Did the Tax Cuts and Jobs Act Remove the Teeth of 280E?

Ben Condon, CPA

Tax Cuts and Jobs Act of 2018 added Sec. 471(c) to the Internal Revenue Code, full text below, in order to simplify accounting for ending inventory for small taxpayers.  

According to this new Code section, "Generally, for taxpayers with annual gross receipts of less than $25 million, and who do not have an applicable financial statement, the tax payer may deduct ending inventor as a non-incidental material and supply OR use their books and records prepared with the taxpayer's accounting produces ("BRAP"). They may also use the cash method of accounting up until this threshold as well under 448(c)." 

Background

Remember that the CHAMPS, Olive, and Harborside, the tax court didn't challenge the fact that the taxpayers can take COGS, but rather how to calculate COGS and which code and treasury regulations apply. Recall that COGS is an adjustment to revenue under Treas Reg. Sec. 1.61-3, see full text below.

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§ 1.61-3 Gross income derived from business.

(a)In general. In a manufacturing, merchandising, or mining business, “gross income” means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. Gross income is determined without subtraction of depletion allowances based on a percentage of incometo the extent that it exceeds cost depletion which may be required to be included in the amount of inventoriable costs as provided in § 1.471-11 and without subtraction of selling expenses, losses or other items not ordinarily used in computing costs of goods sold or amounts which are of a type for which a deduction would be disallowed under section 162 (c), (f), or (g) in the case of a business expense. The cost of goods sold should be determined in accordance with the method of accounting consistently used by the taxpayer. Thus, for example, an amount cannot be taken into account in the computation of cost of goods sold any earlier than the taxable year in which economic performance occurs with respect to the amount (see § 1.446-1(c)(1)(ii)).

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Prior to the TCJA and 471(c), taxpayers of every size needed to account for their ending inventory, which reduces  the current year's COGS. The new 471(c) section now notes that this is not required if certain requirements are met.

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471(c)Exemption for certain small businesses

(1)In general In the case of any taxpayer (other than a tax shelter prohibited from using the cashreceipts and disbursements method of accounting under section 448(a)(3)) which meets the grossreceipts test of section 448(c) for any taxable year—

(A)

subsection (a) shall not apply with respect to such taxpayer for such taxable year, and

(B)the taxpayer’s method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income if such method either—

(i)

treats inventory as non-incidental materials and supplies, or

(ii)

conforms to such taxpayer’s method of accounting reflected in an 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.

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Harborside

The in case of Harborside, the tax court ruled that inventory will be valued at cost, plus freight in, plus or minus trade discounts (under Treas. Reg. Secs. 1.471-3(a) and 1.471-3(b)). No absorption of any rent, budtenders, trimmers, in take personnel, etc. were allowed into inventory/COGS is allowed under 1.471-3(b) "Inventories at cost."  

The tax court also dispelled any notion that IRC. Sec. 263A applies to taxpayers subject to 280E due to the flush clause that states "Any cost which (but for this subsection) could not be taken into account in computing taxable income for any tax year shall not be treated as a cost described in this paragraph."

It should be noted at this time, that the TCJA provisions relating to 471(c) do not go into effect until the 2018 tax year, therefore this change in code would not have benefited Harborside, nor any other cannabis company prior to the 2018 tax year. 

Great, so how would this work?

A taxpayer using 471(c)(1)(B)(i) would claim their inventory costs as "non-incidental materials and supplies". Non-incidental materials and supplies are a deduction under Treas. Reg. Sec. 1.162-3, and therefore would be disallowed as a deduction if subject to 280E. Something we want to avoid at all costs.

So let's take a look at 471(c)(1)(B)(ii).

There now seems to be a lot of leeway given to the taxpayer. The only items explicitly non-includible in COGS are "selling expenses, losses or other items not ordinarily used in computing costs of goods sold or amounts which are of a type for which a deduction would be disallowed under section 162 (c), (f), or (g) in the case of a business expense."

It seems that a cannabis dispensary could make a very strong case to run a portion of rent, payroll, utilities, security, and other overhead items through cost of goods sold under their books, records and procedures as long as they qualify for 471(c), which the vast majority will qualify under.  

This provides the taxpayer a tool to manage their taxable income, as the taxpayer can make it part of their procedure NOT to carry an inventory balance at year end and run purchases through COGS as they occur. The taxpayer could reduce their taxable income by purchasing inventory in December to be sold the following year.

Taxpayers may make an automatic accounting method change by filing a Form 3115 by the extended due date of their 2018 tax returns. One could make the argument to retroactively apply the BRAP to costs incurred in 2017 and run through COGS via 2018 beginning inventory. See full rev proc here: https://www.irs.gov/pub/irs-drop/rp-18-40.pdf

Summary

To summarize, a taxpayer with annual gross receipts less than $25 million can use it's own consistently applied books, records and accounting procedures to calculate COGS. As long as COGS doesn't include selling expenses, losses or other items not ordinarily used in computing cost of goods sold.

The term "ordinarily" is up for debate, but if the taxpayer uses a consistent and prudent method of allocating the costs, it should be respected under  471(c). This could be a point of further clarification from the IRS, though we have spoken live to Counsel at the Service about this and they have noted that guidance does not appear to be forthcoming any time soon. Additionally, if there were to be Federal legalization in the future, taxpayers who have already switched to using 471(c) would have to file for another change in accounting method (if allowed). It is important to think over all related issues as it is ultimately the decision of management to take a tax position.

If you would like to have us review your returns for possible tax savings, please reach out to us at 503-303-3730 or email info@b-cconsulting.com. 

Analysis & Key Takeaways from the Harborside Health Center's Unfavorable U.S. Tax Court Case Decision

In a landmark case between the IRS and Harborside Health Center ("taxpayer"), the U.S. Tax Court held the following judgments--all against the taxpayer and in favor of the IRS: 

1) The Government’s dismissal with prejudice of a civil forfeiture action against taxpayer does not bar deficiency determinations.

The tax court held that a previously dismissed civil forfeiture case against the taxpayer did not preclude the taxpayer from income tax deficiencies. The taxpayer argued a Res judicada defense, essentially a double jeopardy defense for monies. Res judicata--or claim preclusion--is an affirmative defense that bars suits on the same cause of action, and it does apply to tax litigation. The court held that civil forfeiture and income tax deficiencies aren't one in the same, and therefore monies that were successfully defended from a civil forfeiture claim weren't protected from a tax deficiency judgement.  

2) I.R.C. section 280E prevents taxpayer from deducting ordinary and necessary business expenses. 

Despite various grammatical arguments from the taxpayer, the court held that the taxpayers business "consists of" trafficking a controlled subject, and therefore can only claim cost of goods sold, and no deductions or credits. 

26 U.S. Code § 280E - Expenditures in connection with the illegal sale of drugs      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 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. 

3) During the years at issue taxpayer was engaged in only one trade or business, which was trafficking in a controlled substance. 

The taxpayer argued, similar to the CHAMPs case, that the revenue derived from non-cannabis items (clothing, paraphernalia, etc.)  constituted another trade or business not subject to Sec. 280E.  

In a previous court case commonly referred to as "CHAMPs," the court held that CHAMPs was involved in two separate trade or business, one being a cannabis dispensary, the other being a wellness center and were able to take deductions related to their wellness center. The divisions between these two business were much more clear (separate entrances, products & services, and lines of revenue).   

In this case, the Court argued that selling paraphernalia is akin to a bookstore selling stationary in addition to books, and that doesn't rise to the level of two trade or businesses, and further held the sale of paraphernalia is no different than the sale of the cannabis itself.   As a result, the taxpayer was disallowed all deductions, even the percentage allocated to the sale of non-controlled substances. 

4) Taxpayer must adjust for COGS according to the I.R.C. section 471 regulations for resellers.

This is the most painful opinion of the case and puts to rest any and all argument that IRC Sec. 263A can be applied to cannabis retailers, and the answer is "NO." It is written in a way that also makes the section's application to non-retailers highly doubtful as well, although they won't get hit quite as hard as retailers. 

The Court held that the taxpayer must follow the section 1.471-3(b), Income Tax Regs (relevant passages below). Essentially, the taxpayer can only deduct the actual purchase price of inventory from its vendors, and there shall be no absorption of any other costs (storage, intake, etc.) except for freight in.   Even activities such as making pre-rolls do not rise to the level of producer, and any cost associated would be completely disallowed under 280E. 

§ 1.471-3 Inventories at cost.

Cost means:

(a) In the case of merchandise on hand at the beginning of the taxable year, the inventory price of such goods.

(b) In the case of merchandise purchased since the beginning of the taxable year, the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. To this net invoice price should be added transportation or other necessary charges incurred in acquiring possession of the goods. For taxpayers acquiring merchandise for resale that are subject to the provisions of section 263A, see §§ 1.263A-1 and 1.263A-3 for additional amounts that must be included in inventory costs. (Emphasis added, as Sec. 263A doesn’t apply to cannabis businesses.)

Key Takeaways:

• This court erased any notion about applying 263A to cannabis dispensaries, they cannot. 
• Cannabis dispensaries can only deduct their cost of goods sold at cost, and any and all below the line deductions are completely disallowed regardless of any paraphernalia sales. 
• S-Corporations are no longer a viable tax efficient entity for cannabis dispensaries as any W-2 reasonable shareholder compensation will be 0% deductible by the company and 100% taxable to the employee, shareholder, plus payroll taxes on top of that, OUCH! 
• This will spell the end for some struggling dispensaries, and consumers will no doubt feel price increases passed on to them. 
• This will (or in my opinion should) increase the political pressure on law makers to repeal 280E or at a minimum modify the final sentence to state "prohibited by Federal law AND the law of any State." 

Full U.S. Tax Court case can be found here.