Editor: Marcy Lantz, CPA
For decades, cannabis, derivatives of cannabis, and related substances such as hemp and marijuana were classified as Schedule I narcotics under the 1970 Controlled Substances Act. Federally, the production and sale of marijuana have been and remain illegal, although a marijuana business remains obligated to pay federal income tax on its taxable income under Sec. 61(a).
Sec. 280E limits income tax deductions for businesses that traffic in controlled substances. The origin of Sec. 280E dates to 1981 with the Tax Court case Edmondson,T.C. Memo. 1981-623. The court decided that a seller of cocaine, amphetamines, and marijuana could deduct most of his cost of goods sold (COGS); packaging, phone, and automobile expenses; and a portion of his rental expense of his residence, all relating to the seller's illegal business.
In 1982, Sec. 280E was enacted to reverse the Edmondson decision and deny sellers of Schedule I or II controlled substances the right to deduct business expenses. Since marijuana is classified as a Schedule I drug, marijuana businesses are unable to deduct most ordinary business expenses. However, COGS is allowable as an adjustment to gross receipts.
IRS Chief Counsel Advice (CCA) memorandum 201504011, issued in December 2014, requires taxpayers trafficking in a Schedule I or II controlled substance to determine COGS using the applicable inventory costing regulations under Regs. Sec. 1.471 as these regulations existed when Sec. 280E was enacted. Unless a taxpayer is properly using a noninventory method to account for the Schedule I or II controlled substance pursuant to the Code, regulations, or other published guidance, the IRS may require an adjustment to clearly reflect income. When Sec. 280E was enacted, taxpayers using an inventory method were subject to the inventory-costing regulations under Regs. Sec. 1.471. Resellers were subject to Regs. Sec. 1.471-3(b), and producers were subject to Regs. Secs. 1.471-3(c) and 1.471-11.
To conform as closely as possible to the best accounting practices and to clearly reflect income, a taxpayer must take into account direct and indirect production costs in the computation of inventory costs, in accordance with the full-absorption method of inventory costing. Under the full-absorption method, direct production costs include direct materials and direct labor costs that are incident to and necessary for production or manufacturing operations or processes (Regs. Sec. 1.471-11(b)(2)). Direct material costs cover the cost of the materials that become integrated as part of the product and materials that are consumed in the manufacturing process and can be identified or associated with a particular unit or groups of units of the product. Indirect production costs are costs that are included in inventoriable costs regardless of their treatment in the taxpayer's financial reports.
A marijuana reseller using an inventory method would capitalize the invoice price of the marijuana purchased, less trade discounts, plus transportation or other necessary charges incurred in acquiring possession of the cannabis for resale. A marijuana producer using an inventory method would capitalize the direct material costs; direct labor costs; Category 1 indirect costs (Regs. Sec. 1.471-11(c)(2)(i)); and, possibly, Category 3 indirect costs (Regs. Sec. 1.471-11(c)(2)(iii)). Examples of Category 1 indirect costs are repair expenses, maintenance, utilities (such as heat and electricity), rent, indirect labor and production supervisory wages, indirect materials and supplies, and cost of quality control and inspection. Category 3 indirect costs are includible in inventoriable costs if so treated in the taxpayer's financial reports consistent with generally accepted accounting principles including taxes; depreciation and depletion; employee benefits; costs attributable to strikes, rework labor, scrap, and spoilage; factory administrative expenses; officers' salaries; and certain insurance costs.
Under the uniform capitalization rules of Sec. 263A, resellers and producers of merchandise are required to treat as inventoriable costs the direct costs of property purchased or produced, respectively, and a proper share of those indirect costs that are allocable to that property. The Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647, added a retroactive technical correction to clarify that a cost is subject to capitalization under Sec. 263A only to the extent it would otherwise be taken into account in computing taxable income for any tax year. As CCA 201504011 observes, if a taxpayer subject to Sec. 280E were allowed to capitalize additional Sec. 263A costs, then Sec. 263A "would cease being a provision that affects merely timing and would become a provision that transforms non-deductible expenses into capitalizable costs."
For decades, federal law did not differentiate hemp from other cannabis plants. Hemp was considered a Schedule I drug; therefore, Sec. 280E applied. In December 2018, Congress passed the Agriculture Improvement Act of 2018, P.L. 115-334 (also known as the 2018 Farm Bill), which descheduled hemp from the Controlled Substances Act. Hemp is a plant from the cannabis family, but hemp does not contain more than 0.3% THC, the psychoactive compound found in cannabis. (For more on this, see the preceding item, "Industrial Hemp: A Growing Industry.")
Under the 2018 Farm Bill, the states and the federal government share regulatory power over hemp cultivation and production. Under Section 10111 of the Farm Bill, state departments of agriculture must consult with each state's governor and chief law enforcement officer to devise a plan and submit it to the U.S. Department of Agriculture (USDA). A state's plan to license and regulate hemp can commence only once the USDA approves it. In states opting not to devise a hemp regulatory program, the USDA will construct a regulatory program under which hemp cultivators in those states must apply for licenses and comply with a federally run program.
Ultimately, the 2018 Farm Bill legalizes hemp, but it does not create a system in which people can grow it as freely as they can grow, for example, tomatoes. This is a highly regulated crop in the United States for both personal and industrial production. Cannabidiol (CBD) is a natural compound found in the flower of the cannabis plant, including both the hemp and marijuana varieties. The difference is that CBD derived from hemp does not contain THC. Consequently, while federal law still prohibits the cultivation and sale of marijuana, hemp and CBD are legal at the federal level under the 2018 Farm Bill, so long as the hemp is produced in a manner consistent with the 2018 Farm Bill, associated federal regulations, associated state regulations, and by a licensed grower. All other cannabinoids, produced in any other setting, remain Schedule I substances under federal law and are thus illegal. The big difference between hemp and marijuana is that hemp is no longer listed as a Schedule I drug; therefore, Sec. 280E limitations no longer apply to hemp businesses. Hemp resellers and producers are still required to follow the inventory costing methods under Regs. Sec. 1.471, as mentioned above.
Beginning in 2018, small businesses are not subject to the uniform capitalization rules if their average annual gross receipts are $25 million or less for the three preceding tax years and the business is not a tax shelter. If hemp businesses qualify for this exemption, they will not be required to calculate a Sec. 263A adjustment.
Marcy Lantz, CPA, CSEP, is a partner with Aldrich Group in Lake Oswego, Ore.
For additional information about these items, contact Ms. Lantz at 503-620-4489 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica Inc.