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Small Pot Businesses May Be Able to Use Tax Accounting Options

Posted on Nov. 4, 2020

State-legal marijuana businesses may be able to use the small business tax accounting election even though the IRS’s position is that inventory accounting rules define cost of goods sold under section 280E.

The IRS is on the lookout for cannabis businesses trying to use the small business tax accounting elections from the Tax Cuts and Jobs Act to avoid the deduction denial of section 280E. Businesses trafficking in substances the federal government still lists on Schedule 1 under the Controlled Substances Act don’t get normal business deductions other than allowances for cost of goods sold.

In July the IRS released proposed rules (REG-132766-18) that would implement the TCJA’s unified threshold and qualification changes for exceptions from the normal section 448 cash method of accounting restriction, the section 263A uniform capitalization rules, the section 471 inventory accounting rules, and the section 460(e) restrictions on the completed contract method of accounting.

The IRS’s position (ILM 201504011) is that state-legal marijuana businesses must use section 471 inventory rules to compute allowable cost of goods sold. This has raised the question of whether opting out of the normal inventory accounting rules would doom a cannabis business’s attempts at cost recovery normally allowed under section 280E.

Leslie J. Schneider of Ivins, Phillips & Barker Chtd. told Tax Notes that the standard incentives regarding capitalization are reversed for state-legal marijuana businesses. Taxpayers not subject to section 280E generally want to avoid capitalizing costs — for example, by accounting for them as inventoried cost of goods sold — in favor of immediate deductions, he noted. Because state-legal marijuana businesses lose all their normal deductions to section 280E, they have the opposite incentive, he said.

Schneider said he has been involved in an outstanding request for IRS advice in which the agency asserts that a cash-method taxpayer that doesn’t use an inventory method of accounting wouldn’t get to reduce income by cost of goods sold, even if those expenses would have been cost of goods sold under an inventory accounting method. “Their position was you have to be on an inventory method to have cost of goods sold,” he said.

Hitting the Courts

James D. Thorburn of Thorburn Law Group LLC said the IRS’s focus on section 471 when determining what remains after application of section 280E doesn’t necessarily cut to the heart of the issue. He pointed to Alpenglow Botanicals LLC v. United States, 894 F.3d 1187 (10th Cir. 2018), for the proposition that cost of goods sold allowances are constitutional requirements under the 16th Amendment not subject to the legislative grace required for other deductions.

The courts haven’t yet determined whether section 471 matches that constitutional requirement, Thorburn said. Inventory accounting might be a useful guide — especially during an audit — but the real question is the constitutional requirements, he asserted.

That means a state-legal marijuana business eligible for the TCJA’s inventory accounting opt-out shouldn’t worry about losing its cost of goods sold allowances under section 280E, Thorburn said.

Ani Galyan of Galyan Law PC agrees that cannabis taxpayers not looking to expand beyond what would normally be allowable cost of goods sold shouldn’t be too concerned about using the small business section 471 options. She pointed to a taxpayer’s failed attempt to increase cost of goods sold with an accounting method change in Richmond Patients Group v. Commissioner, T.C. Memo. 2020-52, and noted that the Tax Court has been fairly clear on the differences between resellers and cultivators and between direct and indirect costs.

More Methods

Schneider said state-legal marijuana taxpayers might argue that their costs of goods sold are still inventory while using the section 471 exceptions, but face the risk that the IRS, and perhaps the courts, will disagree. Although no official comment letters have requested it, taxpayers would appreciate clarification about what sorts of inventory attributes go away when they elect out of section 471, he said.

Clarifications in the final small business tax accounting regs would be nice, but release of the IRS’s audit guide would be even better, according to Thorburn.

Thorburn said that the loosened section 448 cash method of accounting rules may also be interesting for qualifying marijuana businesses. While some large industry players exceed the $26 million threshold, most standard dispensaries would qualify, he said.

Galyan said that under the Tax Court’s decision in Patients Mutual Assistance Collective Corp. v. Commissioner, 151 T.C. 176 (2018), state-legal marijuana businesses look to the section 471 regs that distinguish between resellers and producers. Because producers have an easier time getting their indirect expenses into cost of goods sold, they may be less inclined to take advantage of the section 448 small business tax accounting option, she said.

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