How the CARES Act of 2020 and Tax Cuts and Jobs Act of 2018 Combined to create a Tax Refund Opportunity for Taxpayers subject to §280E

Ben Condon, CPA

The CARES Act of 2020 provided a five-year carry-back for losses earned in 2018, 2019, or 2020, which allows firms to modify tax returns up to five years prior to offset taxable income from those tax years.

That means a taxpayer could claim refunds from all the way back to 2013 if they generated a loss in 2018, 2014 if 2019 loss, and 2015 if 2020 loss. 

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

This allows a taxpayer with annual gross receipts less than $25 million to use its own consistently applied books, records and accounting procedures to calculate COGS and to write-off ending inventory completely, potentially unlocking losses for  taxpayers. 

An aggressive, but defensible position a taxpayer could make, would be to make the accounting change to 471(c) and capitalize and run through COGS all or a portion of the cumulative costs that were previously not allowed to be taken due to the taxpayers' inventory method.  

For example, if they were a retailer and forced to use 1.471-3(b) inventory at costs for retailers (see Harborside case) previously, where they could only deduct the vendor price of their inventory as COGS and all other costs were denied, they could make the case to capitalize and run through their 2019 or 2020 COGS many years of now capitalize-able costs through COGS. The rent, security, bud-tender wages, etc. that the taxpayer can now include in their COGS could be retroactively quantified and included in beginning inventory which would then flush through COGS resulting in a large current year tax loss.

This would pull costs that were previously nondeductible into the present taxable loss, which would then be carried back to those years when those costs were disallowed under 280E.

The switch to 471(c) typically requires a Form 3115 - Application for Change in Account method, which must be filed by the extended tax deadline.  There's still time to make this change for tax year 2019 if extended, and plenty of time to plan for this if making the change for tax year 2020.

This is a game changer that could eliminate the historical damage 280E has done to many companies and provide historical tax relief via a windfall refund! 

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. 

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. 

The 2018 Farm Bill - What it Means for Hemp Farmers' Tax Bill

Ben Condon, CPA

Ben Condon, CPA Covers the Income Tax Implications for Hemp Farms after the new 2018 Farm Bill

The Agriculture Improvement Act of 2018 (the 2018 Farm Bill) has officially been signed into law.  One of the major components of this legislation of industrial hemp.  This blog post will mainly focus on what the tax implications of this legalization and contrast tax differences of a federal legal hemp business versus a federally illegal business subject to section 280E. 

Why Hemp? For traditional farmers, rising costs and imports of foreign low-priced produce have made it difficult to turn a profit. There is currently a glut of recreational cannabis producers in Oregon driving down the wholesale prices so low most producers can afford to continue to operate. Cannabis cultivation is also heavily regulated including the canopy size a grower can use.  As a result, the switch to hemp is logical choice. 

280E No Longer Applies

Previously, hemp related businesses were often subject to section 280E, and therefore could not take any business deductions or credits, and the only cost recovery is via cost of goods sold. This is no longer the case, now hemp producers can tap into the favorable farm tax rules, which we'll dive into. 

No Need to Track Inventory

For farms with less than $25 million in gross receipts over the past three years, there's no need to track inventory.  What does that mean? It means there's no add-back to taxable income for ending inventory.  If a farm has not sold off all of its year's harvest prior to year end, it still can deduct all of the costs into it took to produce it. Previously, when hemp was a controlled substance, the act of growing hemp (and still for cannabis) was deemed manufacturing, not farming, which requires an add-back of ending inventory at year end. 

Expanded Use of Cash Method of Accounting

Again, farms with less than $25 million in gross receipts over the past three years can use the cash method of accounting. What does this mean? With the cash method available, and no requirement to track inventory, It means that a farms will have a great ability to manage their taxable income by purchasing supplies, fertilizers, equipment, ect. in preparation for the next year's harvest and take those deductions in the current year.  

Bonus Depreciation and Sec. 179 Expending

Until January 1, 2024 eligible equipment is available for immediate 100% bonus depreciation.  This now applies to certain used property too, previously, property needed to be brand new for use to be eligible.  

Sec. 179 provides for the full immediate deduction similar to 100% bonus depreciation, and has generous dollar limits up to $1 million can be immediately deducted in 2018 (with several limitations and thresholds).  Sec. 179 is available for single-purpose horticultural structures. 

Greater Access to Banking and Borrowing

Most businesses take the ability to bank for granted. Without the ability to bank, businesses are at risk of theft and record keeping can be very cumbersome. With banking bookkeeping is made easy, your cash is kept safe and counted at all times, and you're able to send and receive large sums of money safely and securely.   Also, without banking, the ability to borrow or obtain a line of credit was nearly impossible. 

Farms with a solid business plan and history of earnings should theoretically now have access to borrowing. Borrowing or leveraging can allow a business to expand with little capital and can greatly increase the return on investment if done effectively. 

Recipe for Success 

With the ability to borrow and by employing the favorable tax rules listed above, a hemp farm has the ability to expand rapidly virtually income tax-free by reinvesting its earnings into the various immediately deductible items.  That is, of course, until its average gross receipts exceeds $25 million per year, not a bad place to be.