Bloomberg Tax report…

With cannabis clients, normal tax planning is reversed: the goal is to capitalize as many costs as possible, rather than to seek deductions.

This is thanks to tax code Section 280E, which bars cannabis businesses and other “drug traffickers” from reducing gross income by deductions. On the other hand, when a cannabis business sells property, it can still reduce amount realized by adjusted basis, and can still reduce gross receipts by cost of goods sold, in calculating gross income. Better to capitalize a cost and recover it later, than never to recover it at all.

Until recently, Section 280E’s exception for capitalized basis was more useful to some cannabis companies than to others. Under Section 471(a), retailers and distributors could not capitalize costs as aggressively as producers. However, Congress seemed to expand this exception in 2017, when it added Section 471(c) as part of the TCJAThis new provision seemed to say that a qualifying taxpayer can choose any method of accounting for inventory—including one which allocates additional expenses to inventory—so long as it “conforms to … the books and records … prepared in accordance with the taxpayer’s accounting procedures.” If so, retailers and distributors could elect to be treated like producers.

In proposed and final regs, Treasury has challenged the idea that Section 471(c) removes existing limits on capitalization. REG-132766-18 (Aug. 5, 2020); TD 9942 (Jan. 5, 2021). We would paraphrase Treasury’s reasoning as follows:

  • Section 471 is in Subchapter E of Chapter 1, “Accounting Periods and Methods of Accounting,” and not in Subchapter B of Chapter 1, “Computation of Taxable Income.”
  • Therefore, it is a timing provision, not a substantive tax provision.
  • A timing provision cannot be used to turn a non-recoverable cost into a recoverable cost.
  • Thus, it cannot be used to capitalize a cost which is otherwise non-capitalizable and non-deductible.

If Treasury is right, then this new technique can join its friends in the burgeoning Section 280E scrap heap. However, we don’t think Treasury is right.

Rule is inconsistent with Section 471(a)

Of course, Section 471 can be used to capitalize otherwise non-deductible and non-capitalizable costs. It is uncontroversial that producers can capitalize costs which retailers cannot, including costs which are non-deductible under Section 280E. In both cases, this disparate treatment is caused by 471(a)’s requirements.

Since retailers are denied the treatment given to producers by Section 471(a), and since Section 471(c) suspends that provision’s requirements, it follows that Section 471(c) does what we think it does: it eliminates the obstacle that was preventing retailers from capitalizing costs like producers can.