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May 08, 2020

CANNABIS TAX ALERT: Tax Court Decision Upholds 280E and Business Deductions

by Matthew Martin, Tax Director

On May 4th, 2020, the US Tax Court issued an important decision regarding cannabis tax obligations, business tax deductions under 280E, and the calculation of Cost of Goods Sold (COGS) in the case of Richmond Patients Group v. Commissioner. The case went to the Tax Court following Richmond Patients Group’s contesting of an IRS tax return examination that found the dispensary’s returns deficient of $681,679 and $908,855 for the years 2014 and 2015, and liable for accuracy-related penalties of $136,336 and $181,771 for those same years.

At the root of the issue was Richmond Patients Group’s calculation of COGs and application of IRC Sections 471 and 263A. On the tax returns in question, Richmond Patients Group contented that their COGS should be calculated to include indirect costs claiming status as a “producer”. Under 280E, cultivators, manufacturers and other “producers” are afforded the ability to deduct indirect inventory costs when calculating COGS.

In this case, the Tax Court ruled in accordance with the decisions found in the Harborside and Alternative Health Care cases, that packing, trimming, drying and maintain stock do not rise to the level of “producer” for purposes of 471 and 263A.

The Richmond ruling also clarified additional expenses that cannot be considered direct costs for a reseller including inventory obsolescence, shrinkage, packaging, testing and inventory security. Furthermore, the court ruled that charitable contributions are disallowed under Section 280E.

Background of the Richmond Patients Group Case

Richmond Patients Group, located in Richmond, California, is a nonprofit, mutual benefit corporation treated as a C-Corporation for federal tax purposes. According to the case summary, Richmond Patients Group operates a ~3,000 sq. ft. retail location with 50% of the space dedicated to purchasing and processing cannabis products, 25% for the retail floor, and the remaining space used for administrative and storage uses. 90% of the dispensary’s revenue was derived from cannabis sales, with 10% derived from non-cannabis products.

During the tax years in question, the dispensary purchases its cannabis products (60% flower, 20% concentrates, 10% edibles) from members of the dispensary. The selling members were responsible for initial trimming and curing of the flower. Upon receipt, Richmond Patients Group worked with a third-party testing facility to perform testing, and upon passing, the dispensary conducted further trimming, packaging and labeling, and product maintenance.

As a result of the dispensary’s processing activities, they calculated COGS under the uniform capitalization rules of IRC 236A, which allows businesses to capitalize both direct and indirect costs related to goods sold.

The IRS Inspection and Tax Court Decision

In February of 2016, the IRS notified Richmond Patients Group that their 2014 and 2015 federal tax returns were under review. In the ensuing investigation, the IRS determined that Richmond Health Group was a “reseller” rather than a “producer.” In line with other existing IRS precedents and Tax Court decisions, including Health Care Advocates v Commissioner, the dispensary’s processing activities – testing, packaging, labeling, etc. – did not constitute material improvement to the cannabis between the time it was purchased and sold.

In the case report, they note that Richmond Patients Group did not provide clones, seeds, or other live material to the members growing cannabis. Nor was the dispensary in any way obligated to purchase cannabis grown by its members.
The Tax Court decision upheld the initial analysis by the IRS: “holding that the taxpayer was not a producer because it did not grow, create, or improve its marijuana products to the extent required by section 471 or 263A.”

Impact on Cannabis Retailers

As anyone familiar with the cannabis industry knows 280E and other tax obligations are perhaps the biggest obstacle to growth and prosperity. The bad news from the Richmond Patients Group v Commissioner case is that the IRS and US Tax Court are seeing eye-to-eye regarding the interpretation and implementation of 280E and COGS calculations when it comes cannabis retailers and dispensaries. With each definitive ruling on 280E, the IRS etches a deeper divide between “producers” and “resellers” and their subsequent tax regimens. Any gray area, flexibility, or hope that “loopholes” might exist is disappearing.

The only good news for cannabis operators is that previously cloudy interpretation of tax laws is increasingly apparent. A line has been drawn in the sand and the risks of “fudging the details” are clear and present, exemplified by the nearly $2 million Richmond Patients Group owes in back taxes and penalties, not to mention the legal costs of contesting the tax assessment. Until something significant changes in tax law or the IRS Commissioner’s stance on 280E, it is better to be safe than sorry.

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For more insight on maintaining cannabis tax compliance, or to schedule a consultation with MGO’s dedicated Cannabis Tax Practice, contact us here.

Tagged:
cannabis
tax
280E
COGS
deductions