Why a Taxing Situation Grows in the Cannabis Industry
Marijuana is now legal in some capacity in 28 states, however, the federal government still considers the drug an illegal Class I narcotic and business owners in the industry have hit a wall with IRC §280E.
The Internal Revenue Code currently 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) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
What this means is that IRC §280E will only cease to apply to cannabis businesses if and when cannabis is no longer classified as a Schedule I or Schedule II controlled substance. When IRC §280E was enacted in 1982 to overturn the result in the Tax Court case Jeffrey Edmondson v. Commissioner, it held that the taxpayer, who was engaged in an illegal drug dealing business, was entitled to deductions for “telephone, auto, and rental expenses” that he incurred in his business.
The Senate report makes clear that IRC §280E was intended to overturn the decision in Edmondson and deny deductions to illegal drug dealing businesses. However, for Constitutional reasons, Congress did not attempt to prevent taxpayers from using cost of goods sold (COGS) to compute gross income. Thus, IRC §280E denies all deductions from gross income in computing taxable income, but illegal drug dealing businesses are permitted to take COGS into account in computing gross income.
IRC §61 defines “gross income” as “all income from whatever source derived.” One category of income listed in IRC §61 is “gross income derived from business.” Reg. §1.61-3 states that “gross income” for manufacturing and merchandising businesses, “means total sales, less the cost of goods sold.” As the Tax Court has observed, “cost of goods sold is an item taken into account in computing gross income and is not an item of deduction.”
There are various strategies that those in the marijuana industry have employed. The first approach derived from Californians Helping to Alleviate Medical Problems, Inc. (CHAMP) v. Commissioner.
In this Tax Court Case, the California-based marijuana dispensary provided marijuana to its patients, but also provided non-cannabis services, including counseling and caregiving services for its patients. This allowed the company to fully deduct the expenses associated with those practices.
It is perfectly okay to run two separate businesses under one roof. If the business is a medical marijuana dispensary, it could certainly provide other caregiving services under another company.
It can also then share employees with the dispensary, paying the employees minimum wage under the dispensary company, and making up the difference with the caregiving company. The dispensary is only allowed to deduct COGS, whereas the caregiving business isn’t held to the same restrictions.
However, not all cannabis businesses have been successful in separating their businesses between dispensary and non-dispensary activities. In the Tax Court Case Olive v. Commissioner, the Court found that the taxpayer’s activities of providing free yoga classes, chess and other board games, movies with popcorn and drinks, chair massages, use of vaporizers, education on medical marijuana and its responsible use, and snacks, did not constitute a business separate from the taxpayer’s dispensary business.
The second approach to minimizing the impact of IRC §280E is to characterize as many costs as possible as COGS rather than operating expenses. As the Tax Court has observed, “[the concept of COGS] embraces expenditures necessary to acquire, construct or extract a physical product which is to be sold; the seller can have no gain until he recovers the economic investment that he has made directly in the actual item sold.”
In other words, the total costs incurred to create a product or service that has been sold. Generally, a taxpayer first determines gross income by subtracting COGS from gross receipts, and then determines taxable income by subtracting expenses from gross income.
IRC §471 gives broad authority to the IRS to force taxpayers to account for inventory in a way that most clearly reflects income. IRS regulations under IRC §471 provide that a producer of property generally is required to treat indirect costs as COGS if they are “incident to and necessary for production” or manufacturing operations.
In 1986, Congress enacted IRC §263A, which requires purchasing, handling, and storage expenses, as well as a portion of third party service costs such as accounting or legal fees, to be included in COGS, in addition to the costs covered by the IRC §471 regulations. Absent an inclusion in COGS, indirect costs for cannabis businesses are subject to IRC §280E, which denies deductions from gross income.
It does not impact costs for determining gross income. Increasing COGS decreases gross income and decreases the amount of denied deductions from gross income as a result of IRC § 280E. This creates an incentive for cannabis businesses to maximize their costs included in COGS.
Normally, taxpayers with inventories prefer to treat costs as deductible expenses rather than including them in COGS because expenses are currently deductible, while COGS does not reduce income until the taxpayer sells the inventory items to which the COGS relates. However, because IRC §280E prevents the deduction of many cannabis-related costs as current expenses, taxpayers in the cannabis industry have reversed the normal tax planning objective and prefer to maximize the costs treated as COGS.
A recent IRS pronouncement attempts to limit reliance on IRC §263A to maximize COGS and minimize expenses subject to IRC §280E. Chief Counsel Advice memorandum 201504011 (CCA) takes the position that a taxpayer who traffics in a Schedule I or Schedule II controlled substance must determine COGS using the applicable inventory - costing regulations under IRC §471 as that IRC § existed when IRC §280E was enacted. Thus, the IRS is taking the position that IRC §263A does not require — indeed, does not allow — taxpayers to include in COGS cannabis-related costs that would be nondeductible under IRC §280E if they were not capitalized.
The CCA interprets two tax provisions in making its conclusion. First, the CCA interprets language in IRC §263A(a) (2) to limit indirect costs included in COGS to those that are deductible from gross income when calculating taxable income. Stated differently, an indirect cost cannot be included in COGS by reason of IRC §263A for determining gross income, if that cost could not be deducted from gross income if it were not included in COGS.
Second, the CCA points to legislative history to interpret IRC §280E. The Senate report notes the adjustment to gross receipts for COGS was not affected to preclude Constitutional challenge. Congress feared that denying COGS to determine gross income might be held unconstitutional.
Interestingly, the CCA concludes that a business trafficking in cannabis “is entitled to determine [COGS] using the applicable [COGS] regulations under IRC §471 as they existed when IRC §280E was enacted.” The CCA does not explain its basis for making this assertion. It is unclear why changes to the IRC §471 regulations subsequent to the enactment of IRC §280E should not apply to businesses trafficking in cannabis.
It appears the IRS is asserting that COGS as defined by the IRC §471 regulations at the time IRC §280E was enacted, represents COGS that are constitutionally protected when determining costs for gross income. Further, the IRS interpretation permits costs generally included in COGS to be denied as a cost for determining gross income whenever COGS includes incremental costs from when IRC §280E was enacted. Presumably, the IRS does not find these incremental costs to be Constitutionally protected.
The analysis in the CCA is flawed because:
- It provides no support for the position that COGS may be defined differently for certain classes of taxpayers
- IRC § 263A does not apply to indirect costs of a cannabis business does not mean that those costs cannot be capitalized
Cannabis businesses should be entitled to include in COGS all costs that may be included in COGS under all capitalization rules other than IRC §263A. The fact that IRC §263A requires the capitalization of particular costs does not preclude such costs from capitalization under other rules. Capitalization must be decided based on the IRC §471 regulations as currently written, and IRC §280E has no impact on capitalization requirements.
Under the 16th Amendment, Congress has the ability to tax only gross income, not gross receipts. The determination of what is included in COGS determines gross income. Both IRC §471 and IRC §263A determine whether a cost is included in COGS.
The U.S. Supreme Court in New Colonial Ice Co. v. Helvering held that deductions from gross income depend “upon legislative grace,” and a particular deduction can be allowed only if it is clearly provided by the statute. By enacting IRC § 280E, Congress has denied its legislative grace to deductions from gross income for businesses trafficking in Schedule I or Schedule II controlled substances.
However, the IRS provides no evidence that a court has applied the concept of “legislative grace” to the inclusion of costs in COGS. It is therefore unclear whether Congress has the authority to create a separate and narrower definition of COGS for these businesses.
If it does not, the Constitution requires that IRC §263A be taken into account in determining COGS for cannabis businesses in the same manner as it is taken into account for other businesses — that is, without regard to IRC §280E.
One case, Alpenglow Botanicals, LLC, Et Al. v. U.S., is challenging the very concept of IRC §280E. On February 3, 2016, plaintiffs Alpenglow Botanicals, LLC, filed a Complaint against defendant The United States of America, seeking declaratory, injunctive, and monetary relief so as to overturn the Internal Revenue Service's (“IRS’s”) decision to deny deductions to income obtained during the course of plaintiffs' business for the tax years 2010, 2011, and 2012.
More specifically, plaintiffs raised the following claims:
- The IRS went beyond its jurisdiction in administratively determining that plaintiffs were not entitled to certain deductions pursuant to 26 U.S.C. §280E (“§280E”);
- Congress exceeded its power under the Sixteenth Amendment in passing §280E;
- The IRS violated the Fifth Amendment in taking evidence from plaintiffs without informing them that they were under investigation for violating the Controlled Substances Act (“the CSA”); and
- IRC §280E violates the Eighth Amendment's prohibition on excessive fines and penalties.
The appellate court ruled in favor of the government, setting up a showdown that could soon take place in the Supreme Court. One thing is for sure: with marijuana now legal in over half the states in America, IRC §280E may soon be a thing of the past.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...