IRC 471(c) Proposed Regulations and the Cannabis Industry
On Thursday July 29, 2020, the Treasury released Proposed Regulations 132766_18 in part to clarify the application of IRC 471(c) and its role in tax cost accounting. The Proposed Regulations state that IRC 471(c) and a taxpayer’s election to treat their tax cost accounting the same as their financial accounting does not turn nondeductible expenses into deductible ones.
This interpretation of IRC 471(c) and its corresponding election had major consequences for the Cannabis Industry. After the passage of IRC 471(c) through the Tax cut and Jobs Act of 2017, Cannabis tax practitioners have slowly been electing this provision for their clients and testing the limits of how much can be included in cost of goods sold to mitigate the IRC 280E expense disallowance. This has been especially helpful to retail stores and distributors, as the IRS takes the position that resellers only get to deduct their direct product costs and are not able to take any indirect costs into account.
The Treasury’s argument is that IRC 471(c) is a timing provision and does not alter the deductibility. However, this is contrary to IRS past guidance and the Tax Courts’ current interpretation of 280E. Starting with Chief Counsel Advice Memo 201504011, the IRS stated they can use IRC 446 to change a Cannabis Business’s method of accounting that “does not clearly reflect income.” The tax court, in a recent decision, agreed with the IRS’s rejection of the taxpayer’s change in accounting method because it did not “clearly reflect income.” IRC 446 is a timing provision that deals with methods of accounting.
IRC 471(c) states a “taxpayer’s method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income” if such method is used in the books and records in accordance with their accounting procedures. This provision should stop the IRS in its tracks from changing a Cannabis Business’s method for determining cost of goods sold if the business follows proper procedures and uses the method consistently. The tax court has upheld the plain reading of a code section unless the interpretation would produce an absurd result. If taxpayers don’t do absurd cost accounting, such as including advertising in cost of goods sold and the cost accounting method is deemed reasonable, it should be upheld for IRS 280E purposes by reason of IRC 471(c).
The Treasury also inserted a provision in the Proposed Regulations, straight from the Harborside court case. In the Harborside court case, the tax court disallowed the use of IRC 263A cost accounting methods because in 1988 Congress amended section 263A(a)(2). The court stated “by renaming COGS what had been deductions, Congress made it possible for traffickers to adjust for expenses that they couldn't previously claim. They have to make those adjustments in the later year when the inventory is sold, but later is better than never. Except that maybe it's still never. In 1988 Congress amended section 263A(a)(2), adding flush language that says: Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.” The Treasury duplicates this IRC 263A(a)(2) provision in the Proposed Regulations by stating “however, an inventory cost does not include a cost for which a deduction would be disallowed, or that is not otherwise recoverable but for paragraph (b)(4) of this section, in whole or in part, under a provision of the Internal Revenue Code.”
In my opinion, this is not within the power of the Treasury to do this, as it took an act of Congress to make IRC 263A not applicable to IRC 280E. The Treasury cannot pass laws, as only Congress can do that.
All in all, the release of these Proposed Regulations marks a very bad day for the Cannabis Industry, and if not stopped, may end one of the most useful tools to come to the industry within 20 years, mitigation of IRC 280E.
 Richmond Patients Group, TC Memo 2020-52
 Roberta Borenstein v. Commissioner, 149 TC 263
Andrew Hay | 07/31/2020