Pennsylvania recently joined the growing list of states where medical cannabis has been legalized. Pennsylvania is planning on issuing several different licenses, two of which are cannabis growers/processers and cannabis dispensaries. For both types of licenses, the tax effects have yet to be completely understood. At the federal level, marijuana is still considered a controlled substance; therefore, it is illegal in the eyes of the U.S. government. So far the federal government is allowing cannabis businesses to operate in each state where it has been legalized, but licensed medical cannabis businesses must be extremely careful to follow federal tax law. Under Section 61 of the Internal Revenue Code (IRC), gross income includes all income, no matter the source derived (including illegal sources), and is taxable at the federal level. As such, businesses that are operating in the cannabis industry in Pennsylvania must consider the tax ramifications.
On Jan. 23, 2015, the IRS released Office of the Chief Counsel Memorandum Number 201504011 that addresses the capitalization of inventoriable costs for taxpayers trafficking controlled substances. Although this memo holds no precedential value, it can be used to evaluate the position of the IRS on the question of how to maximize inventory costs (i.e., cost of goods sold) for businesses selling cannabis. According to the memo, taxpayers trafficking a controlled substance should determine cost of goods sold using the applicable inventory-costing regulations under Section 471 as they existed when Section 280E was enacted. In 1982, Congress passed Section 280E, which limits deductions for companies trafficking controlled substances to the cost of those substances, while disallowing deductions for items that are not technically illegal, such as rent, salaries, and so on. It also broadened the reach of Section 162(c), which only disallowed bribes and kickbacks. However, the legislative history of Section 280E states that “to preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to cost of goods sold is not affected by this provision of the bill.” Therefore, Section 280E disallowed what are normally considered general and administrative expenses, while allowing deductibility of cost of goods sold.
Complicating matters is Section 263A, which added the uniform capitalization rules to the IRC in 1986. Producers and resellers are required to treat direct costs of property purchased or produced and allocate indirect costs to that property as inventoriable costs. Section 263A increased the types of costs that are inventoriable compared with prior rules. As inventoriable costs, they would be deducted as cost of goods sold upon the sale of the property, therefore delaying the deduction. This is a timing issue. As inventoriable costs, the costs have to flow through the balance sheet in inventory until the sale, at which point the costs are expensed in cost of goods sold. Prior to Section 263, these costs were expensed immediately under general and administrative expenses. Under Section 236A, marijuana growers/processers and dispensaries could argue that service costs – such as payroll, legal fees, and insurance – could be allocated to their products and eventually expensed. However, the language at the end of Section 263A(a)(2) reads, “Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.” It can be argued that this would preclude the deductions that are already limited in Section 280E, and would remain nondeductible under Section 263A. This is the conclusion of the IRS memo. Several tax court cases have also supported this viewpoint.1
Cost of goods sold will differ depending on whether the operation is a grower/processer or a dispensary. According to the memo, a grower/processer using an inventory method would capitalize direct materials, direct labor, and factory overhead costs incurred in creating their product. At the point of sale, the cost would be removed from inventory and expensed as cost of goods sold. A dispensary would be able to include the cost of the invoice of the cannabis, less any trade of discounts, plus transportation and other necessary charges in acquiring the marijuana in the inventoriable costs. General and administrative expenses would be nondeductible for both companies. The chart on this page compares the tax consequences of a medical cannabis business to a similar-sized “legal” business.
As the chart shows, the effective tax rate for a medical cannabis business is significantly more due to the non-deductibility of general and administrative costs. This makes it more difficult to be profitable, and it is a factor that should be examined before investors leap into the medical cannabis business. Likewise, those considering practicing in this area may want to check with their liability insurance carriers and discuss the issue with the State Board of Accountancy before accepting work in this field.
Peyton v. Commissioner, T.C. Memo. 2003-146;
Franklin v. Commissioner, T.C. Memo. 1993-184;
McHan v. Commissioner, T.C. Memo. 2006-84;
Californians Helping to Alleviate Medical Problems Inc. v. Commissioner, 128 T.C. 173 (2007).
Heather M. Demshock, CPA, is an assistant professor of accounting at Lycoming College in Williamsport. She can be reached at email@example.com.