Cannabis Guidance and the IRS
The IRS recently published guidance to provide cannabis businesses insight regarding compliance with IRS regulations. Major questions have been raised regarding Section 471 (c) which allows small business tax payers with revenue under $25 million to adopt the cash basis of accounting and prepare the books and records in accordance with the taxpayer’s accounting records. This seemed to open the door to modifying how cannabis businesses recorded cost of goods sold to minimize the impacted of Section 280E. Changes in Section 471 (c) resulted from the Tax Cuts and Jobs Act of 2018.
Section 280E disallows all deductions or credits for a business that sells or otherwise traffics marijuana. However, Section 280E does allow businesses to reduce its gross receipts by properly calculating cost of goods sold. This means that advertising or selling expenses are not deductible.
The guidance under Section 471 (c) according to the IRS is that it is just a timing provision and would not permit a taxpayer to recover a cost that it would not otherwise be permitted to recover or deduct for Federal income tax purposes solely by reason of it being an inventory cost. We’re not sure if this works and there could a conflict with Section 471 (c). This is a new regulation and is the IRS opinion on the application of Section 471 (c). They are adding Internal Revenue Code “flush language” via a regulation which is the opinion of the Internal Revenue Service.
I work with multiple cannabis businesses and have spent a considerable amount of time dealing with Section 471 (c) and how to apply it. The regulations say that qualifying businesses may choose to treat its inventory as reflected in the taxpayer’s books and records prepared in accordance with the taxpayer’s accounting procedures. If a change in accounting was made to adopt the new regulations, a Form 3115 is required to be filed outlining the changes.
A taxpayer taking the Section 471 (c) approach contrary to the regulations should consider disclosing any position that could be inconsistent with the new regulations. A disclosure should be made by filing a Form 8275R with the tax return. Determining cost of goods sold for cannabis businesses can be complicated and should be based on cost accounting logic. Cannabis businesses and their tax advisors should consult with someone experienced in these areas when applying these regulations.
IRS guidance has indicated that the growth of the marijuana industry will warrant increased tax compliance efforts. Accordingly, extreme care should be taken when developing and preparing cannabis tax returns based on the recent IRS guidance.