California Cannabis Company Denied Deductions by the Tax Court
June 04, 2020
By Benjamin Aspir, CPA, MST
On May 4, 2020, the U.S. Tax Court published its opinion, Richmond Patients Group, T.C. Memo. 2020-52, holding that Richmond Patients Group (“Richmond”) was subject to IRC Sec. 280E as a reseller and not a producer. In 2010, Richmond obtained a license to operate a state legal medical marijuana dispensary under California law; it did not provide any therapeutic or other services.
The IRS had previously determined that Richmond was subject to the deduction limitations of IRC Sec. 280E, assessing a deficiency of $1.59 million and imposing an accuracy-related penalty of approximately $318,000.
IRC Sec. 280E Background
Generally, the Internal Revenue Code allows a business to deduct all of its “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business,” but there are exceptions. For the cannabis industry, the primary exception is IRC Sec. 280E.
In 1982, Congress enacted IRC Sec. 280E. With the exception of direct cost of goods sold (“COGS”), IRC Sec. 280E denies federal tax deductions and credits from gross income if a taxpayer is engaged in the business of the manufacture, distribution or sale of certain controlled substances classified as a Schedule I or Schedule II drug pursuant to the 1970 Controlled Substances Act.
IRC Sec. 280E 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) that are prohibited by federal law or the law of any state in which such trade or business is conducted.”
Cannabis is considered a Schedule I drug. Therefore, any sales activity is considered trafficking under federal law. IRC Sec. 280E prevents cannabis businesses from enjoying the benefit of otherwise ordinary business deductions, thereby dramatically increasing the company’s effective tax rate.
Key Rulings from Richmond Patients Group
The Tax Court concluded that Richmond was a reseller for purposes of IRC Sec. 471, primarily from the fact that Richmond purchased bulk cannabis grown by its members for resale. No improvements were made to the cannabis from the time it was purchased to the time it was sold. Therefore, Richmond was not allowed to deduct additional indirect costs included in COGS for the tax years at issue.
Richmond had previously changed its method of accounting from period costs to inventory costs. The objective of this change was to shift additional expenses into COGS, which are allowable deductions under IRC Sec. 280E. The Tax Court denied the accounting method change as well since Richmond was deemed to be a reseller and did not request permission from the IRS to change its accounting method. Therefore, Richmond did not have an acceptable reason to be granted the accounting method change.
Takeaways from Richmond Patients Group
Yet another loss for the cannabis industry – The Tax Court opinion has again denied deductions in the case of a cannabis dispensary operating legally under state law, reinforcing IRC Sec. 280E and building upon case law precedent set by the Harborside Tax Court opinion and Northern California Small Business Assistants Inc.
IRC Sec. 471 costs are not impacted by IRC Sec. 280E – Generally, direct COGS (IRC Sec. 471 costs) are included as a reduction in determining “gross income” and are not impacted by IRC Sec. 280E limitations. The Tax Court previously stated in Harborside that only IRC Sec. 471 expenses could be applied to calculate inventory costs for purposes of IRC Sec. 280E. The Tax Court has held that the uniform capitalization rules of IRC Sec. 263A, which are broader in scope than those of IRC Sec. 471, do not apply to cannabis businesses.
Retail cannabis dispensaries, such as Harborside and Richmond, are essentially only able to include the purchase price of inventory and freight costs in COGS under IRC Sec. 471. Producers, on the other hand, may still be able to capitalize certain indirect production costs into inventory under IRC Sec. 471. Specifically, producers may capitalize repair and maintenance expenses, utilities, rent, indirect labor and production supervisory wages, indirect materials and supplies, tools and equipment not capitalized, and cost of quality control and inspection.
Producers should review the extent to which they may capitalize certain costs under IRC Sec. 471, if they do so for financial reporting purposes:
- Depreciation reported in financial reports and cost depletion.
- Certain employee benefits.
- Costs attributable to rework labor, scrap and spoilage.
- Administrative costs of production.
- Salaries paid to officers for services performed incidental to and necessary for production or manufacturing operations or processes.
- Insurance costs.
Hiring a professional to prepare a tax return does not absolve a taxpayer from IRS penalties – Generally, accuracy-related penalties can be waived if a taxpayer can prove reasonable cause and good faith. Richmond had contended that it should not have been assessed the penalty since there was a lack of guidance regarding IRC Sec. 280E and that they reasonably relied on professional advice from their accountant. The Tax Court disagreed with Richmond and stated there was relevant authority directly against Richmond’s position based on previous case law. Additionally, the Tax Court held that Richmond provided no evidence that it relied on its accountant for advice regarding IRC Secs. 280E, 471, and 263A.