On March 30, 2020, the Treasury Inspector General for Tax Administration issued a report titled “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance.” The 53-page report discussed several different topics, including that the IRS should conduct more audits under Section 280E, and this discussion focuses on Section 471(c).
The report states that certain qualifying cannabis taxpayers, who would otherwise be subject to business expenses being disallowed under Section 280E, could potentially account for their inventory under Section 471(c) using a method that would classify most or all of their expenditures as inventoriable costs and avoid Section 280E’s disallowance of such expenditures. Accordingly, as all the costs would be capitalized into inventory, they would then reduce taxable income as the inventory was sold. In other words, expenditures previously disallowed under Section 280E would be part of the cost of goods sold and allowed as a reduction of gross receipts. There was no public comment from the IRS in the report on the potential that 471(c) may eliminate 280E.
Before continuing to provide our additional comments, it is important to mention the impact of Section 471(c) on Section 280E has not been reviewed by the Courts and the Inspector General also stated that necessary guidance addressing 471(c) is lacking from the IRS. As such, the impact cannot be stated in certain terms.
The curse of Section 280E on the cannabis industry cannot be overstated – some businesses actually end up paying more in tax than they make and Section 280E can turn an economic loss into a taxable gain. This seemingly unconstitutional result has been justified by the courts and IRS under a very old principle of taxation that “deductions are a matter of legislative grace.” New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934) Legislative grace, according to these authorities, means the legislature has the power to deny all deductions, if they so choose, and it should be said that the limitation of such grace, under the 16th Amendment to the US Constitution, is that 280E cannot disallow costs of goods sold. With Section 471(c), however, legislative grace appears to be on the side of the cannabis industry because, as discussed below, Congress created Section 471(c) and it appears to allow inclusion of deductions into the cost of goods sold where they can’t be disallowed under Section 280E.
The Code states that Section 471(c) allows a small taxpayer, one with less than $25 million in revenues, who is not a tax shelter or public company to account for inventory according to their applicable financial statements, or absent applicable financial statements, according to the actual books and records of the taxpayer. For a qualifying business that doesn’t have applicable financial statements, if their books and records include deductions in COGS, then these deductions may not be subject to 280E.
Question #1 – What are applicable financial statements, what does it mean to have them, and if a taxpayer does not have applicable financials statements what are the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures?
It is our opinion that under IRC § 451(b)(3) if a taxpayer is required to issue audited financial statements in accordance with generally accepted accounting principles (GAAP) for credit purposes, to owners, or for any other nontax purpose, they have applicable financial statements. It would seem that “any other nontax purpose” would include audited GAAP statements required to be issued to state regulatory agencies. As such, because GAAP requires accounting for inventory in a manner similar to Section 471(a), taxpayers who have Applicable Financial Statements appear to be precluded from adding costs disallowed under Section 280E into COGS pursuant to Section 471(c). Of concern are states that require license holders to provide their licensing agency with audited financial statements. However, if the state doesn’t require GAAP financials, then the “Applicable Financial Statements” provision shouldn’t be a problem.
If the taxpayer does not have applicable financial statements, then they are allowed to account for inventory for tax purposes in the same way as they account for inventory on their internal books and records. Thus, their books and records would have to mirror their method of accounting for tax purposes.
Question #2 – Could a small cannabis company, who is not issuing applicable financial statements in accordance with GAAP and is subject to 280E, establish a method of accounting for inventory in which they consider all or most expenditures of the company to be inventoriable costs? If so, does characterizing these otherwise nondeductible costs as inventoriable costs change the nature of the expenditures from non-deductible business deductions to deductible costs of goods sold when the inventory is sold?
As noted above, there is currently no guidance from the IRS regarding this question and, we should assume, that the IRS will not acquiesce to the position that 471(c) eliminates 280E. So, let’s consider the arguments the IRS might make. First to consider is the Service’s conclusion in Chief Counsel Memorandum Number 201504011 regarding Sec 263A. Early on, cannabis taxpayers attempted to use Sec 263A to capitalize general and administrative costs, otherwise subject to 280E, into inventory and then deduct them as part of COGS. This does sound somewhat similar to the approach we are looking at under 471(c).
The IRS concluded in CCA 201504011 that Sec. 263A would not allow an expense disallowed under Section 280E to be added to COGS because of “flush language” added to Sec. 263A(a)(2) in a subsequent congressional amendment. The flush language states:
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.
The U.S. Tax Court agreed with the Chief Counsel memo in several opinions including Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Commissioner.
However, where this language was fatal to the cannabis industry’s attempt to use Section 263A to its benefit – it may help in the case of Section 471(c). It appears to have been necessary for the U.S. Congress to add the Flush Language to Section 263A to prevent the inclusion of otherwise disallowed expenses into COGS. There is no equivalent language added to Section 471(c) and so the argument is that in the absence of an equivalent provision, Section 471(c) can be used to include expenses disallowed under 280E into COGS where they can be used to reduce taxable income.
Another argument the IRS may make is that Treas. Reg. § 1.61-3(a) prevents the inclusion of deductions into cost of goods sold because the regulation states that Gross Income is determined without subtraction of “…selling expenses…” However, Section 1.61-3(a) is part of the Treasury Regs defining gross income and its reference to the non-inclusion of “selling expenses” is from the regulations under Section 471(a). Section 471(c) specifically states that Section 471(a) does not apply (which include the regulations) and a taxpayer’s method of accounting for inventory under Section 471(c) does not fail to accurately reflect income. And, Section 471(c) is a higher authority than the regulations. Thus, it appears that Section 471(c) trumps Treas. Reg. § 1.61-3(a).
Question #3 – Should a taxpayer, eligible to use 471(c) to account for inventory file their tax return taking positions regarding 471(c) as described in this article?
Every taxpayer is different, and accounting for inventory under Section 471(c) is not right for everyone in the cannabis industry. It is also important to understand that it may not work and for taxpayers who use the method to do so with caution and understanding. However, below is a list of issues to discuss with your tax professional:
What is your tolerance for risk and a legal dispute with the IRS? Such a dispute could be time-consuming and costly.
If 471(c) is proven not to eliminate 280E – how will you manage additional tax, interest, and possibly penalties?
Should the position be disclosed as part of your tax filing?
Does the entity have applicable financial statements?
Is the cannabis business a tax shelter?
How aggressive does management and ownership want to be regarding the position?
How will management accomplish the necessary accounting and records to support such a position?
In summary, 471 (c) has left the cannabis industry with several questions and definitive answers are probably not immediately available. License holders should work closely with their advisors as they navigate these questions. But, there is a possibility that Section 471(c) eliminates Section 280E for qualifying taxpayers. Cannabis businesses should take the necessary steps to understand it and protect their ability to benefit from Section 471(c) if it does work.
The Bridge West and GreenspoonMarder teams work tirelessly to understand the tax and accounting issues facing businesses in the cannabis industry and provide the best possible solutions to their clients.
To discuss any of the questions within this article please feel free to contact Calvin Shannon, Nick Richards or any of their team members.
Calvin Shannon is a Pricipal of Bridge West and has over 17 years of experience providing tax, audit, estate planning and trust services. Calvin is skilled at understanding client’s challenges and working with them to develop and implement innovative and unique solutions. Assists organizations to address the industry’s unique and ever-evolving issues. He enjoys having the opportunity to work with cannabis clients to understand their business needs, and to provide timely solutions
Calvin can be reached at: email@example.com and 651-287-6327.
Nick Richards is a Partner in the Tax practice group at Greenspoon Marder LLP. He represents individuals and businesses in tax audits & trials, M&A, in managing tax debt, and he advises cannabis companies, owners and investors regarding tax and regulatory compliance matters. Mr. Richards has been a tax attorney for more than twenty years beginning his career with the IRS where he was a leading trial attorney, a Chief Counsel advisor, and a Special Assistant United States Attorney.
With his broad experience and understanding at all phases of the tax system, from reporting and assessment through appeals, court, and tax debt resolution, Mr. Richards achieves successful legal solutions tailored to his individual client’s needs. Mr. Richards also teaches tax attorneys and CPAs throughout the US and he is an Adjunct Professor of Law at the University of Denver, Graduate Tax Program, where he teaches State and Local Tax and Civil and Criminal Tax.
Nick can be reached at: firstname.lastname@example.org and 720-370-1169.