471(c) & 280E
Most business owners in the cannabis industry know of 280E and have at least a basic understanding of what it is. If 280E is still a mystery, one only needs to “Google it” to find information about it and its potential impact on a business’s tax liability. What isn’t commonly available is information on how to address it.
Years ago, as states started to legalize cannabis, the accounting industry went to work attempting to figure out what the cannabis industry would do about 280E because it made doing business in the cannabis industry painful, if not impossible. Most poignantly, dispensaries, especially those with a low gross profit whose overhead expenses were proportionately much higher than those with large gross profits whose overhead represented a smaller portion of their overall cost. Low gross profiting dispensaries would regularly experience effective tax rates in the 80 and 90 percentiles. This could quickly mire a business owner in tax debt within a year of starting their business. This scenario is still the story for most dispensary owners. Unfortunately, most accounting professionals are still unaware of these consequences, and new business owners often fall victim to uninformed decision-making by their accountants.
Well before the Tax Cuts and Jobs Act, accountants specializing in the cannabis industry quickly discovered IRC section 471. They developed a methodology allowing them to, at least in part, deduct overhead expenses that would otherwise be disallowed. Accountants would encourage their dispensary clients to incorporate manufacturing activities within their businesses, including weighing, packaging, and value-added processing, to tie their facility and payroll expenses to their inventory so that at least a proportion of their otherwise disallowed costs could be capitalized to inventory and deducted. Over the years, even in audits, IRS agents allowed reasonable use of this methodology. However, these companies continued to pay absorbent effective tax rates because the business could still not deduct most of their expenses.
In 2018, the Tax Cuts and Jobs Act was passed, and 471(c) superseded 471(a). 471(c) was Congress’s attempt to simplify the inventory requirements for small businesses, and simplify it, it did. For companies with a gross income of 25 million dollars (currently 26 million) or less, it allows management to choose whether it wants to track and report inventory. 471(c) further states that a company can calculate its inventory based on its “books and records.” Therefore, any business with a gross income under 25 million dollars can calculate inventory however it sees fit, including capitalizing overhead. For example, if a business wants to include 100% of its payroll and facility costs in its inventory calculation, it could do that if it is based on the company’s books and records.
When tax attorneys and accountants discovered the loophole, we high-fived and chest-bumped one another. Between 2019 and 2020, those paying attention had a free-for-all using 471(c) to deduct our clients’ expenses. For businesses operating in the cannabis industry, especially for dispensaries, 471(c) significantly reduces the impact of 280E. Unfortunately, some accountants were too enthusiastic and started making videos and blog posts stating, “280E is dead.” Then the “powers that be” started paying attention. The entity that oversees the IRS, the Treasury Inspector General for Tax Administration (TIGTA), got word that the cannabis industry was using 471(c) to avoid paying taxes. It pressured the IRS to do something about it. As a result, in January of 2021, the IRS passed regulations that “…nothing in section 471(c) permits the deduction or recovery of any cost that a taxpayer is otherwise precluded from deducting or recovering under any other provision in the Code or Regulations.” This translates to if you are subject to 280E, you can’t use 471(c) to avoid paying taxes.
Early on, attorneys and accountants in the cannabis industry explored another code section called 263A. This code section explicitly states that if a taxpayer is disallowed deductions under another code section, they are not allowed to use 263A to capitalize overhead expenses to inventory. Therefore, 263A is not used by the cannabis industry. The critical difference here is that the flush language of 263A was appended to the code, while the IRS wrote 471(c) language into regulation. Regulations are a form of guidance issued by the IRS meant to interpret and give directions on complying with the tax law. The IRS has the authority to issue regulations; however, they are essentially an opinion of the IRS. Fortunately, for businesses subject to 280E, the IRS does not write the tax code; Congress does. Therefore, many professionals in the cannabis industry believe the IRS may have overstepped.
Please note that the fastest way to ruin 471(c) for your clients and everyone else is by attempting to write off all overhead expenses, thereby avoiding the impact of 280E entirely. We do not recommend kicking the hornet’s nest. Instead, we recommend developing a narrative that justifies why you are capitalizing overhead expenses to inventory other than to avoid 280E.
So we will leave it up to you and your accountant to decide how conservative or aggressive you want to be with your deductions. According to 471(c), your cost of goods sold can include otherwise disallowed deductions if they reflect your books and records. One thing is for sure, doing nothing to mitigate 280E is a mistake and very costly. If your accountant is unwilling to take an approach, they are far more likely to end up miring you in tax debt before the IRS does. So rather than fearing the IRS, it would be best if you considered the accountant you are using.