By: Sean Hardwick, Regulatory Analyst at Mr. Cannabis Law

The IRS faces Internal Revenue Code § 280E reporting issues.

One of the many headaches of all marijuana operators, tax professionals, and the IRS is Internal Revenue Code (I.R.C.) § 280E. Regulated marijuana companies often pay taxes that are substantially

higher than operators in other industries. Section 280E of the I.R.C. 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 trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act)…” Because marijuana is a Schedule I controlled substance, marijuana businesses are unable to deduct ordinary businesses expenses. Thus, marijuana companies can pay an effective tax rate upwards of 70% according to the National Cannabis Industry Association.[1] Marijuana companies may only deduct cost of goods sold (COGS), as clarified in Patients Mut. Assistance Collective Corp. v. Comm’r of Internal Revenue, 151 T.C. 176, 204 (2018). In Patients Mut. Assistance Collective Corp., the court clearly articulated, “All taxpayers–even drug traffickers–pay tax only on gross income, which is gross receipts minus COGS.”

 

The meaning of the COGS has created confusion for marijuana operators and tax professionals. According to The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance by the Treasury Inspector General for Tax Administration (TIGTA) published on March 30, 2020, TIGTA conducted analysis of a random sample of marijuana businesses in California, Oregon, and Washington. TIGTA found 59% of marijuana businesses in California, Oregon, and Washington likely required I.R.C. § 280E adjustments in 2016.[2] In other words, the majority of marijuana companies reported taxable income that was lower than required. As a result, TIGTA determined the tax assessment impact from the sample of marijuana businesses in California, Oregon, and Washington was about $7.3M total.[3] Furthermore, TIGTA forecasts that the tax impact for the entire state of California, Oregon, and Washington due to marijuana operators underreporting taxable income was around $48.5M in lost taxable revenue in 2016 and $242.6M in lost taxable revenue when projected over 5 years.[4]

 

Cannabis operators underreport COGS by making adjustments to COGS under I.R.C. §§ 263A, 168(k). To illustrate, I.R.C. § 263A(a)(2) 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.” Therefore, I.R.C. § 263A(a)(2) prevents a marijuana business from obtaining a tax benefit by capitalizing indirect expenses because of the restrictions placed by I.R.C. § 280E. Furthermore, marijuana operators are making adjustments to COGS using accelerated depreciation under I.R.C. § 168(k). Under Treas. Reg. § 1.471-11(c)(2)(iii)(b), the only adjustment to COGS for a marijuana operator in accordance with I.R.C. § 280E would be book depreciation on assets “incident to and necessary for” marijuana production or manufacturing. Book depreciation is the amount of depreciation expense calculated from fixed assets that is recorded in a business’ financial statements. Book depreciation is different than tax depreciation, which is used for a business’ tax return. Book depreciation is often lower than tax depreciation in the early life of the asset as most assets are depreciated using straight-line depreciation for book purposes but accelerated depreciation for tax purposes. Therefore, in the early life of the asset, a business can record a higher profit in its internal income statement, while paying a lower income tax on its tax return. Yet, many marijuana operators are using accelerated depreciation to make greater adjustments to COGS than permitted.

 

Internal Revenue Code § 471(c) creates further complications for state-regulated marijuana operators.

 

In 2018, I.R.C. § 471(c) took effect with The Tax Cuts and Jobs Act. As a result, a small business that generates less than $25M in revenue is not subject to the general rule for determining inventory.[5] Instead, a small business may elect to use an internal accounting procedure as an alternative of the general inventory rule established by I.R.C. § 471(a).[6] Specifically, under I.R.C. § 471(c), a marijuana businesses that generates less than $25M in revenue may be permitted to implement an internal accounting method that labels all or most of the business’ operating expenses as COGS. Therefore, a marijuana operator can make adjustments to COGS by categorizing expenses excluded under I.R.C. §280E as COGS. As a result, the marijuana operator with less than $25M in revenue can substantially reduce its tax liability.

 

[7]

On the surface, this appears to be a victory for marijuana operators. Small marijuana companies can save thousands to millions of dollars in tax liability. Yet, without clear guidance from the IRS on whether I.R.C. § 471(c) applies to marijuana operators, a marijuana operator may unintentionally underreport tax liability while acting in good faith to comply with I.R.C. § 471(c). As a result, the marijuana operator risks an IRS audit, penalties, a potential revocation of the state-issued marijuana license, and criminal tax evasion charges by following I.R.C. § 471(c). Therefore, following I.R.C. § 471(c) could have dire consequences to the marijuana operator. To protect marijuana operators, tax professionals, and the IRS, TIGTA recommended that the IRS provide formal guidance on the application of I.R.C. § 471(c) in conjunction with I.R.C. §280E. However, The IRS did not agree with TIGTA, citing other priorities.[8] The IRS clarified after the the 2019-2020 Priority Guidance Plan is resolved, developing guidance between I.R.C. §§ 280E, 471(c) will be considered.[9] Until the IRS provides guidance to the marijuana industry, marijuana operators and the IRS will continue to struggle to maintain uniform industry compliance. As a result, the IRS will continue to see a greater number of marijuana businesses underreporting tax liability.

 

Another issue created by I.R.C. § 471(c) is the tax treatment of different marijuana businesses. Specifically, small marijuana businesses that generate under $25M in annual revenue may reduce tax liability substantially by implementing an internal accounting method, while larger marijuana operators (e.g., multi-state operators) that generate more than $25M in revenue will have a much greater tax liability following the general inventory rule of I.R.C. § 471(a). Therefore, without clear guidance from the IRS, similar marijuana businesses face disproportionate tax treatment. This uncertainty surrounding I.R.C. § 471(c) creates further complications for a marijuana business to maintain compliance with the IRS.

 

The Founding Partner of Mr. Cannabis Law – Dustin Robinson – is both a CPA and an attorney. While this area of cannabis tax law is extremely gray and has little guidance, Dustin and the rest of the Mr. Cannabis Law team are able to counsel clients on both the legal and tax impacts of different strategic approaches for calculating taxable income. The Mr. Cannabis Law team also works to structure any cannabis operations or deals to attempt to minimize a negative tax impact and to limit exposure to enforcement action. If you are a cannabis business that has questions about the tax implications of your business, do not hesitate to contact Mr. Cannabis Law.

[1] “Internal Revenue Code Section 280E: Creating an Impossible Situation for Legitimate Businesses”, National Cannabis Industry Association, https://thecannabisindustry.org/uploads/2015-280E-White-Paper.pdf

[2] “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance.” Oversight.gov, Treasury Inspector General for Tax Administration, 30 Mar. 2020, oversight.gov/report/tigta/growth-marijuana-industry-warrants-increased-tax-compliance-efforts-and-additional.

[3] Ibid.

[4] Ibid.

[5] I.R.C. § 448(c)(1) states that a corporation or partnership meets the gross receipts test of this subsection for any taxable year if the average annual gross receipts of such entity for the three-taxable-year period ending with the taxable year which precedes such taxable year does not exceed $25,000,000.

[6] I.R.C. § 471(c)(1)(B)(ii)

[7] “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance.” Oversight.gov, Treasury Inspector General for Tax Administration, 30 Mar. 2020, oversight.gov/report/tigta/growth-marijuana-industry-warrants-increased-tax-compliance-efforts-and-additional.

[8] “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance.” Oversight.gov, Treasury Inspector General for Tax Administration, 30 Mar. 2020, oversight.gov/report/tigta/growth-marijuana-industry-warrants-increased-tax-compliance-efforts-and-additional.

[9] Ibid.