Federal, State, Local and
International Taxes -
In Chief Counsel Advice (CCA), IRS has: 1) concluded that persons that traffic
in Schedule I and Schedule II controlled substances (e.g., marijuana) can
currently deduct cost of goods sold (COGS) but must determine COGS by using
rules that existed before the enactment of Code Sec. 263A to determine
inventoriable costs; and 2) drawn conclusions on the proper way for IRS to
treat drug traffickers that deduct otherwise inventoriable costs from gross
income.
Background. Congress has
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). Marijuana is a
Schedule I controlled substance.
Though any marijuana
business is illegal under federal law, it remains obligated to pay federal
income tax on its taxable income because Code Sec. 61(a) does not differentiate
between income derived from legal sources and income derived from illegal
sources. Code Sec. 61(a)(3) provides that gross income includes net gains
derived from dealings in property. Gains derived from dealings in property
means gross receipts less COGS; COGS is the term given to the adjusted basis of
merchandise sold during the tax year. (Reg. § 1.61-3(a))
However, under Code Sec.
280E, a taxpayer may not deduct any amount for a trade or business where the
trade or business (or the activities which comprise the trade or business)
consists of trafficking in Schedule I or Schedule II controlled substances.
On the other hand, the
Senate Report that accompanied the '82 legislation that enacted Code Sec. 280E
provided that “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 Rept No. 97-494) The Supreme
Court has held that the Sixteenth Amendment, which authorized the income tax,
precludes taxing the return of capital. (Doyle v. Mitchell Bros Co, (S Ct 1918)
3 AFTR 2979)
When Code Sec. 280E was
enacted, taxpayers using an inventory method were subject to the
inventory-costing regs under Code Sec. 471. Specifically, resellers were
subject to Reg. § 1.471-3(b), and producers were subject to Reg. § 1.471-3(c)
and Reg. § 1.471-11 (“full-absorption regs”).
Four years after
enacting Code Sec. 280E, Congress added the uniform capitalization rules of
Code Sec. 263A to the Code. Under Code Sec. 263A(a), resellers and producers of
merchandise are required to treat as inventoriable costs the direct costs of
property purchased or produced, respectively, and a proper share of those
indirect costs that are allocable to that property. Flush language at the end
of Code Sec. 263A(a)(2) provides, “Any cost which (but for this subsection)
could not be taken into account in computing taxable income for any tax year
shall not be treated as a cost described in this paragraph.”
“Additional Code Sec.
263A costs” are the costs, other than interest, that were not capitalized under
the taxpayer's method of accounting immediately prior to the effective date of
Code Sec. 263A, but that are required to be capitalized under Code Sec. 263A.
(Reg. § 1.263A-1(d)(3))
In general, taxpayers
are required to use an inventory method. Those taxpayers will capitalize
inventoriable costs when incurred and will remove these costs from inventory
when units of merchandise are sold. Stated differently, the taxpayer will
compute COGS as an adjustment to gross receipts. On the other hand, when not
required to use an inventory method, a taxpayer might be permitted to use the
cash method. Under the modified cash method as described in Rev Proc 2001-10,
2001-1 CB 272 and Rev Proc 2002-28, 2002-1 CB 815, certain small businesses,
e.g., resellers, don't have to use an inventory method; when a unit of
merchandise is sold, the reseller will account for that cost as a deduction
from gross income in the tax year that the unit is sold or the payment is
received, whichever is later. Similarly, a cash-method farmer will deduct production
expenses from gross income in the tax year paid and, thus, will have no basis
in the merchandise that it eventually sells. (Reg. § 1.61-4(a))
Code Sec. 446(b)
provides that if no method of accounting has been regularly used by the
taxpayer, or if the method used does not clearly reflect income, the
computation of taxable income must be made under such method as, in the opinion
of IRS, does clearly reflect income.
Issues. (1) How does a
taxpayer trafficking in a Schedule I or Schedule II controlled substance
determine COGS for the purposes of Code Sec. 280E? (2) How should IRS treat the
deductions of a taxpayer who traffics in a Schedule I or Schedule II controlled
substance and who deducts currently from gross income otherwise inventoriable
costs?
Issue 1—IRS limits costs
includible in inventoriable costs. IRS noted that, when Code Sec. 280E was
enacted in 1982, “inventoriable cost” meant a cost that was capitalized to
inventories under Code Sec. 471 (under regs that existed before the enactment of
Code Sec. 263A). Thus, a marijuana reseller using an inventory method would
have capitalized the invoice price of the marijuana purchased, less trade or
other discounts, plus transportation or other necessary charges incurred in
acquiring possession of the marijuana. Similarly, a marijuana producer using an
inventory method would have capitalized direct material costs (marijuana seeds
or plants), direct labor costs (e.g., planting; cultivating; harvesting;
sorting), Category 1 indirect costs (Reg. § 1.471-11(c)(2)(i)), and possibly
Category 3 indirect costs (Reg. § 1.471-11(c)(2)(iii)).
Code Sec. 263A increased
the types of costs that are inventoriable compared to the rules under Code Sec.
471. As a result, a reseller also is required to capitalize purchasing,
handling, and storage expenses. In addition, both resellers and producers are
required to capitalize a portion of their service costs, such as the costs
associated with their payroll, legal, personnel functions.
Code Sec. 263A is a
timing provision. It does not change the character of any expense from
nondeductible to deductible, or vice versa.
Read together, Code Sec.
280E and the flush language at the end of Code Sec. 263A(a)(2) prevent a
taxpayer trafficking in a Schedule I or Schedule II controlled substance from
obtaining a tax benefit by capitalizing disallowed deductions. Congress did not
repeal or amend Code Sec. 280E when it enacted Code Sec. 263A.
If a taxpayer subject to
Code Sec. 280E were allowed to capitalize additional Code Sec. 263A costs as
defined in Reg. § 1.263A-1(d)(3), Code Sec. 263A would cease being a provision
that affects merely timing and would become a provision that transforms
non-deductible expenses into capitalizable costs. Thus, IRS concluded that a
taxpayer trafficking in a Schedule I or Schedule II controlled substance is
entitled to determine inventoriable costs using the applicable
inventory-costing regs under Code Sec. 471 as they existed when Code Sec. 280E
was enacted.
Issue 2—IRS should allow
similar deductions to cash method traffickers. IRS noted that, in the case of a
cash-method taxpayer, the obligation to pay an income tax on gains derived from
the sale of a controlled substance creates a tension between a) the accepted interpretation
of “income” under the Sixteenth Amendment and b) Code Sec. 280E, which
disallows all deductions of a trade or business trafficking in a Schedule I or
Schedule II controlled substance. Applied literally, Code Sec. 280E severely
penalizes taxpayers that traffic in a Schedule I or Schedule II controlled
substance but don't use an inventory method for the controlled substance. When
Code Sec. 280E is applied in the case of a producer trafficking in a Schedule I
or Schedule II controlled substance, and all deductions from gross income are
disallowed, the producer's taxable income will be significantly higher than
what it would have been if the producer had used a permissible inventory method
and recouped its production costs through COGS.
The CCA then concluded
that, in these circumstances, the cash method does not clearly reflect income
because of the operation of Code Sec. 280E. It said that it has the authority
under Code Sec. 446(b) to require a taxpayer to change from a method of
accounting that does not clearly reflect income to a method that does clearly
reflect income. As a result, if a producer or reseller of a Schedule I or
Schedule II controlled substance is deducting from gross income the types of
costs that would be inventoriable if that taxpayer were properly using an
inventory method under Code Sec. 471, it is an appropriate exercise of
authority for IRS to require that taxpayer to use an inventory method, to use
the applicable inventory-costing regime (as discussed under Issue 1, above),
and to change from the cash method to the accrual method.
However, the CCA said,
if the taxpayer is not required to use an inventory method (for example, small
taxpayers properly using the modified cash method under Rev Proc 2001-10 or Rev
Proc 2002-28 or farmers), it is not an appropriate exercise of authority for
IRS to require that taxpayer to use an inventory method. Instead, IRS should
permit that taxpayer to continue recovering, as a return of capital deductible
from gross income, the same types of costs that are properly recoverable by a
taxpayer both trafficking in a Schedule I or Schedule II controlled substance
and using an inventory method under Code Sec. 471.
References: For the
disallowance of deductions or credits for illegal drug trafficking, see FTC
2d/FIN ¶ L-2632 ; United States Tax Reporter ¶ 280E4
; TaxDesk ¶ 304,815 ; TG ¶
16455.
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