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IRS Memo Addresses Limits to Deductions for Marijuana Businesses
On January 23, the IRS released Chief Counsel Memorandum 201504011, which sheds light on how taxpayers trafficking in controlled substances, such as marijuana, determine costs of goods sold (also known as “COGS”), and if the IRS can require taxpayers trafficking in controlled substances to change their method of accounting for costs if the taxpayer currently deducts costs of goods sold from gross income.
Just because a business is illegal does not mean that income received in that business is not taxable. Section 61 of the Internal Revenue Code makes clear that taxable income includes revenue from all sources, regardless of the legality of the activity generating the income. As a result, income generated from a business that is illegal under federal law must still be reported on a taxpayer’s tax return, and the taxpayer must pay the tax thereon.
Prior to 1982, taxpayers engaged in illegal income-producing activities were able to reduce their taxable income by the cost of goods sold in the activity, as well as other ordinary and necessary business expenses, including rent, labor, packaging, utilities, travel expenses, and more.
All this changed in 1982, when Congress enacted section 280E of the Internal Revenue Code. Section 280E prevents taxpayers from taking deductions on their tax returns for activities that involve banned controlled substances, including marijuana. The Senate Report providing for the law change, however, made clear that even a business subject to section 280E should be able to deduct its cost of good sold.
In the realm of marijuana, costs of goods sold typically includes the costs of seeds or marijuana plants, rent and utilities for growing operations, labor directly related to growing operations, and others (but does not include labor for selling operations, rent for retail space, packing costs for the product, and most other general and administrative expenses).
Costs of Goods Sold Deductions
When a taxpayer has inventory, the taxpayer is generally required to report its income on the accrual method of accounting under section 471. Under the accrual method, when accounting for inventory, the taxpayer will capitalize the costs to acquire or produce its inventory and eventually deduct these amounts as costs of good sold when the merchandise is sold. Generally speaking, if the costs are incurred or paid in a year prior to the year in which the merchandise is sold, the taxpayer must wait until the year in which merchandise is sold to deduct the costs of goods sold.
When section 263A was enacted in 1986, it provided taxpayers greater leniency with respect to costs that are inventoriable. Under section 263A, both producers and sellers are required to capitalize into inventory all of the costs required under section 471, and also a portion of their general and administrative costs, to include costs associated with payroll, legal, and personal functions.
Taxpayers in the marijuana business have taken advantage of the rules of section 263A to maximize their cost of goods sold deductions by capitalizing as much of their general and administrative expenses as possible into inventory. This is problematic however, as section 280E otherwise renders these general and administrative expenses as nondeductible.
The IRS memo specifically addresses this issue. In the memo, the IRS ruled that taxpayers in the marijuana industry may not use the section 263A to capitalize general and administrative costs into inventory, because such costs are not deductible under section 280E. Instead, the IRS says the taxpayer may only include those costs required by section 471 in its costs of goods sold.
Cash Method of Accounting
As stated above, in general, taxpayers who have inventory must be on an accrual method of accounting under section 471. Under limited circumstances, however, a taxpayer with inventory may be on a cash method of accounting. Under a cash method, taxpayers report their income in the year it is actually received, and deduct expenses in the year they are actually paid.
By definition, taxpayers using a cash basis method of accounting have no inventoriable costs, and thus no costs of goods sold. Rather, the costs of acquiring or producing inventory may be treated as non-incidental materials and supplies, and deducted as general and administrative costs, rather than costs of goods sold.
This is problematic for marijuana business, however, as they are only permitted to deduct costs of goods sold and are not able to deduct general and administrative costs. A marijuana business using a cash method of accounting would have higher taxable income than its counterparts using an accrual method of accounting because it would not be able to deduct its costs of goods sold.
The IRS memo also addresses this issue. When auditing a taxpayer in the marijuana business, if the taxpayer is a cash basis taxpayer is not required (per IRS rules and regulations) to be on an accrual method of accounting, the IRS has the authority to allow the taxpayer to deduct the costs of goods sold that would have been inventoriable if the taxpayer had used an accrual method of accounting.
One thing is clear from the IRS memo: Section 280E and the interplay between it, other Code sections and developments in the law is exceedingly complicated.
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