On Jan. 23, the IRS released Office of Chief Counsel Memorandum Number 201504011, providing useful insight into the IRS chief counsel’s view of how cannabis businesses are required to calculate taxable income for federal income tax purposes. The memo presented a clear disapproval of the method many in the cannabis industry are using to capitalize costs as cost of goods sold (COGS).
What is Section 280E?
Although cannabis farming and retail businesses are considered illegal under federal law, the IRS still requires them (along with all other businesses with revenues derived from illegal activities) to pay federal income taxes. Cannabis businesses are subject to a very high effective tax rate because of Internal Revenue Code Section 280E.
Normally, a business is entitled to calculate its taxable income by deducting any ordinary and necessary business expenses from its gross income. However, section 280E provides:
“No deduction or credit shall be allowed for any expenditure paid or incurred in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
Because cannabis is classified as a Schedule I controlled substance under federal law, Section 280E means that cannabis businesses, even if legal under state law, cannot make normal business deductions. Nevertheless, cannabis businesses have found some relief from Section 280E by deducting their COGS.
The importance of COGS
Federal income taxes are, essentially, based on a simple formula: add up all income, from whatever source derived (known as your gross income), then subtract all your ordinary and necessary businesses expenses to get your taxable income.
However, in the case of taxpayers who have “gains derived from dealings in property” (such as cannabis growers and retailers, among many others), gross income means something slightly different: gross receipts minus COGS.
Therefore, knowing a business’ COGS — and what, in particular, may be treated as a cost of goods sold — is critical to understanding and properly calculating taxable income for any inventory-based business, and especially a cannabis business. COGS is important because, in calculating gross income, those costs are netted against gross receipts. In other words, generally, the higher your COGS, the lower your gross income. The concept of COGS enjoys the support and approval of the U.S. Supreme Court, which has held that congressional power to lay and collect income taxes in the context of a reseller or producer means gross income, not gross receipts.
COGS has been described by the U.S. Tax Court as the expenditures needed “to acquire, construct or extract a physical product which is to be sold; the seller can have no gain until he recovers the economic investment that he has made directly in the actual item sold.” As a simple example, if you received $100 for something that took you $40 worth of labor and capital to grow (in other words, COGS), then your gross income is $60.
For cannabis businesses, COGS and the ability to capitalize expenditures represents the sole opportunity to reduce taxable income by expenditures. When an inventory-costing regulation applies, the business “capitalizes” the expense and keeps that cost in inventories until the taxable year it sells the associated plant or inventory. At that point, the business includes the expense in COGS, which in turn reduces gross receipts, which in turn reduces taxable income.
Many types of businesses might prefer to deduct an expenditure immediately, in the year a piece of equipment or inventory is purchased, rather than having to capitalize it and have its tax benefit spread over future years.
This is not the case for a cannabis business. Because of Section 280E’s prohibition on normal business deductions, it is clearly preferable for a cannabis business to capitalize an expenditure whenever possible, rather than having it treated as a non-deductible ordinary and necessary business expense.
This raises an important question: What are the rules for determining which expenses may be included in a cannabis business’ cost of goods sold?
Cannabis industry COGS
The Chief Counsel Memorandum released Jan. 23 sheds some light on these rules, addressing two “accounting-related” issues concerning cannabis businesses.
First, the memo addressed the question: “How does a taxpayer trafficking in a Schedule I or Schedule II controlled substance determine COGS for the purposes of §280E?”
The memo concludes that cannabis businesses are entitled to determine inventoriable COGS using the applicable regulations “as they existed when §280E was enacted” in 1982. Therefore, such businesses are NOT allowed to use more recent IRS regulations found in Section 263A (also known as the UNICAP rules) that have increased the types of expenditures to be included in COGS.
The 1982 regulations are Section 471 and are referred to as the “full absorption method.” After 1982, the IRS pushed for more expenses to be treated as COGS rather than currently deductible, and those rules are UNICAP.
UNICAP goes beyond 471’s rules to include purchasing, handling and storage expenses, and service costs such as the costs associated with their payroll, legal and personnel functions.
Obviously, the more expenses a cannabis business can include in its COGS, the lower its gross income, and, therefore, its tax burden. Because UNICAP greatly expanded the categories of costs that qualify as COGS, it is quite favorable to a cannabis business looking to reduce its tax burden.
Unfortunately, one of the biggest impacts of the recent chief counsel memo is that the IRS will no longer allow cannabis businesses to use UNICAP, and, instead, will only allow them to capitalize costs includible in COGS as of the passage of 280E in 1982.
The memo states: “When §280E was enacted in 1982, ‘inventoriable cost’ meant a cost that was capitalized to inventories under §471 (as those regulations existed before the enactment of §263A). The specific regulations are §1.471-3(b) in the case of a reseller of property and §§1.471-3(c) and 1.471-11 in the case of a producer of property.”
By the memo’s reasoning, cannabis retail businesses utilizing Section 471’s inventory rules would include in its COGS:
- Invoice price of the cannabis purchased, less trade or other discounts; and
- Transportation or other necessary charges incurred in acquiring possession of the cannabis.
Similarly, a cannabis grower/producer using the Section 471 inventory method would include in its COGS:
- Direct material costs (cannabis seeds or plants);
- Direct labor costs (planting, cultivating, harvesting, sorting, etc.);
- Category 1 indirect costs (§1.471-11(c)(2)(i)); and
- “Possibly” Category 3 indirect costs (§1.471-11(c)(2)(iii)).
Why, according to the IRS memo, must a cannabis business use 471 and not the UNICAP rules?
- Section 263A states (in a passage commonly referred to as the “flush” language) that “Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.” Therefore, sections 280E and 263A, when read together, prevent a taxpayer trafficking in a Schedule I or Schedule II controlled substance from obtaining a tax benefit by capitalizing otherwise disallowed deductions.
- Congress did not repeal or amend 280E when it enacted 263A.
- Nothing in the legislative history of 263A suggests that Congress intended to permit a taxpayer to circumvent 280E by treating a disallowed deduction as an inventoriable cost or as any other type of capitalized cost.
- The legislative history of 263A states that “a cost is subject to capitalization … only to the extent it would otherwise be taken into account in computing taxable income for any taxable year.”
Therefore, according to the memo: “If a taxpayer subject to §280E were allowed to capitalize additional §263A costs, §263A would cease being a provision that affects merely timing and would become a provision that transforms non-deductible expenses into capitalizable costs.”
The memo also concludes that in situations where the accounting method used by a cannabis business causes a tax result contrary to the 16th Amendment of the U.S. Constitution, to Section 61(a)(3), and to the legislative history of Section 280E, the IRS has broad authority to require the business to change its method of accounting regardless of whether that change results in a positive or negative adjustment.
The cannabis industry — and especially, in light of the recent passage of House Bill 3460 and Measure 91, the Oregon cannabis industry — is looking for clarity regarding its federal income tax obligations, so the IRS memo is timely and educational, if not especially welcome. Remember, however, that the memo is only an internal discussion and does not carry any sort of legal weight. It is not a law, regulation or court case, and may not be used or cited as precedent. The IRS could change its mind or take a contrary position any time it desires. However, the memo likely signals more aggressive audits regarding cannabis businesses that may have used the UNICAP rules.
Sooner or later, the U.S. Tax Court (and, ultimately, the U.S. Supreme Court) will have to answer the following questions:
- Did Congress intend that cannabis businesses must use a definition of COGS as it existed in 1982?
- The U.S. Tax Court, in Franklin (a case that is cited in the memo), said that 280E “deals only with deductions and credits … and does not disallow exclusions from gross income on account of cost of goods sold,” and that 280E would not preclude a taxpayer “from taking account of any cost of goods sold.” Does the memo conflict with the U.S. Tax Court’s view, or perhaps signal a new view, of the reach of 280E?
- If the IRS takes the view held in the memo, does it create constitutional issues? Might the IRS be viewed as impermissibly trying to limit a cannabis business’ ability to capitalize its costs?
These questions, and many more, will be on the minds of every taxpayer in the cannabis industry in the coming years.