HARBORSIDE’S NEW LAWYERS
Harborside’s New Lawyers has new tax lawyers. Harborside’s new tax lawyers have appealed the DECISION of the United States Tax Court entered October 19, 2019, that determined Harborside has deficiencies in income tax in the total amount of $11,013,236.75 for the years 2007-2012. Harborside has appealed this DECISION to the Ninth Circuit Court of Appeals. Harborside filed its Opening Brief on May 26, 2020. [See Case: 19-73078, 05/26/2020, ID: 11701759, DktEntry: 19-1]
The determination Harborside has an additional $11+M federal income tax liabilities for the years 2007-2012 is based on Judge Mark V. Holmes’ Opinion on the substantive income tax issues filed on November 29, 2018. Patients Mut. Assistance Collective Corp v. Comm’r, 151 T.C. 176 (2018). In a related Opinion filed December 20, 2018, Judge Holmes declined to impose an accuracy-related penalty on Harborside in connection with these income tax deficiencies. Patients Mut. Assistance Collective Corp v. Comm’r, 151 T.C. Memo. 176 (2018).
Law Professor Bryan Camp wrote an outstanding article relating to COGS and Cannabis that Harborside’s new lawyers should have carefully read before they filed this Opening Brief. Professor Camp states,
“In real life . . . inventory accounting, Alterman & Gibson v. CIR,, TC Memo 2018-82. June 1, 2018] a case involving poor representation of a medical marijuana business. Disclaimer: not only do I not teach COGS but I also never practiced it, so if you dive below the fold, you may catch me out in error. I know for some readers that is actually an incentive to read on—kind of like waiting for a crash on the racetrack. But if you find yourself guffawing at something, please do not hesitate to publicize the error in the comments section. And remember, at least I’m not representing anyone!”
HARBORSIDE’S NEW LAWYERS
We wrote several articles relating to Harborside’s dispute with the Internal Revenue Service (“IRS”) for its tax years 2007-2012. [[ We criticized Harborside’s counsel for pursuing an argument that was not likely to succeed while at the same time foregoing the opportunity to maximize the tax savings that the IRS gave to cannabis dispensaries in Chief Counsel Memorandum 201504011. We predicted Judge Holmes first Opinion. [[ We did not anticipate Judge Holmes second Opinion. [[
While we stand behind our criticism of Harborside’s original tax counsel, Harborside has made a grievous error in changing counsel. Harborside’s new tax lawyers lack adequate education and experience in federal tax law and accounting to pursue this appeal. Harborside’s costs for tax counsel have no doubt increased, but the quality of the representation has not. As I read Harborside’s Opening Brief I recalled something my mother told me on a number of occasions when I was in grade school, “Be sure you understand what a word means before you use it.”
Lest anyone think we are being too harsh, we will concede Harborside’s new tax lawyers may actually prevail in this appeal, although success in this appeal seems highly unlikely for multiple reasons. This appeal should not have been taken. It is unnecessary. The Tax Cuts and Jobs Act [“TCJA”] gave most cannabis businesses the precise relief with respect to Cost of Goods Sold (“COGS”) that Harborside is seeking in this appeal. The Act was effective January 1, 2018.
Harborside’s original tax lawyers could have saved Harborside substantial amounts by taking the actions that were available to minimize federal income tax liabilities instead of trying to change the law. Harborside’s new tax lawyers are following the same futile path. We will devote the balance of this article to explaining how the [[ Act can be utilized to avoid this aspect of Harborside’s federal tax problems. In [[ we explained how the impact of IRC §280E could be neutralized.
HARBORSIDE’S NEW LAWYERS
The provisions related to the treatment of “trafficking expenses” and the composition of Cost of Goods Sold have been complex since Congress created IRC Sec. 280E in response to the decision in
In January 2015, the Internal Revenue Service issued an internal memorandum [CCM201504011] that opined on how state-legal cannabis businesses should compute federal income taxes. Drafted by the IRS Chief Counsel, the memo rejects many of the tax deductions that these businesses have traditionally made. The memo challenges tax strategies that allow these businesses to stay afloat, and imposes a strict interpretation of IRC Sec. 280E.
The expenditures which had been traditionally scrutinized under IRC Sec. 280E include:
Utility costs such as electricity, internet, and telephone service
Health insurance premiums
Marketing and advertising costs
Repairs and maintenance
Rental fees for facilities
Routine repair and maintenance
Payments to contractors
The disallowance of IRC Sec. 263A principles by the CCM added
General and administrative costs (bookkeeping, legal expenses, technology costs)
State excise taxes
Storage of cannabis
Depreciation of cannabis
The Tax Court decisions in Harborside has been viewed as creating an entire set of new rules related to accounting for inventories and the calculation of the cost of goods sold [“COGS”] for the cannabis industry. The most significant aspect of the opinion in the Harborside case is that it is a reviewed opinion. As a reviewed opinion, Harborside is binding on all of the judges of the Tax Court unless and until some substantive issue addressed in this opinion is reversed or modified by a higher court. The substantive decisions addressed in the Harborside opinion largely confirmed and clarified earlier, and in many instances memorandum, opinions issued by other Tax Court judges. Judge Mark V. Holmes’ opinion in Harborside is comprehensive, thoughtful, and well-written as is invariably true of opinions written by Judge Holmes.
HARBORSIDE’S NEW LAWYERS
The most significant aspect of the Harborside opinion for California’s cannabis industry lies not in the opinion but in the interplay between this opinion and California’s regulation of its cannabis industry. The Harborside opinion rejected the use of IRC Sec. 263A and approved the use of IRC Sec. 471 in the determination of COGS.
[Lead in to IRC Sec. 471(c)(3)
(c)Exemption for certain small businesses
(1)In general In the case of any taxpayer (other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3)) which meets the gross receipts test of section 448(c) for any taxable year—
- subsection (a) shall not apply with respect to such taxpayer for such taxable year, and
- the taxpayer’s method of accounting for inventory for such taxable year shall not be treated as failing to clearly reflect income if such method either—
(i) treats inventory as non-incidental materials and supplies, or
(ii) conforms to such taxpayer’s method of accounting reflected an applicable financial statement of the taxpayer with respect to such taxable year or, if the taxpayer does not have any applicable financial statement with respect to such taxable year, the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.
(2) Applicable financial statement – For purposes of this subsection, the term “applicable financial statement” has the meaning given the term in section 451(b)(3).
(3) Application of gross receipts test to individuals, etc.
In the case of any taxpayer which is not a corporation or a partnership, the gross receipts test of section 448(c) shall be applied in the same manner as if each trade or business of such taxpayer were a corporation or partnership.
(4) Coordination with section 481
Any change in method of accounting made pursuant to this subsection shall be treated for purposes of section 481 as initiated by the taxpayer and made with the consent of the Secretary.
HARBORSIDE’S NEW LAWYERS
We were amused by the article [Member Blog: IRC Section 471(c) of the TCJA May Mitigate the Curse of 280E for the Cannabis Industry]
which appeared in the CCIA Journal in May 2020 which was authored by a member of the same firm the prepared the CA-9 brief.
 The article continues
Most businesses that sell stuff must comply with the inventory accounting rules in §471. COGS becomes even more important to businesses that get hit with §280E, the section that prohibits deductions and credits for any trade or business activity that “consists of trafficking in controlled substances…which is prohibited by Federal law….” [Note: that is not a grammatical error: it is the prohibition of trafficking that is the trigger, not the prohibition of the substances themselves].
The restrictions in §280E give affected businesses every incentive to cram as much of their business costs into COGS as they can. That is because the idea underlying COGS is that costs of acquiring or producing property that held for sale is not a §162 “expense” (hence deductible from the income the sale of property produces) but is instead part of the computation of gross income when the property is sold.
I am thinking that this idea of COGS is a necessary result from the famous formula in §1001 that says the income produced by the sale of property is the amount realized minus the taxpayer’s basis in the property sold. COGS is the method of allocating basis to the items of property a business sells. If I sell a bottle of car wax for $10, I am selling property. I do not have $10 of gross income minus the expenses of acquiring that bottle. COGS accounting allows me to report as gross income only the net of the $10 over the cost of acquiring the bottle because I have a basis in the bottle (I wonder…had a CPA written the classic song by Police would it have been titled “Basis in A Bottle”?). But if I wax your car for $10, I must report the entire $10 as gross income. I have no basis in my labor. If I can deduct my costs of performing that service from the $10, then perhaps it’s the same result.
COGS reminds me of form over substance. For those interested in more theory, you cannot do better than Joe Dodge’s “The Netting of Costs against Income Receipts (Including Damage Recoveries) Produced by Such Costs, without Barring Congress from Disallowing Such Costs,” 27 Va. Tax Rev. 297 (2007)(advocating a computational netting approach to the treatment of contingent attorneys fees). My takeaway from that article is that there is no principled distinction between netting expenses against gross receipts to arrive at gross income and netting expenses against gross income to arrive at net income. Both methods of accounting are based on the same underlying principle: it takes money to make money and the money used should be deducted from the money made.
Take salaries, for example. Treas. Reg. 1.471-11(b) tells you that some salaries can be accounted for as part of the COGS calculation of gross income while other salaries must be taken as deductions from gross income. Now, for a business that sells stuff, perhaps it does not make much of a tax difference whether a particular employee’s salary is taken as a §162 deduction or goes into COGS. But a business subject to the limitations in §280E really needs to get its COGS numbers right.”
 The inventory costing methods available under IRC Sec. 471 includes
Small businesses which have average gross receipts for trailing three years of less than $25 million
- and are not a tax shelter
- may rely on their book method of determining COGS for tax purposes. Stated differently, qualifying taxpayers do not need to make book-to-tax adjustments for COGS.
HARBORSIDE’S NEW LAWYERS
IRC Sec. 471(a) states
“Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income”.
If an industry adopts best practices of capitalizing the majority of direct and indirect costs into COGS and the use of such a method clearly reflects income, then the IRS cannot adjust the taxpayer’s method of determining COGS solely for the purpose of “clearly reflecting income” based on IRC Sec. 471(a).
The Regulations define “Inventories at Cost” as:
For merchandise on hand at the beginning of the taxable year, the inventory price of such goods [See Reg. 1.471-3(a)
In the case of merchandise purchased since the beginning of the taxable year, the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate. The cost of transportation or other necessary charges incurred in acquiring possession of the goods [See Reg. 1.471-3(b)]
In the case of merchandise produced by the taxpayer since the beginning of the taxable year;
the cost of raw materials and supplies entering into or consumed in connection with the product, expenditures for direct labor, and
indirect production costs incident to and necessary for the production of a particular article, including in indirect production costs an appropriate portion of management expenses, but not including any cost of selling or return on capital, whether by way of interest or profit. See Reg. Sec. 1.263A-1 and 1.263A-2 for specific rules regarding the treatment of production costs [Reg. 1.471-3(c)]
Inventories of a Retailer – A retailer may use the retail inventory method. The retail inventory method uses a formula to convert the retail selling price of ending inventory to an approximation of cost (retail cost method) or an approximation of lower of cost or market (retail LCM method) [Reg. Sec. 1.471-8 – Further, a taxpayer may use the retail inventory method instead of valuing inventory at cost under Reg. Sec. 1.471-3 or lower of cost or market under Reg. Sec.1.471-4.]
Manufacturer’s Inventory – To conform as nearly as possible to the best accounting practices and to clearly reflect income, both direct and indirect production costs must be taken into account in the computation of inventory costs in accordance with the “full absorption” method of inventory costing.
Under the full absorption method of inventory costing production costs must be allocated to goods produced during the taxable year, whether sold during the taxable year or in inventory at the close of the taxable year, determined in accordance with the taxpayer’s method of identifying goods in inventory. Thus, the taxpayer must include as inventoriable costs all direct production costs and all indirect production costs [Reg. Sec. 1.471-11, for the purposes of this section, the term financial reports refer to the GAAP.
A taxpayer should be able to capitalize the cost of goods sold when doing so is consistent with industry practices. Taxpayers in the cannabis industry could justifiably assert that substantial authority existed to sustain the use of IRC Sec. 263A in the calculation of the cost of goods sold prior to the release of Chief Counsel Memorandum 201504011.’
HARBORSIDE’S NEW LAWYERS
This CCM requires:
Taxpayers trafficking in a Schedule I or Schedule II controlled substance to determine the cost of goods sold using the applicable inventory-costing regulations under IRC Sec. 471 as these regulations existed when IRC Sec. 280E was enacted; and
Unless the taxpayer is properly using a non-inventory method to account for the Schedule I or Schedule II controlled substance pursuant to the Code, Regulations, or other published guidance, the IRS may require an adjustment to clearly reflect income.
The ability to use IRC Sec. 263A and assert that the IRC Sec. 6662 “substantial understatement” penalties do not apply ended with the publication of CCM 201504011. The methodology that Harborside utilized for the years 2007-2012 is not acceptable for years after 2014.
The situation becomes particularly grim for California dispensaries beginning after 2017. California’s Bureau of Cannabis Control adopted regulations beginning in 2018 that require Retailers to purchase cannabis
- a financial statement which is certified as being prepared in accordance with generally accepted accounting principles and which is—
(i) a 10–K (or successor form), or annual statement to shareholders, required to be filed by the taxpayer with the United States Securities and Exchange Commission,
(ii)an audited financial statement of the taxpayer which is used for—
(II)reporting to shareholders, partners, or other proprietors, or to beneficiaries, or
(III)any other substantial nontax purpose, but only if there is no statement of the taxpayer described in clause (i), or
(iii) filed by the taxpayer with any other Federal agency for purposes other than Federal tax purposes, but only if there is no statement of the taxpayer described in clause (i) or (ii),
(B)a financial statement which is made on the basis of international financial reporting standards and is filed by the taxpayer with an agency of a foreign government which is equivalent to the United States Securities and Exchange Commission and which has reporting standards not less stringent than the standards required by such Commission, but only if there is no statement of the taxpayer described in subparagraph (A), or
(C) a financial statement filed by the taxpayer with any other regulatory or governmental body specified by the Secretary, but only if there is no statement of the taxpayer described in subparagraph (A) or (B).
 On March 30, 2020, the Treasury Inspector General for Tax Administration issued a report titled “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance.” The 53-page report discussed several different topics, including that the IRS should conduct more audits under Section 280E, and this discussion focuses on Section 471(c).
The report states that certain qualifying cannabis taxpayers, who would otherwise be subject to business expenses being disallowed under Section 280E, could potentially account for their inventory under Section 471(c) using a method that would classify most or all of their expenditures as inventoriable costs and avoid Section 280E’s disallowance of such expenditures. Accordingly, as all the costs would be capitalized into inventory, they would then reduce taxable income as the inventory was sold. In other words, expenditures previously disallowed under Section 280E would be part of the cost of goods sold and allowed as a reduction of gross receipts. There was no public comment from the IRS in the report on the potential that 471(c) may eliminate 280E.
Before continuing to provide our additional comments, it is important to mention the impact of Section 471(c) on Section 280E has not been reviewed by the Courts and the Inspector General also stated that necessary guidance addressing 471(c) is lacking from the IRS. As such, the impact cannot be stated in certain terms.
The curse of Section 280E on the cannabis industry cannot be overstated – some businesses actually end up paying more in tax than they make and Section 280E can turn an economic loss into a taxable gain. This seemingly unconstitutional result has been justified by the courts and IRS under a very old principle of taxation that “deductions are a matter of legislative grace.” New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934) Legislative grace, according to these authorities, means the legislature has the power to deny all deductions if they so choose, and it should be said that the limitation of such grace, under the 16th Amendment to the US Constitution, is that 280E cannot disallow costs of goods sold. With Section 471(c), however, legislative grace appears to be on the side of the cannabis industry because, as discussed below, Congress created Section 471(c) and it appears to allow the inclusion of deductions into the cost of goods sold where they can’t be disallowed under Section 280E.
The Code states that Section 471(c) allows a small taxpayer, one with less than $25 million in revenues, who is not a tax shelter or public company to account for inventory according to their applicable financial statements, or absent applicable financial statements, according to the actual books and records of the taxpayer. For a qualifying business that doesn’t have applicable financial statements, if their books and records include deductions in COGS, then these deductions may not be subject to 280E.