Analysis IRC Sec. 280E

Analysis IRC Sec. 280E

The following is our most recent analysis IRC Sec. 280E. The article is 3,500 words long, the footnotes add another 7,800. This is not for the faint of heart, it is written with a target audience assumed to be CPA’s with an MST and attorneys with an LLM-Tax. You may also be interested in the companion article 280E – Beyond Dispensaries

A Methodology for Cost and Expense Allocations for IRC Sec. 280

Cannabis businesses come in all shapes and sizes.  Each one is a little different.  One could argue each is unique.  All cannabis businesses share one attribute.  Every cannabis business is subject to the potential disallowance under IRC Sec. 280E[1] of otherwise deductible ordinary and necessary business expenses under Internal Revenue Code [“IRC”] Sec. 162(a)[2]. The language in IRC Sec. 280E references the Comprehensive Drug Abuse Prevention and Control Act of 1970 [the “Controlled Substances Act” or “CSA” [3]. Cannabis has been listed as a “Schedule I” drug since IRC Sec. 280E became law. We will revisit the inter-relationship between IRC. Sec. 280E, the status of medical and adult-use cannabis under state law, and the potential consequences of cannabis being reclassified from Schedule I to Schedule II under CSA at a later point.

Introduction

The potential scope of IRC Sec.280E is likely to come as a surprise to many involved in the cannabis industry, just as Congress certainly could never have contemplated that medical and ultimately adult-use of cannabis would have become legal under the laws of individual states[4].

The drafters of the statute could never have contemplated the current situation where cannabis is legal for medical use in the majority of states, for recreational use in an increasing number of states, and remains illegal under Federal law. There was a period of relative calm after the issuance of the Cole Memorandum and the IRS Chief Counsel Memorandum [“CCM”] 201504011. However, Attorney General Jeffrey Sessions rescinded the Cole Memorandum[5] with the release of Dept. of Justice Press Release 18-8  in early 2018.[6].

The cannabis industry has historically been an underground industry.  Many involved in the industry under-reported gross income or did not report at all. With the passage of Proposition 215[7] in 1996 in California, medical cannabis dispensaries began appearing.  The public appearance of such businesses came to the attention of the Internal Revenue Service (“IRS”).

Income from illegal sources is taxable[8].  In the eyes of the IRS, medical cannabis dispensaries were a particularly attractive target.  The Department of Justice could find such dispensaries.  The targets of the Department of Justice, whether or not they were put out of business, were subject to IRC Sec.280E.  Such dispensaries had substantial income tax liabilities as a consequence of IRC Sec.280E even if they broke-even.

As a result of the focus of the IRS on dispensaries, substantially all of the reported income tax cases involve dispensaries.  The cases reported to date are not particularly instructive, however, regarding the proper contours of IRC Sec.280E because of the manner in which most dispensaries have been operated.

Medical cannabis dispensaries are largely cash businesses[9].  Most lack adequate internal accounting controls over cash.  The books and records which are the financial record-keeping systems for the businesses have been historically weak.  Those medical cannabis dispensaries with systems of internal accounting controls and financial record-keeping systems typically have lapses in the enforcement and maintenance of those systems. The IRS provides taxpayers with detailed suggestions for the types of records which they are required to keep[10]. The IRS further describes how records should be maintained[11] and how long the records must be retained[12] This may well change in the near future as there are a couple of United States Tax Court cases pending decision that are likely to provide significant guidance on the application of IRC Sec.280E to cannabis dispensaries.

Finally, the agencies within the State of California with primary responsibility for oversight of the cannabis industry for regulatory compliance, which are the Bureau of Cannabis Control [“BCC”] for Retail [Dispensaries, Offsite Event and Distribution licensees, the California Department of Food and Agriculture’s [“CDFA”] CalCannabis Unit for Cultivation licensees, the California Department of Public Health’s [“CDPH”] Manufactured Cannabis Safety Bureau [“MCSB”] for Manufacturing, Extraction and Testing Laboratories and the California Department of Tax and Fee Administration [“CDTFA”], have issued a significant number of administrative pronouncements, regulations and Special Notices that expand upon the IRS’s requirements for financial records, recordkeeping, document formats, retention requirements and audit guidelines. The creation of a seed to sale “Track and Trace system, known as METRC[13] is particularly onerous and detailed.

The application of Sec.280E to dispensaries is, however, the tip of the iceberg. IRC Sec.280E applies to “any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances…”. The unequivocal language of IRC Sec.280E, however, is equally applicable to cultivators, processors, manufacturers, distributors and cannabis delivery-services.

There may be some limits to the application of IRC Sec.280E to the cannabis industry.  It appears unlikely the IRS will stretch IRC Sec.280E to apply its disallowance to a service business, such as  marketing or representation businesses, or professional services such as attorneys, certified public accountants, that does not actually “touch the cannabis”.  The use of the word “trafficking” suggests that IRC Sec.280E is solely applicable to in-line businesses that are directly involved in the series of activities that move an agricultural material from cultivation to the sale of the material to a consumer. Consider, however, whether a cannabis transportation-only service business is subject to IRC Sec.280E.

MMRSA was followed by clean up legislation and Proposition 64 [“Prop. 64”] was passed California became a state that permitted adult use cannabis. Following Prop. 64,  the California legislature passed the Medical and Adult-Use Cannabis Regulation and Safety Act [“MARUCRSA”]. MAUCRSA was the foundation for multiple agencies to write of regulations for oversight of the cannabis industry in California.

California has moved from a largely unregulated cannabis market to a comprehensively regulated industry in three years. The transition is a work in progress[14]. A myriad of agencies are involved, Numerous questions remain unanswered with details to yet to be addressed. The transition to regulated markets in California is a complex tale which has yet to have its conclusion revealed.

IRC Sec. 280E Interpretation

As is noted above, substantially all litigation involving IRC Sec.280E has involved dispensaries [“Retail Licensees”].  The application of IRC Sec.280E to businesses other than dispensaries is beyond the scope of this brief memorandum.  This memorandum has been written in order to describe a general methodology for the application of IRC Sec.280E to the expenses of a dispensary that will minimize the adverse impact of the provision.  It is worthy of note before moving on from general observations relating to the application of IRC Sec.280E that the application of this statute to a cannabis distributor [“Distribution” licensee] may be far more onerous than to a cannabis dispensary.

The IRS has formally agreed those costs and expenses that are properly included in Cost of Goods Sold[15] (“COGS”) can be utilized to reduce Gross Revenue in the determination of Gross Profit for a cannabis business. The IRS generally seeks to minimize COGS in order to maximize the impact of IRC Sec.280E on a cannabis dispensary.  Of greater significance, the IRS generally takes the position that IRC Sec.280E requires the disallowance of any deduction for costs and expenses incurred by a dispensary that are not properly included in COGS. We believe that the total disallowance of all expenditures which are not included in COGS is a draconian approach that does not comport with the language of IRC Sec. 280E, or the intent of Congress as articulated in the Committee Reports. In those states where the sale of cannabis is legal under state law, this approach is patently absurd.

We believe that such position is unreasonable with respect to costs such as legal advice, tax and accounting advice and executive management, as well as all comparable costs that relate to all aspects of the business as a whole. Further, expenditures such as rent, utilities, payroll and comparable general expenses are properly subject to allocation on a number of bases.

We believe that the argument advanced by the IRS is particularly weak, because the IRS’ position ignores the unusual wording and structure of IRC Sec.280E.  The disallowance language is clear and unequivocal,

“[n]o deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business . . . .”

It is the unusual terminology utilized in the statute to describe the scope and application of the IRC Sec.280E disallowance that creates confusion. The disallowance of a deduction pursuant to IRC Sec.280E applies to amounts paid or incurred “in carrying on” any trade or business that is “trafficking” in a controlled substance.  The phrase “in carrying on” suggests that IRC Sec.280E applies solely to amounts directly connected to the activity of “trafficking.”  The substitution of the word “of” or the phrase “in connection with” for “in carrying on” illustrates this point.  Both the word “of” and the phrase “in connection with” would provide greater support for IRS’s assertion that IRC Sec.280E disallows any deduction for any cost or expense incurred by a dispensary in a taxable year.

The unusual language used to describe the taxpayers subject to IRC Sec.280E provides further support for this narrower application of the disallowance language. The statute describes the taxpayers to which it applies as, “any trade or business if such trade or business . . . consists of trafficking in controlled substances.”  The proper interpretation of this statement is complicated by the parenthetical language which was omitted from the quotation, “or the activities which comprise such trade or business.”  The utilization of both the statement and the parenthetical to describe the taxpayers to which IRC Sec.280E applies indicates the disallowance of costs or expenses pursuant to IRC Sec.280E should be narrowly limited to the amounts directly paid or incurred in “trafficking” in controlled substances by the taxpayer.  The meaning of the word “trafficking” as applied to cannabis for the purpose of applying laws, of course,  includes all of the activities from the cultivation of cannabis to the sale of cannabis to a consumer.

A Defensible IRC Sec.280E Methodology

Historically California cannabis dispensaries have purchased cannabis flower in bulk and prepared the flower for retail sale at the dispensary.  In some instances, dispensaries have also purchased oil in bulk and packaged the oil for retail sale.  More frequently oil is purchased by a dispensary already packaged for retail sale.  California dispensaries generally also sell items other than cannabis and cannabis products.  California cannabis dispensaries, of course, sold only medical cannabis and medical cannabis products until 2018, although the differences between medical and recreational cannabis are irrelevant for the purposes of this memorandum[16].

For the purpose of describing a defensible methodology for allocating costs and expenses of a dispensary to determine the disallowance pursuant to IRC Sec.280E, it will be assumed a storefront dispensary makes all sales on-site and all of the revenue of the dispensary is generated by such sales.  It is also assumed for the purposes of this memorandum 80% of the total sales of merchandise by the dispensary are sales of cannabis and cannabis products and 20% of the sales are of other products not subject to IRC Sec.280E.

Further, it is assumed the dispensary purchases substantially all of its cannabis and cannabis products in bulk and processes and packages the bulk material for retail sale.  It is assumed thirty percent of the total square footage of the dispensary is devoted to the processing, packaging and storage of cannabis material held for retail sale, thirty percent of the square footage is devoted to management, back-office record-keeping and personnel needs.

The dispensary has sales revenue from the sale of cannabis and cannabis products as well as from the sale of non-cannabis products.  Both these classes of products will have associated COGS.  For the purposes of this memorandum, it is assumed the non-cannabis products are purchased by the dispensary and packaged and labeled for retail sale on site.  Based on this assumption, all additions to COGS for costs and expenses incurred by the dispensary for the processing and packaging of products for retail sale will be added to the COGS for the cannabis and cannabis products.

The first allocation of the costs and expenses of the dispensary that must be made is the allocation of costs and expenses between operating expenses and COGS.  As a starting point, it is assumed all of the costs and expenses of the dispensary will be allocated among three functions:

  • costs and expenses associated with the processing and packaging of cannabis and cannabis products for retail sale;
  • costs and expenses associated with the general administration and management of the dispensary; and
  • costs and expenses associated with the retail sale function.

Direct costs and expenses must be first allocated among these three functions as a first step. As a second step the indirect costs must be determined and allocated. As a third step,  costs and expenses allocated to general administration and management must in turn be allocated between the processing and packaging function and the retail sale function.

Some specific costs and expenses will be directly attributable to one of the three functions described in the preceding paragraph.  Other costs and expenses are only indirectly allocable among these three functions.  In some instances, a specific type of cost or expense may be partially attributable to one of the functions as a direct cost and partially allocable among the functions as an indirect cost.  For example, if an item of equipment that utilizes a substantial amount of power in connection with processing and packaging, the cost of power for this equipment could be directly attributed to this function while the balance of the power cost was attributed to the facilities and allocated among the three functions as an indirect cost.

Each item of cost or expense must be separately examined, although the various items will fall into a fairly limited number of categories for the purposes of attribution among the functions.

Each specific item of cost or expense must be classified into categories for the purpose of attributing these costs to the appropriate functions of a business.  Labor costs are useful for illustrating the methodology that should be followed.  Labor costs are a significant portion of the total cost of the operation of a dispensary and a portion of the labor costs generally will be allocable to each of the functions of a business operation.  The compensation of the employees of a dispensary generally can be allocated based on job title and time expended in connection with a particular function.

In the case of a dispensary, the compensation of most of the employees should be easily allocated among the processing and packaging function, the general administration function, and  the retail sale function, based on the activities of employees.  The associated employment costs relating to these employees should be allocated in proportion to the compensation costs in most instances.  There is one category of compensation cost for most dispensaries that must be separately considered.  Most dispensaries will also have a significant compensation cost for security personnel.  In the instance of a California dispensary that has a substantial processing function, a strong argument can be made that the entire cost of compensation for security personnel is allocable to the processing and packaging function.

Each specific item of cost or expense that is financially significant should be examined in a manner similar to the evaluation given to labor costs in the preceding paragraph.  Items of cost and expense that are not specifically allocable to processing and packaging function or to the retail sale function should be allocated to the general administration function.  When each specific item of cost and expense has been allocated to one of the three categories, the total amount of the cost and expense attributed to the general administration function should be allocated between the processing and packaging function and the retail sale function based on the relative proportions of the compensation allocated to the two functions.

The total amount of the direct and indirect costs and expenses are allocated to the processing and packaging function.  The total amount of these costs and expenses will be an addition to COGS.  The total amount of the direct and indirect costs and expenses allocated to the retail sale function must then be allocated between sales of cannabis and cannabis products and sales of other products.  Based on the assumptions described above 80% of the total amount of the direct and indirect costs and expenses will be allocated to the sale of cannabis and cannabis products and not deductible pursuant to IRC Sec.280E.

The methodology described above can be readily applied to the unique facts of the conduct of business by any cannabis dispensary.  This principles that are the foundation for this methodology can also be readily adapted to other cannabis businesses.  Of course, as the material moves up the chain of commerce from the cultivator to dispensary, the acquisition cost for each step will be the starting point for the computation of COGS for the next step in the chain of commerce.

[1]No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”

[2] IRC Sec. 162(a)In general There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including—

  • a reasonable allowance for salaries or other compensationfor personal services actually rendered;
  • traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and
  • rentals or other paymentsrequired to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.

[3] In the Controlled Substances Act, 21 U.S.C. Sec.801–971 (1970), Congress created a regime to curtail the unlawful manufacture, distribution, and abuse of dangerous drugs (“controlled substances”). Congress assigned each controlled substance to one of five lists (Schedule I through Schedule V). See Sec. 812 of the CSA. Schedule I includes: (a) opiates; (b) opium derivatives (e.g., heroin; morphine); and (c) hallucinogenic substances (e.g., LSD; cannabis(a/k/a cannabis); mescaline; peyote).

The CSA’s Schedules are:

  • Schedule I – drugs, substances, or chemicals are defined as drugs with no currently accepted medical use and a high potential for abuse. Some examples of Schedule I drugs are: heroin, lysergic acid diethylamide (LSD), cannabis (cannabis), 3,4-methylenedioxymethamphetamine (ecstasy), methaqualone, and peyote
  • Schedule II – drugs, substances, or chemicals are defined as drugs with a high potential for abuse, with use potentially leading to severe psychological or physical dependence. These drugs are also considered dangerous. Some examples of Schedule II drugs are: combination products with less than 15 milligrams of hydrocodone per dosage unit (Vicodin), cocaine, methamphetamine, methadone, hydromorphone (Dilaudid), meperidine (Demerol), oxycodone (OxyContin), fentanyl, Dexedrine, Adderall, and Ritalin
  • Schedule III – drugs, substances, or chemicals are defined as drugs with a moderate to low potential for physical and psychological dependence. Schedule III drugs abuse potential is less than Schedule I and Schedule II drugs but more than Schedule IV. Some examples of Schedule III drugs are: products containing less than 90 milligrams of codeine per dosage unit (Tylenol with codeine), ketamine, anabolic steroids, testosterone
  • Schedule IV – drugs, substances, or chemicals are defined as drugs with a low potential for abuse and low risk of dependence. Some examples of Schedule IV drugs are: Xanax, Soma, Darvon, Darvocet, Valium, Ativan, Talwin, Ambien, Tramadol
  • Schedule V – drugs, substances, or chemicals are defined as drugs with lower potential for abuse than Schedule IV and consist of preparations containing limited quantities of certain narcotics. Schedule V drugs are generally used for antidiarrheal, antitussive, and analgesic purposes. Some examples of Schedule V drugs are: cough preparations with less than 200 milligrams of codeine or per 100 milliliters (Robitussin AC), Lomotil, Motofen, Lyrica, Parepectolin.

[4] Under Explanation of Provision, the Senate Report reads as follows: All deductions and credits for amounts paid or incurred in the illegal trafficking in drugs listed in the Controlled Substances Act are disallowed. To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill. S. REP. NO. 97-494 (Vol. I), at 309 (1982). The Senate bill was adopted in conference. CONF. REP. NO. 97-760, at 598 (1982), 1982-2 C.B. 661.

[5] In 2013 Deputy Attorney General Jim Cole issued a formal statement of priorities for federal prosecutors operating in states where the drug had been legalized for medical or other adult use. The Cole Memorandum represented a major shift from strict enforcement to a more hands-off approach so long as the cannabis-related activity didn’t threaten other federal priorities, such as preventing the distribution of the drug to minors and cartels.

[6] The release provides:

“The Department of Justice today issued a memo on federal cannabis enforcement policy announcing a return to the rule of law and the rescission of previous guidance documents. Since the passage of the Controlled Substances Act (CSA) in 1970, Congress has generally prohibited the cultivation, distribution, and possession of cannabis.

In the memorandum, Attorney General Jeff Sessions directs all U.S. Attorneys to enforce the laws enacted by Congress and to follow well-established principles when pursuing prosecutions related to cannabis activities. This return to the rule of law is also a return of trust and local control to federal prosecutors who know where and how to deploy Justice Department resources most effectively to reduce violent crime, stem the tide of the drug crisis, and dismantle criminal gangs.

“It is the mission of the Department of Justice to enforce the laws of the United States, and the previous issuance of guidance undermines the rule of law and the ability of our local, state, tribal, and federal law enforcement partners to carry out this mission,” said Attorney General Jeff Sessions. “Therefore, today’s memo on federal cannabis enforcement simply directs all U.S. Attorneys to use previously established prosecutorial principles that provide them all the necessary tools to disrupt criminal organizations, tackle the growing drug crisis, and thwart violent crime across our country.”

[7] California Proposition 215, also known as the Medical Use of Cannabis Initiative or the Compassionate Use Act, was on the November 5, 1996, general election ballot in California as an initiated state statute where it was approved.

The passage of Proposition 215 is considered a significant victory for medical cannabis. It exempts patients and defined caregivers who possess or cultivate cannabis for medical treatment recommended by a physician from criminal laws which otherwise prohibit possession or cultivation of cannabis.

In May 2009, the U.S. Supreme Court declined to hear an appeal of a California state appellate ruling from 2008 that upheld Proposition 215 and concluded that California can decide whether to eliminate its own criminal penalties for medical cannabis regardless of federal law. The appellate ruling came about because of a lawsuit against Proposition 215 filed by San Diego and San Bernardino counties.

These counties objected to Proposition 215 on the grounds that it requires them, in their view, to condone drug use that is illegal under federal law. They also challenged a law that requires counties to issue identification cards to medical cannabis patients, so these patients can identify themselves to law enforcement officials as legally entitled to possess small amounts of cannabis. [ San Francisco Chronicle, “Solano to allow medical cannabis ID cards,” June 24, 2009]

Proposition 215 also led to the lawsuit, People v. Kelly  This case was decided in January 2010 by the California Supreme Court, which ruled that the state of California cannot, through the legislative process, impose a state limit on medical cannabis that is more restrictive than what is allowed under Proposition 215. People v Kelly helps define laws governing the initiative process in California especially as it relates to legislative tampering.

The language that appeared on the ballot stated:

  • Exempts patients and defined caregivers who possess or cultivate cannabis for medical treatment recommended by a physician from criminal laws which otherwise prohibit possession or cultivation of cannabis.
  • Provides physicians who recommend the use of cannabis for medical treatment shall not be punished or denied any right or privilege.
  • Declares that measure not is construed to supersede prohibitions of conduct endangering others or to condone the diversion of cannabis for non-medical purposes.
  • Contains severability clause.

In 2004, the California State Legislature passed the Medical Cannabis Program Act (MMPA). The MMPA was intended to clarify which specific practices with regard to medical cannabis were to be considered lawful in the state. The MMPA:

  • Established a voluntary statewide identification card system;
  • Set limits on the amount of medical cannabis each cardholder could possess;
  • Laid out rules for the cultivation of medical cannabis by collectives and cooperatives.

In 2007, the California Fourth Appellate District ruled against the City of Garden Grove, and in favor of a medical cannabis patient (Felix Kha), saying that “it is not the job of the local police to enforce the federal drug laws.”

The case resulted from the seizure of medical cannabis from Kha by the Garden Grove police force in June 2005.

Kha was pulled over by the Garden Grove Police Department on June 10, 2005, and cited for possession of cannabis, despite Kha showing the officers proper documentation of his status as a medical cannabis patient.

The charge against Kha was subsequently dismissed, with the Superior Court of Orange County issuing an order to Garden Grove that the city must return to Kha 8 grams of medical cannabis that was seized from him by the police. The police, backed by the city of Garden Grove, refused to return Kha’s medicine and the city appealed.

In the 2007 state court decision, the court ruled that the federal Controlled Substance Act of 1970, enacted to combat recreational drug abuse and trafficking, did not intend to regulate the practice of medicine, “a task that falls within the traditional powers of the states.”

Before the California Fourth District Court of Appeal issued its decision, California Attorney General Jerry Brown filed a “friend of the court” brief on behalf of Kha’s right to possess his medicine. The justices noted they were convinced by Brown’s arguments that local agencies are bound by state laws in approaching medical cannabis.

The California Supreme Court denied a case review in March 2008, and Garden Grove then went to the United States Supreme Court, which turned the case down in late November 2008.

Medical cannabis advocates called the decision a huge victory in clarifying law enforcement’s obligation to uphold state law – in this case, Proposition 215.

[8] IRC Sec. Sec.61(a) does not differentiate between income derived from legal sources and income derived from illegal sources. See, e.g., James v. United States, 366 U.S. 213, 218 (1961). Under the Sixteenth Amendment to the United States Constitution (“Sixteenth Amendment”), Congress is authorized to lay and collect taxes on income.

In a series of cases, the United States Supreme Court has held that income in the context of a reseller or producer means gross income, not gross receipts. In other words, Congress may not tax the return of capital. See, e.g., Doyle v Mitchell Bros. Co., 247 U.S. 179, 185 (“As was said in Stratton’s Independence v. Howbert, [citation omitted], ‘Income may be defined as the gain derived from capital, from labor, or from both combined.’”); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934) (“The power to tax income like that of the new corporation is plain and extends to the gross income.

Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.”).

[9] The IRS has specific reporting requirements for business transactions involving over $10,000 in cash. Specifically, you must file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, if you receive more than $10,000 in cash in one transaction or two or more related business transactions. Cash includes U.S. and foreign coin and currency. It also includes certain monetary instruments such as cashier’s and traveler’s checks and money orders. For more information, see IRS Publication 1544, Reporting Cash Payments of Over $10,000 (Received in a Trade or Business).

[10] The IRS provides guidance about the purposes of records, uses of records, and outlines their expectations about the types of records that they expect taxpayers to maintain. We have provided an overview:

  • Monitor the progress of your business. – You need good records to monitor the progress of your business. Records can show whether your business is improving, which items are selling, or what changes you need to make. Good records can increase the likelihood of business success.
  • Prepare your financial statements. You need good records to prepare accurate financial statements. These include income (profit and loss) statements and balance sheets. These statements can help you in dealing with your bank or creditors and help you manage your business. An income statement shows the income and expenses of the business for a given period of time. A balance sheet shows the assets, liabilities, and your equity in the business on a given date. Identify source of receipts. You will receive money or property from many sources. Your records can identify the source of your receipts. You need this information to separate business from nonbusiness receipts and taxable from nontaxable income.
  • Keep track of deductible expenses. You may forget expenses when you prepare your tax return unless you record them when they occur.
  • Prepare your tax returns. You need good records to prepare your tax returns. These records must support the income, expenses, and credits you report. Generally, these are the same records you use to monitor your business and prepare your financial statements.
  • Support items reported on tax returns. You must keep your business records available at all times for inspection by the IRS. If the IRS examines any of your tax returns, you may be asked to explain the items reported. A complete set of records will speed up the examination.
  • Electronic records. All requirements that apply to hard copy books and records also apply to electronic storage systems that maintain tax books and records. When you replace hard copy books and records, you must maintain the electronic storage systems for as long as they are material to the administration of tax law.

An electronic storage system is any system for preparing or keeping your records either by electronic imaging or by transfer to an electronic storage media. The electronic storage system must index, store, preserve, retrieve, and reproduce the electronically stored books and records in a legible format. All electronic storage systems must provide a complete and accurate record of your data that is accessible to the IRS.

Electronic storage systems are also subject to the same controls and retention guidelines as those imposed on your original hard copy books and records. The original hard copy books and records may be destroyed provided that the electronic storage system has been tested to establish that the hard copy books and records are being reproduced in compliance with IRS requirements for an electronic storage system and procedures are established to ensure continued compliance with all applicable rules and regulations. You still have the responsibility of retaining any other books and records that are required to be retained.

The IRS may test your electronic storage system, including the equipment used, indexing methodology, software and retrieval capabilities. This test is not considered an examination and the results must be shared with you. If your electronic storage system meets the requirements mentioned earlier, you will be in compliance. If not, you may be subject to penalties for non-compliance, unless you continue to maintain your original hard copy books and records in a manner that allows you and the IRS to determine your correct tax. For details on electronic storage system requirements, See Revenue Procedure 97-22

  • Specific Records to Keep – Purchases, sales, payroll, and other transactions you have in your business generate supporting documents. Supporting documents include sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks. These documents contain information you need to record in your books. It is important to keep these documents because they support the entries in your books and on your tax return. Keep them in an orderly fashion and in a safe place.
  • Gross Receipts. Gross receipts are the income you receive from your business. You should keep supporting documents that show the amounts and sources of your gross receipts. Documents that show gross receipts include the following. Cash register tapes. Bank deposit slips. Receipt books. Invoices. Credit card charge slips. Forms 1099-MISC.
  • Inventory is any item you buy and resell to customers. If you are a manufacturer or producer, this includes the cost of all raw materials or parts purchased for manufacture into finished products. Your supporting documents should show the amount paid and that the amount was for inventory. Documents reporting the cost of inventory include the following. Canceled checks. Cash register tape receipts. Credit card sales slips. Invoices. These records will help you determine the value of your inventory at the end of the year.
  • Expenses are the costs you incur (other than the cost of inventory) to carry on your business. Your supporting documents should show the amount paid and that the amount was for a business expense. Documents for expenses include the following. Canceled checks. Cash register tapes. Account statements. Credit card sales slip. Invoices. Petty cash slips for small cash payments.

[11] Recording Business Transactions,  A good recordkeeping system includes a summary of your business transactions. (Your business transactions are shown on the supporting documents just discussed.) Business transactions are ordinarily summarized in books called journals and ledgers. You can buy them at your local stationery or office supply store. A journal is a book where you record each business transaction shown on your supporting documents. You may have to keep separate journals for transactions that occur frequently. A ledger is a book that contains the totals from all of your journals. It is organized into different accounts.

Whether you keep journals and ledgers and how you keep them depends on the type of business you are in. For example, a recordkeeping system for a small business might include the following items. Business checkbook. Daily summary of cash receipts. Monthly summary of cash receipts. Check disbursements journal. Depreciation worksheet. Employee compensation record.

[12] You must keep your records as long as they may be needed for the administration of any provision of the Internal Revenue Code. Generally, this means you must keep records that support an item of income or deduction on a return until the period of limitations for that return runs out. The period of limitations is the period of time in which you can amend your return to claim a credit or refund, or the IRS can assess additional tax.

The following table provides a basic summary of record retention requirements:

IF YOUTHEN THE RETENTION PERIOD IS
1. Owe additional tax and situations (2), (3), and (4), below, do not apply3 Years
2. Do not report income that you should report, and it is more than 25% of the gross income shown on the return6 Years
3. File a fraudulent returnNot Limited
4. Do not file a returnNot Limited
5. File a claim for credit or refund after you filed your returnLater of: 3 years or 2 years after tax was paid
6. File a claim for a loss from worthless securities or a bad debt deduction7 Years

 

[13] METRC Regulations

Sec. 8400. Record Retention. – For the purposes of this chapter, the term record includes all records, applications, reports or other supporting documents required by the department.

(a) Each licensee shall keep and maintain the records listed in subsection (d) for at least seven (7) years from the date the document was created.

(b) Records shall be kept in a manner that allows the records to be provided at the licensed premises or delivered to the department, upon request.

(c) All records are subject to review by the department during standard business hours or at any other reasonable time as mutually agreed to by the department and the licensee. For the purposes of this section, standard business hours are deemed to be 8:00 am – 5:00 pm (Pacific Standard Time). Prior notice by the department to review records is not required.

(d) Each licensee shall maintain all of the following records on the licensed premises, including but not limited to:

  • Department issued cultivation license(s);
  • Cultivation plan;
  • All records evidencing compliance with the environmental protection measures pursuant to sections 8304, 8305, 8306 and 8307 of this chapter;
  • All supporting documentation for data or information input into the track-and-trace system;
  • All UIDs assigned to a product in inventory and all unassigned UIDs. UIDs associated with product that has been retired from the track-and-trace system must be retained for six (6) months after the date the tags were retired;
  • Financial records related to the licensed commercial cannabis activity, including but not limited to, bank statements, tax records, sales invoices, and sales receipts;
  • Personnel records, including each employee’s full name, social security, or individual tax payer identification number, date of beginning employment, and date of termination of employment if applicable
  • Records related to employee training for the track-and-track system or other requirements of this chapter. Records shall include, but are not limited to, the date(s) training occurred, description of the training provided, and the names of the employees that received the training;
  • Contracts with other state-licensed cannabis businesses;
  • Permits, licenses, and other local authorizations to conduct the licensee’s commercial cannabis activity;
  • Records associated with composting or disposal of cannabis waste.
  • Documentation associated with loss of access to the track-and-trace system prepared pursuant to section 8402(d) of this chapter.

(e) All required records shall be prepared and retained in accordance with the following conditions:

(1) Records shall be legible; and

(2) Records shall be stored in a secured area where the records are protected from debris, moisture, contamination, hazardous waste, fire, and theft.

Sec. 8401. Sales Invoice or Receipt Requirements. The licensee shall prepare a sales invoice or receipt for every sale, transport, or transfer of cannabis or nonmanufactured cannabis product to another licensee. Sales invoices and receipts may be retained electronically but must be readily accessible for examination by the department, other state licensing authorities, any state or local law enforcement authority, and the California Department of Tax and Fee Administration. Each sales invoice or receipt shall include all the following:

 

  • Name, business address, and department issued license number of the seller;

 

(b) Name, business address, and department issued license number of the purchaser;

 

(c) Date of sale or transfer (month, day and year). The date of any sale or transfer of cannabis and nonmanufactured cannabis products shall be the date of transfer to the licensee receiving it;

 

(d) Invoice or receipt number;

 

(e) Weight or quantity of cannabis and nonmanufactured cannabis products sold;

 

  • For the purposes of this section a licensee must use wet weight or net weight. Wet weight and net weight shall be measured, recorded and reported in U.S. customary units (e.g., ounce or pound); or International System of Units (e.g., kilograms, grams, or milligrams).

 

  • Weighing Devices. A licensee shall follow weighing device requirements pursuant to section 8213 of this chapter.

 

(3) Count. For the purposes of this section, “count” means the numerical count of the individual plants or units.

 

(f) Cost to the purchaser, including any discount applied to the total price, shall be recorded on the invoice.

 

(g) Description for each item including strain or cultivar, and all of the applicable information below:

 

  • Plant;

 

  • Flower;

 

  • Leaf;

 

  • Shake;

 

  • Kief; and

 

(6) Pre-rolls.

 

(h) Signature of the seller, or designated representative of the seller, acknowledging accuracy of the cannabis and nonmanufactured cannabis products being shipped.

 

(i) Signature of the purchaser, or designated representative of the purchaser, acknowledging receipt or rejection of the cannabis or nonmanufactured cannabis products.

 

Sec. 8408. Inventory Audits. The department may perform an audit of the physical inventory and inventory as reported in the track-and-trace system of any licensee at the department’s discretion. Audits of the licensee shall be conducted during standard business hours or at other reasonable times as mutually agreed to by the department and the licensee. For the purposes of this section standard business hours are 8:00am – 5:00pm (Pacific Standard Time). Prior notice of audit is not required.

 

Sec. 8501. Inspections, Investigations and Audits. The department shall conduct inspections, investigations and audits of licensees including, but not limited to, a review of any books, records, accounts, inventory, or onsite operations specific to the license.

 

(a) The department may conduct an inspection, investigation or audit for any of the following purposes:

 

  • To determine accuracy and completeness of the application prior to issuing a license;

 

  • To determine compliance with license requirements including, but not limited to, the cultivation plan;

 

  • To audit or inspect any records outlined in section 8400 of this chapter;

 

  • To respond to a complaint(s) received by the department regarding the licensee;

 

  • To inspect incoming or outgoing shipments of cannabis and nonmanufactured cannabis products; and

 

(6) As deemed necessary by the department.

 

(b) All inspections, investigations and audits of the licensed premises shall be conducted during standard business hours or at other reasonable times as mutually agreed to by the department and the licensee. For the purposes of this section, standard business hours are 8:00am – 5:00pm (Pacific Standard Time). Prior notice of inspection, investigation or audit is not required.

 

(c) No applicant, licensee, its agent or employees shall interfere with, obstruct or impede the department’s inspection, investigation or audit

.

This includes, but is not limited to, the following actions:

 

  • Denying the department access to the licensed premises;

 

  • Providing false or misleading statements;

 

  • Providing false, falsified, fraudulent or misleading documents and records; and

 

(4) Failing to provide records, reports, and other supporting documents.

 

(d) Upon completion of an inspection, investigation or audit, the department shall notify the applicant or licensee of any violation(s) and/or action(s) the department is taking.

 

[14] The Medical Cannabis Regulation and Safety Act [“MMRSA”], which went into effect in 2016, included a multitude of regulatory procedures involving many agencies, but much of the regulation of cannabis growing will now fall under the CDFA on both state and local levels. Regulations will include not only compliance with environmental requirements such as the regional water board cultivation permits, but with regulations concerning pesticide use, testing, sales, distribution, and a host of other standards akin to those faced by commercial agricultural producers around the state.

 

California Governor Jerry Brown signed the MMRSA into law on October 09, 2015, and it became effective on January 01, 2016. The Act, composed of 3 bills (AB 266, AB 243, and SB 643) established a licensing and regulatory framework for the cultivation, manufacture, transportation, storage, distribution, and sale of medical cannabis in the State of California. The MMRSA established the Medical Cannabis Cultivation Program within the California Department of Food and Agriculture [“CDFA”] to license cultivators, establish conditions under which indoor and outdoor cultivation may occur, establish a track and trace program for reporting the movement of medical cannabis items through the distribution chain, and assist other state agencies in protecting the environment and public health.

Subsequently, California voters passed the Adult Use of Cannabis Act (Proposition 64), which also designated responsibilities for oversight of commercial cannabis to multiple state agencies.

  • CDFA was granted the authority to establish a cannabis cultivation licensing process for the state and develop a track-and-trace system to record the movement of cannabis and cannabis products through the state’s supply chain.
  • CDFA created a new division called CalCannabis Cultivation Licensing, which is tasked with overseeing these projects.

On June 27, 2017, California Governor Jerry Brown signed a trailer bill (also known as California Senate Bill 94). This Bill was drafted for the purpose of merging the regulatory scheme of MMRSA with the regulatory provisions of Prop. 64, into one streamlined bill. The laudable purpose was to have one comprehensive state law provide a more unified and efficient regulatory process governing both medicinal and adult-use (recreational) cannabis. 

[15] Cost of Goods Sold [“COGS”] is not a deduction but actually, an adjustment which is taken into account in arriving at gross income. Reg. Sec. 1.61-3(a) provides, “gross income” means “…the total sales, less the cost of goods sold.” Although IRC Sec. 280E disallows any deduction for a cannabis seller’s ordinary and necessary business expenses, the legislative history fails to include the cost of goods sold in this rule. The literature suggests that Constitutional concerns of the Sixteenth Amendment, which taxes ‘incomes’, are the reason for this exclusion.

In the Senate hearings prior to passing IRC Sec. 280E, discussion suggested including the cost of goods sold in the ‘disallowed’ expenses for drug traffickers. However, the feeling that this could create a constitutional issue leading to court challenges (and delays) prevailed, and cost of goods sold remained an available adjustment to drug traffickers.

Although the IRS has not issued regulations related to IRC Sec. 280E, the IRS allows the adjustment for Cost of Goods Sold on the tax returns of businesses engaged in drug trafficking. On November 24, 2010, U.S. Representatives Fortney Pete Stark, Barney Frank, Jared Polis, Linda Sanchez, Raul Grijalva, and Sam Farr wrote to the office of the Chief Counsel of the IRS, asking the service to create guidance for regulations related to deductions for state-licensed cannabis businesses.

The Chief Counsel’s Office replied to the Congressman on December 16, 2010, stating that the IRS is unable to issue regulations for IRC Sec. 280E since neither the CSA nor IRC Sec. 280E makes an exception for medical cannabis. Further, the Chief Counsel places blame on Congress to change either IRC Sec. 280E or the CSA.

Cost Method for Cost of Goods Sold

A business must use an inventory method of accounting whenever “the production, purchase or sale of goods is an income-producing factor. Under an inventory method, costs related to producing, acquiring, storing, and handling goods are not currently deductible. These costs must be included in the costs of inventory and deducted when inventory is sold. In the typical business, tax professionals look to minimize current income by taking deductions during the current period.

IRC Sec. 263A does not magically transform otherwise disallowed costs under IRC Sec. 280E into allowed capitalized costs, although the tax professional should look to maximize the number of expenditures which can be justifiably capitalized. Generally, the current year inventory costs are added to the beginning of the year inventory amount and reduced by the costs of inventory on hand at the end of the year to calculate costs of goods sold for the year.

IRC Sec. 471 and methods required by IRC Sec. 263A provide that marketing, advertising and selling expenses are “not required” to be treated as inventory costs. Under Reg. Sec. 1.471–11, 6(a), taxpayers must include as inventoriable costs all direct (e.g., the cost of inventory and delivery, and the cost of materials and labor for manufactured inventory) and indirect production costs (e.g., rent and utilities related to inventory)

 

 

[16] However, if any of the following changes were to occur at the Federal level such as:

 

  • Reclassification of cannabis by the Drug Enforcement Administration or if Congress were to pass legislation causing cannabis to be transferred from CSA Schedule I to CSA Schedule II or

 

  • Congress were to enact legislation with provisions such that the laws of state which had provided for the legal use of cannabis for medical or adult-use purposes were to be respected by the Federal government.

 

the legal validity of any application of IRC Sec. 280E in such states would be substantially undercut.

Analysis IRC Sec. 280E comprehensive article detailed from r/cacannabisregulation

IRC Sec. 280E