IRS USES 280E TO YANK DEPRECIATION DEDUCTIONS FROM CANNABIS COMPANIES
In light of the upcoming income tax filing season for 2022, we felt it was noteworthy to remind cannabis taxpayers that Section 179 depreciation is unavailable in the industry due to the 2022 tax court case discussed below. Read through for some other possible but aggressive options.
In a March 2022 tax court decision, a judge upheld the IRS’s position that two Colorado cannabis businesses could not take bonus depreciation or section 179 accelerated depreciation as part of their Cost of Goods Sold (COGS), due to section 280E. Section 280E is the part of the tax code that applies to all businesses trafficking in a controlled substance, which includes cannabis, disallowing every deduction other than direct COGS.
The case, Lord v. Commissioner, involved a cultivation/processing company and a dispensary, both owned by Coloradans John and Belinda Lord. The two businesses, Beyond Broadway, LLC, an LLC filing as a partnership, and Artistant Dispensary Center, Inc., an S-Corp, were reported on the Lord’s 2012 personal tax return, and it wasn’t until July 2018 that the IRS issued them a notice disallowing the depreciation deductions they’d claimed.
Several sections of the Internal Revenue Code are used to calculate COGS, including section 471 (direct COGS like the purchase of inventory) and section 263A (indirect COGS like depreciation). The COGS disallowed by 280E are the labor and indirect costs listed under section 263A, which are based on otherwise deductible expenditures. That means retailers may only use merchandise costs for COGS, and producers such as cultivators and manufacturers may only use direct labor and indirect costs along with merchandise costs. Previous cases disallowed section 179 and bonus depreciation in COGS for retailers. Lord v. Commissioner disallows section 179 and bonus depreciation for producers such as cultivators and manufacturers.
This 2022 tax court decision highlights our contention that, in order for cannabis companies to minimize their federal taxes, their only option is to take an aggressive 471(c) position. Section 471(c) of the IRC seems to say that a qualified small business with gross revenues under $25M (adjusted for inflation) can express COGS based on its own books and records. This appears to be true even if the accounting method used is non-standard, since the law specifically exempts a “clear reflection of income.” That would seem to allow any immediate depreciation method such as section 179 or bonus depreciation. See our article written on 471(c) to discuss further. Bloomberg Tax 471(c) Article
However, Treasury regulation 1.471-1(b)(3) contradicts the law and states that only accepted accounting methods, as mentioned in section 446, may be used, which precludes section 179 and bonus depreciation in COGS. Treasury regulations are presumed to be correct. That means a taxpayer using 471(c) for section 179 and bonus depreciation must be prepared for the long process of a tax audit, appeals, and finally, tax court confirmation that the Treasury Regulations have incorrectly interpreted the law. This process which could take about seven years.
If you decide to use a 471(c) approach in your business’s tax filings, it’s important that you discuss this with your CPA as soon as possible. This approach is NOT for the faint of heart and must be carefully discussed with tax advisors to confirm that the risk makes good business sense.
