Sec. 280E and the impact of tax reform
Editor: Anthony S. Bakale, CPA
The industry generated $9 billion in revenues in 2017 (which excludes the California recreational market that came on line in January 2018) and by some estimates is forecast to grow to $21 billion by 2021 (Smith, “The U.S. Legal Marijuana Industry Is Booming,” CNN Money (Jan. 31, 2018), available at money.cnn.com.
As a result, practitioners are more likely now than ever to be asked to consult with clients that may either be considering or are currently involved, directly or indirectly, in a state–legal cannabis business.
The production or sale of marijuana is still illegal under U.S. federal law, however. Pursuant to the Controlled Substances Act (CSA) of 1970, P.L. 91–513, marijuana is listed as a Schedule I narcotic (21 U.S.C. §812). And while there has been much discussion regarding the Department of Justice’s ability and/or willingness to enforce the CSA as it relates to marijuana in states that have legalized its use either medicinally or recreationally, the CSA is still in place, and therefore any references to it, e.g., in Sec. 280E, still apply.
Practitioners must also consider the professional and legal risks associated with assisting a client that is directly involved in the cannabis business. In January 2018, the AICPA and the National Association of State Boards of Accountancy issued a summary of current state board positions on the subject (see Providing Services to Businesses in the Marijuana Industry: A Sample of Current Board Positions, available at www.aicpa.org. The list of published positions is relatively small considering the burgeoning size and scope of the industry.
The risks to practitioners conceivably could include liability under federal criminal law of aiding and abetting an offense. According to 18 U.S.C. Section 2(a): “Whoever commits an offense against the United States or aids, abets, counsels, commands, induces or procures its commission, is punishable as a principal.” Furthermore, Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), requires practicing tax professionals to demonstrate good character and good reputation.
It is unclear how those characteristics are defined, and, as of this writing, clarification is awaited from the IRS Office of Professional Responsibility (Wooten, “Tax Practice: IRS Guidance Coming for Practitioners Preparing Returns for Marijuana Retailers,” BNA Daily Tax Report (Nov. 20, 2014), available at www.irs.gov.
Nondeductible expenses under Sec. 280E
In 1982, Congress enacted Sec. 280E, which reversed a Tax Court decision (Edmondson, T.C. Memo. 1981–623) that had allowed deductions incurred in carrying on the production, distribution, and sale of controlled substances. Sec. 280E reads:
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of the 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.
In the context of marijuana, trafficking was defined by the Tax Court as the regular buying or selling of marijuana(Californians Helping to Alleviate Medical Problems (CHAMP), Inc., 128 T.C. 173 (2007)).
Sec. 61(a) taxes “all income from whatever source derived,” which includes income from illegal activities (see, e.g., James, 366 U.S. 213 (1961)). The 16th Amendment to the Constitution gave Congress authority to tax income from any source without apportionment. The U.S. Supreme Court has held that income in the context of a reseller or producer means gross income, not gross receipts. In other words, Congress may not tax the return of capital (see, e.g., Doyle v. Mitchell Bros. Co., 247 U.S. 179 (1918)). This concept is bolstered under Sec. 61(a)(3), which provides that gross income includes only net gains derived from dealings in property. In addition, Regs. Sec. 1.61–3(a) defines gross income as total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources (see also Rodriguez, T.C. Memo. 2009–22, in which the Tax Court clearly states that cost of goods sold is an adjustment to gross income and not a deduction; see also Regs. Sec. 1.162–1(a): “The cost of goods purchased for resale, with proper adjustment for opening and closing inventories, is deducted from gross sales in computing gross income.”).
This is critical because it allows a grower, producer, wholesaler, or retailer of marijuana to deduct from its gross receipts the costs of goods sold, despite the language of Sec. 280E.This was affirmed in Olive, 139 T.C. 19 (2012), as well as Chief Counsel Advice (CCA) 201504011, in which the IRS provided guidance as to how a taxpayer subject to Sec. 280E determines costs of goods sold and whether the IRS can require a business subject to Sec. 280E to use an inventory method when that taxpayer currently deducts otherwise inventoriable costs from gross income.
No other amount appears to be allowed as a deduction or credit for amounts paid or incurred with respect to the business subject to Sec. 280E, including expenses paid or incurred and otherwise allowable under Sec. 162(a). Thus, a taxpayer subject to Sec. 280E would benefit from an accounting or inventory method that results in the largest allowable amount allocated to costs of goods sold.
Inventory methods and techniques
Inventory costing rules typically require producers to capitalize costs that are incident to and necessary for the production or manufacturing operations or processes. Under Sec. 263A, a taxpayer is generally required to capitalize to inventory, in addition to direct costs, certain indirect costs, and mixed service costs that typically would not have been required to be capitalized under the earlier provisions of Sec. 471. So, given the objective of a business subject to Sec. 280E to capitalize as much of its costs as possible, one would assume the business would want to apply Sec. 263A to the inventory calculations. However, flush language at the end of Sec. 263A(a)(2) 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.
In addition, the Senate Finance Committee report related to this section reads:
A cost is subject to capitalization under this provision only to the extent it would otherwise be taken into account in computing taxable income for any taxable year. Thus, for example, the portion of a taxpayer’s interest expense that is allocable to personal loans, and hence is disallowed under section 163(h), may not be included in a capital or inventory account and recovered through depreciation or amortization deductions, as a cost of sales, or in any other manner. [S. Rep’t No. 100–445, 100th Cong. 2d Sess. 104 (1988)]
In addition, the IRS concluded in CCA 201504011 that Sec. 263A is simply a timing provision that “does not change the character of any expense from ‘nondeductible’ to ‘deductible’ or vice versa.” So, to the extent that Sec. 263A applies to a producer or reseller of property subject to Sec. 280E, the capitalization of expenses specific to Sec. 263A does not change their character as nondeductible under Sec. 280E. The IRS then concluded that a taxpayer trafficking in a Schedule I or II narcotic can deduct as costs of goods sold only those costs that would have been included under the provisions of Sec. 471 as they existed when Sec. 280E was enacted. While this guidance is not controlling on the issue, businesses need to carefully consider the potential risks of adopting a contrary position that may be challenged in an IRS examination.
Therefore, businesses subject to Sec. 280E should look to Sec. 471 to determine the proper inventory capitalization and valuation methods, allocation of expenses, and their impact on cost of goods sold. This analysis starts with applying the inventory rules relating to the producer of a product, which includes one engaged in the manufacture or growing of real and tangible personal property (Regs. Sec. 1.263A–2(a)(1)(i)). With respect to growing, Regs. Sec. 1.263A–4(a)(4)(i) defines a farming business as:
a trade or business involving the cultivation of land or the raising or harvesting of any agricultural or horticultural commodity. Examples include the trade or business of operating a nursery or sod farm; the raising or harvesting of trees bearing fruit, nuts, or other crops; the raising of ornamental trees (other than evergreen trees that are more than 6 years old at the time they are severed from their roots); and the raising, shearing, feeding, caring for, training, and management of animals.
Regs. Sec. 1.263A–4(a)(4)(i)(A) defines a plant produced in a farming business as including but not limited to “a fruit, nut, or other crop bearing tree, an ornamental tree, a vine, a bush, sod, and the crop or yield of a plant that will have more than one crop or yield raised by the taxpayer.” If the preproduction period of the plant is less than two years (the time from planting until first harvest), then there are two exceptions under the regulations to the application of Sec. 263A to a farming business: (1) taxpayers not required to use the accrual method of accounting (Regs. Sec. 1.263A–4(a)(2)(i)(A)); and (2) tax shelters (Regs. Sec. 1.263A–4(a)(2)(i)(B)). However, neither of these exceptions to Sec. 263A allows a taxpayer to deduct expenses that would otherwise be capitalized under Sec. 263 or 471 (Regs. Sec. 1.263A–4(a)(3)).
Sec. 471(a) provides that:
Whenever in the opinion of the Secretary the use of inventories is necessary in order to clearly determine the income of any taxpayer, inventories shall be taken by the taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and most clearly reflecting the income.
Regs. Sec. 1.471–1 provides that inventories are required when the production, purchase, or sale of merchandise is an income–producing factor.
Regs. Sec. 1.471–2 establishes two tests by which ending inventory must be valued. Regs. Sec. 1.471–2(a)(1) states that the valuation method must conform as nearly as possible to the best accounting practice in the trade or business, and Regs. Sec. 1.471–2(a)(2) requires that it clearly reflect income. Regs. Sec. 1.471–2(c) states that, typically, ending inventory will be valued at cost, or the lower of cost or market. This second option provides some opportunity for taxpayers using an inventory method to recognize a loss from inventory that is obsolete, damaged, or otherwise unsalable at normal prices based on the realizable values net of any direct cost of disposition. Realizable value should be based on the actual price at which those goods are offered for sale during the period ending not later than 30 days after the inventory date (Regs. Sec. 1.471–2(c)).
Note that the burden of proof with respect to the inventory writedown from cost rests with the taxpayer, and adequate records must be maintained to establish the values. It should be noted that the adoption of the lower–of–cost–or–market method of accounting should not subject the inventory costs expensed under this method to the limitations of Sec. 280E, as the adoption of this method determines timing of the recognition of the deduction rather than its character.
Regs. Sec. 1.471–6 provides an alternative inventory valuation method for farmers, the “farm–price method,” in which ending inventories are valued at market price, less direct cost of disposition (Regs. Sec 1.471–6(d)). While this might simplify recordkeeping, once elected, any change to or from this method must be authorized by the IRS as provided in Regs. Sec. 1.446–1(e)(2).
Regs. Sec. 1.471–3(c) defines inventoriable costs for a producer to include raw materials and supplies entering into or consumed in connection with the production of the product, and this includes expenditures for direct labor and indirect production costs incident to and necessary for the production of the particular item. Included in this production cost is an appropriate portion of management expenses allocable to the production process. But that would not include any costs of selling, or return on capital, whether by interest or profit.
Regs. Sec. 1.471–11(a) generally requires that a producer maintain inventories using the full–absorption method of inventory costing as described in the regulations. Under this method, both direct and indirect production costs must be taken into account in the computation of inventoriable costs. Regs. Sec. 1.471–11 further sets forth in detail costs that are specifically includible and excludable from inventoriable cost (cost of goods sold). Under this regulation, costs are considered to be production costs to the extent that they are incident to and necessary for production or manufacturing operations or processes.
Regs. Sec. 1.471–11(b)(2)(i) defines direct production costs as those costs that are incident to and necessary for the production or manufacturing operations or processes and are components of the costs of either direct material or direct labor. Direct material costs include the cost of materials that become an integral part of the specific product and materials that are consumed in the ordinary course of manufacturing and can be identified or associated with particular units or groups of products. Direct labor costs include basic compensation, overtime pay, vacation and holiday pay, sick leave pay, shift differential, payroll taxes, and payments of supplemental unemployment benefits.
Regs. Sec. 1.471–11(b)(3)(i) defines indirect production costs as all costs incident to and necessary for production or manufacturing operations or processes, other than direct production costs. Regs. Sec. 1.471–11(c)(1)(i) provides the general rule by which indirect costs must be capitalized to ending inventory (see the chart, “Sec. 471 Full–Absorption Accounting for Inventory,” below). It is important to note that indirect costs identified under Regs. Sec. 1.471–11(c)(2)(i) are required to be capitalized to inventory. Costs identified under Regs. Sec. 1.471–11(c)(2)(ii) (see the chart) are not required to be capitalized under the regulations, regardless of the taxpayer’s method of accounting for financial reporting purposes.
Of particular interest is the flush language of Regs. Sec. 1.471–11(c)(2)(ii), which states:
Notwithstanding the preceding sentence, if a taxpayer consistently includes in his computation of the amount of inventoriable costs any of the costs described in the preceding sentence, a change in such method of inclusion shall be considered a change in method of accounting within the meaning of sections 446, 481, and paragraph (e)(4) of this section.
In the author’s opinion, this flush language may open the door to include items in inventoriable cost under Regs. Sec. 1.471–11(c)(2)(ii) if their method is consistently applied. However, before adopting such a position, the taxpayer should review CCA 201504011. More likely than not, if the law changed so that Sec. 280E no longer applied to a taxpayer trafficking in cannabis, the taxpayer would be required or need to request and be granted permission to change the method of accounting to Sec. 263A or another acceptable method. Costs identified under Regs. Sec. 1.471–11(c)(2)(iii) are capitalized only to the extent the taxpayer capitalizes them for financial reporting purposes (see the chart).
Capitalizable indirect costs under Regs. Sec. 1.471–11 can be allocated to ending inventory using a number of methods. The most common of these for a producer would be the manufacturing–burden–rate method under Regs. Sec. 1.471–11(d)(2) or the standard–cost method under Regs. Sec. 1.471–11(d)(3). Under Regs. Sec. 1.471–11(d)(2)(ii), indirect costs are allocated in a way that attempts to represent how the costs are incurred. For example, $10 of indirect costs would be allocated for every $5 of labor. The rate of $10 would be determined by taking total expected variable indirect costs over total expected direct labor for the measurement period. Examples of additional statistical–based methods that would be acceptable would be an allocation based on direct labor hours, or machine hours incurred in producing the product.
Under the standard–costs method, direct and indirect costs are allocated to items based on fixed or standard rates. Variances, both positive and negative, would need to be allocated to ending inventory if significant (Regs. Sec. 1.471–11(d)(3)(ii)(a)).
Inventory methods and techniques for sellers
With respect to sellers, Regs. Sec. 1.471–3(b) states that, generally, only the cost of the merchandise purchased, net of any trade or other discounts, plus any freight in and any other cost incurred in acquiring the goods and preparing them for sale, are includible in inventory.
Additional cost-allocation considerations
Another significant tax issue to consider is the allocation of costs in a business that includes not only the production or sale of marijuana but also activities outside the scope of Sec. 280E.
The seminal case in this area is the CHAMP case, in which the taxpayer (a not–for–profit organization) charged its customers a monthly membership fee that included counseling and other caregiving services to individual members who had debilitating diseases including AIDS, cancer, and multiple sclerosis. Part of its services included providing medical marijuana to its patients. The IRS disallowed all expenses under Sec. 280E. However, the court sided with the taxpayer and determined that the organization operated two separate trades or businesses and apportioned the income and expenses to each.
It should be noted that the court in this case placed much weight on the fact that the company held discussion groups, regularly distributed food and hygiene supplies, and provided specific counselors and counseling services. In other words, the weight of evidence convinced the court that these activities were separate and distinct and did not primarily support the trafficking of marijuana.
Impact of the TCJA on the cannabis industry
The centerpiece of the 2017 tax reform proposals was the reduction of tax rates. Under the law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115–97, C corporations are now afforded a maximum tax rate of 21%. In addition, the TCJA provided for a deduction under Sec. 199A (subject to myriad limitations) of up to 20% of flowthrough income (income from a partnership, S corporation, or sole proprietorship). This deduction was added in an attempt to level the playing field between C corporations and entities structured as something other than a C corporation.
As previously discussed, Sec. 280E precludes a business that is considered to traffic in a Schedule I or II narcotic from taking a deduction or credit for anything other than costs of goods sold. As of this writing, there is no guidance with respect to the interaction between Sec. 280E and the Sec. 199A deduction. One argument may be that since the deduction was not “paid or incurred,” it would not be an excluded deduction under Sec. 280E (much like a standard deduction or exemption), or that the deduction is taken on the individual return, not on the return of the business that is actually “trafficking,” and Sec. 280E applies only at the business level. Another argument would be that Sec. 280E specifically states that no deduction is allowed with respect to the applicable business activity and that the Sec. 199A “deduction” is simply excluded by the plain language of Sec. 280E.
Tax practitioners should carefully weigh the potential pitfalls in advising clients with respect to the interaction of Sec. 199A and Sec. 280E until further guidance is provided. Taxpayers may want to consider that the lower current C corporation tax rate, coupled with potential gain exclusion under Sec. 1202 for qualified small business stock, as well as sequestering income tax obligations at the corporate level versus the individual level, could outweigh the cost of the double tax on C corporation profits and any other benefits available to the flowthrough structure.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.