IRS Limits Expenses Deductions To Costs Of Goods (COGS) For Cannabis Related Companies
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Cannabis-related enterprises remain illegal under federal law. However, all the enterprises in this industry are nevertheless obliged to pay federal income tax on their taxable income following IRC § 61(a), which does not differentiate between legal income and illegal income.
The deductions for cannabis enterprises are limited to the COGS under § 280E of the Internal Revenue Code (IRC) as enacted in 1982- and § 471 – which provides for the use of inventories to determine income. Under § 280E, an inventorial cost was any cost that could be capitalized to inventories under § 471.
The IRS held that these enterprises could not calculate COGS following recent IRS regulations under § 263A, including additional expenses like purchasing, handling, storage, and service costs. Therefore, for cannabis enterprises to claim any permitted deductions, the items must be ordinary and necessary under § 162.
⇒ 162 is a critical part of the tax code that defines what a ‘deduction’ is. It requires six elements to describe something as an expense for claiming a deduction. These elements are that a cost is:
⇒ Ordinary & necessary.
⇒ In carrying on.
⇒ A trade or business activity.
⇒ That it is an expense.
⇒ That it was paid or incurred during the taxable year for which the return will be filed.
The IRS’s Chief Counsel Advice (CCA) 201504011 was provided to clarify the COGS deductions available to cannabis enterprises. As a result, the IRS determined that the items that can be included in COGS for a cannabis reseller are §1.471-3(b) and for a cannabis producer, § 1.471-3(c) and 1.471-11. However, these regulations do not list the specific items a cannabis enterprise can deduct. Also, the IRS concluded that the agency itself has the broad authority to require cannabis-related enterprises to change their accounting methods and that the agency could challenge the deductions claimed.
COGS For Cannabis Resellers
The costs they incur that are otherwise non-deductible under § 280E may not be deducted as COGS. These non-deductible costs are those directly related to the trafficking of marijuana.
According to the IRS determination, the cannabis enterprise is only allowed to deduct COGS expenses related to inventory. Therefore, the following items can be deducted:
⇒ The invoice price for cannabis less trade or other discounts.
⇒ Electric bills for designated inventory areas.
⇒ Electricity used in sales areas are not eligible for deduction as COGS.
⇒ Transportation costs and costs for travel to purchase cannabis and the shipping costs for the cannabis.
These deductions are only allowed for charges that are strictly related to storage and handling of inventory and the acquisition of cannabis for resale. Therefore, it is recommended that resellers create an inventory space secluded from the sales are in their cannabis enterprise. This will prevent any challenges to your deductions from the IRS.
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COGS For Cannabis Producers
Significantly more opportunities to claim COGS exist for cannabis production businesses. In the regulations, the IRS explained how cannabis enterprises should treat production costs and define which expenses can be deducted as COGS. The IRS recommends the ‘full absorption method’ of computing COGS, including direct and indirect production costs.
Direct production costs are those expenses required for the production of cannabis and the materials consumed as a part of the production costs. Indirect production costs, in addition, can only be deducted when relatable to the production of cannabis.
Direct Production Costs That Are Deductible
⇒ Raw materials and supplies:
⇒ Costs of direct labor to:
⇒ Clean cannabis
⇒ Trim cannabis
⇒ Cure cannabis
⇒ Package cannabis
⇒ Package inventory
⇒ The associated wages, payroll, taxes, and insurance.
Indirect Production Costs That Are Deductible
⇒ Repairs to production and storage facilities.
⇒ Maintenance of production and storage facilities.
⇒ Utilities used to grow cannabis:
⇒ Rent paid for the production facility.
⇒ Indirect materials and supplies:
⇒ Grow supplies.
⇒ Indirect labor:
⇒ Supervisory wages
⇒ Costs of quality control and inspection.
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Californians Helping To Alleviate Medical Problems (CHAMP)
CHAMP was a caregiving program designed to provide members with medical cannabis and one-on-one counseling, medical supplies, yoga instruction, healthy meals, and internet access.
In the 2007 case of Caregiving Californians Helping to Alleviate Med. Problems, Inc. v CIR, 128 TC 173 the tax court determined that CHAMP could take business deductions for the patient care portions of the non-profit’s medical marijuana dispensaries.
The tax court agreed that CHAMP consisted of two separate enterprises. As a result, it found that caregiving services were CHAMP’s primary enterprise, which permitted their deduction of business expenses otherwise excluded by § 280E.
Congress enacted § 280E to prohibit deductions and credits for enterprises trafficking in controlled substances. In this case, the government agreed that § 280E does not prevent the taxpayer from claiming COGS. In subsequent cases, the tax court recognized that § 280E does not disallow adjustments to gross receipts for COGS for non-medical marijuana and other Schedule I controlled substances.
Following the CHAMP decision, cannabis enterprises can operate multiple businesses under one roof. Hence, it is recommended that cannabis entrepreneurs add additional services to their cannabis enterprise location. This way, it can take full advantage of many of these COGS deductions.
Cannabis enterprises can add patient services like counseling and advocacy. Ensure that all the other enterprises have real purpose and separate financial records. This way, cannabis enterprises can improve profits and increase COGS deductions that they can claim.
Impact Of GOGS On Effective Tax Rate Of Cannabis-Related Enterprises
⇒ Business XYZ has gross receipts of $776,772. It had COGS of $435,829 to deduct.
⇒ $776,772 – $435,829 = GROSS INCOME – $726,772.
⇒ Resultant Effective Tax Rate – 44%.
⇒ Business ABC has gross receipts of $776,772. It had COGS of $50,000 to deduct.
⇒ $776,772 – $435,829 = GROSS INCOME – $726,772.
⇒ Resultant Effective Tax Rate – 94%.
The differences in COGS deductions brought about a 50% difference in the effective tax rate of the above two businesses. Therefore, maximizing your COGS deduction claims can save your business a significant sum of money.
Additional COGS For GAAP Compliant Cannabis Producers
The IRS permits producers to claim additional COGS deductions IF the enterprise produces financial statements following Generally Accepted Accounting Principles (GAAP):
⇒ Taxes deductible under § 164 other than state, local, and foreign income taxes.
⇒ Depreciation and depletion.
⇒ Deductible employee benefits including:
⇒ Some profit-sharing contributions
⇒ Worker’s compensation expenses
⇒ Stock bonus plans
⇒ Premiums on life & health insurance
⇒ Miscellaneous employee benefits including:
⇒ Medical treatment
⇒ Recreational facilities
⇒ Membership dues
⇒ Costs related to:
⇒ Rework Labor
⇒ Administrative expenses related to production.
⇒ Insurance costs related to production.
The IRS does not allow the cannabis enterprises that qualify for these tax breaks to take the same deductions as businesses in other industries. Thus, if § 280E were repealed, it would reduce the burden for cannabis enterprises that suffer from tax liabilities of as much as 70% of total income.
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