14 Nov The Intersection of ‘Trafficking under IRC 280(E)’ & Cost of Goods Sold (COGS) Relevant to Taxable Income for Marijuana Distributors in Colorado
As many of you who follow me and/or this tax blog know I have been actively tracking a handful of select medical marijuana dispensaries in Colorado who have been denied the opportunity to deduct ordinary and necessary business expenses by the IRS when arriving at net income subject to income tax. One of the first things I learned is that this industry is messy in several regards and perhaps left to more courageous practitioners of the US Tax Code. Along the journey I witnessed first hand what appears to be systematic profiling and haphazard application of the Internal Revenue Code (IRC) including threats of US Treasury Circular 230 violations against quality practitioners in search of the truth by overzealous IRS Examiners as they work towards a standard enforcement framework. Being at the forefront of this topic is seemingly NOT for the faint of heart.
Nevertheless my motivation to stay involved is rooted in a professional passion to successfully navigate uncharted aspects of the tax code so as to be fully assured that any developed standards are both understandable by industry participants as well as uniformly enforceable by the Service. Personally I am unappreciative of the fact that our court system routinely allows tax deductions for all sorts of taxpayers engaged in ‘other’ illegal activity including prostitution, racketeering and organized crime yet when it comes to marijuana the gates into the abyss of the IRS seem to open. Hence the Napoleonic influences of my ancestors remain ignited.
This is where the rubber hits the road for me. There is a distinct difference between selling a medical substance fully legal under state law and trafficking in an illegal drug and it is my opinion that the Service now has an obligation according to the precepts of efficient tax administration to differentiate in these regards and establish a standard of enforcement. However because the Service is woefully underfunded and lacking sufficient resources to engage in these regards they are relying on the federal court systems to set standards which seems both tragic and unfortunate.
Ultimately this is because of the poor wording of IRC 280(E):
“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) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
Allow me to digress for a minute and draw your attention back up to the word ‘or‘ above to point out the fact that if this ONE WORD was changed to ‘and‘ all this kerfuffle regarding state versus federal rights and the doctrine of supremacy could be unilaterally disregarded. Unfortunately due to the lunacy of our federally elected officials very little statutorily significant changes seem to happen including SIMPLY CHANGING ONE WORD IN THE TAX CODE.
Since someone has to step up and demonstrate leadership this is where I presently stand on the matter:
1. Guidance needs to be provided as to exactly when Costs Of Goods Sold (COGS) ends and ‘trafficking in a controlled substance’ under IRC 280(E) begins so as to respect both the profit motive of businesses engaged in this fully legal activity under Colorado law and also respect the fact that presently (and perhaps not much longer) marijuana is a level one Food and Drug Administration (FDA) classified drug.
2. Most significantly in my opinion is the matter of inventory dominion. Guidance needs to be provided as to when marijuana switches in characterization from being treated as an inventory item, with all direct expenses related to producing it deductible as a COGS, to an illegal product, subject to ‘trafficking under IRC 280(E).’
As this is the uncharted aspect of the tax code referenced earlier presently I am of the opinion that the re-characterization event happens when marijuana is placed on a display shelf in a licensed dispensary and that all other actions taken to get the product to shelf can and should be accounted for as a cost of goods sold (COGS) offset against gross receipts based on Marcor v. Commissioner, 89 T.C. 181 (1987), nonacq., 1990-C.B.1.
In this file the Tax Court addressed the distinction between COGS and costs incurred after full dominion and control over the merchandise is re-characterized out of inventory. As such my further opinion is that the very limited act of selling the marijuana or medicine to a patient directly in a restricted space is the only activity that could be correlated to the concept of trafficking under IRC 280(e).
3. Regarding the allocation of overhead expenses to COGS under IRC 263A(a) and Treas. Reg. sec. 1.263A-1(c)(2), a taxpayer can only capitalize something under 263A that would be “otherwise deductible.” Since, by operation of IRC 280E, expenses are not otherwise deductible for a business selling marijuana, dispensaries should not use 263A to include expenses prohibited by section 280E in their Cost Of Goods Sold (COGS).
In other words, since section 263A only allows the taxpayer to capitalize expenses that are otherwise deductible, and since section 280E prohibits the taxpayer from claiming an IRC 162 deduction for any expense, the taxpayer may not rely on section 263A as authority to capitalize a particular expense.
4. Marijuana sellers in my opinion should consider voluntarily complying with uniform capitalization and full absorption inventory rules including capitalization of an expense category in its entirety if only a portion of the expense qualifies to be capitalized. Yes, a special allocation rule does exist in these regards. So even though I understand and appreciate the IRS’ perspective on 263A I am not entirely prepared as of yet to roll over on full absorption and UNICAP inventory rules. The ‘discussion’ endures in these regards.
5. I am of the opinion and will fight all the way to the Supreme Court as needed that taxpayers should be able to use IRC 471 specifically stating “whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income” to determine whether costs are to be included in COGS or would need to be claimed as an IRC 162 expense subsequently prohibited in this context under IRC 280E.
6. Under Treas. Reg. section 1.471-3 “cost” means:
“(c) In the case of merchandise produced by the taxpayer since the beginning of the taxable year, (1) the cost of raw materials and supplies entering into or consumed in connection with the product, (2) expenditures for direct labor, and (3) indirect production costs incident to and necessary for the production of the particular article, including in such indirect production costs an appropriate portion of management expenses, but not including any cost of selling.”
Presently the IRS Local Area Counsel in Denver is essentially relying on two US Tax Court cases in structuring their arguments:
Californians Helping to Alleviate Medical Problems (CHAMP) v. Commissioner and
Martin Olive v. Commissioner.
Neither case files are reasonable in my opinion in actually helping define a standard for income tax calculations going forward. Whereas many dispensary owners that I personally interviewed tend to share the common characteristic that they wish to be compliant with the taxing authorities and they crave a reasonable standard of enforcement consistently applied to all industry participants that simply isn’t satisfactorily provided through these 2 tax court cases.
Now all that remains is building consensus around these interpretations and convincing the taxing authorities.
Hop on board!