There are many reasons to be optimistic for those following the growth of the cannabis industry and even more reasons to begin planning tax compliance strategies for practitioners. At present, a handful of states — New Jersey and New York being among them — are heavily discussing the possibility of expanding their medical marijuana programs and putting recreational marijuana legislation up for a vote. Currently nine states and the District of Columbia have legalized marijuana for recreational, adult-use. Medical-use is allowable in thirty states and the District of Columbia as of the time of this blog, with additional states allowing for CBD-only products to be used.
Legislative change will come slowly though, as it always does. Until the shift in public policy is complete and marijuana is removed from Schedule I or Schedule II of the Controlled Substances Act, all companies engaged in the industry will need to prepare their tax-basis financials with Internal Revenue Code §280E in mind. Business owners would therefore be well-advised to seek the advice of a professional tax accountant or tax lawyer before preparing their business tax filings. Such tax practitioners will likewise have to examine their appetite for risk before serving such clients as all levels of industry involvement are subject to certain risks.
Education will allow tax practitioners to best protect themselves from scrutiny. They would be wise to study and then apply conservatively the following Internal Revenue Code sections for cannabis clients:
- IRC §61 – Gross Income Defined – dictates that all income, regardless of the manner derived, by reported and subjected to income tax on the Federal level.
- IRC §162 – Trade or Business Expenses – outlines which ordinary and necessary expenses can be reasonably deducted against ordinary business income.
- IRC §280E – Expenditures in Connection with the Illegal Sale of Drugs – specifies that ordinary business deductions shall be disallowed when connected to a business which is illegally trafficking Schedule I or Schedule II narcotics, per the Controlled Substances Act.
Beyond the obvious trap of applying IRC §280E and carving out inappropriate ordinary deductions from the calculation of net taxable income, there is an even more treacherous debate which tax practitioners will need to ponder: the calculation of cost of goods sold (COGS). When IRC Section 280E was written, Congress specifically left COGS alone as a viable deduction for the drug-trafficking industry, fearing a legal challenge on constitutional grounds. However, it was not until more than 20 years later that any legislative authority provided guidance on how to calculate COGS. The Office of the Chief Counsel of the IRS in 2015 wrote a position paper advising that tax practitioners, instead of applying IRC §263A – UNICAP rules to the cannabis industry (codified in the 1986 IRC), they should instead employ the full absorption method consistent with IRC §471 (codified first in the 1954 IRC).
While a full analysis of this quandary is beyond the scope of this short blog post, the Chief Counsel’s argument here is an odd one. At no other point in the code (that this author is aware of), are tax practitioners advised to dismiss current law in favor of former law. Further, IRC §263A was created in the 1986 IRC specifically to provide for a more accurate means by which to calculate COGS for taxpayers. Therefore, shouldn’t taxpayers in the cannabis industry, who are allowed only COGS as their sole deduction, per their constitutional right, employ uniform capitalization rules so as to most correctly calculate their COGS? It can be argued that they should.
Further, despite a position in CCA 2015014011 to the contrary, it can be argued that relying on IRC §263A(a)(2) (which states that otherwise nondeductible expenses cannot be capitalized into inventory) to say that uniform capitalization cannot be employed in the cannabis industry, is flawed logic because IRC §280E is to be applied in the determination of ordinary business expenses after the calculation of gross profit, not before (where COGS is the only adjustment to income calculated). A more substantial analysis of IRC §280E vs. IRC §263A can be found at bsfllp.com/images/content/1/4/v2/1495/MAG-05-15-Kosnitzky-Kaden.pdf.
It is important to remember at the end of the day that a Chief Counsel Advice does not hold legal weight. A CCA is only a directive to the public about the mood of the IRS on a particular topic. Unfortunately, there are also no tax court cases which definitively provide guidance on this issue. Therefore, it is on each individual tax practitioner to analyze the arguments and determine whether or not they believe it is worth the risk to calculate COGS for the cannabis clients using uniform capitalization instead of full absorption.
In addition to determining how aggressive they want to be when calculation ordinary deductions and COGS, tax practitioners should analyze their own appetites for risk in the following areas:
- There is the increased risk of criminal prosecution as cannabis clients are operating in violation of the Federal Controlled Substances Act.
- Cannabis clients who conduct business in multiple states may be running afoul of federal interstate commerce laws as they are trafficking in illegal substances under federal law.
Summarily, it is advisable for all tax practitioners to consult their applicable State Board of Accountancy (BOA) before taking on clients in the cannabis industry. To date, most state boards have issued statements which recognize the pivotal role of tax practitioners in assisting cannabis clients in correctly calculating taxable net income and liability and remitting such sums to the various governments. All BOAs to date which have issued position statements on the issue have conveyed that while there is no guaranteed protection from federal prosecution, the BOA will support and defend any tax practitioner who supports the cannabis industry in good faith and does not explicitly commit any otherwise acts discreditable. In addition to state boards, the American Institute of CPAs has dedicated resources resources to help tax practitioners to educate themselves on the cannabis industry.
Tax practitioners in New Jersey who are considering servicing the industry should also consider joining the NJCPA’s Cannabis Interest Group for the latest industry updates.