Costs of Goods Sold (COGS) Summary
Cost of goods sold (COGS) is one of the key factors to reducing your taxable income, however, for cannabis related businesses there are certain provisions that you must be aware. The Internal Revenue Code (“IRC”), has specific provisions regarding the businesses that are permitted to take (COGS) deductions and which particular expenses may be included within the provisions.
It’s in your best interest to claim all of the deductions that your business is allowed because it can be difficult to figure out which deductions are permitted. COGS are important for your business because the deductions can have a considerable influence on the effective tax rate for your cannabis industry.
Claiming deductions for COGS could gain considerable tax savings for your Cannabis business. As a result from the scenarios above, the COGS deductions rendered a 50% difference in the effective tax rate for both of the businesses.
Here is a quick guide to help you understand what COGS deductions are permitted for your cannabis-related business.
Claiming COGS in Cannabis related Businesses
Cannabis-related businesses are currently illegal under federal law, However, every business in this industry is still obligated to pay federal income tax on its taxable income because IRC § 61(a) does not differentiate between income that has been earned from legal sources and income that has been earned from illegal sources.
In 1982, congress passed § 280E , prohibiting credits and deductions for business trafficking in controlled substances. However, the government soon acknowledged that § 280E doesn’t prohibit a taxpayer from claiming COGS from the case, Californians Helping to Alleviate Medical Problems, Inc., v. Commissioner, 128 T.C. 173 (2007) (“CHAMP”) . Other cases involving non-medicinal cannabis or additional Schedule I controlled substances, § 280E was recognized by the Tax Court and determined that it does not disallow adjustments to gross receipts for COGS.
Chief Counsel Advice (CCA) 201504011
The IRS determined Cannabis related businesses can claim certain COGS deductions. The IRS Office of Chief Counsel issued Chief Counsel Advice (CCA) 201504011 , on Jan. 23, 2015. Which added some clarity because the CCA allows a cost of sales deduction for indirect production-related business expenses, although deductions may not be claimed for trafficking cannabis.
Cannabis related business must use the § 280E that was enacted in 1982 and § 471 , which allows a use of inventories provision to determine business income. The ‘inventoriable cost’ was enacted in 1982, referring to capitalized gain to inventories under § 471 .
Capitalization is used by business that operate on the accrual basis of accounting. By delaying the recognition of an expense by viewing items as fixed assets rather than a recognized cost in the period that it was incurred.
The IRS concludes businesses are not permitted to calculate COGS using IRS regulations found in § 263A . This permitted expenses such as service expenses, handling and storage expenses, and purchasing.
To claim any of the permitted deductions it’s essential that the items are “ordinary and necessary” within the meaning of § 162 .
An important section in the tax code is the IRC § 162 because it outlines what a deduction is. In order to claim a deduction, the IRC requires six elements to claim an item as a business expense.
These elements are that the cost is:
The IRS has a broad authority to require Cannabis Related business to change its accounting methods and challenge the deductions claimed. The findings from the IRS explain what a deduction is and which expenses can be considered COGS.
What Expenses Can Be Considered as COGS?
The IRS has made specific provisions for Cannabis resellers versus producers.
Costs that are non-deductible are directly related to the trafficking of marijuana.
CCA 201504011 clarified, for resellers that the costs incurred are otherwise nondeductible under § 280E and may not be deducted as COGS.
This means the invoice price of purchased cannabis, the transportation and other costs essential to gain inventory possession can be considered as COGS.
For producers of cannabis there is more opportunity to claim items as COGS. The sale of the inventory for accrual-basis taxpayers and immediately for cash-basis taxpayers that are cannabis-production businesses can be considered as COGS as well as production-related rents, wages, and repair. Marketing and general business expensive remain nondeductible.
Indirect production costs that may be considered as COGS include:
The IRS has permitted producers to claim additional COGS deductions, as long as the company produces financial statements that are in accordance with Generally Accepted Accounting Principles (GAAP) .
These expenses include:
The provisions of the tax code gives cannabis-related businesses tax break opportunities, however, the IRS doesn’t allow such businesses to take the same dedications as businesses in other industries. Cannabis businesses that have reported tax liabilities of up to 70% of their income have a lesser burden thanks to the repeal of § 280E of the IRC.
Keep in mind, these rules can change at any time. It is important for all Cannabis businesses to establish appropriate record keeping in order to meet IRS Requirements.