Court Clarifies Inventory Capitalization Rules for Producers

Published Categorized as Federal Income Tax, Tax, Tax Deductions
Court Clarifies Inventory Capitalization Rules For Producers
Court Clarifies Inventory Capitalization Rules For Producers

There are a few items that are low hanging fruit that make for easy adjustments for IRS auditors.  The adjustment for indirect costs is an example of such an adjustment that can be made for any taxpayer that has inventory.  The recent Patients Mutual Assistance Collective Corporation v. Commissioner, 151 T.C. No. 11 (2018), case provides some needed clarity that can help taxpayers who are facing this type of IRS audit adjustment.

Facts & Procedural History

The taxpayer is a marijuana dispensary. It purchased marijuana edibles and non-marijuana-containing products from third parties that it resold to its customers.

The taxpayer also purchased marijuana bud it sold to its customers. The taxpayer was involved in the marijuana manufacturing process, but it’s involvement was limited. It bought clones from nurseries and either sold them to growers with no strings attached or gave clones to growers expecting that they’d sell bud back to the taxpayer. The taxpayer only purchased the resulting marijuana bud that met its standards, leaving the farmers to sell the other marijuana to others.

The IRS audited the taxpayers return and disallowed the expenses taken on the returns.

The Section 280E Limitation

The dispute focuses on the Section 280E limitation, which prevents marijuana dispensaries from taking most tax deductions. Absent most tax deductions other businesses enjoy, marijuana dispensaries are left with just their cost of goods sold (“COGS”) deduction.

For taxpayers who use an inventory method of accounting, a cost-of-goods-sold allowance is calculated for each year. Cost of goods sold is reflected in gross income as a reduction. The formula for cost of goods sold is essentially as follows: cost of beginning inventory + costs of purchases and production — cost of ending inventory.  Under certain circumstances, the costs in the formula may be calculated not from actual costs but from values of the relevant assets.

Given these rules, the taxpayer wanted and was arguing that expenses were COGS and the IRS was arguing that the costs were not COGS, but deductions that were denied under the Section 280E limitation.

It should be noted that, as explained below, the IRS was put in the position of arguing against the position it normally asserts in other non-Section 280E limitation cases. Thus, the case provides other non-Section 280E limitation taxpayers with a case they can point to in support of their position.

COGS for Retailers vs. Producers

The tax rules say that inventory is to be included in COGS.  It goes on to say that retailers can include “transportation or other necessary charges incurred in acquiring possession of the goods.”

For producers, the tax rules require taxpayers to include even more expenses in COGS.  Producers include direct and indirect costs of creating their inventory, including the cost of raw materials, expenditures for direct labor, and indirect production costs incident to and necessary for the production of the particular article, including a portion of management expenses.

The inventory and UNICAP rules then say that these producer expenses have to be capitalized and deducted over time.  Most taxpayers do not include all of the costs, allowing more immediate deductions.  The IRS frequently audits this issue and includes additional expenses, thereby disallowing the immediate deductions.  IRS revenue agents are armed with a spreadsheet that allows them to analyze and make these allocations.

Who is a Producer Anyway?

The term “producer” is not well defined.  This case helps in that regard.  The court looked to prior case law from the Ninth Circuit Court of Appeals for the answer.  This case law sets out a rule whereby the taxpayer is a producer if it has control over the manufacturing process.

In this case, the court concluded that the taxpayer did not have control over the manufacturing process.  It noted:

[The taxpayer] didn’t create the clones, maintain tight control over them, order specific quantities, prevent sales to third parties, or take possession of everything produced. [The taxpayer] bought clones from nurseries and either sold them to growers with no strings attached or gave clones to growers expecting that they’d sell bud back to [the taxpayer]. Nothing prevented either type of grower from selling to another collective, and [the other party] thought it would be futile to try to use the courts to stop them. [The taxpayer] had complete discretion over whether to purchase what bud growers brought in, paid growers only if it purchased their bud, and at times rejected the “vast majority” of its growers’ bud. And [the taxpayer] thought growers could do whatever they wanted with the rejected bud.

By reaching this conclusion, the court rejected the taxpayer’s attempt to include additional indirect costs in its COGS.  But as noted above, most taxpayers argue for the opposite position.  Thus, the language quoted above provides the argument these other taxpayers will need to make to secure additional immediate deductions.

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