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. 

Guest Article From Jim McKinley - Tax Time: How to Make the Most of Your Refund

Guest Article From Jim McKinley 

Tax Time: How to Make the Most of Your Refund

Tax time can either come at the best or the worst time for many Americans; some find themselves owing money to the IRS, but in many cases, a refund is due after a year full of hard work, and it’s important to think about how you want to use it. There are several ways you can take that extra cash and turn it into something beneficial, but it’s not always easy to narrow them down. If your home needs maintenance or repairs, this might be a great time to take care of them; after all, you never know when you’ll have the money to spare. You can also use the money for a treat, such as a vacation or a downpayment on a new car.

Sit down and think of some ideas on how to spend your refund. Look over your budget, go through existing debts and bills, and take a look around your home to see if anything needs to be replaced or repaired. Talk to your partner or family member for ideas on how best to use the money; in some cases, it may pay off to save it for a future endeavor or for a rainy day. If you have kids, you might think ahead for back-to-school shopping, summer activities, and extra-curricular necessities (such as a band instrument).

Here are a few ideas on how best to use your tax refund.

Start an Emergency Home Repair Fund

Every homeowner knows how devastating a major repair can be when it comes along at the wrong time. For instance, a roof replacement can be one of the most expensive repairs homeowners face (an asphalt roof replacement in Portland averages just over $8,700). If some damage is present, or if there are broken or missing shingles, make sure you get your roof inspected (an inspection costs an average of $217). Try to save this fund for emergencies only. For example, other repairs may not be as pressing, such as repaving or repairing the driveway.

Prepare for the Coming Months

If summer is coming up, you may need some extra cash on hand for activities with the kids; cooler months may necessitate a new wardrobe for everyone. Think about what the next few months will bring and whether you’re prepared for them. If not, having some cash set aside will likely come in handy. You might also consider where you’ll be; for instance, if you know you’ll be taking unpaid time off work to go on a trip, having some extra money in savings will help you get through that week without disrupting your routine or budget.

Pay Off Your Debt

Paying off debt can be beneficial in many ways, from relieving stress to helping you boost your credit score. Take a look at your bills and think about the best way to use your tax refund to get ahead. In some cases, you may be able to make an extra payment on your car or home — just make sure it will go toward the principal rather than the interest; otherwise, it may not be beneficial to you to do so. Credit card bills are often the biggest hurdle that Americans have to get over, and paying them down can help you get ahead in more ways than one.

Look Into Life Insurance

Although nobody wants to think about tragedy and death, it’s always best to have a plan in mind just in case. One way you can prepare for this worst-case scenario is by having a life insurance policy. So, when your tax refund arrives, put it in the bank and set it aside for your monthly premiums, which will give you peace of mind and give your family a safety net were something to happen to you. Of course, it’s important to understand the different terms you can select and the payouts they provide in the event of your passing. Newcomers to the world of life insurance can check out online tools that will help you determine how much insurance you need.

Start a Savings Account

One of the best ways to use extra money is to not use it at all. Setting aside spare cash for a rainy day, starting a savings account for your child’s college fund or for retirement, or opening up an account for home repairs can help to prevent stress and last-minute scrambles to gather enough cash to pay for the things you need. Look online for more information about the best types of savings accounts for your needs.

Making the most of your tax refund can be tricky, but with careful consideration, you can do it with ease. Create a plan for your money that will help you feel secure for the foreseeable future, and talk to your family members about ideas on how to make your dollars stretch.

For more Contact jmckinley@moneywithjim.org

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. 

Pros and Cons of Extending your Business Tax Returns

To extend or not to extend that is the question. 

Business Taxpayers often worry that extending their tax returns will send a red flag to the IRS. 

An additional 6 months to file is automatically granted to businesses with the filing of Form 7004 - Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns

The extension is automatically granted upon filing the Form. Meaning, there doesn't need to be a specific reason to extend.

PROs

• The extension provides 6 additional months to file.
• Taxpayer may file a superseding return (rather than having to amend) within the extended filing deadline. A superseding return is similar to an amended return, except it takes the place of the originally filed return, rather than having to formally submit an amended tax return. 
• An extension payment can be used to satisfy the previous years tax liability and then carried forward as a first quarter payment for the current year. 
• More time can be used to clean up the accounting records, analyze accounts, and prepare a tax return that is audit ready, instead of rush because of a soft deadline. 
• It is necessary due to missing tax return information like a Schedule K-1 from an investment. 

CONs

• It doesn't extend the time to pay.  Taxpayers are generally required to make estimated tax payments during the year. 
• The statute of limitations is extended as the filing of the return is extended. Meaning the return is potentially subject to audit for a longer period of time as the statute of limitations doesn't start until the return is filed and/or tax is paid, whichever is later. The statute of limitations is 3 years for Federal income tax returns if filed in good faith.

As a best practice, we recommend extending even in the event that the business still intends to file by the original due date.  The extension payments should be equal or close to the return liability and can be paid prior to the filing of the returns. This eliminates the due date rush of scheduling payments. It gives the business the option to wait and file, for example, if there are pending tax court cases of interest or if the books and records are still in process. 

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. 

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.

How to Reduce your Portland / Multnomah County Tax via Additional Nexus

Portland and Multnomah are one of the only jurisdictions which impose three levels of business income tax, Federal, Oregon and Portland/Multnomah County.  This can dissuade business from new business owners from setting up a business in Portland/Multnomah County and head for the tax friendlier Washington or Clackamas Counties, which don't impost a local income tax.  But what about companies that are already in Portland/Multnomah County? Are there any tax savings opportunities?

The most overlooked tax savings opportunity that I've encountered is the non-apportioning of gross receipts. What does that mean?  Businesses only need to pay tax on a percentage of their income based on their relative percentage of sales to customers located in Portland/Multnomah County. However, there's one caveat: sales of tangible personal property may be apportioned only if a business has payroll or property outside the jurisdiction . In other words, if the company doesn't have payroll or property outside of Portland/Multnomah County it must to pay tax on 100% of its income to Portland/Multnomah county even if 99% or even 100% of its sales are to customers outside of these jurisdictions. Conversely, a company could be based out of Portland/Multnomah County and have a small presence outside of the jurisdictions, and if 100% of its sales are to customers outside of the jurisdictions, then the company would only pay the minimum taxes of $100 each to Portland/Multnomah County.

Establishing a property presence outside the jurisdiction can be done very easily through renting a PO box or even data storage outside of Portland/Multnomah County.  In tax terminology, this typically refereed to a establishing "Nexus" or a taxable presence.

Let's run through a scenario.  Imagine an cannabis producer located in the city Portland and Multnomah County.   This grower has an exclusive contract with a processor/extractor in Clackamas County.  The company's Portland/Multnomah County taxable income is $1,000,000. If the company has not established nexus outside of Portland/Multnomah County, it would pay tax on 100% of this income resulting in $36,500 in tax.

Now, let run the numbers to see what the tax liability if the company did have property outside of the jurisdiction.  The same company would have a Portland/Multnomah County tax liability of only $200 if it had established nexus outside of the jurisdiction.

This may seem too good to be true, however it is an often overlooked opportunity by many unsuspecting taxpayers based in Portland/Multnomah County.

The same concept may often be applied at the state level in order to minimize the income allocated to higher tax states and shift to lower tax rate states. For example, an Oregon based company would want to establish Nexus in Washington (which has no business income tax) in order to shift a portion of its income based on the relative gross receipts to Washington.