When building a knowledge base in the Cannabis industry as a CPA, one’s tax research typically starts with Internal Revenue Code (IRC) Section 280E. For those that are unfamiliar, 280E is only three lines long. With this in mind, we at Janover realized that we needed to understand the context for this highly influential tax section.
The genesis of 280E dates back to 1981 with a Tax Court case: Jeffrey Edmonson v. Commissioner. The decision in this case was that a seller of cocaine, amphetamines, and Cannabis could deduct most business expenses, cost of goods sold, packaging, home, phone, and automobile expenses relating to the seller’s illegal business.
In 1982, 280E was enacted to reverse the Edmonson decision and deny sellers of Schedule 1 or 2 controlled substances the right to deduct business expenses. Under the Controlled Substances Act, the Federal government defined Schedule 1 drugs as drugs that have no currently acceptable medical use and a high potential for abuse. Since Cannabis is classified as a Schedule 1 drug, Cannabis businesses were unable to deduct most business expenses.
To get a better understanding of what the legislators were trying to accomplish, House and Senate reports provided insight into what their goals might have been. Under the Explanation of Provision, the Senate Report reads:
All deductions and credits for amounts paid or incurred in the illegal trafficking in drugs listed in the Controlled Substances Act are disallowed. To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill.
As the Senate Report explanation provides, 280E specifically excluded cost of goods sold (COGS) from the disallowance of deductions. This treatment was affirmed by the Tax Court in 2012 in Olive v. Commissioner (139 T.C. 19 2012).
To date, there are not many cases that have dealt with the tax issues of 280E. In a 2007 decision involving Californians Helping to Alleviate Medical Problems (CHAMP), the Tax Court ruled that a taxpayer may deduct expenses allocable to an affiliated business that was separate from the entity “trafficking in a controlled substance.” In CHAMP, the legal caregiving business, which was a separate business, was able to deduct the allocated portion of shared expenses. This set a legal precedent that allowed a taxpayer engaged in the selling of a Schedule 1 or 2 controlled substance to distinguish expenses incurred on behalf of other non-prohibited business lines and deduct these expenses.
In addition to these court cases, tax professionals can rely on IRS Chief Counsel Memorandum CCA 201504011. The IRS Chief Counsel released this memorandum in January 2015 in order to respond to questions the IRS was receiving from practitioners. Although Chief Counsel Memoranda, in general, may not be cited by taxpayers as precedent, this memorandum is the current and best authority outlining the IRS’s position with respect to the extent to which a Cannabis business may deduct business expenses. The memorandum also refers to IRC Section 162, ordinary and necessary business expenses that would be disallowed, as well as separately identifying certain direct and indirect business expenses that would be allowed. Citing methods in Treas. Reg. 1.471, the memorandum states that a Cannabis producer may allocate to inventory and COGS direct production costs, including direct material costs (Cannabis seeds or plants), direct labor costs (e.g., planting, cultivating, harvesting, sorting, etc.), and transportation or other costs to acquire of the Cannabis. It also indicates certain indirect costs that may be taken as COGS.
As the industry continues to mature, more cases are finding their way to the Tax Court. On June 13th 2018, the Tax Court issued a ruling in Alterman v. Commissioner that specifically disallowed the use of 263A under 280E and applied only Section 471 to determine COGS. While we need to follow the facts and circumstances of each case, the broad language used might very well disallow capitalizing of inventoriable costs for companies subject to 280E.
IRC Section 471 is the general rule for inventory accounting for tax. IRC Section 263A is the uniform capitalization rules for tax. Most businesses need to utilize both 471 and 263A when accounting for inventory and to properly capitalize costs into COGS.
Many resellers and retailers of Cannabis thought they could use 263A to capitalize more costs into inventory decreasing their tax burden. The Chief Counsel Memorandum disagreed and more recently the Tax Court in Patients Mutual Assistance Collective Corp v Commissioner sided with the IRS and upheld some of the precedents set in Alterman v. Commissioner. In siding with the IRS, the judge concluded that a taxpayer who is subject to 280E can only deduct costs of goods sold under 471 as the IRC existed when 280E was enacted (in 1982). The taxpayer in the case used two arguments that were not new to the Cannabis industry, but to no avail. The first argument was that the business was not trafficking in a controlled substance because the government had abandoned a civil forfeiture action. The second argument that was rejected was that a portion of the business involved branding, marketing and the sales of other non-illegal products. The claimant tried to convince the court that deductions related to these operations should not be subject to the same disallowance of deduction as outlined in 280E.
This second argument is very important for structuring purposes. The court used a significant portion of its opinion to address why the entire business is integrated and completely subjected to 280E. This opinion may have lasting effects on the part of the industry trying to create brands associated with their Cannabis products.
This case has even more implications given part of the ruling in which the courts stated that being state licensed in no way effected the Schedule 1 determination at the federal level and, therefore, subjected them to 280E. The judge went so far as to separate the Department of Justice, which enforces the Schedule 1 status of Cannabis, and the Department of the Treasury, which has full authority and enforcement rights to treat Cannabis as a Schedule 1 drug subject to 280E for income tax purposes. This ruling made it clear that even if the Department of Justice is not pursing criminal charges against state licensed Cannabis businesses the IRS is not precluded from fully enforcing the Internal Revenue Code.
While 280E is the most influential code section for the Cannabis industry, structuring never happens in a vacuum. There are many open questions that each business must answer for themselves without court adjudication. We believe that among the most risky of questions is whether a Cannabis business can claim research and development credits.
There is no clear legal authority that either allows these credits or disallows them but certainly utilizing such credits comes at great risk. At the beginning of this article we talked about Congress and the purpose of 280E. Congress’s intention was to make sure that only the minimum required tax deductions were available to Schedule 1 and 2 sellers. A Cannabis business receiving a research and development credit would not be with the intension of Congress. While the credits would be computed based on COGS expenditures, at this time we do not believe that a Cannabis business should take this credit. Disallowance of COGS would create a constitutional challenge which is why Congress allowed the COGS deduction. Disallowance of Research and Development Credits disallowance does not open up the same constitutional issue since the credit is not part of COGS although calculated based on COGS expenditures. 280E states very clearly that credits arising from other code sections are disallowed in the entirety.
More recently the Tax Cut and Jobs Act (TCJA) opened up new issues for Cannabis companies that are still unfolding. Two of the most publicized are Qualified Opportunity Funds and Section 199A, the 20% deduction (Qualified Business Deduction).
The 199A deduction allows eligible pass-through entities to claim an additional deduction of 20% of the income (subject to certain limitations) at the individual level potentially lowering the tax rate from 37% to 29.6%. While the American Institute of Certified Public Accountants (AICPA) and others have asked the IRS to clarify if 280E would make a Cannabis business ineligible, the final regulations on the subject did not address this issue. There are other significant limitations and hurdles in 199A regulations that any business would have to first pass to be considered for the rate deduction. If a Cannabis business meets all other eligibility and limitation criteria, should the pass-through income to their investors be qualified income under 199A? The answer will depend on whether the courts will treat this “deduction” as falling under the general prohibition of 280E.
We believe that there is a reasonable chance that the courts will allow the 199A deduction for Cannabis companies. That does not mean, however, that we advise Cannabis companies to claim this on their pass-through returns as Qualified Business Income. Much like everything else, it depends on the particular business and the risk profile that management is willing to tolerate. This is one area of tax law that is sure to be challenged in court. The more risk adverse business should pass on claiming this deduction on their returns, but monitor development with an eye to amending at a later date if favorable precedent emerges. If the amounts are large enough, consideration should be given to applying for a Private Letter Ruling, but that also has its own tax risks.
Another new tax incentive that was in the TCJA was Section 1400Z or Qualified Opportunity Zones (QOZ). The incentive allows for the deferral of capital gains until December of 2026. The use of 1400Z also results in up to a 15% decrease in capital gains tax and tax free appreciation if all requirements are met. While the IRS has only released proposed regulations and we anticipate significant changes to them when they are released as final, there was nothing in the proposed regulations limiting Cannabis businesses from using Qualified Opportunity Funds (QOF) in their structure. It is interesting to note that the TCJA and proposed regulations did list other types of businesses that could not make investments under 1400Z along with all its benefits. Liquor stores, golf courses and sun tan parlors were among those listed but Cannabis growers and dispensaries were not.
Using Opportunity Zones to entice investors sounds like a great opportunity, but there are significant risks. The first risk is that the proposed regulations, while currently proposed, may not be final. There is always a chance that the IRS will take a different position when the final regulations are released and add Cannabis to the type of businesses that do not qualify. Another risk, and one that was previously mentioned as part of 199A and other areas of structuring, is that the IRS and the courts can always disagree with the taxpayer’s position. This is a new area of tax law and will eventually be litigated. The loss of the Opportunity Zone benefits can significantly change the return to the investors and lead to other issues.
All of these issues come into play when structuring businesses in this industry. These issues must be evaluated as they pertain to the business needs. This can be very complex and requires a great deal of research for each business opportunity. We have found that professionals operating in this industry like to know about all their options. The most important thing we can do for the industry is to continue to educate the professionals working in it.
Accountants should be available to assist their clients and their clients’ attorneys with structuring techniques aimed at asset protection and minimizing 280E disallowances. Accountants should also be ready to speak to the questions outlined above and be prepared to explain the risks associated with each choice. As the industry continues to mature, new issues and precedents will require CPAs and attorneys to find new solutions to best serve the industry.
Jason Hoffman, CPA is a senior manager at Janover LLC. He is a member of the Real Estate Group and is a co-leader of the Cannabis Industry Group. Jason serves as the vice-chair of the NYSSCPA’s Real Estate Committee. He can be reached at: Jason.Hoffman@janoverllc.com or 212-792-0414.
Zachary Gordon, CPA is a senior manager at Janover LLC. He is a member of the Real Estate Group and member of the Cannabis Industry Group. Zachary is the chair of NYSSCPA’s Cannabis Committee. He can be reached at Zachary.Gordon@janoverllc.com or 212-792-0474.