Having doubted that square footage (or canopy) fees or taxes could be deductible under 280E on the federal income tax return of a cannabis-growing business, I asked Todd Arkley, a Washington State CPA with a lot of cannabis clients. Todd knows more than I hope ever to learn about tax accounting. Whether you call a payment based on square footage a tax or a fee, he makes the case that it is deductible. Property taxes can go into cost of goods sold, he writes. The rest of this post is verbatim from Todd Arkley.
As has been established, not only in the “Explanation of Provision” when 280E was passed, but also in CHAMP, Olive, and other IRS memos, a cannabis business can make an adjustment to their gross revenue via Cost of Goods Sold (COGS). Furthermore, COGS is not a “stand-alone” expense (such as rent or wages or office supplies). COGS is, to put it very simply, the plug number in inventory calculations, stated as: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold.
So in order to find out what expenditures will end up in COGS, what we really need to do is find out what expenditures can be put into Inventory.
There are two code sections which deal with inventory: IRC 471 and IRC 263a. IRC 263a is an expansion of IRC 471 and, for certain taxpayers, it is the code that must be followed. Primarily, it is aimed at larger taxpayers with average annual revenues exceeding ten million dollars. Because the IRS has indicated that IRC 263a does not apply to cannabis businesses (http://www.irs.gov/pub/irs-wd/201504011.pdf), I am going to focus on IRC 471, which they do allow cannabis businesses to use. However, you will see that, regardless of which code section is used, taxes are treated the same.
IRC 471, in particular, IRC 1.471-11, divides costs that need to be included in Inventory into two categories – Direct Production Costs and Indirect Production Costs. Direct Production Costs are direct labor costs (wages, payroll taxes, etc.) and direct material costs (soil, clones, fertilizer, etc.). I should note here that 1.471-11 is the section of the code that relates to producers of inventory and it does not apply to resellers. A retail shop would look to 1.471-3. We can certainly discuss retailers in another email in more detail but for now, I am focusing on growers/processors.
Indirect Production Costs can be understood as overhead. And within the category of Indirect Production Costs, the IRS as three subcategories.
Category 1 costs “must enter into the computation of the amount of inventoriable costs (regardless of their treatment by a taxpayer in his financial reports)”. These costs are items such as rent, utilities, maintenance, tools, equipment, and other “standard” overhead expenditures. Nothing too flashy here.
Category 2 costs “are not required to be included for tax purposes in the computation of the amount of inventoriable costs (regardless of their treatment by a taxpayer in his financial reports)”. Within Category 2, there are some taxes listed (which essentially means that they cannot be included in Inventory). Specifically, these are “(j) Income taxes attributable to income received on the sale of inventory“. Other costs in this category include marketing, advertising, and selling expenses.
Finally (and what we are interested in) are Category 3 costs. These are described as follows: “In the case of costs listed in this subdivision, the inclusion or exclusion of such costs from the amount of inventoriable costs for purposes of a taxpayer’s financial reports shall determine whether such costs must be included in or excluded from the computation of inventoriable costs for tax purposes, but only if such treatment is not inconsistent with generally accepted accounting principles.”
The last sentence is key – not inconsistent with generally accepted accounting principles. The reason for this is so that a taxpayer cannot include an expense into inventory – such as advertising or commission payments – which, according to GAAP, have no connection with the production of inventory.
Category 3 lists seven different expenses and the first is taxes:
“(a) Taxes. Taxes otherwise allowable as a deduction under section 164 (other than State and local and foreign income taxes) attributable to assets incident to and necessary for production or manufacturing operations or processes. Thus, for example, the cost of State and local property taxes imposed on a factory or other production facility and any State and local taxes imposed on inventory must be included in or excluded from the computation of the amount of inventoriable costs for tax purposes depending upon their treatment by a taxpayer in his financial reports.”
And for comparison purposes, here is how taxes are described in IRC 263a:
“(L) Taxes. Taxes include those taxes (other than taxes described in paragraph (e)(3)(iii)(F) of this section) that are otherwise allowable as a deduction to the extent such taxes are attributable to labor, materials, supplies, equipment, land, or facilities used in production or resale activities.”
Here are the taxes “described in paragraph (e)(3)(iii)(F)” and these, under IRC 263a, cannot be included in Inventory:
“(F) Taxes assessed on the basis of income. Taxes assessed on the basis of income include only state, local, and foreign income taxes, and franchise taxes that are assessed on the taxpayer based on income.”
As you can (hopefully) see, it is rather clear what taxes can, and cannot, be included into inventory and, thus, deducted via COGS.
Most definitely we can help cannabis businesses with the federal tax problem. As long as an expense can be included in COGS, then we are on very solid footing for deductibility.