IRC §280E: WHAT IS IT?

I AM BEING AUDITED. I NEED HELP.

  • Disallows the deduction of normal business expenses.
  • Must use full absorption accounting under Treasury Regulation 1.471.
  • Results in effective tax rate on dispensaries up to 75% of revenue.
  • Aggressive enforcement by the IRS.
  • Requires expense tracking and tax planning.
  • Is part of the continuing war being waged by the Federal Government against cannabis businesses.
  • Expense document and support is critical.
  • Give us a call at (916) 292-9412.
  • Have our firm handle all communications.
  • We will review your records and assist in preparation for the audit review.
  • Accounting records with full support lessen the exposure.
  • Do not wait until the IRS auditors arrive.
  • Act professional with IRS personnel.
  • Be prepared to answer tough questions.
  • We can calculate potential exposure.

IRC 280e
"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."

IRC §280E AND COST OF GOODS SOLD OVERVIEW:

Many cannabis-related businesses would like to take deductions for the costs related to their business activities. However, the tax code, Internal Revenue Code (“IRC”), has some very specific provisions regarding the businesses that are permitted to take cost of goods sold (COGS) deductions and which expenses may be included.  COGS is at the core of all marijuana related businesses as its one of the key factors to reducing your taxable income. 

The “War on Drugs” and Federal Government's use of the tax law

The Tax Equity and Fiscal Responsibility Act, P.L. 97-248, added Sec. 280E to the Code. It provides:

"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."

When IRC §280E was enacted in 1982 to overturn the result in the Tax Court case Jeffrey Edmondson v. Commissioner, it held that the taxpayer, who was engaged in an illegal drug dealing business, was entitled to deductions for “telephone, auto, and rental expenses” that he incurred in his business. The Senate report makes clear that IRC §280E was intended to overturn the decision in Edmondson and deny deductions to illegal drug dealing businesses.  However, for Constitutional reasons, Congress did not attempt to prevent taxpayers from using cost of goods sold (COGS) to compute gross income. IRC §280E denies all deductions from gross income in computing taxable income, but illegal drug dealing businesses are permitted to take COGS into account in computing gross income. The legislative history of Sec. 280E includes a reminder about the reach of the Sixteenth Amendment, which permits taxes to be levied on “incomes.” The Senate report to TEFRA states:

“To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill” (S. Rep’t 97-494 (Vol. 1), 97th Cong., 2d Sess., at 309 (1982)). The rationale for this statement is that the U.S. income tax structure requires gross receipts to be reduced by the cost of sales to derive gross income (also see Regs. Sec. 1.61-3(a)).​ The effects of § 280E can be drastic on dispensaries. According to a 2013 CNNMoney report, the inability of dispensaries to take business deductions has resulted in dispensaries paying an effective tax rate as high as 75 percent. The practical effect of this massive tax burden makes business operations difficult, if not impossible. IRC § 280E was enacted for public policy reasons at a time when the idea of legalizing marijuana, even for medical purposes, was unheard of. Today, given so many state laws to the contrary, we question whether denying deductions to state-sanctioned dispensaries is at all consistent with the legislative intent of § 280E. 

Chief Counsel Advice (CCA) 201504011 

Chief Counsel Advice (CCA) 201504011 

As a result of these rulings, the IRS determined that marijuana-related businesses could claim certain COGS deductions. On Jan. 23, 2015, the IRS Office of Chief Counsel issued Chief Counsel Advice (CCA) 201504011 to clarify that although deductions may not be claimed for trafficking marijuana, the CCA allows a cost-of-sales deduction for indirect production-related business expenses. The memo concluded that although marijuana-related businesses are permitted to determine COGS, they must do so using the § 280E as it was enacted in 1982 and § 471, which makes the provision for the use of inventories to determine business income. When §280E was enacted in 1982, an ‘inventoriable cost’ referred to any costs that could be capitalized to inventories under §471. Capitalization simply means delaying the recognition of an expense by treating the item as a fixed asset rather than recognizing the cost in the period that it was incurred. Capitalization is generally only used by companies that operate on the accrual basis of accounting.
 
In addition, the IRS concluded that these businesses are not permitted to calculate COGS using the more recent IRS regulations which can be found in § 263A, which permitted the inclusion of additional expenses, namely purchasing, handling and storage expenses, and service costs. In order to claim any of the permitted deductions, the items must be “ordinary and necessary” within the meaning of § 162. The IRC requires different elements to claim an item as a business expense in order to claim a deduction.

  • Ordinary and necessary; 
  • In carrying on;
  • A trade or business activity;
  • That it is an expense; and
  • That it was paid or incurred during the taxable year for which the return will be filed.
The Rules Are Complex and Mistakes Are Costly
What Expenses Can Be Considered as COGS? 

The IRS has made specific provisions for marijuana resellers versus producers.

For Resellers 


CCA 201504011 clarified that, for resellers, the costs that they incur that are otherwise nondeductible under § 280E may not be deducted as COGS. These costs that are non-deductible are those that are directly related to the trafficking of marijuana. For resellers, this means that only the invoice price of purchased cannabis, less any trade or other discounts, as well as, the transportation and other costs necessary to gain possession of the inventory can be considered as COGS.
 
For Producers 


For cannabis-production businesses, there are significantly more opportunities to claim items as COGS. Production-related wages, rents, and repair can be considered as COGS upon the sale of the inventory for accrual-basis taxpayers and immediately for cash-basis taxpayers that are cannabis-production businesses. However, marketing and general business expenses remain nondeductible. Indirect production costs that may be considered as COGS include:
 
  • Repair expenses;
  • Maintenance;
  • Utilities;
  • Rent;
  • Indirect labor & production supervisory wages, basic compensation, overtime pay, vacation and sick leave,
  • Indirect materials and supplies;
  • Tools and equipment not capitalized; and
  • Costs of quality control and inspection.
The IRS has also permitted producers to claim some additional COGS deductions, as long as the company makes sure to produce financial statements that are in accordance with Generally Accepted Accounting Principles (GAAP). These expenses include:
 
  • Taxes deductible under § 164, other than state, local, and foreign income taxes;
  • Depreciation and depletion;
  • Deductible employee benefits;
  • Costs pertaining to strikes, rework labor, scrap, and spoilage;
  • Administrative expenses related to production;
  • Officers' salaries related to production; and
  • Insurance costs related to production.
 
Until Congress passes legislation to no longer make IRC 280E applicable to cannabis products, it is important for all cannabis businesses to establish proper record keeping in order to meet IRS requirements.  If you have any questions, please feel free to contact us. 

IRC §280E denies all deductions from gross income in computing taxable income, but illegal drug dealing businesses are permitted to take COGS into account in computing gross income.