Arguments continue to surface that small cannabis taxpayers can simply elect their way around the tax code Section 280E deduction disallowance as a result of new tax accounting rules of tax code Section 471(c) and that the new regulations prohibiting this strategy are little more than a speedbump.
These arguments seem to fall into two camps: the first camp aggressively seeks full tax code Section 280E avoidance by simply treating everything as an inventory cost, and the second camp more modestly seeks only further parity between resellers and producers by allocating some additional indirect costs to inventory. Articles advancing the workaround are not clear on this point and seem to straddle both aggressive and moderate interpretations of tax code Section 471(c).
Courts will find aggressive 280E avoidance strategies absurd and unreasonable
Utilizing tax code Section 471(c) to entirely circumvent deduction disallowance provisions is not a viable strategy, even without the new regulations. This is in part because courts have previously defined cost of goods sold as the cost of items acquired or produced for resale. See Hultquist v. Commissioner. Cost of goods sold, like adjusted basis, is “the measure of the taxpayer’s unredeemed investment in an item of property,” often its cost. Lenihan v. Commissioner. Look also to Treasury Regulation Section 1.61-3(a), which expressly excludes from cost of goods sold “selling expenses, losses or other items not ordinarily used in computing costs of goods sold.” Tax code Section 471(c) did not change the definitions of gross income or cost of goods sold.
The aggressive strategy also makes the mistake of ignoring tax code Section 280E’s place in the tax code as one of many deduction disallowance provisions, even if it is the most unfair. As a result, even if the aggressive interpretation of tax code Section 471(c) were inherently reasonable (it’s not), courts would see an absurd result because suddenly every deduction disallowance provision in the tax code becomes moot for small business taxpayers, like tax code Section 262 (prohibiting deductions for personal expenditures). If small taxpayers could electively nullify tax code Section 280E, then they could also nullify these other provisions and, for example, capitalize a family vacation or a home mortgage paid via company accounts.
Furthermore, courts have previously found and rejected a similar result. Readers need only look to Patients Mutual Assistance Collective Corporation v. Commissioner (PMACC), where the court dismissed an interpretation of tax code Section 280E that would have rendered the provision “ineffective and absurd.” It is not difficult to imagine how a court would treat an interpretation of tax code Section 471(c) that renders every deduction disallowance provision ineffective for resellers and producers.
Moderate 280E avoidance via 471(c) is probably not even worthwhile
On the other hand, the argument that tax code Section 471(c) allows a retailer to capitalize only costs which are related to producing or acquiring inventory is at least somewhat reasonable. This more moderate argument does not run afoul of Treas. Reg. Section 1.61-3(a) or definitions of cost of goods sold, nor does it steamroll every deduction disallowance provision in the tax code. Still, this position probably would not generate cost savings worth defending in court, especially against the new regulations.
Arguments assert that tax code Section 471(c) “eliminates the obstacle that was preventing retailers from capitalizing costs like producers can.” The “obstacle” is possibly the flush language of tax code Section 263A(a), which prohibits use of the uniform capitalization (UNICAP) rules as a way around deduction disallowance provisions like tax code Section 280E. In PMACC, the petitioner tried to allocate indirect costs to inventory via the UNICAP rules. The petitioner had a “processing room” where it reinspected, packaged, and labeled its products and wanted to capitalize these indirect costs to mitigate 280E, but the Tax Court denied such treatment since it found petitioner to be a reseller instead of a producer.
Even without tax code Section 263A(a)’s flush language, the UNICAP rules wouldn’t even be that helpful for cannabis businesses in allowing tax benefits for indirect costs as their potential benefit would be limited.
A brief review of the UNICAP rules through the lens of a cannabis retailer is illustrative:
For retailers, indirect costs under UNICAP are costs other than acquisition costs that directly benefit or are incurred by reason of the performance of resale activities. Treas. Reg. Section 1.263A-1(e)(3)(i)(A). These costs typically include purchasing, handling, and storage, which should sound familiar to readers of the PMACC decision. See Treas. Reg. Section 1.263A-3(c)(1).
Purchasing costs are associated with operating a purchasing department or office, including: personnel costs relating to the selection of merchandise; the maintenance of stock assortment and volume; the placement of purchase orders; the establishment and maintenance of vendor contacts; and the comparison and testing of merchandise. This is sort of helpful, but some of these costs may already be capitalizable via Treas. Reg. Section 1.471-3(b) as “other necessary charges incurred in acquiring possession of the goods.” See also Treas. Reg. Section 1.263(a)-2(f)(2)(iv)(B).
Handling costs are attributable to processing, assembling, repackaging, transporting, and other similar activities for property acquired for resale. Importantly, handling costs under UNICAP do not include handling costs at a retail sales facility, like costs to unload, unpack, mark, and tag goods where a taxpayer sells merchandise exclusively to retail customers in on-site sales. Treas. Reg. Section 1.263A-3(c)(5)(ii)(B). Many dispensaries would not benefit from the UNICAP rules with respect to handling costs unless they had a separate facility.
Storage costs are also capitalized under UNICAP rules but only to the extent they are attributable to the operation of an off-site storage or warehousing facility. Treas. Reg. Section 1.263A-3(c)(5)(i). Again, not great.
Contrast these costs with the laundry list of expenditures expressly excluded in Treas. Reg. Section 1.263A-1(e)(4), too numerous to list here.
Notably, a court could easily find that cannabis business indirect costs under UNICAP are not ordinarily used in computing goods sold as required by Treas. Reg. Section 1.61-3(a) because no taxpayer is able to use the UNICAP rules to circumvent deduction disallowance. PMACC, supra; tax code Section 263A(a); see also Treas. Reg. Section 1.263A-1(c)(2)(i).
The harsh reality
Whatever method proposed, supporting arguments are inconsistent with the legislative intent of tax code Section 471(c). Just look at the conference report to accompany H.R. 1, 115-466, which stated the purpose of tax code Section 471(c) was to “expand the universe of taxpayers eligible to use the cash method, exempt certain taxpayers from the requirement to keep inventories, and expand the exception from the uniform capitalization rules.” Arguments seem to read “deduction disallowance avoidance” into this, but they shouldn’t.
Businesses following the aggressive strategy outlined above will be harmed by interest and penalties while promoters share none of their burden. See, e.g., Treas. Reg. Section 1.6664-4(c)(1) (reliance on a tax professional must be reasonable). Furthermore, simply disclosing the position is not sufficient to avoid penalties. Treas. Reg. Section 1.6662-3(c)(1) (disclosure exception does not apply to position without reasonable basis). Cannabis businesses may therefore find the moderate strategy more appealing given its relative reasonability, but it is just as unlikely to survive a challenge.
To be fair, both strategies have reasonable premises since state-regulated cannabis businesses should be taxed like all others. The tax code is no place for public policy provisions like tax code tax code Section 280E, but the reality is state-regulated cannabis businesses are stuck with disparate tax treatment until marijuana is removed from the Controlled Substances Act, bumped to Schedule III or higher, or until Congress finally gets around to modifying this ridiculous provision. Until then, state-regulated cannabis businesses are better off cutting nondeductible operating costs and conforming their businesses to the tax code instead of wasting time and money trying to get the tax code to conform to them.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Kat Allen is a tax attorney with Wykowski Law in San Francisco.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.