OVERVIEW OF TIGTA REPORT DATED MARCH 30, 2020
The Treasury Inspector General for Tax Administration (“TIGTA”) was established in the 1980’s to provide independent oversight of the Internal Revenue Service’s (“IRS”) activities. On March 30, 2020, TIGTA released a report titled “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance” in response to an audit that was initiated to evaluate the IRS’ examination and education approach to certain cash-based industries with an emphasis on legal marijuana operations.
Through statistical random sampling of 2016 tax year filed returns, TIGTA found marijuana businesses in California, Oregon, and Washington (“the population”) likely had the following issues and projected unassessed Federal income taxes over the tested population:
|Tax Issue||Projection||5-Year Forecast|
|IRC 280E adjustments||$48.5 million||$242.6 million|
|Failed to comply with IRC 280E||$95 million||$475.1 million|
|Failed to report all gross income *||$3.9 million*||$19.3 million*|
*The population for this finding was limited to Washington State
With the amount of projected unpaid federal income taxes on the table, this means that taxpayers and tax practitioners can expect to see an increase in cannabis related tax audits in the coming months ahead.
TIGTA also stated that the IRS lacks guidance to taxpayers and tax professionals in the marijuana industry, which impairs the ability to file tax returns with the correct application of IRC 280E and 471(c).
As a result of the audit findings, TIGTA recommended the following six items for the Commissioner of Internal Revenue Small Business/Self-Employed (“SB/SE”) Division to do:
- Develop a comprehensive compliance approach, i.e., national Compliance Initiative Project (“CIP”), for the marijuana industry and leverage State marijuana business lists to identify noncompliant taxpayers;
- Direct all examination areas to use Aging Reason Codes to track non-CIP marijuana business examination results;
- Develop guidance specific to the marijuana industry, such as Frequently Asked Questions (“FAQs”), and document and publicize it on its IRS.gov website to improve awareness of the tax filing requirements for taxpayers in this industry, such as the application of IRC 280E;
- Develop and distribute, internally and externally, specific guidance on the application of IRC 471(c) in conjunction with IRC 280E for taxpayers that report Schedule I related activities on Federal tax returns;
- Leverage publicly available State tax information and expand use of Federal/State agreements to identify nonfilers and unreported income in the marijuana industry; and
- Increase educational outreach towards unbanked taxpayers making cash deposits regarding the unbanked relief policies available.
IRS COMMISSIONER SB/SE RESPONSE
While the IRS agreed with five of the six TIGTA recommendations, the IRS did not agree with the recommendation to develop and provide guidance on IRC 471(c) in conjunction with IRC 280E citing other priorities. The IRS did comment that once the 2019-2020 Priority Guidance Plan is resolved, developing guidance to ensure coordination between IRC 280E and 471(c) will be considered.
INTERPRETING THE LACK OF IRS AGREEMENT OF TIGTA’S RECOMMENDATION
The lack of IRS agreement with the recommendation to develop and provide guidance on IRC 471(c) in conjunction with IRC 280E has created discussion in the cannabis community. Some legal and tax advisors are calling the IRS omission deliberate as they believe the intention of IRC 471(c) was to create a tax loophole for small business cannabis taxpayers without having to change IRC 280E. Other tax practitioners are claiming the IRS omission a safe bet, as the IRS can now target taxpayers who claim the position under 471(c) and select those for audit where the IRS believes they will prevail. But as we have seen time and time again in the tax court system, the lack of IRS guidance for cannabis taxpayers has proven to be detrimental as the interpretation of what constitutes a trade or business (Olive v. Commissioner), the use of a management company (Alternative Health Care Advocates v. Commissioner), and application of IRC 263A (Patients Mutual Assistance Collective Corporation v. Commissioner) have all been disallowed by the courts, setting precedent for what structures, methodologies, and allowable deductions by cannabis companies.
INTERPLAY OF IRC 280E AND 471(c)
While cannabis remains a Schedule I controlled substance, as stated under IRC 280E, deductions or credits shall not be allowed for any amount paid or incurred during the taxable year if such trade or business consists of trafficking in controlled substances. As discussed in many court cases, including Patients Mutual Assistance Collective Corporation v. Commissioner, taxpayers subject to IRC 280E are also subject to the application of IRC 471 for purposes of computing cost of goods sold (“COGS”). COGS are not expenses or deductions, but rather, adjustments to income made in arriving at gross income.
IRC 471(a) outlines when the use of inventories is necessary to clearly determine the income of any taxpayer, and that inventories shall be accounted for on the basis as the Secretary of the Treasury may prescribe. The regulations under IRC 471 provide additional guidance on how to account for inventories depending on whether the taxpayer is considered a reseller or a producer.
The Tax Cuts and Jobs Act (“TCJA”) contained a new provision, IRC 471(c), which is applicable to taxable years after December 31, 2017, and allow small businesses with less than $25 million in average annual gross receipts to reduce the burden for tracking inventory under IRC 471. Businesses qualifying under IRC 471(c) would not be subject to the general rule for determining inventory, but instead, may elect to use internal financial statements or accounting procedures to account for costs in lieu of applying inventory accounting as outlined by IRC 471(a).
As TIGTA states, “under this new provision, marijuana businesses could argue they are entitled to use a method of accounting that includes all expenses in cost of goods sold to potentially avoid the impact of IRC 280E. According to IRS Chief Counsel, at least two practitioners have identified this issue and have questioned IRS personnel on how the IRS plans to handle IRC 471(c) as applied to the marijuana industry taxpayers.”
ANALYSIS OF IRC 471(c) IN CONJUNCTION WITH IRC 280E
If you are considering implementing the position that IRC 471(c) applies to your cannabis business:
- First determine if you qualify. IRC 471(c) applies to taxpayers:
- Other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under IRC 448(a)(3). Many people think tax shelters involve offshore entities and large corporations, but would be surprised to learn that entities other than C-Corporations (referred to as Syndicates) with more than 35% of the entity’s losses allocated to limited partners are considered a tax shelter.
- Who meet the gross receipts test of IRC 448(c). The $25 million average annual gross receipts are determined year by year and are indexed for inflation (for tax years beginning in 2019 and 2020, the adjusted amount is $26 million). Meaning, if the company had gross receipts for the 2016 to 2018 tax years that averaged $26 million or less, the company would meet the test for the 2019 tax year. However, if gross receipts increased significantly in 2019, the company may no longer qualify under IRC 471(c) in 2020. Care should be given to evaluate forecasted sales and how they may disqualify the company. Furthermore, the average annual gross receipts test should be applied in conjunction with the aggregation rules under IRC 52 and 414. If the company is part of a controlled group, the company will need to further evaluate whether it qualifies under IRC 471(c).
- Whose method of accounting for inventory reflected in applicable financial statements (“AFS”) or books and records of the taxpayer are prepared in accordance with the taxpayer’s accounting procedures. AFS refers to audited or reviewed financial statements, and if you require a financial statement audit or review, you likely need to account for inventory in accordance with GAAP, which would bar you from implementing IRC 471(c).
- Second, you should evaluate your company’s risk tolerance. As TIGTA properly found, there is no guidance currently from the IRS on how IRC 471(c) applies to taxpayer’s subject to IRC 280E. Until guidance is provided by the IRS or taxpayers are taken to court to clarify the application of IRC 471(c) for cannabis taxpayers, pushing additional costs into COGS is a tax position that is subject to interpretation, possible audit and assessment of additional tax liabilities and penalties.
- Third, evaluate the costs to change your method of accounting against potential income tax savings. To properly comply with IRC 471(c), taxpayers should document and continue to annually monitor that they meet the non-tax shelter and average annual gross receipts tests as outlined above. But perhaps even more importantly, the taxpayer will need to adopt and implement an accounting method change within their books and records. How much time will it take for your CFO to determine an appropriate methodology in determining which costs should be treated as COGS versus selling, general, or administrative (“SGA”) costs? Will your accounting department be able to make changes retroactively to the beginning of the tax year and on an ongoing basis on top of other month-end close and other compliance filings? What legal and accounting fees will you incur to support the position of changing your accounting method?
- Fourth, consider non-tax implications of changing your accounting procedures to account for additional costs as inventory. Does this require a restatement for financial statement reporting purposes of prior years? Will lenders question the decrease to gross margin? Are investors willing to invest in a company that does not have more traditional financial metrics and potential underpaid federal income taxes? Does this impact other non-income tax filings and reporting requirements? As the adage goes, don’t let the tax tail wag the investment dog.
- Finally, do not forget that TIGTA’s findings have no legal authority for taking a position. By adopting IRC 471(c) and running additional costs through COGS, your return may be selected for audit and your position challenged. Once challenged, you will need to undergo an IRS audit, which opens all other matters within your returns and other positions taken (how solid are your other tax matters?). If you lose the audit, you can choose to appeal the findings and take your case to tax court. Anyone who has been through an IRS audit, in particularly a cannabis IRS audit, can tell you how long they take and how difficult they can be due to a lack of guidance in tax law (as noted by TIGTA). On top of internal time spent defending the audit, you may also incur significant legal and accounting fees to defend your position. On top of these costs, you may owe back taxes, interest, and penalties for the underpayment of taxes. Now imagine your case going to tax court…
If you have determined you qualify under IRC 471(c) and are comfortable with the risk:
- Document your qualifications under IRC 471(c). Document now, document any time there are any structural changes (adding subsidiaries, creating joint ventures, merging, or acquiring new entities), and document on an annual basis. Once you fail to meet the test outlined under IRC 471(c), you no longer qualify for the exception and are required to account for inventories under IRC 471(a). This may require another change in accounting procedure, change in how your books and records are maintained, and even filing Form 3115, Application for Change in Accounting Method.
- Write and adopt an internal accounting procedure to account for costs as a component of inventory. You will need to determine which costs should be categorized as inventory (should all or just a portion of SGA costs be considered?) and an effective date (retroactive to beginning of tax year for a return yet to be filed or starting next tax year?). Outline a plan and timeline for your accounting team to implement the change in policy.
- File Form 3115, Application for Change in Accounting Method, with an originally filed return on or before the due date. The change should be considered an automatic change where no approval is needed from the IRS.
- Disclose your tax position on Form 8275, Disclosure Statement with your tax return every year you take this position until further guidance is provided by the IRS. The form is filed to avoid portions of the accuracy-related penalty due to disregard of rules or to a substantial understatement of income tax for non-tax shelter items if the return position has a reasonable basis.
- Continue to monitor potential underpaid tax exposure. Generally, the IRS can include returns filed within the last three years in an audit. If a substantial error is identified, the IRS may add additional years, but typically will not go back more than the last six years. If your returns were selected for audit and the position was denied, how much back taxes would you owe? Will you set this money aside each year to ensure an audit would not cause financial hardship? Will you be able to re-create financials under IRC 471(a) for prior years if your IRC 471(c) position is denied?
While there are tax practitioners quick to claim there is a newly discovered tax loophole available to cannabis companies, particular care should be taken when evaluating the IRC 471(c) position and whether there is a reasonable basis for your company to take it. As the taxpayer, you remain responsible for the information reported and filed on your tax returns. While there is hope that IRC 280E will be deemed unconstitutional (Harborside is currently filing an appeal with the U.S. Court of Appeals for the 9th Circuit), prior tax court cases have previously ruled against more aggressive deduction methods for cannabis companies (IRC 263A determined not to apply, collapse of management company structure, denial of separate trade or business). Perhaps a more reasonable position is to maximize costs in accordance with IRC 471(a) and reduce your SGA expenditures by doing an inventory costing methodology review and re-evaluating vendor relationships and fees.
We recommend speaking with your tax advisor and legal counsel before adopting a change.
Dana R. Borys, An Accountancy Corporation is a boutique tax consulting, compliance, and representation firm working with start-up/emerging growth companies in the cannabis industry. Building connections beyond the code.