Federal Tax Court Clarifies Cannabis Income Tax Liability

While it remains illegal to buy and sell cannabis under the federal Controlled Substances Act, the IRS collects income taxes from cannabis businesses, which largely operate under various state laws. By selling a Schedule I controlled substance, cannabis businesses are largely restricted from claiming business expense deductions and certain costs of goods sold (COGS) to reduce their tax liability. Failing to properly report and pay income tax can lead to hefty penalties, so it is important for cannabis business owners to be aware of Internal Revenue Code (IRC) provisions and IRS regulations that impact the reporting of cannabis-related income and expenses.

The United States Tax Court recently addressed this issue in Richmond Patients Grp. v. Comm’r of Internal Revenue, 119 T.C.M. (CCH) 1342 (T.C. 2020), in which the court considered whether:

1. Richmond Patients Group (Richmond), a California medical marijuana dispensary, can reduce its tax liability through (a) costs of goods sold or (b) business expense deductions;
2. Richmond was a producer of marijuana entitled to include certain indirect costs in COGS or a reseller ineligible to do so;
3. Richmond properly changed its accounting method from one used by resellers to that of producers; and
4. Richmond is liable for accuracy-related penalties.

Cannabis Tax Background

Section 280E of the IRC, which was adopted to reverse Jeffrey Edmondson v. Commissioner, T.C. Memo. 1981-623 (in which the court allowed costs and deductions involved in the sale of controlled substances), states that:

“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.”

Thus, Section 280E currently prohibits reducing gross income by deducting business expenses incurred in the sale of cannabis. However, it does not bar cannabis businesses from adjusting gross receipts to take into account COGS. COGS, which is the cost of producing and/or purchasing inventory, is not a business deduction under the IRC but is instead viewed by the IRS as a subtraction from gross receipts to determine gross income.

The Tax Court affirmed Section 280E’s bar against the deduction of business expenses by cannabis businesses in Californians Helping to Alleviate Med. Problems, Inc. v. Comm’r (CHAMP), 128 T.C. 173 (2007). CHAMP operated a counseling center in San Francisco that provided caregiving services to people with serious, often terminal, diseases, and provided cannabis to its members. On its federal tax returns, CHAMP claimed typical business deductions, including officer compensation, salaries, repairs, rent, supplies, and utilities. As the Richmond court stated, CHAMP held that Section 280E prohibits the deduction of business expenses directly attributable to the activity of dispensing marijuana. (The Richmond court noted that “the dispensing of medical marijuana, while legal in California, is illegal under Federal law.”) However, Section 280E neither: (a) bars the deduction of all business expenses where only a portion of business involves cannabis nor (b) categorically precludes cannabis businesses from taking into account COGS.

Richmond

Richmond Patients Group purchased and sold various marijuana products through a co-op membership model previously authorized by California law. Richmond acquired products, had them tested offsite, and then re-packaged the products for resale; it did not manufacture or produce any products.

Beginning in 2009, Richmond used the first-in-first-out (FIFO) cost inventory method of accounting, typical for resellers, on its tax returns. On its original 2014 return, Richmond reported COGS of approximately 65% of its gross receipts and business deductions equaling approximately 32% of its gross receipts. Then, beginning with the 2015 tax year, Richmond applied for a change in its accounting method from period costs to inventoriable costs (i.e., indirect COGS). Accordingly, on its 2015 tax return, Richmond reported COGS of approximately 95% of its gross receipts, and business deductions equaling less than 1% of its gross receipts. Meaning, Richmond likely reported expenses as COGS in 2015 that it had previously deducted as business expenses in 2014. In 2016, the IRS notified Richmond that its 2014 return was under review. Later in 2016, Richmond filed an amended tax return for 2014, which, mimicking its 2015 return, moved significant deductions for business expenses to COGS, as well as an amended tax return for 2015 to further reduce its tax liability. The Richmond court made four significant findings.

1) Richmond Could Reduce Some, but Not Most, of Its Tax Liability

Generally, the IRC allows taxpayers to deduct from gross income ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. The court averred that the calculation of COGS must be based on Section 471 of the IRC, and its accompanying regulations, and instructed that, under Section 263A of the IRC, producers, and resellers must include indirect inventory costs in COGS. Section 263A provides that inventoriable costs include the direct cost of property, and the “proper share” of “indirect costs (including taxes) part or all of which are allocable to such property.” Drawing on Section 263A, the court defined these indirect costs broadly as “all costs other than direct material costs and direct labor costs (for producers) and acquisitions costs (for resellers).” Further, the court clarified that Section 263A “includes in COGS only expenses that are otherwise deductible.” Because cannabis-related expenses are not deductible under Section 280E, they are not eligible for inclusion in COGS

Because Richmond primarily purchased and sold marijuana products, it was not entitled to claim any typical business deductions, such as rent, compensation and benefit programs, repairs and maintenance, taxes, contributions, or depreciation, to name a few. The IRS conceded that Richmond’s costs for testing and packaging, arguably direct costs of the products Richmond sold, were permitted to be included in COGS. It is unclear why testing and packaging costs were allowed, but not other expenses such as rent, repairs and maintenance, and depreciation.

2) Richmond Was a Reseller, and Therefore Not Eligible for Additional Producer Deductions

Richmond argued that, because it was a producer of the products it sold, a majority of its business expenses were attributable to said products, thereby permitting those expenses to be included in COGS. However, the court disagreed because Richmond was not involved in the actual production of the products and it did not otherwise make any improvements to those products; Richmond simply inspected, tested, and packaged the products before selling them, which are the typical activities of a reseller. Therefore, Richmond was not allowed to include any of its indirect costs in COGS as a producer might have been able to do.

3) Richmond Did not Properly Change Its Accounting Method

The court then turned its attention to a related claim Richmond asserted – that it should be allowed a change in accounting method to that used by a producer. If allowed, this would have permitted Richmond to capitalize most of its costs and recognize those costs as COGS as the products are sold. The IRS’s position is that a taxpayer’s method of accounting must clearly reflect income. When Richmond attempted to change its accounting method in 2015, it did not provide any evidence of changes in its business to justify the change, such as a shift in the way its income was produced. Further, changes must be approved by the IRS, and Richmond implemented its change without first obtaining consent from the IRS. It is noteworthy that the IRS has the authority to retroactively approve changes in the method of accounting, but opted not to do so here. The court (and the IRS) apparently viewed Richmond’s actions as a conscious and disingenuous attempt to avoid paying income tax.

4) Consequently, Additional Penalties Were Assessed

An additional penalty of 20% is imposed if an underpayment of tax is attributable to “negligence or disregard of rules or regulations” and/or a “substantial understatement of income tax” (the lesser of 10% of the tax required to be shown on the return or $10 million). A defense to the penalty is that the taxpayer had reasonable cause and acted in good faith, which the court did not find here. In short, the court held that the following actions by Richmond did not constitute “reasonable cause” or “good faith”: (1) providing no evidence to support a change in the method of accounting; (2) “merely hiring a professional to prepare an income tax return, without giving the professional necessary information or relying on his or her advice;” and (3) changing the reporting from one year to the next to move impermissible deductions to COGS, which suggests an awareness that the deductions were not allowed pursuant to Section 280E.

Conclusions & Takeaways

• Section 280E prohibits deductions for expenses related to trafficking in a Schedule I or II controlled substance. Because cannabis remains a Schedule I controlled substance despite legalization by over half of the states, cannabis businesses cannot claim business deductions related to cannabis activities but may deduct business expenses related to non-cannabis activities.
• Section 280E does not bar cannabis businesses from subtracting the costs of producing and/or purchasing inventory (i.e., COGS) from gross receipts, which can significantly reduce their tax liability. Direct costs to produce and/or purchase inventory are usually permitted to be included in COGS, while the inclusion of indirect costs will be dependent on the business’s activities as it relates to the production and/or purchase of inventory (e.g., producer vs. reseller).
• To change its method of accounting, a taxpayer must receive consent from the IRS and should provide evidence showing the change in business activity, so that the IRS can confirm that the change in method of accounting will accurately reflect income.
• Regulatory compliance for cannabis businesses is complicated, so it is important to rely on experienced professionals to effectively navigate the myriad rules, exceptions, and nuances that apply. As Richmond shows, failure to comply with government regulations can lead to hefty penalties.

The Richmond opinion can be found here.