Harborside, a California cannabis dispensary, appealed the tax court’s ruling on tax deficiencies totaling over $ 29 million for the period from 2007 to 2012. Harborside’s tax liability results from the IRS’s refusal to make any deductions under IRC §280E and the disallowance of charges on goods sold reported on Harborside’s tax returns. Internal Revenue Code §280E prohibits tax deductions for companies whose activities involve a federally controlled substance (within the meaning of Annex I and II of the Regulated Substances Act). Unfortunately, cannabis is still and as of the date (the facts in the case) a Schedule I controlled substance.
On appeal, Harborside makes two arguments: (1) whether IRC §280E is in violation of the Sixteenth Amendment to the US Constitution; (2) Whether the IRC §471 provisions exclude certain inventory costs for harborsides (cannabis companies). This article will not address the constitutionality of IRC §280E in relation to the Sixteenth Amendment, but will focus on the Cost of Goods Sold (COGS) and the issuance of IRC §471.
The tax court wrongly found that “processing costs related to inventory are not included in the cost of goods sold by Harborside”.
The IRS did not allow Harborside to include purchase, handling and storage costs for goods purchased for resale (“indirect costs”) – costs such as testing, labeling, curing, storage, trimming, manicuring, servicing and packaging [cannabis], or [cannabis] Products – in the cost of goods sold. Harborside would refuse [cannabis] if it was not properly cured, if it was not properly trimmed, if it had an incurable safety problem like pathogenic mold, or if it did not contain the correct “cannabinoid profile”.
In response to Harborside, the IRS acknowledges in the Respondent’s statement: “If Harborside could demonstrate that Section 471 allowed it to include indirect costs in the cost of goods sold, Section 280E would not prevent that result, as this section would only Harborside claim prohibits deductions. “Section 471 states that” the use of supplies is necessary to uniquely determine income, “and that” on a basis which the secretary may dictate, use the best possible commercial or commercial accounting practice corresponds and the clearest is reflected the income. ”
For more clarity on Section 471, let’s take a look at the guidelines for guidance. Sweetheart. Reg. § 1.471-3 (b) determines in the relevant part:
costs [i.e., inventory cost] Means: For goods that have been purchased since the beginning of the tax year, the invoice price applies minus trade or other discounts, with the exception of discounts, which roughly correspond to a fair interest rate and can be deducted or not at the discretion of the taxpayer, provided that a consistent rate will be followed. To this net bill should be added the price of transportation or any other necessary charges incurred in acquiring possession of the goods. * * * For taxpayers purchasing goods for resale that are subject to the provisions of Section 263A, see Sections 1.263A-1 and 1.263A-3 for additional amounts to be included in the cost of storage.
Harborside’s calling will boil down to when Harborside gains possession of the good.
COGS is the cost of acquiring inventory through purchase or production. See e.g. B. Reading v Commissioner, 70 TC 730, 733 (1978). In support of non-admission of port inventory costs, the IRS states that the costs of testing, labeling, curing, storing, trimming, manicuring, servicing, and packaging products are costs incurred after goods are purchased.
But when does Harborside actually acquire the “goods”? Because we cannot assume that cannabis buds are “good” when they are still attached to the plant, cannot be consumed due to mold, or have not been properly tested to determine their CBD / THC levels. At this point, and before it is properly packaged and labeled, the cannabis bud is a raw material. Thus it could be argued that Harborside did not “acquire” possession of a “good” until the cannabis product is ready for sale and consumption, which is in accordance with state cannabis laws.
Is Harborside a Producer?
Although the argument was not brought up in the appeal, Harborside is more like a producer than a reseller. This would put Harborside under Treasury. Reg. §1.471-3 (c) for the analysis of the cost of goods sold. Manufacturers must include both the direct and indirect costs of compiling their inventory in COGS. See honey. Reg. §1.471-3 (c), 1.471-11. The regulations stipulate that the manufacturers capitalize the “raw material costs”, the “expenses for direct labor” and the “indirect production costs that are incurred and required for the manufacture of the respective article …”. This would allow Harborside to include the cost of COGS in COGS the cannabis plant, the cost of testing, labeling, curing, storage, etc. However, the problem that Harborside encounters as a producer of this regulation is the idea of control. The IRS places great emphasis on whether a taxpayer has any stake in the raw materials or products throughout the process.
In Suzy’s Zoo® v. Commissioner, 273 F.3d 875 (9th Cir. 2001), the IRS stated: “[t]The only requirement to be a “producer” is that the taxpayer “is considered the owner of the property produced”. A taxpayer can also be a “producer” even if he uses contract manufacturers for the actual production. Although Harborside only buys cannabis from its members who meet quality control standards, Harborside still has no ownership interest in the cannabis plant / products from cultivation to packaging, so the control requirements for Treas are not met. Reg. §1.471-3 (c).
The Internal Revenue Service is consistent with the treatment of cannabis companies and the question of whether they are classified as “producers” under Sec. 1.471-3 (c). In the Richmond Patients Group v Commissioner case, TC Memo 2020-52, the taxpayer attempted to argue it was a producer, but to no avail. The Court concluded that the taxpayer lacked the property interest as a producer, and even analogized the taxpayer’s facts with Harborside, in which it stated:[n]o Improvements have been made [cannabis] from the time of purchase to the time of sale. “
Although the appeals court has not yet issued an opinion on Harborside, they will most likely uphold the lower court. The gap between cannabis and the IRS goes beyond §280E and we’re now more concerned with a §471 issue. There’s a lot to learn and to gain at Harborside. Most importantly, how to qualify as a “Producer” for the IRC §471 regulations. If Harborside had entered into exclusive rights agreements with the producers (members) to sell only to Harborside, ownership interests might have been established that are significant enough to meet the requirements of Section 471. In some states, however, exclusivity agreements are prohibited. Or if Harborside had retained the ownership rights to the clones or seeds given to members to grow, Harborside would have an even better argument for being a producer. Again, some states do not allow retailers to have that much control over a producer (bound house laws). There are even more scenarios that other cannabis business models could implement to avoid the port situation and include direct and indirect costs in their COGS as a producer. Last but not least, Harborside has acted as a roadmap for the changing sands and the ever-changing landscape of the interplay between cannabis and tax law, as it has done for over a decade.