The U.S. Tax Court’s recent Harborside opinion confirmed what we have warned our clients for quite some time: section 263A is unavailable for any cannabis business that traffics a Schedule I or II controlled substance. This conclusion is consistent with the IRS view espoused in a 2015 IRS Chief Counsel Advice memorandum and the flush language in section 263A, which states taxpayers cannot use section 263A to deduct an otherwise nondeductible item. Many cannabis businesses have relied on section 263A to capitalize expenses that would otherwise be non-deductible under section 280E. Those taxpayers should reconsider their tax return filing positions on not only a go-forward basis, but also for purposes of correcting previously filed returns.
Query: How should cannabis businesses account for their inventories going forward?
There are really two parts to the answer. First, taxpayers should consider the impact of changing their method of accounting for determining cost of goods sold (COGS), and whether it is appropriate to file IRS Form 3115 (Application for Change in Accounting Method) because they adopted a different COGS accounting method. Remember, even an erroneous method of accounting is still a method that usually requires filing that form and sometimes requires IRS permission.
Second, taxpayers should identify and use a permitted method under section 471. Those methods include the following:
Certain Small Businesses (section 471(c))
Taxpayers that are not a tax shelter under section 448(a)(3) and meet the gross receipts test found in section 448(c) may rely on their book method of determining COGS for tax purposes. Stated differently, qualifying taxpayers do not need to make book-to-tax adjustments for COGS. The gross receipts test in section 448(c) generally requires average annual gross receipts for the trailing three tax years not to exceed $25 million. Taxpayers in this category may face little or no impact when they aggressively capitalize costs into COGS for book purposes.
Herd Mentality (Reg. § 1.471-2(a)(1))
Section 471(a) grants broad authority to the IRS to adjust inventories to (1) clearly reflect income and (2) conform to the best practices of the trade or business. The conjunctive “and” requirement is interesting. It suggests that if the industry adopts best practices of capitalizing the majority of direct and indirect costs into COGS, then the IRS cannot adjust the taxpayer’s method solely for the purpose of “clearly reflecting income.” The IRS can only make an adjustment to “clearly reflect income” if it also satisfies the second prong of conforming as nearly as possible to best accounting practices. This suggests that a herd mentality within the industry may limit IRS ability to make COGS adjustments using authority granted to them in section 471.
Inventories at Cost (Reg. § 1.471-3)
Most accountants are familiar with using the inventories at cost method. Taxpayers calculate COGS using the following formula: Beginning inventory + purchases – ending inventory = COGS.
For companies that manufacture the inventory they sell, the formula modifies the purchase component to include: (1) the cost of raw materials and supplies entering into or consumed in the production process, (2) direct labor costs, and (3) indirect production costs incident and necessary for the production of the inventory (not including management expenses, selling costs, or return on capital). As you may suspect, cannabis producers receive a much better result under this method than resellers get.
Lower of Cost or Market (Reg. § 1.471-4)
The lower of cost or market method generally permits taxpayers to write down ending inventory when the carrying or book cost of that inventory is less than its current market value. Such a rule is generally taxpayer favorable because it permits the taxpayer to claim earlier the loss that otherwise arises when the taxpayer eventually sells the inventory. Cannabis businesses should receive a similar benefit. For instance, most markets face declining prices. Using the lower of cost or market method might increase the business’s COGS when production or purchasing costs are higher than the market value of their ending inventory.
Retail Merchants (Reg. § 1.471-8)
The retail method of inventory accounting is the following formula: a “Cost Compliment” multiplied by the retail sales price of goods on hand at the end of the taxable year. The cost compliment is a fraction calculated as (1) the value of beginning inventory plus the cost of goods purchased during the year divided by (2) the retail selling prices of beginning inventory plus the retail selling prices of goods purchased during the year, adjusted for all permanent markups and markdowns. This method is unlikely to produce a very favorable result for most cannabis companies as it does not capitalize indirect costs into COGS. As such, taxpayers would likely be denied deductions for indirect costs under section 280E.
Manufacturers (Reg. § 1.471-11)
This method is the closest method to section 263A and permits capitalization of both direct and indirect production costs — full absorption — to compute COGS. Production costs include direct production costs, as well as fixed and variable indirect production costs. The regulation places indirect costs into one of three buckets: (1) costs that must be included in COGS, (2) costs that are not required to be included in COGS, and (3) costs that are includable in COGS depending on the taxpayer’s book treatment. The word choice in the not required bucket is interesting. It suggests that taxpayers do not face a blanket prohibition of using those costs in COGS, and that taxpayers might in fact be able to capitalize COGS whenever doing so is consistent with industry best practices.
Query: What is the penalty risk for using section 263A?
On December 20, the Tax Court released a subsequent opinion in Harborside that is limited to discussing the application of penalties under section 6662. Harborside avoided penalties because the court determined that they acted reasonably and in good faith. However, it is interesting and noteworthy that the tax years in question were 2007 through 2012. All of those years are prior to the IRS CCA stating the IRS position that cannabis companies cannot rely on section 263A. This suggests that the Tax Court may be less forgiving for tax returns filed after the IRS published the CCA and taxpayers should consider amended returns for open tax years. The Tax Court does provide some insight into penalty relief for tax returns filed after the CCA. They note that the IRS had not promulgated regulations for section 280E, and no such regulations exist today.
There are significant tax advantages to cannabis businesses that “manufacture” their inventory rather than buying it for resale. As such, cannabis businesses can better position themselves by vertically integrating — typically by producing or processing cannabis — along with retail activities. Tax policy may drive both vertical integration and consolidation within the industry.