In the latest Tax Court opinion addressing the application of Section 280E to cannabis businesses there is no good news. However, there is some new guidance. In Patients Mutual Assistance Collective Corp. v. Comm’r, 151 T.C. No. 11, the taxpayer made a litany of arguments to convince the court that their business, or a portion of their business was not subject to Section 280E. These include arguments we have seen before, including (1) that the business was not trafficking in controlled substances, here, because the government had abandoned a civil forfeiture action, and (2) that because a portion of the business involved branding and the sales of non-marijuana products, deductions related to these operations should not be subject to Section 280E. These arguments failed and only make it clear that similar arguments are likely to be unavailing. In fact, the Court spends ten pages discussing why the entire business is integrated and subject to Section 280E. Taxpayers hoping to establish a separate trade or business that is not subject to Section 280E now have clarity, but also an extremely high bar.
New Holdings: Inventory Accounting Rules
The new developments addressed in this case involve the application of inventory rules to cannabis businesses. Previous cases focused primarily on the previously discussed arguments and failed to give any detailed guidance on how to apply the inventory rules. The Court clearly and strongly concluded that the more expansive Section 263A inventory cost rules do not apply to businesses subject to Section 280E. The Court reasoned that “if something wasn’t deductible before Congress enacted section 263A, taxpayers cannot use that section to capitalize it..Section 263A makes taxpayers defer the benefit of what used to be deductions-it doesn’t shower that as grace on those previously damned.” Slip Op. at 53.
The Court’s conclusion is based on the notion that we go back in time to 1982 to determine what is includible in inventory costs. The Court refers to Treas. Reg. section 1.263A-1(c)(2) which states:
Any cost which (but for section 263A and the regulations thereunder) may not be taken into account in computing taxable income for any taxable year is not treated as a cost properly allocable to property produced or acquired for resale under section 263A and the regulations thereunder. Thus, for example, if a business meal deduction is limited by section 274(n) to 80 percent of the cost of the meal, the amount properly allocable to property produced or acquired for resale under section 263A is also limited to 80 percent of the cost of the meal.
While this reasoning is understandable, if we turn the question on its head, we could also ask whether the section 280E disallowance is determined before or after inventory costs are calculated. For example, even if there is a meals and entertainment expense that is clearly includible in inventory costs, no one is going to argue that 100% of meals and entertainment is includible in inventory costs. In this case, you are determining inventory costs and deductions, and then applying Section 274. So, it is easy to see how those provisions overlap. However, if inventory costs are determined based on the applicable inventory rules and then Section 280E is applied, then you have a different result because Section 263A expands what can be included in inventory costs, and the remaining deductions are subject to Section 280E. That result is not inconsistent with the notion that items such as meals and entertainment and penalties are not deducted in determining taxable income regardless of whether they are a deduction under Section 162 or an inventory cost under Section 471 or 263A.
The Harsh Result
It is important to note that the Court analyzed and concluded that the taxpayer was a reseller and not a producer. Because the taxpayer did not itself grow marijuana, this is not surprising. The Section 471 rules that apply to resellers do not allow for extensive indirect costs to be included in inventory. Thus, for businesses that do not produce or manufacture, they will continue to face significant challenges by the IRS if they are including indirect costs in inventory costs. For cultivators and producers, careful consideration should be given to how the 471 rules apply, depending on the activities of the business.
Still to Come
The Court reserved its analysis of whether penalties apply for a opinion to be issued at a later date. However, the Court hints that there might be some relief when it states that the overlap between Section 280E and 263A created a “confusing legal environment.” One can hope that given the lack of guidance addressing the specifics of how the inventory rules apply to cannabis businesses, the IRS and the court will give taxpayers doing their best to apply Section 280E the benefit of reprieve from penalties.
Other Notes
If you are entertained by Judge Holmes’ opinions, be sure you read the footnotes. Footnotes 3 and 6 are my favorites.
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