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.
Although figuring out which deductions are permitted can be tricky, it's in your best interest to claim all of the deductions that your business is allowed. COGS is a important deductions that marijuana-related businesses are allowed and can have a considerable effect on the effective tax rate for your business.
Consider the following examples:
Example 1. For a business with gross receipts totaling $776,772, a business with a high COGS could deduct $435,829, leaving a gross income of $340,953. Thanks to these allowed deductions, this business paid taxes on $340,953 instead of on $776,772. As a result, the business’s effective tax rate was 44% of its final earnings.
Example 2. For a business with gross receipts totaling $776,772 and a low COGS with only $50,000 in COGS deductions, the gross income of the business was $726,772. Therefore, this business would pay taxes on $726,772. For this business, the effective tax rate was 94% of its final earnings.
Simply taking COGS deductions rendered a 50% difference in the effective tax rate of each of these two businesses! As a result, claiming deductions for COGS could mean substantial tax savings for your business.
Here is a quick guide to help you understand what COGS deductions are permitted for your cannabis-related business.
Cannabis-related Businesses and Claiming COGS
Although, cannabis-related businesses are currently illegal under federal law, every business in this industry is still obligated to pay federal income tax on its taxable income because IRC § 61(a) does not differentiate between income that has been earned from legal sources and income that has been earned from illegal sources.
In 1982, Congress enacted § 280E, which prohibits deductions and credits for businesses trafficking in controlled substances. However, in a later case, Californians Helping to Alleviate Medical Problems, Inc., v. Commissioner, 128 T.C. 173 (2007) (“CHAMP”), the government acknowledged that § 280E does not prohibit a taxpayer from claiming COGS. In other cases involving non-medical marijuana or other Schedule I controlled substances, the Tax Court recognized that § 280E does not disallow adjustments to gross receipts for COGS.
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.
IRC § 162 is one of the most important sections in the tax code because it defines what a deduction is. The IRC requires six different elements to claim an item as a business expense in order to claim a deduction.
These elements are that the cost is:
1. Ordinary and necessary;
2. In carrying on;
3. A trade or business activity;
4. That it is an expense; and
5. That it was paid or incurred during the taxable year for which the return will be filed.
The IRS findings explain what a deduction is and which expenses could be considered as COGS. Finally, it should be noted that the IRS concluded that the IRS has broad authority to require the marijuana-related business to change its method of accounting and to challenge the deductions claimed.
What Expenses Can Be Considered as COGS?
The IRS has made specific provisions for marijuana resellers versus producers.
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 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,
● Indirect labor and production supervisory wages, including basic compensation, overtime pay, vacation and holiday pay, sick leave pay (other than payments pursuant to a wage continuation plan under section 105(d)), shift differential, payroll taxes and contributions to a supplemental unemployment benefit plan,
● Indirect materials and supplies,
● Tools and equipment not capitalized, and
● Costs of quality control and inspection,
only if these costs are incident to and necessary for the production of cannabis. If these expenses are not related to cannabis production then they are nondeductible.
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, including pension and certain profit sharing contributions, workers' compensation expenses, stock bonus plans, premiums on life and health insurance, and miscellaneous employee benefits such as safety, medical treatment, cafeteria, recreational facilities, and membership dues;
● 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.
While the provisions of the tax code do give some cannabis-related businesses the opportunity for some tax breaks, the IRS does not allow such businesses to take the same deductions as businesses in other industries. However, the repeal of § 280E of the IRC could make the burden lesser for cannabis-related businesses who have reported tax liabilities of up to 70% of their income.
In addition, these rules could change at any time. Until the law changes, it is important for all businesses in this industry to establish proper record keeping in order to meet IRS requirements. If you have any questions, please feel free to contact us.