By: Rachel K. Gillette & James B. Mann , Partners
The Tax Cuts and Jobs Act enacted in December 2017 included a section entitled Small Business Accounting Method Reform and Simplification.[1] This was a series of provisions that increased the number of small business taxpayers that would no longer be required to use the accrual method of accounting and also would be able to break free from the complex inventory accounting provisions in Sections 471 and 263A of the Internal Revenue Code.
New Section 471(c) is of particular interest to taxpayers that are subject to the draconian deduction disallowance provisions of Section 280E for cannabis-touching enterprises. These new 471(c) rules apply to all tax years after 2017.
New Section 448(c)(1) defines a qualifying taxpayer as a corporation or partnership for a taxable year “if the average annual gross receipts of such entity for the 3-taxable-year period ending with the taxable year which precedes such taxable year does not exceed $25,000,000.” There’s also a subsequent cost-of-living adjustment, aggregation rules for businesses that would be treated as a single employer under other provisions of the Internal Revenue Code, and similar (albeit less clear) provisions for non-corporate, non-partnership taxpayers.[2]
Section 471(c)(1) provides that “[i]n the case of any taxpayer…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 such 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 tosuch taxpayer’s method of accounting reflecting 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 taxableyear, the books and records of the taxpayer prepared in accordance with the taxpayer’s accounting procedures.”
This language is strikingly broad and worth examining in a little more detail. To begin with, Section 471(c)(1)(A) states that Section 471(a) shall not apply to any qualifying taxpayer. That’s significant because it’s the general rule of Section471(a) that gives the IRS sweeping power over inventory accounting methods: [i]nventories 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.” A Supreme Court case, Thor Power, holds that the IRS has broad discretion under Sections 446 and 471 to force a taxpayer to adopt a different method of accounting. However, if Section 471(c)(1)(A) applies, the IRS can’t cite Thor Power and force the taxpayer to adopt whatever non-taxpayer friendly inventory accounting method suits its purpose in that particular audit.[3]
Section 471(c)(1)(B) goes even further, depriving the IRS of its power under Section 446 to force a taxpayer to change its method of accounting to more clearly reflect income. Section 471 applies to inventory accounting methods while Section 446 is the broader requirement that all accounting methods must clearly reflect income.
A small business taxpayer can fall under the powerful protection of Section 471(c)(1)(B) one of two ways, by either treating inventory as non-incidental materials and supplies or having its accounting method conform to its applicable financial statements or, in the absence of applicable financial statements, its own books and records. For taxpayers subject to Section 280E, treating inventory as non-incidental materials and supplies is a disaster since it may well mean those expenses would be treated as current deductions and thus disallowed under Section 280E.[4]
All of which leads us to Section 471(c)(1)(B)(ii) – if a small business taxpayer’s method of accounting is reflected in its applicable financial statements, the IRS can’t force the taxpayer to change its method of accounting.[5] The implications are quite significant for cannabis taxpayers – if a taxpayer subject to Section 280E adopts a method of accounting that allocates indirect as well as direct expenses to the cost of goods sold, those expenses will reduce taxable income and there’s nothing the IRS can do about it. For example, if a taxpayer’s financial statements allocate indirect costs to the cost of goods sold, the types of costs that would have been allocable under Section 263A, that’s an acceptable accounting method for tax purposes.
If a taxpayer does not have applicable financial statements, then there is even greater latitude. As long as the taxpayer’s books and records are consistent, then whatever method being used is acceptable. Privately-held cannabis companies should take full advantage of this opportunity.
Furthermore, Section 471(c)(4) of the statute explicitly provides that a taxpayer that is changing its method of accounting to take advantage of Section 471(c) gets automatic IRS consent to the change in method.[6] This provides the opportunity for all affected taxpayers to review their accounting methods to determine the most advantageous method of calculating cost of goods sold.
The American Institute of CPAs (AICPA) submitted comments on the new small business accounting rules, and urged the IRS to “direct examiners to suspend current examination activity for taxpayers with average annual gross receipts of $25 million or less” for issues involving capitalizing costs and methods of accounting for inventory and suggests that“prior year audit protection” is necessary for issues where the taxpayers will file a Form 3115 changing accounting methods for 2018 and later.[7]
The impact of new Section 471(c) on qualifying cannabis taxpayers is immense. For example, the IRS Office of Chief Counsel Memorandum 201504011 is the principal expression of IRS thinking about Section 280E. Issue 2 in that memorandum is: “May Examination or Appeals require a taxpayer trafficking in a Schedule I or Schedule II controlled substance to change to an inventory method for that controlled substance when the taxpayer deducts otherwise inventoriable costs from gross income?” The memorandum concludes that the IRS has that power, citing Sections446, 471 and Thor Power. However, if a taxpayer qualifies under new Section 471(c), the answer to that question is NO.
The conclusion is obvious – all small business taxpayers that are subject to Section 280E should review their accounting methods and consider filing for changes in accounting method.
To discuss your cannabis business’s options regarding this rule, please contact Rachel K. Gillette at rachel.gillette@gmlaw.com or James B. Mann at james.mann@gmlaw.com.
[1] Pub L No 115-97, Section 13102, 115th Cong, 1st Sess (2017).
