Bonus depreciation is an accelerated business tax deduction that allows businesses to deduct a large percentage of the purchase price of eligible assets upfront. This reduces a company’s income tax, which, in turn, reduces its tax liability.
Now, you may be curious if bonus depreciation is available to state legal cannabis companies. The short answer is no. In this article we dive into the details of a tax court case that will leave you frustrated, but help you better understand why bonus depreciation is a no-go.
In March 2022, the US Tax Court ruled in favor of the IRS, denying two cannabis businesses in Colorado the opportunity to claim bonus depreciation or Section 179 accelerated depreciation for their cost of goods sold (“COGS”).
Under IRC Section 280E, the IRS slaps restrictions on businesses dealing with controlled substances, including cannabis. Essentially, unlike for mainstream businesses, no deductions other than direct and indirect COGS are allowed. And, depreciation is not COGS.
Lord v. Commissioner
The Lord family, proud owners of a cultivation/processing company and a dispensary in Colorado, found themselves in a tight spot. Beyond Broadway, LLC and Artistant Dispensary Center, Inc., both reported on their 2012 personal tax return, were hit with an unpleasant surprise in July 2018. The IRS decided to disallow their depreciation deductions. Ouch.
Several sections of the Internal Revenue Code are used to calculate COGS, including section 471 (direct COGS like the purchase of inventory) and section 263A (indirect COGS like depreciation). The COGS disallowed by 280E are the labor and indirect costs listed under section 263A, which are based on otherwise deductible expenditures.
That means retailers may only use merchandise costs for COGS, and producers such as cultivators and manufacturers may only use direct labor and indirect costs along with materials costs. Previous cases disallowed section 179 and bonus depreciation in COGS for retailers. Lord v. Commissioner extended those disallowances to cultivators and manufacturers.
Another strategy?
Some are promoting that the only way for cannabis companies to beat 280E is by adopting a position available to mainstream small businesses, but aggressive for cannabis companies. According to Section 471(c) of the IRC, a small business with gross revenues under $25 million can calculate COGS based on its own books and records, even if it’s a non-standard accounting method. This means that immediate depreciation methods like Section 179 and bonus depreciation might be fair game.
A word of caution
Treasury Regulation 1.471-1(b)(3) throws a wrench in these works. It clarifies that only accepted accounting methods mentioned in section 446 can be used, effectively blocking Section 179 and bonus depreciation from being included in COGS. And guess what? These regulations are presumed to be correct.
So if you want to take advantage of 471(c) with Section 179 and bonus depreciation, get ready for a lengthy journey of tax audits, appeals, and ultimately, a tax court battle to try to prove those Treasury regulations wrong. Brace yourselves for a process that could drag on for about seven long years. And since the IRS is winning case after case against cannabis companies, that’s a very risky strategy.
Our advice
If you’re thinking about going the 471(c) route in your cannabis business’s tax filings, make sure you have a chat with your CPA as soon as possible. This approach is not for the faint of heart and requires careful consideration with your tax advisor and lawyer to determine if the risk is worth it.
