Tax Court Confirms No Deductions for State-Legal Cannabis Business, Part V: Arguing Cost of Goods Sold

In the recent Harborside Health Center v. IRS decision, the government insisted that Harborside applied the incorrect code section in its adjustments for COGS. The Tax Court agreed.

In our previous posts in this series, we explained how 26 U.S. Code § 280E prohibits businesses whose activities “consist of” trafficking in controlled substances that are prohibited by federal or state law to take deductions under 26 U.S. Code § 162(a). Although marijuana businesses can’t take Section 162(a) deductions, even “drug traffickers” only need to pay tax only on their gross income, which is their gross receipts less their cost of goods sold (COGS).

The correct adjustment for COGS was the fourth main issue raised by the Harborside medical marijuana dispensary in its most recent run-in with the IRS.

What is “Cost of Goods Sold”?

COGS refers to direct costs associated with the actual creation of a particular product. This includes manufacturing overhead such as materials, labor, repairs, rental, repairs, and other operating costs, but not transportation costs or advertising expenses.

With the Section 162(a) business expenses deduction, a business can claim at least part of a deductible expense in the year that it is incurred. In the case of COGS, however, the cost of the item must be capitalized in the year that it is acquired or produced, and either amortized or the taxpayer must wait until they sell the item and then make the corresponding adjustment to their gross income. The COGS delay in recovering the cost of a purchase is why most businesses prefer taking the business deduction in year 1.

Since marijuana businesses are unable to deduct their expenses under Section 162(a), they have to maximize their tax savings by taking best advantage of what is available to them. That includes making the most advantageous adjustments for COGS, which is not prohibited to them under Section 280E.

Cost of Goods Sold: The Statutes

There isn’t just a single way of calculating COGS:

Under 26 U.S. Code § 471 a business may recover its inventory costs on an accrual basis (as that inventory is sold). For example, if a business spends $100 for 100 units, and sells of those 10 units each year, it may deduct as COGS $10 per year and recover the expense over the course of 10 years. This is certainly not preferable to an immediate deduction of costs, but for marijuana businesses that are barred from doing that under Section 280E, it’s better than nothing.

26 U.S. Code § 263, enacted in 1986, added that producers and resellers must include “indirect” inventory costs into their COGS, and broadened the definition of what those “indirect” costs include. What this means is that businesses that used to be able to deduct certain items must now treat them as capital expenditures and wait until there is related income to make adjustments. This is clearly a disadvantage for most businesses, but for Harborside, a state-legal marijuana dispensary that is otherwise banned from taking business deductions in the first place, it was seen as an opportunity to adjust for business expenses that had been denied them in the past.

Another Harborside argument rejected by the Court

One of the main issues in the Harborside vs. IRS case was whether Section 263 applied to the medical marijuana dispensary. Harborside (relying on 16th Amendment claims that were summarily dismissed by the court) claimed that it should be permitted to include its indirect inventory costs per Section 263. The IRS claimed that it was limited to the Section 471 rules.

The court stated that the section 263A capitalization rules do not apply to drug traffickers: “Section 263A expressly prohibits capitalizing expenses that wouldn’t otherwise be deductible, and drug traffickers don’t get deductions.” It notes, however, that even if their product was illegal under state law, Harborside could still adjust for COGS under Section 471.

Harborside also argued that since it produced marijuana it could include in its COGS some additional expenses that are applicable to producers. The court rejected this claim as well, explaining that Harborside is clearly a marijuana reseller as it has no ownership interest in marijuana plants – it just purchases them from growers; furthermore, having a “processing room” does not turn a dispensary into a producer. The court therefore held that Harborside must adjust its COGS according to the reseller rules of Section 1.471-3(b) of the Income Tax Regulations.

Canabusiness accounting rules are complicated

The IRS can deny any deductions that are not COGS, so we recommend that you keep meticulous records have a qualified professional advising you from the outset. Professional tax assistance can help you ensure that you are recording your opening and closing inventory, properly allocating your costs, maximizing your COGS, and that you are minimizing your taxable income.

In our next post in this series, we will address the final issue of whether or not the Harborside medical marijuana dispensary was liable for accuracy-related penalties.