Simplified Inventory Election for Small Businesses May Be a Tax Disaster for Marijuana Businesses

An interesting article appeared in Tax Notes Today on February 1, 2019[1] that raised a question regarding whether a business that is deemed to be trafficking in a federally controlled substance might significantly increase its federal tax if it makes the election added by the Tax Cuts and Jobs Act to escape the provisions of IRC §471(a) and account for its inventory either:

  • By accounting for such inventory as non-incidental materials and supplies pursuant to Reg. §1.162-3, or

  • Conforms to such taxpayer’s method of accounting reflected in an applicable financial statement of the taxpayer with respect to such taxable year or, if the taxpayer does not have any applicable financial statement with respect to such taxable year, the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.[2]

This election is open to businesses that have average annual gross receipts of $25 million or less for the prior three years (adjusted for inflation[3]) and which is not a tax shelter as defined by IRC §448(a)(3).[4]

The most significant of such controlled substance trafficking businesses that are arising in tax controversies are those selling marijuana in states where such sales are now legal (either for medical or recreational use, depending on the state). 

IRC §280E strictly limits deductions for such businesses, providing:

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.

The bar on deduction of expenses does not extend to cost of goods sold.

In the case of Patients Mutual Assistance Collective Corp. et al. v. Commissioner, 151 TC No. 11, the Tax Court pointed out that:

All taxpayers — even drug traffickers — pay tax only on gross income, which is gross receipts minus the cost of goods sold (COGS). See, e.g., New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); CHAMP, 128 T.C. at 178 n.4; secs. 1.61-3(a), 1.162-1(a), Income Tax Regs. Congress understood that when it enacted section 280E. See S. Rept. No. 97-494, supra at 309, 1982 U.S.C.C.A.N. at 1050. We've understood it ourselves. See Olive, 139 T.C. at 32-36.

But that same opinion continues on to determine that such deductions are determined under the provisions of IRC §471 without regard to the uniform capitalization rules of §263A.  As the Court notes:

The section 263A capitalization rules don't apply to drug traffickers. Unlike most businesses, drug traffickers can't capitalize indirect expenses beyond what's listed in the section 471 regulations. Section 263A expressly prohibits capitalizing expenses that wouldn't otherwise be deductible, and drug traffickers don't get deductions. Because federal law labels Harborside a drug trafficker, it must calculate its COGS according to section 471.

The question that is poised in the article regards the impact of making the election to avoid the use of the provisions of §471(a) added by the Tax Cuts and Jobs Act on such enterprises.  In the Patients Mutual Assistance Collective Corp. case the Court specifically applied the provisions of Reg. §1.471-3 to determine the type of costs that were included in the cost of sales of the taxpayer.

But such rules would not appear to be applicable to a taxpayer that elects under IRC §471(c) to avoid IRC §471(a).  So the question then arises regarding what expenditures, if any, would now be part of cost of goods sold for purposes of §280E?

The article cited above quotes Scott H. Rabinowitz of Skadden, Arps, Slate, Meagher & Flom LLP, that making this small business inventory simplification election could significantly increase the amount of taxable income for a seller subject to §280E.  As the article notes from the author’s conversation with Mr Rabinowitz:

Losing the potential argument that inventory accounting proves cost of goods sold would probably override any other relief from the exception, he said.

However, even without the inventory accounting rules, which allow indirect costs for some businesses, there would still be a question whether a small marijuana business would be allowed to account for direct costs as cost of goods sold offsets, Rabinowitz said. Without the section 471 rules, indirect costs would clearly not be deductible, but the constitutional mandate to pare gross receipts down to gross income would leave treatment of particular direct cost items uncertain, he said.[5]

The article goes on to cite other advisers who conclude that this level of uncertainty regarding what would happen to cost of sales under §280E suggests that such sellers should avoid making this simplifying election[6]—at least until such time as either the IRS or the courts clarify the impact of switching away from the rules under §471(a) on what is considered cost of sales under §280E.

Although this election to avoid §471(a)’s provisions would arguably simplify accounting for inventories (that was the reason Congress put it into the law), most likely at least some of the costs currently rolled into inventory by the rules developed by the IRS under §471(a) would not be captured under the simplified inventory methods allowed by §471(c).  Any client that wants to push forward regardless should be warned in writing about the potential risks of making this election.

[1] Nathan J. Richman, “Small Business Inventory Accounting Exception May Not Fit Pot,” Tax Notes Today, February 1, 2019, 2019 TNT 22-5

[2] IRC §471(c)

[3] IRC §448(c)(4)

[4] IRC §471(c)

[5] Nathan J. Richman, “Small Business Inventory Accounting Exception May Not Fit Pot,” Tax Notes Today, February 1, 2019, 2019 TNT 22-5

[6] Nathan J. Richman, “Small Business Inventory Accounting Exception May Not Fit Pot,” Tax Notes Today, February 1, 2019, 2019 TNT 22-5