Menu
Tax Notes logo

IRS Eyes Guidance on Cannabis Inventory Accounting Ploy

Posted on Oct. 22, 2020

The IRS intends to issue guidance eventually to address cannabis businesses trying to skirt section 280E by using the expanded small business inventory accounting exception enacted under the Tax Cuts and Jobs Act.

“The IRS will issue some guidance,” Daniel Lauer, director of field examinations (Midwest), IRS Small Business/Self-Employed Division, said October 20 at the virtual UCLA Extension Tax Controversy Institute.

Section 280E denies even state-legal marijuana businesses any normal federal deductions other than an allowance for cost of goods sold. But Ani Galyan of Galyan Law PC said that with the enactment of section 471(c) in the TCJA, some practitioners and taxpayers saw an opportunity to adopt an accounting method allowing for deductions that would otherwise be nondeductible under section 280E.

“Unfortunately, I think this is the wrong position, and some taxpayers are following this position and are following it to their detriment,” Galyan said.

Section 471(c) is part of the unification and expansion of the small business tax accounting exceptions — including the rule allowing a business to skip the inventory rules and treat all those expenses as non-incidental materials and supplies instead of inventory — to include businesses with less than $25 million of average annual gross receipts over the prior three years, indexed to inflation.

In a report released in March, the Treasury Inspector General for Tax Administration noted the potential for marijuana businesses to argue that they’re entitled to use a method of accounting that includes expenses in cost of goods sold to avoid section 280E. Practitioners had warned cannabis businesses to be cautious about taking that tack even before that report was released, and following the report, Kat Allen of Wykowski Law wrote in Tax Notes that trying to circumvent section 280E using section 471(c) was a “quixotic strategy” unlikely to end well for taxpayers.

In its report, TIGTA called on the IRS to issue guidance on the interaction between section 471(c) and section 280E, but the IRS responded that it lacked resources for such guidance until other items on its prior guidance plan are completed.

And although the latest priority guidance plan doesn’t include the project, both Lauer and Vladislav Rozenzhak, an attorney in the IRS Office of Chief Counsel, said the IRS will look at it and issue guidance when appropriate.

Still, Lauer suggested that Galyan’s take on the issue was the right one. “Your opinion is that it’s not applicable, and . . . I think that your opinion is educated,” he said.

Consistent Application of the Law

Speaking on cannabis tax compliance more broadly, Lauer said the IRS is putting together audit specialization teams focused on the industry. “What we’re striving for there is consistency of application of the tax law within the scope of the cannabis industry,” he said.

Lauer explained that he is the “executive champion” for the cannabis industry in SB/SE’s examination function. Each of the seven SB/SE field areas also has a director involved in cannabis compliance and a territory or group manager who is the cannabis champion for the area, he continued.

There are also subject matter experts at IRS headquarters and cannabis specialists in chief counsel who help support the industry, Lauer said.

Rozenzhak said he’s part of a cadre of chief counsel attorneys specializing in cannabis issues who assist in all aspects of related investigations, including assisting agents in examinations of cannabis businesses and litigating cases at the Tax Court.

The involvement of chief counsel attorneys in marijuana exams stems from the unusual issues that can crop up, Rozenzhak said. “If you happen to see an attorney in an examination, it’s not because we think something is particularly egregious about the case or there’s any reason for you to be concerned,” he said. “It’s something we’re doing typically now.”

Galyan said she doesn’t see the need for counsel to be involved with examinations focused on substantiation issues.

“When an exam is being done and there’s IRS counsel, it seems like the agent is not the one working the IRS case; it would be as if they’re being guided by the counsel and the legal issues that are involved,” Galyan said. “And now we’re dealing with mostly legal issues rather than substantiation issues if counsel is present.”

But Rozenzhak said he’s found that counsel participation in exams is helpful both to the IRS agents and to the taxpayers involved, because if a legal question arises, an answer can be provided quickly.

Coordination With States

Jonathan Kalinski of Hochman Salkin Toscher Perez PC noted that the March TIGTA report recommended that the IRS coordinate with states to obtain cannabis-related data that they had collected.

To that end, the IRS has been concentrating over the last year or two on developing better relationships with states where marijuana has been legalized in some form, Lauer said. “We kind of have prioritized those states where it’s legal for recreational purposes, where we’re going to try to engage our state partners,” he said.

The IRS hopes the relationships it builds at the high levels of state governments will lead to memoranda of understanding regarding the cannabis industry and the sharing of cannabis data, Lauer said. The agency is also exploring the possibility of engaging in joint enforcement activities with some states, he added.

At a more local level, Lauer said, the IRS is building teams to develop relationships with state law enforcement officers, regulatory enforcement offices, licensing organizations, and revenue arms to work jointly on compliance efforts.

“What we want to try to have is folks that know each other, understand each other’s laws, understand each other’s challenges, and can pick up the phone and request assistance or help each other and then help the taxpayers through additional knowledge, education, and a consistent compliance approach,” Lauer said.

Copy RID