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Background on Capitalization Post-Harborside
A number of articles and comments have addressed the application of IRC Sec. 280E and inventory costing methods for “Cost of Goods Sold” for a legal cannabis 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 under 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 three trailing years of less than $25 million and are not a tax sheltermay 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 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.
In the case of merchandise produced by the taxpayer since the beginning of the taxable year, inventory cost includes the cost of 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 the treatment of production costs.
To conform as nearly as possible to the best accounting practices and to clearly reflect income, 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.
A taxpayer should be able to capitalize the cost of goods sold when doing so is consistent with industry practices. Taxpayers in the cannabis industry could justifiably assert that substantial authority existed to sustain the use of IRC Sec. 263A in the calculation of the cost of goods sold prior to the release of Chief Counsel Memorandum [“CCM”] 201504011.
This CCM requires:
“Taxpayers trafficking in a Schedule I or Schedule II controlled substance to determine the 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 to assert that IRC Sec. 6662 “substantial understatement” penalties do not apply, ended with the publication of CCM 201504011.
Application to Cultivators
We have routinely advised businesses that were engaged in cannabis cultivation that IRC Sec. 280E and the inventory costing provisions have minimal impact on them. With minor exceptions, all of the expenditures of such businesses were part of Cost of Goods Sold [“COGS”]. We find ourselves having to revisit that guidance due to the fiasco that has developed within CalCannabis over the licensing of cultivators. The situations that we must address include:
Where an Applicant has filed for “temporary licensure” by a mandated deadline, the Applicant met the deadline, and has waited for months without receiving a “temporary license”
Where an Applicant has received a “Temporary License” and submitted an Application for an “Annual License” and the “Temporary License” has lapsed prior to the Annual License being issued, and the Applicant has received no definitive action. Such Applicants are left the position of growing plants without having a valid license.
We have reviewed the issues and believe that the following conclusions will meet the “more likely than not standard” for tax reporting positions.
Prior to having obtained a “temporary license”, or any type of license for that matter, a cultivator may NOT commence the conduct of an active trade or business for income tax purposes. Costs of a taxpayer in such circumstances may be addressed as follows:
Ground Rent, or rent on a space lease, may be deducted currently prior to the any type of license being obtained.
Raw materials, direct labor, direct and indirect production costs must be capitalized pursuant to the “full absorption costing” provisions under IRC Sec. 471.
The costs associated with accounting, tax preparation, administration and operation of an office, but for the portion which is properly allocated in indirect production which should be capitalized, may be expensed.
Tangible property should not be treated as “placed in service” until such time as a temporary license is obtained. The same logic would apply to amortizable intangible property.
The treatment of interest expense is highly complex and requires a separate evaluation
It is our opinion in a instance in which a cultivator that has received a “temporary license” or other license that lapses solely due to the passage of time may continue to treat their cultivation operation as properly engaged in a trade or business for income tax purposes.
There are many nuances and complexities to the analysis in this post, and we welcome the opportunity to clarify the application of the rules to a specific business
-  IRC Sec. 448(c)
-  IRC Sec. 448(a)(3)
-  Reg, Sec, 1,471-3(a)
-  Reg. Sec. 1.471-3(b)
-  Reg. Sec. 1.471-3(c). For taxpayers acquiring merchandise for resale that is 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.
-  IRC Sec. 471(a)
-  Reg. Sec. 1.471-11, for the purposes of this section, the term financial reports refer to Generally Accepted Accounting Principles :GAAP”.
-  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.
-  October 25, 2018, CalCannabis issued a notice stating:
“Due to the large number of applications being submitted for temporary cannabis cultivation licenses, the California Department of Food and Agriculture (CDFA) hereby notifies prospective applicants that any application for a temporary license received after December 1, 2018, may NOT be processed in time for us to issue a temporary license before January 1, 2019. After December 31, 2018, the authority for CDFA to issue temporary licenses expires. To provide sufficient processing time, please submit your temporary application to CDFA’s CalCannabis Cultivation Licensing Division by December 1, 2018”
-  Note: The application of the likelihood of prevailing on an issue is reserved for clients of our firm for which we have an executed Engagement Letter.
The “more likely than not standard” [“MLTN”] – Greater than 50% probability of success if Greater than 50% probability of success if challenged by IRS which is the standard described in AICPA Statements on Standards for Tax Services [“SSTS”] 1
The MLTN standard is contrasted with the “reasonable basis” standard in IRC Sec. 6694
See Re. 1-6694(1)(d)
“(d)Exception for adequate disclosure of positions with a reasonable basis –
(1)In general. The section 6694(a) penalty will not be imposed on a tax return preparer if the position taken (other than apposition with respect to a tax shelter or a reportable transaction to which section 6662A applies) has a reasonable basis and is adequately disclosed within the meaning of paragraph (c)(3) of this section. For an exception to the section 6694(a) penalty for reasonable cause and good faith, see paragraph (e) of this section.
(2)Reasonable basis. For purposes of this section, “reasonable basis” has the same meaning as in § 1.6662-3(b)(3) or any successor provision of the accuracy-related penalty regulations. For purposes of determining whether the preparer has a reasonable basis for a position, a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer and information and advice furnished by another advisor, another tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer‘s firm), as provided in §§ 1.6694-1(e) and 1.6694-2(e)(5).”
A further exception is provided in Reg. Sec. 1.6694-1(e)
“(e)Exception for reasonable cause and good faith. The penalty under section 6694(a) will not be imposed if, considering all the facts and circumstances, it is determined that the understatement was due to reasonable cause and that the tax return preparer acted in good faith. Factors to consider include:
(1)Nature of the error causing the understatement. The error resulted from a provision that was complex, uncommon, or highly technical, and a competent tax return preparer of tax returns or claims for refund of the type at issue reasonably could have made the error. The reasonable cause and good faith exception, however, does not apply to an error that would have been apparent from a general review of the return or claim for refund by the tax return preparer.
(2)Frequency of errors. The understatement was the result of an isolated error (such as an inadvertent mathematical or clerical error) rather than a number of errors. Although the reasonable cause and good faith exception generally applies to an isolated error, it does not apply if the isolated error is so obvious, flagrant, or material that it should have been discovered during a review of the return or claim for refund. Furthermore, the reasonable cause and good faith exception does not apply if there is a pattern of errors on a return or claim for refund even though any one error, in isolation, would have qualified for the reasonable cause and good faith exception.
(3)Materiality of errors. The understatement was not material in relation to the correct tax liability. The reasonable cause and good faith exception generally applies if the understatement is of a relatively immaterial amount. Nevertheless, even an immaterial understatement may not qualify for the reasonable cause and good faith exception if the error or errors creating the understatement are sufficiently obvious or numerous.
(4)Tax return preparer’s normal office practice. The tax return preparer‘s normal office practice, when considered together with other facts and circumstances, such as the knowledge of the tax return preparer, indicates that the error in question would occur rarely and the normal office practice was followed in preparing the return or claim for refund in question. Such a normal office practice must be a system for promoting accuracy and consistency in the preparation of returns or claims for refund and generally would include, in the case of a signing tax return preparer, checklists, methods for obtaining necessary information from the taxpayer, a review of the prior year‘s return, and review procedures. Notwithstanding these rules, the reasonable cause and good faith exception does not apply if there is a flagrant error on a return or claim for refund, a pattern of errors on a return or claim for refund, or a repetition of the same or similar errors on numerous returns or claims for refund.
(5)Reliance on advice of others. For purposes of demonstrating reasonable cause and good faith, a preparer may rely without verification upon advice and information furnished by the taxpayer and information and advice furnished by another advisor, another tax return preparer or other party, as provided in § 1.6694-1(e). The tax return preparer may rely in good faith on the advice of, or schedules or other documents prepared by, the taxpayer, another advisor, another tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer‘s firm), who the tax return preparer had reason to believe was competent to render the advice or other information. The advice or information may be written or oral, but in either case the burden of establishing that the advice or information was received is on the tax return preparer. A tax return preparer is not considered to have relied in good faith if –
(i) The advice or information is unreasonable on its face;
(ii) The tax return preparer knew or should have known that the other party providing the advice or information was not aware of all relevant facts; or
(iii) The tax return preparer knew or should have known (given the nature of the tax return preparer‘s practice), at the time the return or claim for refund was prepared, that the advice or information was no longer reliable due to developments in the law since the time the advice was given.
(6)Reliance on generally accepted administrative or industry practice. The tax return preparer reasonably relied in good faith on generally accepted administrative or industry practice in taking the position that resulted in the understatement. A tax return preparer is not considered to have relied in good faith if the tax return preparer knew or should have known (given the nature of the tax return preparer‘s practice), at the time the return or claim for refund was prepared, that the administrative or industry practice was no longer reliable due to developments in the law or IRS administrative practice since the time the practice was developed.”
-  We are not commenting on how a cannabis regulatory agency would treat a Licensee with an expired license, as that is a matter for legal counsel.