26 Jan Marijuana Dispensary Income Tax Guidance Update: IRS Memo 201504011
As many of you know who follow my tax musings via this blog, I recently led a team of people that shepherded a Marijuana Dispensary through the IRS Examination and Appeals functions. The dispensary in question was owned and operated by a taxpayer who in all regards was a good, honest, hard working, caring, person that kept detailed records accounting for every penny.
By engaging a taxpayer with this profile up front I was able to challenge the nuanced understanding of IRC §280E – Expenditures in Connection with the Illegal Sale of Drugs, §263A – Capitalization & Inclusion of Inventory Costs of Certain Expenses & §471 – General Rules for Inventories inside the IRS without having to get bogged down with the drama of the taxpayer’s character and efficacy of intent as in the Olive Tax Court Case.
As a direct result of these efforts and arguably one other case A MEMO FROM THE IRS CHIEF COUNSEL regarding taxation of income from Marijuana Dispensaries was produced. Just in the nick of time I might add as it is indeed tax filing season again and this guidance was first promised last year at this time. In this memo the IRS addressed 2 issues:
First, how do marijuana dispensaries which are from a federal law perspective trafficking in a controlled substance determine their cost of goods sold (COGS) for the purposes of IRC §280E of the Internal Revenue Code? In a nut shell the IRS Office of Chief Counsel is directing marijuana dispensaries to determine COGS using the applicable inventory-costing regulations under IRC §471 as they existed when §280E was enacted.
What does this mean?
1. A marijuana seller using an inventory method to account for income is to capitalize the price paid for the marijuana he or she resells, less of course trade or other discounts, plus transportation or other necessary charges incurred in acquiring possession of the marijuana including purchasing, handling, and storage expenses.
2. A marijuana producer using an inventory method is to capitalize the following:
- direct material costs (marijuana seeds or plants),
- direct labor costs (e.g., planting; cultivating; harvesting; sorting),
- Category 1 indirect production costs as defined by (§1.471-11(c)(2)(i)), including: Repair expenses, Maintenance, Utilities, such as heat, power and light, Rent, Indirect labor and production supervisory wages, including basic compensation, overtime pay, vacation and holiday pay, sick leave pay not subject to IRC §105(d), Indirect materials and supplies, Tools and equipment not expensed, and Costs of quality control and inspection to the extent these costs are necessary for production or manufacturing operations and/or processes.
- Category 3 indirect costs as defined by (§1.471-11(c)(2)(iii)) to the extent adequate and reflective financial records are kept including: Taxes, Depreciation/depletion, Employee benefits, Costs attributable to strikes, rework labor, scrap and spoilage, Factory administrative expenses, Officers’ salaries, and Insurance costs.
3. Both sellers and producers are required to capitalize a portion of their service costs, such as the costs associated with their payroll, legal, personnel functions. Thus, under §263A, resellers and producers of property are required to treat some deductions as inventoriable costs, but according to this memo not those defined as ‘trafficking’ under 280E.
4. IRC Section 263A is a timing provision that does not change the character of an expense from “nondeductible” to “deductible,” or vice versa. So you should not rely on it as substantial authority to assert a claimed deduction unless you want to challenge the IRS in Court because that is where this issue is headed.
5. Basically the IRS is hanging their hat on a joint (pardon the pun) interpretation of §280E and §263A(a)(2). When these two sections of the IRC are evaluated together a marijuana dispensary should not obtain a tax benefit by capitalizing disallowed deductions under IRC §280E. In other words you should not capitalize a percentage of your general selling and administrative costs to an account called overhead in COGS no matter how good you are with Quick Books.
6. Where this part of the memo falls short is that it fails to define “trafficking” under 280(E) in an environment where a product is fully legal under state law and presently treated as a controlled substance and technically illegal under federal law.
7. Marijuana sellers generally speaking also happen to produce their own product usually in a separate and distinct location from where it is sold for obvious reasons. When you both produce AND sell marijuana there needs to be a clear delineation point when a product that is perfectly legal by state law becomes an unlawfully trafficked narcotic according to federal regulation. IMHO that happens at the time the marijuana is placed on a retail shelf for distribution however this memo did not effectively address this issue so tread lightly.
8. Marijuana sellers fundamentally speaking operate under a cash basis because they cannot as of yet have bank accounts and quite literally transact a preponderance of their business in cash. They also have an inventory with inventory costs that per Rev. Procs. 2001-10 and 2002-28 they believe as a result are allowed as deductions when the expenditure actually happens.
9. Marijuana sellers should keep their records and report the income to the IRS using an accrual method taking into consideration applicable inventory costing regulations under IRC 471 without consideration for items that are considered to be trafficking under IRC 280E. But how can something be trafficked if it is fully legal under state law?
10. IMHO the intersection of trafficking under IRC 280E & COGS relevant to taxable income for marijuana distributors lies specifically in defining “trafficking” for income tax purposes and unfortunately we are not quite there yet causing a very unpopular federal government to assert its reliance on the doctrine of supremacy.
So that was the first issue.
The second issue was whether the IRS Examination or Appeals function can require a marijuana dispensary to change to an inventory method for their product when they deduct “otherwise inventoriable costs” from gross income?
In this circumstance the IRS Office of Chief Counsel is a little more nuanced stating that yes that authority exists UNLESS the taxpayer is properly using a non-inventory method to account for the weed pursuant to the Code, Regulations, or other published guidance which is the same as saying if you do not keep an effective accounting system to account for inventory an IRS Examiner has the authority to create one for the examination based on their interpretations of what falls into COGS.
What does this mean?
1. Generally speaking a weed producer should be permitted to deduct wages, rents, and repair expenses attributable to its production activities, but should not be permitted to deduct wages, rents, or repair expenses attributable to its general business activities or its marketing activities.
2. If you have a non inventory accounting method established that regularly and consistently reports income and taxation the IRS examination or appeal function cannot necessarily force you to report income using an inventory method, you’ll just have to pay taxes on all gross receipts. In other words keep your books reliable and consistent using the accrual method to account for inventory and costs of goods sold (COGS) and get as many expenditures categorized under COGS as you can reasonably substantiate.
So what do these two matters together distill down to in plain terms for general understanding.
Well if you’ve made it far enough in this post – thank you. IMHO it means:
1. Keep detailed books and records of all financial transactions that are reliable and consistent year over year. Hire an accountant and engage an accounting method that accounts for inventory and produce a statement of financial position regularly and consistently complete with a Profit/Loss and Balance Sheet that ties out to recorded receipts.
2. Consider selling other products besides weed in your retail establishment and minimizing the area where you actually sell the weed so as to minimize the non deductible rent expense associated with “trafficking” under IRC 280E.
3. Have as few people (aka employment expense) “doing” the “illegal trafficking” or said otherwise taking the customers money and handing the customer the weed. The expense of that employee engaging in that fashion is presently interpreted as non deductible under 280E. Weed consultants, counselors or whatever other nomenclature you want to assign was not effectively addressed in this memo though so tread lightly if you try to deduct their expenses as you may be headed to Court.
4. Don’t advertise just marijuana for sale as that expense will not be allowed either under 280E. Instead if you happen to also sell fully legal products under federal law as well as state law consider branding your advertising in the realm of holistic services or something of that ilk. Direct advertising of marijuana is a general sales and administrative expense disallowed under IRS 280E.
5. To avoid trench warfare with the IRS follow the advice provided in this memo until substantial authority like a Court case or Federal Regulation supersedes, which in this fast changing world could happen sooner rather than later. My guess is though that the FDA is not too terribly far from getting its head out of its ass on this one.