Almost everyone in the cannabis industry loathes Section 280E of the Federal Income Tax Code. For more on why this is the case, check out In the Wake of Marijuana Legalization, It’s Time to Repeal Section 280E.
Section 280E prevents cannabis producers, processors and retailers from deducting expenses from their income, except for those considered a Cost of Goods Sold (COGS). As a consequence, marijuana businesses are required to determine what expenses are included in COGS and, therefore, what expenses are deductible. To date, very little guidance was available to help taxpayers make this determination.
On January 23, 2015, the IRS released an internal legal memorandum outlining how Section 280E should be applied in the cannabis industry. Though this memorandum may not be used or cited by taxpayers as precedent it does outline how some IRS officials analyze Section 280E and how to determine COGS.
In the memorandum, marijuana retailers and producers are required to compute COGS under inventory rules that predate the enactment of Section 280E. According to the memorandum, a retailer can include in COGS the invoice price of cannabis, less trade or other discounts, plus transportation and other “necessary charges” incurred in acquisition.
A producer may include in COGS direct material costs (such as seeds) and direct labor costs (such as planting, harvesting, sorting, cultivating). Indirect costs are included so long as they are “incidental and necessary for production,” such as the following:
- Indirect labor
- Indirect material and supplies
- Cost of Quality control
In addition, certain other indirect costs may be included (such as depreciation, excise taxes, factory administration expenses, and insurance), depending on accounting treatment.
The memorandum outlines a very narrow reading of the cost included in COGS by suggesting that the IRS will not allow cannabis businesses to allocate purchasing, handling, storage and administrative costs to COGS.
The memorandum suggests that a cannabis producer or retailer should be on an accrual basis of accounting unless explicitly allowed to use the cash basis in the tax code (e.g., farmers and certain small businesses). Under the cash basis, a producer generally may deduct costs in the year of payment and includes income in the year cash is received. Under the accrual method, a producer would report income in the year it is earned and deduct costs in the year incurred. Taxpayers need to look at their specific facts to determine the impact of cash accounting vs accrual accounting, but it is important to note that the tax liability difference between these two accounting methods could end up being substantial.