The Tax Cuts and Jobs Act of 2018 added Sec. 471(c) to the Internal Revenue Code, full text below, in order to simplify accounting for ending inventory for small taxpayers.
According to this new Code section, “Generally, for taxpayers with annual gross receipts of less than $25 million, and who do not have an applicable financial statement, the tax payer may deduct ending inventory as a non-incidental material and supply OR use their books and records prepared with the taxpayer’s accounting produces (“BRAP”). They may also use the cash method of accounting up until this threshold as well under 448(c).”
Remember that in the CHAMPS, Olive, and Harborside cases, the tax court didn’t challenge the fact that the taxpayers can take COGS, but rather how to calculate COGS and which code and treasury regulations apply. Recall that COGS is an adjustment to revenue under Treas Reg. Sec. 1.61-3, see full text below.
§ 1.61-3 Gross income derived from business.
(a)In general. In a manufacturing, merchandising, or mining business, “gross income” means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. Gross income is determined without subtraction of depletion allowances based on a percentage of income to the extent that it exceeds cost depletion which may be required to be included in the amount of inventoriable costs as provided in § 1.471-11 and without subtraction of selling expenses, losses or other items not ordinarily used in computing costs of goods sold or amounts which are of a type for which a deduction would be disallowed under section 162 (c), (f), or (g) in the case of a business expense. The cost of goods sold should be determined in accordance with the method of accounting consistently used by the taxpayer. Thus, for example, an amount cannot be taken into account in the computation of cost of goods sold any earlier than the taxable year in which economic performance occurs with respect to the amount (see § 1.446-1(c)(1)(ii)).
Prior to The cash method of accounting—also known as cash-basis accounting (TCJA) and 471(c), taxpayers of every size needed to account for their ending inventory, which reduces the current year’s COGS. The new 471(c) section now notes that this is not required if certain requirements are met.
471(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—
(A) subsection (a) shall not apply with respect to such taxpayer for such taxable year, and
(B) 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 in 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.
In the case of Harborside, the tax court ruled that inventory will be valued at cost, plus freight in, plus or minus trade discounts (under Treas. Reg. Secs. 1.471-3(a) and 1.471-3(b)). No absorption of any rent, bud tenders, trimmers, in take personnel, etc. were allowed into inventory/COGS is allowed under 1.471-3(b) “Inventories at cost.”
The tax court also dispelled any notion that IRC. Sec. 263A applies to taxpayers subject to 280E due to the flush clause that states “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.”
It should be noted at this time, that the TCJA provisions relating to 471(c) do not go into effect until the 2018 tax year, therefore this change in code would not have benefitted Harborside, nor any other cannabis company prior to the 2018 tax year.
Great, so how would this work?
A taxpayer using 471(c)(1)(B)(i) would claim their inventory costs as “non-incidental materials and supplies”. Non-incidental materials and supplies are a deduction under Treas. Reg. Sec. 1.162-3, and therefore would be disallowed as a deduction if subject to 280E. Something we want to avoid at all costs.
So let’s take a look at 471(c)(1)(B)(ii).
There now seems to be a lot of leeway given to the taxpayer. The only items explicitly non-includible in COGS are “selling expenses, losses or other items not ordinarily used in computing costs of goods sold or amounts which are of a type for which a deduction would be disallowed under section 162 (c), (f), or (g) in the case of a business expense.”
It seems that a cannabis dispensary could make a very strong case to run a portion of rent, payroll, utilities, security, and other overhead items through cost of goods sold under their books, records and procedures as long as they qualify for 471(c), which the vast majority will qualify under.
This provides the taxpayer a tool to manage their taxable income, as the taxpayer can make it part of their procedure NOT to carry an inventory balance at year end and run purchases through COGS as they occur. The taxpayer could reduce their taxable income by purchasing inventory in December to be sold the following year.
Taxpayers may make an automatic accounting method change by filing a Form 3115 by the extended due date of their 2018 tax returns. One could make the argument to retroactively apply the BRAP to costs incurred in 2017 and run through COGS via 2018 beginning inventory. See full rev proc here: https://www.irs.gov/pub/irs-drop/rp-18-40.pdf
To summarize, a taxpayer with annual gross receipts less than $25 million can use it’s own consistently applied books, records and accounting procedures to calculate COGS; as long as COGS doesn’t include selling expenses, losses or other items not ordinarily used in computing cost of goods sold.
The term “ordinarily” is up for debate, but if the taxpayer uses a consistent and prudent method of allocating the costs, it should be respected under 471(c). This could be a point of further clarification from the IRS, though we have spoken live to Counsel at the Service about this and they have noted that guidance does not appear to be forthcoming any time soon.
Additionally, if there were to be Federal legalization in the future, taxpayers who have already switched to using 471(c) would have to file for another change in accounting method (if allowed). It is important to think over all related issues as it is ultimately the decision of management to take a tax position.