On March 30th, the Treasury Inspector General for Tax Administration (“TIGTA”) released a report which concluded, based on its estimates, that the IRS could have collected significant additional tax revenue from cannabis companies if IRS audits of such companies were increased. In particular, TIGTA reported on potential income tax deficiencies arising from the denial of business deductions and credits under Internal Revenue Code Section 280E.
As a general matter, Section 280E prohibits cannabis businesses from claiming most tax deductions that are otherwise available to taxpayers. As a result of Section 280E, cannabis companies generally are limited to deducting only their cost of goods sold (“COGS”) in determining their taxable income. TIGTA specifically identified three potential sources of Section 280E audit adjustments:
- Internal Revenue Code Section 263A. Section 263A provides for certain indirect costs to be capitalized. However, the cost must otherwise be deductible in the year which the cost is incurred, which Section 280E generally would prohibit. Accordingly, costs that are subject to Section 280E cannot be capitalized under Section 263A.
- Accelerated depreciation. Producers or manufacturers who are required to include asset depreciation in the calculation of their COGS generally are required to depreciate the assets in the same manner as in their financial statements, or if none, in their books and records. Any accelerated depreciation in excess of financial statement or book depreciation would be prohibited by Section 280E.
- Depreciable assets expensed under Internal Revenue Code Section179. Section 179 generally permits taxpayers to deduct the cost of certain depreciable business property as an expense in the year such property is placed in service. The Section 179 deduction would be disallowed by Section 280E.
In its report, TIGTA recommended that the IRS develop a comprehensive compliance approach for cannabis businesses, including by using state cannabis business lists to aid in finding non-compliant taxpayers. While the IRS responded that they will use data analytics such as those provided by TIGTA to identify non-compliant taxpayers in the cannabis industry, the IRS was clear that targeting the cannabis industry, or any industry, is dependent on IRS priorities and availability of resources.
Cannabis companies may want to review their federal and state income tax returns to assess whether they have potential exposure with regard to the issues identified in the TIGTA report.
Treasury Report Highlights Potential Section 280E Relief under the TCJA
Due to Section 280E, a cannabis business can only deduct expenses that are properly includible in COGS, which includes inventory costs as generally determined under Section 471(a). Section 471(c), as enacted by the Tax Cuts and Jobs Act of 2017 (“TCJA”), allows businesses with less than $25 million of gross receipts more flexibility in calculating their inventory costs. Among other things, Section 471(c) allows such a business to calculate its COGS in the same manner as it calculates COGS for purposes of its financial statements, or, if no financial statements are available, as calculated in the books and records of the business in accordance with the business’s accounting procedures. As a result, Section 471(c) may allow cannabis businesses with inventory and less than $25 million of gross receipts to substantially reduce their costs that are subject to (and non-deductible under) Section 280E.