AUTHORED BY: JORDAN ZOOT

Managing Director & CEO – aBIZinaBOX Inc. – CPA’s 

Accounting, Attest, Tax, Regulatory Compliance and Technology

Evanston HQ [Chicago] – Oakland – New York

CPA.CITP.CISM.CGEIT.CGMA 

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Cannabis Inventory Costing Update Post-Harborside

 

A number of articles and comments have addressed the application of IRC Sec. 280E and inventory costing methods in the determination of “Cost of Goods Sold” for a legal cannabis industry retailer in light of the two Harborside decisions. We have read no analysis that appeared to completely “get it right.” Judge Holmes failure to impose accuracy related penalties pursuant to IRC Sec. 6662 seems to have confused many commentators. Let us see if we can produce a clearer articulation of inventory costing for the cannabis industry.

 

The inventory costing methods available under IRC Sec. 471 include

 

  • Small businesses which have average gross receipts for trailing three years of less than $25 million[1] and are not a tax shelter[2] may rely on their book method of determining COGS for tax purposes. Stated differently, qualifying taxpayers do not need to make book-to-tax adjustments for COGS.

 

  • IRC Sec. 471(a) states

 

“Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income”.

 

If an industry adopts best practices of capitalizing the majority of direct and indirect costs into COGS and the use of such a method clearly reflects income, then the IRS cannot adjust the taxpayer’s method of determining COGS solely for the purpose of “clearly reflecting income” based on IRC Sec. 471(a).

 

The Regulations define “Inventories at Cost” as:

 

  • For merchandise on hand at the beginning of the taxable year, the inventory price of such goods[3].
  • In the case of merchandise purchased since the beginning of the taxable year, the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate. The cost of transportation or other necessary charges incurred in acquiring possession of the goods[4].
  • In the case of merchandise produced by taxpayer since the beginning of the taxable year
    • the costof raw materials and supplies entering into or consumed in connection with the product,
    • expenditures for direct labor, and
    • indirect production costs incident to and necessary for the production of a particular article, including in indirect production costs an appropriate portion of management expenses, but not including any cost of selling or return on capital, whether by way of interest or profit. See Reg. Sec. 1.263A-1 and 1.263A-2 for specific rules regarding treatment of production costs[5].
  • Inventories of a Retailer – Aretailer may use the retail inventory method. The retail inventory method uses a formula to convert the retail selling price of ending inventory to an approximation of cost (retail cost method) or an approximation of lower of cost or market (retail LCM method)[6].
  • Manufacturer’s Inventory – In order to conform as nearly as possible to the best accounting practices and to clearly reflect income[7], both direct and indirect production costs must be taken into account in the computation of inventory costs in accordance with the “full absorption” method of inventory costing.

 

Under the full absorption method of inventory costing production costs must be allocated to goods produced during the taxable year, whether sold during the taxable year or in inventory at the close of the taxable year, determined in accordance with the taxpayer’s method of identifying goods in inventory. Thus, the taxpayer must include as inventoriable costs all direct production costs and all indirect production costs[8].

 

A taxpayer should be able to capitalize cost of goods sold, when doing so is consistent with industry practices[9]. Taxpayers in the cannabis industry could justifiably assert that substantial authority existed to sustain the use of IRC Sec. 263A in the calculation of cost of goods sold prior to the release of Chief Counsel Memorandum 201504011.

 

This CCM requires:

 

  • Taxpayers trafficking in a Schedule I or Schedule II controlled substance to determine cost of goods sold using the applicable inventory-costing regulations under IRC Sec. 471 as these regulations existed when IRC Sec. 280E was enacted; and

 

  • Unless the taxpayer is properly using a non-inventory method to account for the Schedule I or Schedule II controlled substance pursuant to the Code, Regulations, or other published guidance, the IRS may require an adjustment to clearly reflect income.

 

The ability to use IRC Sec. 263A and assert that the IRC Sec. 6662 “substantial understatement” penalties do not apply ended with the publication of CCM 201504011. The methodology that Harborside utilized for the years 2007-2012 is not acceptable for years after 2014.

 

The situation becomes particularly grim for California dispensaries beginning after 2017. California’s Bureau of Cannabis Control adopted regulations beginning in 2018 that require Retailers to purchase cannabis that has been tested, packaged, and labeled by a Distributor. The adoption of these regulations renders virtually all adjustments to COGS by a dispensary improper.

 

 

[1] IRC 448(c)

 

[2] IRC Sec. 448(a)(3)

 

[3] Reg. Sec. 1.471-3(a)

 

[4] Reg. Sec. 1.471-3(b)

[5] Reg. Sec. 1.471-3(c). For taxpayers acquiring merchandise for resale that are subject to the provisions of IRC Sec. 263A, see Reg. Secs. 1.263A-1 and 1.263A-3 for additional amounts that must be included in inventory costs.

 

[6] Reg. Sec. 1.471-8 – Further, a taxpayer may use the retail inventory method instead of valuing inventory at cost under Reg. Sec. 1.471-3 or lower of cost or market under Reg. Sec.1.471-4.

[7] IRC Sec. 471(a)

 

[8] Reg. Sec. 1.471-11, for the purposes of this section, the term financial reports refer to the GAAP.

 

[9] See also Reg. Sec.1.263A-1T with respect to the treatment of production costs incurred in taxable years beginning after December 31, 1986, and before January 1, 1994. See also Reg. Secs. 1.263A-1 and 1.263A-2 with respect to the treatment of production costs incurred in taxable years beginning after December 31, 1993.