Cost of Goods Sold

As cannabis remains illegal under federal law, IRC 280E has left cannabis businesses with limited avenues for reducing taxable income. However, one method that remains available is properly calculating Cost of Goods Sold, but unsurprisingly the IRS has interpreted the “proper” calculation of COGS for cannabis businesses in the least favorable manner to the industry. As a result of Chief Counsel Advice 20150411 and the complicated COGS calculation for cannabis producers vs. retailers, some in the marijuana industry have found their taxable income adjusted by the IRS, resulting in back taxes, interest, and penalties.

California tax attorney Jin Kim helps cannabis businesses resolve their tax debt with the IRS for cost of goods sold adjustments. To learn more about your cannabis tax case call her office at (916) 299-9913.

Breaking Down the IRS Guideline on Determining COGS for Cannabis Businesses

After the enactment of IRC 280E by Congress in 1982, things looked bleak for the cannabis industry. Although marijuana was first legalized in the State of California in 1996, it was decriminalized by several states starting in 1973 in the state of Oregon. And yet the more liberal treatment of cannabis under state law did little to impact its treatment by the IRS, which still firmly used 280E to determine the tax obligations of legitimate cannabis businesses – a provision designed to penalize traffickers of controlled substances under federal law.

The first real breather for cannabis businesses took place after the promulgation of the Tax Court of its decision in the case of CHAMP v Commissioner, 128 TC 173 (2007). While the court there reiterated the application of 280E in disallowing ordinary and necessary trade or business expenses, it also noted that while the IRS, in another recent Tax Court case, challenged the amount of a taxpayer’s deduction for cost of goods sold (where the goods consisted of illegal drugs) the IRS did not, however, challenge the principle that such amounts were deductible. Ergo, it must be deductible.

The rules on how to calculate cost of goods sold (COGS) have never really been clear, but in 2015, the Office of Chief Counsel of the IRS issued Chief Counsel Advice (CCA) 20150411 which provided some guidance on how a taxpayer trafficking in a controlled substance would determine COGS, as well as some of the basic rules and principles underlying the taxation of cannabis businesses. 

The authority of Congress to lay and collect taxes on income under the Sixteenth Amendment, for resellers and producers, pertains to gross income, not gross receipts.

The significant difference here, between gross income and gross receipts, is that income pertains to the net gain derived from capital, and the taxing power of Congress only applies to income or gains derived from either capital, labor, or both. Congress may not, however, tax the return of capital.

So while gross receipts refer to the total amount of revenue, gains that are derived from dealings in property refer to gross receipts less COGS. COGS, here, refers to the adjusted basis of merchandise sold in a taxable year, or “the expenditures necessary to acquire, construct or extract a physical product which is to be sold.” (Reading v. Commissioner, 70 T.C. 730, 733 (1978)) In other words, the return of capital. As the Tax Court went on to explain in the Reading case: “[There can be] no gain until [the seller] recovers the economic investment made directly into the actual item sold.

The applicable inventory-costing regulations are determined under §471 as it existed when §280E was enacted in 1982. Marijuana businesses, however, are not allowed to use §263A in calculating COGS.

As the CCA 20150411 notes: “When §280E was enacted in 1982, “inventoriable cost” meant a cost that was capitalized to inventories under §471 (before the enactment of §263A). So:

• A marijuana reseller using an inventory method would have capitalized the invoice price of the marijuana purchased, less trade or other discounts, plus transportation or other necessary charges incurred in acquiring possession of the marijuana.”
• A marijuana producer using an inventory method would have capitalized direct material costs (marijuana seeds or plants), direct labor costs (e.g., planting, cultivating, harvesting, sorting), Category 1 indirect costs under §1.471-11(c)(2)(i) (indirect production costs such as repair expenses, maintenance, utilities, rent, indirect labor and production supervisory wages, indirect materials and supplies, tools and equipment not capitalized, and costs of quality control and inspection), and possibly Category 3 indirect costs under §1.471-11(c)(2)(iii) (indirect production costs includible in inventoriable costs, depending upon treatment in taxpayer’s financial reports).

Additional inventoriable costs under §263A are not, however, included because the same provision also prevents taxpayers from capitalizing disallowed deductions. Hence: “Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph” (§1.263A-1(c)(2)(i)).

-By Jin Kim.

California tax attorney Jin Kim helps clients resolve their tax debt with the IRS, FTB, and CDTFA. Learn more about her tax resolution practice call her office at (916) 299-9913.