The IRS issued a set of proposed regulations on July 30, 2020 that addresses several key accounting issues for small businesses. The issues addressed uncertainties under the Tax Cuts and Jobs Act (TCJA) in connection with simplified accounting procedures covered under TCJA for small businesses.

 

A small business is defined as a business with average 3-year annual gross receipts under a certain dollar threshold ($26m as of 2019 and 2020) and this number is adjusted for inflation annually. A qualified small business also cannot be a tax shelter as defined in the Internal Revenue Code (IRC).

 

One of the key issues that these set of proposed regulations addresses (albeit indirectly) is whether a company subject to IRC 280E can apply the provisions of IRC 471(c) and potentially include additional indirect costs as inventoriable costs, which may not have been allowed under the IRC 471 regulations. Based on a plain reading of IRC 471(c), this would appear to be the case as this has been an item of dispute among tax attorneys and tax practitioners alike. However, the IRS has made it clear that companies cannot include items which were otherwise disallowed as a deduction into Cost of Goods Sold (COGS) by way of IRC 471(c).  Specifically, the proposed regulations state:

 

  • The Treasury Department and the IRS are aware that some taxpayers may interpret section 471(c)(1)(B)(ii) as permitting a taxpayer to capitalize a cost to inventory for Federal income tax purposes when that cost is included in the taxpayer’s AFS inventory method irrespective of: (1) whether the amount is deductible or otherwise recoverable for Federal income tax purposes; or (2) when the amount is capitalizable under the taxpayer’s overall method of accounting used for Federal income tax purposes. 

 

  • The Treasury Department and the IRS do not agree with this interpretation because section 471 is a timing provision. Section 471 is in subchapter E of chapter 1, Accounting Periods and Methods of Accounting. It is not in subchapter B of chapter 1, Computation of Taxable Income. A method of accounting determines when an item of income or expense is recognized, not whether it is deductible or recoverable through cost of goods sold or basis.

 

  • Accordingly, the Treasury Department and the IRS view section 471(c)(1)(B)(ii) as an exemption from taking an inventory under section 471(a) for certain taxpayers that meet the Section 448(c) gross receipts test and not as an exemption from the application of Code provisions other than section 471(a). While Congress provided an exemption from the general inventory timing rules of section 471(a), Congress did not exempt these taxpayers from applying other Code provisions that determine the deductibility or recoverability of costs, or the timing of when costs are considered paid or incurred.

 

  • For example, Congress did not modify or alter section 461 regarding when a liability is taken into account, or any of the provisions that disallow a deduction, in whole or in part, such as any disallowance under section 274, to exempt these taxpayers. Accordingly, these proposed regulations require an AFS taxpayer that uses the AFS section 471(c) method to make book-tax adjustments for costs capitalized in its AFS that are not deductible or otherwise recoverable, in whole or in part, for Federal income tax purposes or that are taken into account in a taxable year different than the year capitalized under the AFS as a result of another Code provision.

 

  • Consistent with the rules applicable to AFS taxpayers, proposed §1.471-1(b)(6)(ii) clarifies that a non-AFS taxpayer is not permitted to recover a cost that it otherwise would not be permitted to recover or deduct for Federal income tax purposes solely by reason of it being an inventory cost in the taxpayer’s non-AFS inventory method.

 

The position that the IRS has taken in the proposed regulations are consistent with the widely publicized Harborside vs. Commissioner tax court case. In this case, the IRS challenged Harborside’s use of the application of the UNICAP rules under IRC 263A which mandate certain taxpayers include additional indirect costs into their inventory rather than deducting them in the period incurred (i.e., to show a clear reflection of income by deferring the deduction of these indirect costs into the period in which the inventory is sold).

 

Until another tax court decision says otherwise, companies that are subject to IRC 280E should continue to apply the statute of IRC 471 and the regulations thereunder as clearly outlined in the Harborside case. As the cannabis industry continues to evolve, one thing is certain: The IRS will not back down on challenging deductions for taxpayers subject to IRC 280E.

 

 

Aura Advisors is a boutique tax consulting and compliance firm working with start-ups, emerging growth companies, and affluent individuals. Making it safer for good people and good companies to continue to do good things.