IRS Letter Ruling 201504011, dated December 10, 2014 addresses two issues raised by taxpayers regarding the application of the federal tax laws to the business of “trafficking in a Schedule I or Schedule II controlled substance.”
1. How does a taxpayer trafficking in a Schedule I or Schedule II controlled substance determine cost of goods sold?
2. 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 currently deducts otherwise inventoriable costs from gross income?
The IRS’s conclusions were that 1) traffickers determined their cost of goods sold using the inventory-costing regulations under Section 471 of the Regulations as they existed when Section 280E was enacted, and 2) the IRS has the authority to require specific inventory costing calculations in determining how the traffickers account for their cost of goods (unless the taxpayer is properly using a non-inventory method).
Internal Revenue Code Section 280E, enacted in 1982, states that “no deduction or credit shall be allowed” for any amount paid in carrying on any trade or business consisting of trafficking in Schedule I and II Controlled Substances prohibited by Federal law.
The IRS explains that resolving the inventory costing issue depends on three things: 1) how an item becomes an inventoriable cost, 2) what Congress intended when they enacted Section 280E, and 3) whether Congress changed their definition when they enacted Section 263A.
The IRS explains that under Section 471 (prior to enactment of Section 280A) a marijuana reseller would have capitalized the invoice price of the marijuana purchased, less trade or other discounts, plus transportation or other necessary charges incurred in acquiring possession of the marijuana, and that a marijuana producer would have capitalized direct material costs (marijuana seeds or plants), direct labor costs (e.g., planting, cultivating, harvesting, sorting), “Category 1” indirect costs and possibly “Category 3” indirect costs.
– Mark S Gleason CPA