FEDERAL TAXATION OF CANNABIS – AN OVERVIEW SECTION 280E – NONDEDUCTIBLE EXPENSES
In 1982, Congress enacted Internal Revenue Code Section 280E, which states:
“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 Californians Helping to Alleviate Medical Problems (CHAMP), Inc., the Tax Court defined trafficking in a controlled substance by reference to the verb “traffic,” which according to the Court denotes “to engage in commercial activity: buy and sell regularly.”
In James v. United States, 366 U.S. 213 (1961), the Supreme Court held that “embezzled money is taxable income of the embezzler in the year of the embezzlement under Section 22(a) of the Internal Revenue Code of 1939, which defines ‘gross income’ as including ‘gains or profits and income derived from any source whatever,’ and under Section 61(a) of the Internal Revenue Code of 1954, which defines ‘gross income’ as ‘all income from whatever source derived.”
Regulation Section 1.61-3(a) states in part that “gross income means total sales, less costs of goods sold, plus any income from investments and from incidental or outside operations or sources.” Regulation Section 1.162-1(a) states in part that “The cost of goods purchased for resale, with proper adjustment for opening and closing inventories, is deducted from gross sales in computing gross income.”
The language of Regulation Section 1.61-3(a) and Regulation Section 1.162-1(a) is critical in that it allows businesses in the cannabis industry to deduct cost of goods sold from gross receipts in arriving at gross income. The method(s) available to businesses in the cannabis industry for computing cost of goods sold are discussed next.
COMPUTING COST OF GOODS SOLD – SECTION 263A VS. SECTION 471
Generally, taxpayers look to the provisions of Internal Revenue Code Section 263A for rules regarding the capitalization of costs that are incident to and necessary for production or manufacturing operations or processes. Under Section 263A, a taxpayer is generally required to capitalize to inventory direct costs, certain indirect costs, and mixed service costs.
As it is the objective of businesses subject to the provisions of Section 280E to capitalize as much of its costs as possible, one may conclude that such businesses would want to apply Section 263A to its inventory calculations. Unfortunately, the provisions of Section 263A are not available to businesses in the cannabis industry as such businesses are subject to the provisions of Section 280E. Specifically, Section 263A(a)(2) states in part that “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.”
Additional guidance on this matter can be found by reference to Office of Chief Counsel Internal Revenue Service Memorandum Number 201504011, released 1/23/2015, which states in part the following:
“Section 263A is a timing provision. It does not change the character of any expense from “nondeductible” to “deductible,” or vice versa. For a taxpayer to be permitted to treat an expense as an inventoriable cost, that expense must not run afoul of the flush language at the end of §263A(a)(2) — “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.” See §1.263A-1(c)(2)(i).”
“If a taxpayer subject to §280E were allowed to capitalize “additional §263A costs,” as defined for new taxpayers in §1.263A-1(d)(3),3 §263A would cease being a provision that affects merely timing and would become a provision that transforms non-deductible expenses into capitalizable costs. Thus, we have concluded that a taxpayer trafficking in a Schedule I or Schedule II controlled substance is entitled to determine inventoriable costs using the applicable inventory-costing regulations under §471 as they existed when §280E was enacted.”
Internal Revenue Code Section 471(a) provides that:
“Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such 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.”
Regulation Section 1.471-1 states that “In order to reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.”
Regulation Section 1.471-2 discusses the valuation of inventories. Regulation Section 1.471-2(a) states that the valuation method must “conform as nearly as may be to the best accounting practice in the trade or business” and “must clearly reflect the income.” According to Regulation Section 1.471-2(c), the bases of inventory valuation most commonly used by business concerns and which meet the requirements of Section 471 are (1) cost and (2) the lower of cost or market.
Regulation Section 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.
Due to the constraints placed on businesses in the cannabis industry by Internal Revenue Code Section 280E and Section 471, it is of the utmost importance that such businesses seek the guidance of tax professionals with expertise in these matters who can assist their clients to best navigate this challenging terrain. HL