The US Supreme Court’s decision in June in Loper Bright Enterprises v. Raimondo provides immediate assistance to cannabis companies and their advisors in challenging IRS interpretations of Section 471(c) of the Internal Revenue Code. With the elimination of Chevron Because of the regulators’ deference to legislative ambiguities, cannabis businesses may be in a stronger position to use this section of the tax code to mitigate the burdensome tax consequences of Section 280E.

Section 280E prohibits deductions and credits for expenses related to the illegal sale of drugs and requires most cannabis businesses to include such significant expenses as rent and wages for sales personnel when calculating their federal income tax. The only expenses that were deductible for cannabis businesses were those related to the cost of goods sold.

While some states have opted out of 280E and allow their cannabis businesses full deductions at the state level, the overwhelming tax burden from this section falls on the federal government and is the primary reason marijuana businesses have paid over $2 billion more in federal taxes compared to businesses in other sectors. This also explains why about 75% of cannabis businesses currently operate without profit.

This has been particularly problematic for cannabis dispensaries and delivery services, which spend a much larger portion of their expenses on distribution and general and administrative expenses than cultivation or manufacturing businesses. Section 471(c) has been used by some cannabis tax professionals to allocate a larger portion of these expenses to cost of goods.

Section 471(c), added in 2017 by the Tax Cuts and Jobs Act, provides an exemption for small businesses with annual gross sales of less than $30 million in determining inventory accounting methods for tax purposes, beginning in 2024. Under 471(c), small businesses can treat inventory for tax purposes the same as they do in their financial statements or books and records.

If their tax return matches their accounting records, a qualified cannabis business can capitalize many more overhead costs, including payroll and facility costs such as rent, thereby increasing their cost of goods sold and reducing their 280E tax burden.

While some accountants and tax advisors have had success with this method, many others have been reluctant to use it because they found it too aggressive. Even those who have used it successfully have been more cautious in their use so as not to stir up a hornet’s nest.

In January 2021, the IRS pushed back against this approach with a regulation that stated, in part, “Section 471(c) does not permit the deduction or refund of any expense that is otherwise disallowed from deduction or refund to a taxpayer under any other provision of the Act or regulations.” The battle lines are clear, and tax court will be the future battleground.

Control options

In its decision of Loper BrightThe Supreme Court has overturned a doctrine that had guided judicial decisions in administrative cases for the past 40 years, thereby limiting judicial restraint in respect of certain agency rules.

Initial legal analysis of the decision is mixed. Some experts say it will result in further challenges to some tax provisions, possible additional problems with the IRS, and further complications in rulemaking. However, many tax experts agree that existing resistance to challenging the IRS’s interpretation of the tax law has waned since the problems were resolved by Chevron Homage has been removed.

This is good news for cannabis companies and their advisors. Cannabis companies may now be in a stronger position to challenge IRS interpretations of 471(c) that they believe are overly restrictive or unfair. Tax courts will no longer automatically follow the IRS’s interpretation, potentially leading to more favorable outcomes for these companies.

Action elements

Cannabis businesses and their advisors who wish to utilize 471(c) must get their books in order and ensure that they reflect expense movements in cost of goods sold in a way that matches the deductions reported on the tax return. These businesses must be prepared for an audit and be able to substantiate the existence of each expense claimed.

In addition, the amount and type of expenses included in the cost of goods sold must be determined in a discussion between the cannabis company and its advisor.

The tax and legal landscape surrounding cannabis has changed following the Drug Enforcement Administration’s decision in April to reclassify cannabis as a less dangerous controlled substance, which bodes well for cannabis’ tax status in the long run.

And although Loper Bright does not directly address Section 471(c), but its principles are consistent with the need for clear accounting practices, which can benefit cannabis businesses seeking fair treatment under tax laws. Consulting with a tax advisor can help businesses in this situation obtain sound financial advice.

Information about the author

Abraham Finberg is a Principal at AB Fin and has worked in the cannabis sector since 2009. He advises clients on all phases of business advisory and tax consulting.

Simon Menkes supports accounting firms, their clients and consultants through accounting and advisory services.

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