle v. Commissioner of Internal Revenue Respondent – Appellee., U.S. Court of Appeals, ninth Circuit 2021-1 U.S.T.C. ¶50,130, (Apr. 22, 2021)

  •  Harborside tried to argue that expenses they cannot deduct due to IRC section 280E should be deductible under inventory costs under general inventory tax accounting rules of section 471. But with various cases like Thor Power Tool Co. v. Commissioner 79-1 USTC, and Treasury Regulation 1.471-3(d), it has already been stated items that are part of COGS and items of overhead ARE NOT costs which are part of COGS which are costs related to the purchase costs or the produced costs.
  • The case also discussed that even if Harborside decided to create an accounting method to treat overhead costs as inventory costs or COGS costs, based on Thor Power Tool and Regulation 1.471-3(d) a taxpayer CANNOT just make up COGS calculations which are not based on COGS calculations which have already been litigated and created laws.

Law / Analysis:

IRC section 471 discusses the general rules for inventory. IRC section 471(a) states, Whenever in the opinion of the Secretary the use of inventories is necessary in order to clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be the best accounting practice in the trade or bus9iness and as most early reflecting the income.
IRC section 471(c) was amended by Section 13102(c) of the Tax Cuts and Jobs Act, P.L. 115-97 on December 22, 2017. The effective date was for tax years beginning after 12/31/2017. IRC section 471(c) is an Exemption of certain small businesses. IRC section 471(c) specifically states:
IRC section 471(c)(1): In general, in the case of any taxpayer other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under IRC section 448(a)(3) which meets the gross receipts test (which is generally $25MM of gross receipts or less. It used to be $10MM) of section 448(c) for any taxable year:

  1. Subsection (a) which discussed tracking inventory, shall not apply with respect to such taxpayer for such taxable year, and
  2. The taxpayer’s method of accounting for inventory for such taxable year shall not be treated as failing to clear reflect income if such method either:
    1. Treats inventory as non-incidental materials and supplies, or
    2. Conforms to such taxpayer’s method of accounting reflected in applicable financial statement of the taxpayer with respect to such taxable year or, if the taxpayer does not have any applicable financial statement with respect to such taxable year, the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.
  3. Applicable financial statements have the meaning of IRC section 451(b)(3), which states, that is being certified as being prepared in accordance with GAAP, audited financial statements used for credit purposes, or any other substantial nontax purpose, but only if there is no statement of the taxpayer described pursuant to GAAP. Generally, it seems that GAAP must be a requirement.
  4. Application of gross receipts test to individuals, etc. In the case of any taxpayer which is not a corporation or partnership, the gross receipts test of section 448(c), which states:
    1. “Corporation or partnership meets the gross receipts test of this subsection for any taxable year if the average annual gross receipts of such entity for the 3-taxable-year period ending with the taxable year which precedes such taxable year does not exceed $25,000,000.?
    2. Pursuant to IRC section 448(c)(2), the aggregation rules apply also.
  5. Coordination with IRC section 481. Any change in method of accounting made pursuant to this subsection shall be treated for purposes of IRC section 481 as initiated by the taxpayer and made with consent of the secretary.

Other Items to Consider:

  1. The US Treasury Inspection General for the Tax Administration wrote a request for tax guidance related to the marijuana industry dated March 30, 2020 with reference number: 2020-017. It can be viewed at https://www.treasury.gov/tigta/auditreports/2020reports/202030017fr.pdf
    1. The inspector general wrote amongst other items about tax compliance approach related to IRC section 471(c), and in conjunction with IRC section 280E.
  2. The IRS can use State licensing information to target Cannabis companies to exam their IRC section 280E application.
  3. A management company that manages a Cannabis industry can’t get out of IRC section 280E. Read the Alternative Health Care Advocates, et al., v Commissioner, 151 TC No 13.

**Please discuss with your tax advisor**

 

 

 

 

 

 

 

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