On September 9, 2020 the IRS made available an FAQ page designed specifically for marijuana businesses. Although for the most part, this FAQ reiterates well known limitations – an obligation to pay taxes even if income is gained through illegal activity, the requirement under Internal Revenue Code (I.R.C.) § 280E that taxable income equals gross receipts less cost of goods sold (COGS) – but IRS did make one important clarification in the FAQ. The IRS made it known that I.R.C. § 471(c) does applies to marijuana operators.
It is well known that COGS deductions are limited to expenses directly incurred in the sale or production of marijuana or marijuana products, indirect deductions such as advertising expenses and payroll are not included in COGS. In 2018, The Tax Cuts and Jobs Act implemented I.R.C. § 471(c), which permits small businesses generating less than $25M in revenue annually to elect to use an internal accounting of inventory as an alternative of the general inventory rule established by I.R.C. § 471(a). Previously, it was unclear among the cannabis industry and tax professionals whether I.R.C. § 471(c) applies to marijuana businesses, but the newly released FAQ does clarify that marijuana operators can take advantage of this new section of the IRC.
This is good news, because under I.R.C. § 471(c), marijuana businesses making less than $25M in revenue can implement an internal accounting method that labels certain indirect expenses as COGS, significantly reducing tax liability.
You may be thinking that utilizing such accounting procedures would result in an increased risk of audit. Although audits are always a possibility, the Association of International Certified Public Accountants (AICPA) has requested that the IRS limits audits for businesses with less than $25M in revenue for issues dealing with capitalization of costs or methods of accounting for inventory. Further, the Tax Cuts and Jobs Act prevents the IRS during an audit from changing the method of accounting utilized by the tax-payer as long as the method is supported by the books and records of the company. More specifically, if a marijuana taxpayer adopts an internal method of accounting, supported by books and records, that allocates indirect and direct expenses to the costs of goods sold, those expense will reduce taxable income and the IRS is powerless to force the taxpayer to modify its method of inventory accounting.
We at DLG always advise clients to obtain a CPA with experience in the cannabis industry – one that will work within the limits of the I.R.C to reduce tax liability.