For a cannabis business, it is important to understand if the business is considered a producer, reseller or perhaps a bit of both, since that impacts the calculation of the one thing that such a business can deduct under the restrictions of IRC §280E—cost of goods sold. In the case of Richmond Patients Group v. Commissioner, TC Memo 2020-52[1] the taxpayer attempted to argue it was a producer based on the actions it took. The taxpayer’s position was rejected by the Tax Court.

The issue presents an “Alice in Wonderland” world for many tax professionals—generally a business wants to avoid having costs classified as items that have to be treated as part of cost of goods sold, since such costs are held in inventory until the product is sold. But since §280E bars a deduction for any items except costs of good sold, a cannabis business generally wants to capitalize into inventory as much as the business can.

Cost of goods sold are generally governed by the provisions of IRC §471 and the regulations under that provision. The key regulation governing the calculation of cost of goods sold is found at Reg. §1.471-3. For businesses other than producers Reg. §1.471-3(b) provides that the items in cost of sales are:

Merchandise purchased;
Transportation costs and
Other necessary charges incurred in acquiring the product.[2]

Basically, the costs that end up in cost of goods sold are limited to direct costs of acquiring the merchandise.

However, the regulations cast a much broader net for inventoriable expenses for producers. Reg. §1.471-3(c) provides that the inventoriable costs for a producer include:

Raw materials and supplies;
Direct labor; and
Indirect production costs, including an appropriate portion of management costs.[3]

The topic is complex enough that an entirely separate regulation is devoted to the topic of the calculation of such costs for manufacturers/producers (Reg. §1.471-11).

As should be clear, producers get to include a much larger portion of their expenses incurred in their cost of sales calculation which, in this Alice in Wonderland world of cannabis taxation, is a good thing.

Note that neither a reseller nor a producer gets access to §263A which normally requires capitalizing additional expenses into inventory. IRC §263A(a)(2) provides in part that “[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.”

So what did the taxpayer in this case actually do in its cannabis business? The Tax Court provides the following description of the entity’s activities:

Richmond’s marijuana dispensary was around 3,000 square feet, and approximately 50% of the total space was designated for purchasing and processing marijuana products. The reception and retail floor occupied 25% of the total space, and administration and storage occupied the remaining 25%. Richmond employed a staff of approximately 22 members, including 2 buying managers and an accounting manager.

The buying managers were responsible for purchasing bulk marijuana products. Richmond purchased marijuana-containing products consisting of flowers, concentrates, and edibles. Marijuana flowers accounted for at least 60% of its products, concentrates accounted for 20%, and edibles accounted for 10%. The remaining purchases were nonmarijuana products. For the years in issue Richmond acquired all of its bulk marijuana products from individuals who were members of the dispensary, referred to as member providers. These transactions took place in a designated area of the dispensary. Richmond did not provide any of its member providers with clones or seeds. All nonmarijuana products were purchased from third-party vendors.

Richmond purchased marijuana flowers in one-pound increments and concentrates in one-ounce increments. The buying managers inspected product quality, graded marijuana products, and determined how much to offer member providers for the products. Member providers who had an existing relationship with Richmond or who offered a product that was in high demand were paid in full at the time of purchase. Richmond often paid member providers a 25% to 50% downpayment when the product was brought in and paid the remainder once the product passed testing. All marijuana that failed testing was returned to the member providers.

Consistent with a city of Richmond ordinance, all marijuana products had to be tested offsite by an independent laboratory before Richmond could sell the products to its members. Richmond contracted with a third-party independent laboratory to test the products it purchased. After initial inspection the buying managers were responsible for contacting the laboratory to collect product samples for testing. Richmond paid the laboratory for the cost of testing.

After testing, marijuana products were transferred into separate storage safes. Marijuana flowers from member providers came already trimmed and dried (or cured) to a certain degree. Richmond further trimmed marijuana flowers of nonsellable stems and dried them in its storage safes. During this process the flowers could lose 3-10 grams of their weight. Richmond used a portion of the trimmings to create secondary products such as pre-rolled joints and smaller buds.

Richmond’s employees processed and broke down marijuana flowers and concentrates into salable units — marijuana flowers into increments of 1 gram, 1.75 gram, and 3.25 grams, and concentrates into half- and one-gram increments. Edibles were purchased in bulk but came in individually prepackaged units ready for immediate resale. Other than testing, edibles did not require further processing.

Richmond stored marijuana flowers in plastic bags or glass containers while they continued drying until they reached an optimal moisture content. Richmond used humidity control systems designed to ensure that marijuana flowers would not dry out too quickly or increase moisture content before being sold to members. Other than the humidity-controlled storage area, drying the marijuana flowers did not require any special type of machinery. Richmond packaged marijuana flowers in safety-sealed Mylar bags with warning labels required by the State of California. Richmond packaged concentrates in small glass or plastic containers. Richmond labeled the products to conform with California labeling laws.

Richmond used MJ Freeway Business Solutions (MJ Freeway), a point of sale system, to track its inventory from purchase through processing to final sale. All marijuana products stayed in MJ Freeway as bulk inventory until Richmond received the test results. Richmond used MJ Freeway to track byproducts, stem and weight loss of marijuana flowers, packaging loss, and any weight variances.[4]

Richmond claimed it was a producer based on these facts, eligible to use a much broader category of expenses in calculating cost of goods sold, while the IRS claimed Richmond was simply a reseller, and thus stuck with the very narrow category of direct costs. The Tax Court sided with the IRS on this issue.

The Tax Court noted they had decided an earlier case on a similar issue, writing:

In Patients Mut., 151 T.C. at 213, also involving a California medical marijuana dispensary, we held that the taxpayer was a reseller, not a producer, for purposes of section 471. The taxpayer did not own the marijuana plants during cultivation, did not own or control the grower-provider, and was under no obligation to purchase what the grower produced. Id. at 212-213. However, the taxpayer did provide marijuana clones to its members to grow. Id. at 212.[5]

The Court found that Richmond’s activities did not even rise to the level of Patients Mutual:

In contrast Richmond did not provide live plants, clones, or seeds to its members. Richmond was under no obligation to purchase what its member providers offered for sale. Rather, it purchased bulk marijuana grown by its members for resale. Member providers trimmed the marijuana flowers before Richmond purchased them. No improvements were made to the marijuana from the time it was purchased to the time it was sold. Richmond inspected, sent out for testing, trimmed, dried and maintained the stock, and packaged and labeled marijuana. These activities are those of a reseller and not a producer. See Alt. Health Care Advocates v. Commissioner, 151 T.C. 225, 243 (2018) (holding that the taxpayer was not a producer because it did not grow, create, or improve its marijuana products to the extent required by section 263A or 471 as the only evidence before the Court was “that the dispensary, inspected, packaged, trimmed, dried, and maintained the stock”); Patients Mut., 151 T.C. at 213 n.26 (noting that the taxpayer’s processing, which included reinspection, packaging, and labeling, were activities that “resellers do without losing their character as resellers”).

We conclude that Richmond was a reseller for purposes of section 471. Therefore, Richmond is not allowed to deduct additional indirect costs included in COGS for the tax years in issue.[6]

[1] Richmond Patients Group v. Commissioner, TC Memo 2020-52, May 4, 2020, https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=12223 (retrieved May 5, 2020)

[2] Reg. §1.471-3(b)

[3] Reg. §1.471-3(c)

[4] Richmond Patients Group v. Commissioner, TC Memo 2020-52, pp. 3-7

[5] Richmond Patients Group v. Commissioner, TC Memo 2020-52, p. 16

[6] Richmond Patients Group v. Commissioner, TC Memo 2020-52, pp. 16-17