The IRS, in Chief Counsel Memorandum 201504011, decided that a class of taxpayers is effectively “exempt” from the provisions of IRC §263A. But it turns out not to be a win for these taxpayers.
Because the group of taxpayers who are found to not be subject to the rules of §263A are those who are growing marijuana under various state laws that make their business legal at the state law level, although the production and sale of the product remains illegal at the federal level.
Under IRC §280E, the following limitation applies to businesses that traffic in controlled substances (such as marijuana):
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.
But, despite what this says, that does not mean the entity is taxable on its gross receipts. Rather, the memorandum notes:
Though a medical marijuana business is illegal under federal law, it remains obligated to pay federal income tax on its taxable income because §61(a) does not differentiate between income derived from legal sources and income derived from illegal sources. See, e.g., James v. United States, 366 U.S. 213, 218 (1961). Under the Sixteenth Amendment of the United States Constitution ("Sixteenth Amendment"), Congress is authorized to lay and collect taxes on income. In a series of cases, the United States Supreme Court has held that income in the context of a reseller or producer means gross income, not gross receipts. In other words, Congress may not tax the return of capital. See, e.g., Doyle v Mitchell Bros. Co., 247 U.S. 179, 185 ("As was said in Stratton's Independence v. Howbert, [citation omitted], 'Income may be defined as the gain derived from capital, from labor, or from both combined.'"); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934) ("The power to tax income like that of the new corporation is plain and extends to the gross income. Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.”).
Section 61(a) defines "gross income" broadly using 15 examples of items that are includible in gross income. Consistent with the Sixteenth Amendment, §61(a)(3) provides that gross income includes net gains derived from dealings in property, which includes controlled substances produced or acquired for resale. "Gains derived from dealings in property" means gross receipts less COGS, which is the term given to the adjusted basis of merchandise sold during the taxable year. Section 1.61-3(a) of the Income Tax Regulations. See also §§1001(a); 1011(a); 1012(a). As the Tax Court explained in Reading v. Commissioner, 70 T.C. 730, 733 (1978), "[t]he 'cost of goods sold' concept embraces expenditures necessary to acquire, construct or extract a physical product which is to be sold; the seller can have no gain until he recovers the economic investment that he has made directly in the actual item sold." A taxpayer derives COGS using the following formula: beginning inventories plus current-year production costs (in the case of a producer) or current-year purchases (in the case of a reseller) less ending inventories. In general, the taxpayer first determines gross income by subtracting COGS from gross receipts, and then determines taxable income by subtracting all ordinary and necessary business expenses (e.g., §162(a)) from gross income.
When Congress enacted §280E in 1982, it did so to reverse the Tax Court’s decision in Jeffrey Edmondson v. Commissioner, TC Memo 1981-263 which allowed deductions related to the illegal sale of controlled substances. However, due to concerns about the Constitutional issues raised above, the Congress intentionally did not address the deduction for cost of goods sold related to the illegal drugs.
So, for such taxpayers, it would appear that 1986’s adoption of the uniform capitalization rules under IRC §263A actually reduced his/her taxes, taking what would have been nondeductible expenses into cost of goods sold that will be deductible once the drugs are sold.
However, the IRS concluded that this was not truly the case. Rather, the IRS noted that when §280E was adopted what was includable in inventory was governed only by the rules found in IRC §471, with resellers subject to §1.471-3(b) and producers subject to rules found at Regs. §§1.471-3(c) and 1.471-11 otherwise known as the full-absorption regulations.
The memorandum notes that §263A was not added to the law until four years later. The language at the end of §263A(a)(2) states “[a]ny cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.”
The memorandum holds that this language means that something that would not be deductible without §263A does not become taxable via the application of §263A. In support of this position the memorandum cites the Senate Report of the provision in TAMRA describing the retroactive technical correction that added this provision that provided:
The bill also clarifies that a cost is subject to capitalization under this provision only to the extent it would otherwise be taken into account in computing taxable income for any taxable year. Thus, for example, the portion of a taxpayer's interest expense that is allocable to personal loans, and hence is disallowed under section 163(h), may not be included in a capital or inventory account and recovered through depreciation or amortization deductions, as a cost of sales, or in any other manner. [S. Rep. No. 100-445, at 104 (1988)]
The memorandum therefore holds:
Section 263A is a timing provision. It does not change the character of any expense from “nondeductible” to “deductible,” or vice versa. For a taxpayer to be permitted to treat an expense as an inventoriable cost, that expense must not run afoul of the flush language at the end of §263A(a)(2) — “Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.” See §1.263A-1(c)(2)(i).
Read together, §280E and the flush language at the end of §263A(a)(2) prevent a taxpayer trafficking in a Schedule I or Schedule II controlled substance from obtaining a tax benefit by capitalizing disallowed deductions. Congress did not repeal or amend §280E when it enacted §263A. Furthermore, nothing in the legislative history of §263A suggests that Congress intended to permit a taxpayer to circumvent §280E by treating a disallowed deduction as an inventoriable cost or as any other type of capitalized cost.
Thus, no amounts will be added to the cost of goods of goods sold of an entity trafficking in marijuana via §263A.
Not all is “bad news” for the marijuana trafficker, though. The memo next goes on to look at issues that would arise if the trafficker used the cash method of accounting.
The ruling concludes generally that if a trafficker was using the cash method, the IRS generally properly could force the trafficker to use the accrual basis. The memorandum concluded:
A cash-method producer of a Schedule I or Schedule II controlled substance, such as marijuana, typically will deduct all production costs in the taxable year paid and, thus, will not have any adjusted basis in the product that it produces. When §280E is applied in the case of a producer trafficking in a Schedule I or Schedule II controlled substance, and all deductions from gross income are disallowed, the producer’s taxable income for each taxable year will be significantly higher than what it would have been if the producer had used a permissible inventory method and recouped its production costs through COGS. Furthermore, the producer will not be able to take those disallowed production costs into account in any future taxable year. Thus, in this scenario, the overall cash method does not clearly reflect income because of the operation of §280E. Stated differently, even a producer trafficking in a Schedule I or Schedule II controlled substance is subject to tax on “gains derived from dealings in property,” not on gross receipts. Section 61(a)(3). This rule regarding “gains derived from dealings in property” applies equally to a reseller trafficking in a Schedule I or Schedule II controlled substance.
In our view, Examination and Appeals have the authority under §446(b) to require a taxpayer to change from a method of accounting that does not clearly reflect income to a method that does clearly reflect income regardless of whether that change results in a positive or negative §481(a) adjustment.5 When a producer or reseller of a Schedule I or Schedule II controlled substance uses a method of accounting that causes a tax result contrary to the Sixteenth Amendment, to §61(a)(3), and to the legislative history of §280E, the proper exercise of the above-mentioned authority is warranted. Section 446(b). See also Rev. Proc. 2002-18. See also IRM 126.96.36.199.1 (05-13-2005). Consequently, if a producer or reseller of a Schedule I or Schedule II controlled substance is deducting from gross income the types of costs that would be inventoriable if that taxpayer were properly using an inventory method under § 471, it is an appropriate exercise of authority for Examination or Appeals to require that taxpayer to use an inventory method, to use the applicable inventory-costing regime (as discussed under Issue (1) of this memo), and to change from the overall cash method to an overall accrual method.
That seems like not good news—but it turns out that the taxpayer may qualify for the various relief provisions that will allow the use of the cash basis of accounting and, in that case, they will get a deduction for product costs.
The memorandum concludes:
However, if that taxpayer is not required to use an inventory method (for example, small taxpayers properly using the modified cash method under Rev. Proc. 2001-10 or Rev. Proc. 2002-28 or farmers), it is not an appropriate exercise of authority for Examination or Appeals to require that taxpayer to use an inventory method. Instead, Examination or Appeals should permit that taxpayer to continue recovering, as a return of capital deductible from gross income, the same types of costs that are properly recoverable by a taxpayer both trafficking in a Schedule I or Schedule II controlled substance and using an inventory method under § 471. Thus, for example, a producer of a Schedule I or Schedule II controlled substance 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.