On May 4th, an incredibly important tax court ruling, Richmond Patients Group v. Commissioner, came out that will surely make waves in the cannabis industry.
The ruling made some very clear distinctions for cannabis retailers including the difference between being a producer and reseller as well as how much responsibility you have, even if you hire a professional to prepare your taxes.
Let’s dig in and see what the situation was, the results of the case, and what this could mean for your cannabis business.
Understanding the Facts of the Scenario
Dispensary Operations Details
Richmond Patients Group (Richmond) was a California nonprofit mutual benefit corporation with members, rather than shareholders, that was treated as a C corporation for Federal tax purposes.
Access to the dispensary, for purposes of buying or selling cannabis, was only granted through membership. Membership required a valid physician’s recommendation to use cannabis, a proper form of picture identification from the state of California, and a signed membership agreement form.
In 2010 Richmond obtained a license from the city of Richmond to open a medical marijuana dispensary. So this was a state-legal business.
They had a 3,000 square foot dispensary layout where ~50% of the space was designated for purchasing and processing of cannabis, reception and retail took up 25% of the space and admin offices took up the last 25% of the space.
They had a couple buying managers that were responsible for procuring products including flower, edibles, and concentrates. They would purchase all of their bulk cannabis products from people who were members of their dispensary (which was 90% of their business) and other non-cannabis related items were bought from third-party vendors.
Richmond would get their products tested as per local regulations and if it passed, these member providers got paid and if not, the product was returned to them.
A few important details to note.
First, Richmond purchased bulk cannabis that was already trimmed, dried, and cured, but Richmond did do some ‘finish’ trimming such as removing stems and smaller ‘popcorn’ buds.
Second, Richmond used a portion of the trimmings to create secondary products such as pre-rolled joints and smaller buds.
Third, Richmond also broke down the bulk flower and concentrates into sellable sizes such as eighths and grams. Edibles were purchased in bulk but came in individually prepackaged units ready for immediate resale. Other than testing, edibles did not require further processing.
Richmond also used MJ Freeway POS to track inventory from purchase through processing to final sale and they also used Quickbooks for their accounting, so there were information systems in place to track the business operations.
They even used MJ Freeway to track byproducts, stems/weight loss of flower, packaging loss and weight variances. So to a certain extent, this was a well-organized operation.
Dispensary Tax Filing Details
Richmond filed their Federal tax return for 2009 adopting FIFO cost inventory accounting method which means first in, first out, which is typical for resellers.
On their 2014 tax return, they had gross revenue of nearly $5MM with CoGS of $3.2MM which included damage/shrinkage, depreciation, inventory security, packaging as well as testing costs.
Richmond also claimed business expense deductions totaling $1.6MM for the following: compensation to officers, salaries and wages, repairs and maintenance, rents, taxes and licenses, charitable contributions, depreciation, pension, profit-sharing, etc., plans, employee benefits programs, and other expenses.
In February 2016, the Internal Revenue Service notified Richmond that its 2014 tax filings were under examination.
The IRS agent came out to tour the facility in March that year, but right before that, Richmond filed their Form 1120 (their corporate tax return) which had $6.3MM in gross receipts and almost $6MM in CoGS. They claimed business expense deductions totaling ~$43,000 which included taxes, licenses and charitable contributions. Also in CoGS that year they included $1.4MM in other costs including amortization, damage/shrinkage, depreciation, misc. indirect costs of $1.1MM, security, local fees on gross revenue, packaging, testing fees and labor of $1.4MM
Along with its Form 1120 Richmond submitted Form 3115, Application for Change in Accounting Method, for 2015, which changed its method of accounting from period costs to inventoriable costs, referred to as indirect COGS. On its Form 3115 Richmond reported that it did not have any Federal income tax returns under examination which is an obvious misstatement of the facts.
So what you can see is that they had sizable revenues, put a lot of indirect costs into CoGS, were under examination, and they even decided to change their accounting methodology.
Results of the Richmond Tax Case
So how this shook out, nearly a year later after the initial examination started, in February 2017 the IRS mailed Richmond a response that defined their tax deficiencies and accuracy-related penalties.
The IRS disallowed nearly every business expense in CoGS including rent, compensation of officers, salaries, wages, repairs and maintenance, taxes, licenses, charitable contributions, depreciation, pension and profit-sharing plans, employee benefits, and other expenses.
It’s important to know that 280E is very, very clear, and there is nothing to be misunderstood in this tax code. You can deduct the direct costs of your product, but you can’t just put every business expense that would fall under Section 162(a) which are Trade or business expenses into CoGS (in most cases).
Note that the IRS did allow the cost of the product, packaging, and testing as CoGS, but everything else was disallowed.
It’s important to understand that generally, the determinations made by the IRS in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving those determinations untrue.
This is where having an experienced CPA can help. Someone with experience would have known not to allocate all of these disallowed expenses or at least know that most of them couldn’t be allocated in whole, but potentially in part.
Now one final important nuance to this case was the determination that Richmond was a reseller and not a producer.
Richmond took the position that they were a producer which would allow them access to other tax codes such as 263(a) and 1-471 to capitalize indirect inventory costs.
The IRS said that Richmond was a reseller, not a producer, for purposes of section 1-471.
They took this stance because Richmond:
- Did not own the plants during cultivation,
- Did not own or control the grower-provider, and
- Was under no obligation to purchase what the grower produced which were member providers of their business.
Now, Richmond did provide cannabis clones to its members to grow, but they did not provide the clones for products they bought and they were under no obligation to purchase what its member providers offered for sale.
Instead, they purchased bulk cannabis grown by its members for resale.
These member providers trimmed the flower before Richmond purchased them.
No improvements were made to the cannabis from the time it was purchased to the time it was sold. Richmond inspected, sent out for testing, trimmed, dried and maintained the stock, and packaged and labeled cannabis. These activities are those of a reseller and not a producer.
So all in all, in January 2018, the IRS determined Richmond Patients Group (Richmond) had deficiencies of $681,679 and $908,855 and was liable for accuracy-related penalties pursuant to section 6662(a) of $136,336 and $181,771 for 2014 and 2015 (years in issue).
That’s nearly $2MM in back taxes and penalties, which doesn’t account for all of their legal fees.
What This Means For Cannabis Dispensaries
Know the difference between reseller vs. producer/processor/manufacturer
This ruling has provided a bit more clarity into what the IRS views as a producer and that does not include buying bulk flower and repackaging it.
With other tax court rulings, these light-manufacturing tasks seemed to be generally accepted as production activities which gave your business access to 1-471. Now, that doesn’t seem to be the case.
You must have a reasonable methodology to allocate costs
Even if Richmond were to have been classified as a producer, they made a big mistake on cost allocations.
Many of those indirect costs that Richmond added into Cannabis CoGS were taken at the full cost and had no allocation factors such as being based on square footage or time spent on certain tasks.
For example, maybe they could have allocated a percentage of security to CoGS if they prove that the guards spent a certain amount of time with the inventory. Maybe it may have worked out differently for them.
You must ask permission to change accounting methodology
Truly, what Richmond did was pretty surprising by filing the change in status because to change our accounting method, you need to get permission from the IRS commissioner.
With Richmond, they initially elected to use FIFO which is typical of resellers, not producers.
And when they tried to change their methodology from period costs to inventoriable costs, it didn’t fit their business because they were determined to be resellers. Also, they lied on the form that none of their returns were under examination so that probably didn’t help either.
As early as you can in your business, hopefully from day one, you need to get thoughtful guidance from your CPA on what your accounting methodology should be because, as you can see here, it can have incredible long-term effects on your business’ ability to allocate certain costs.
Hiring a CPA doesn’t absolve you of responsibility
Richmond tried to say that they acted reasonably and in good faith because there was a lack of guidance regarding section 280E, which is not true. Richmond made some questionable accounting and then tried to pin the blame back on their CPA.
When the IRS hears this, they establish the standing of good faith by the TAXPAYER proving three factors including:
- The adviser was a competent professional who had sufficient expertise to justify reliance,
- The taxpayer provided necessary and accurate information to the adviser, and
- The taxpayer actually relied in good faith on the adviser’s judgment.
The record of the case show that Richmond provided its accountant with financial statements to prepare its tax returns. Richmond provided no evidence that it relied on its accountant for advice regarding sections 280E, 471, and 263A.
Tax preparers can only prep taxes with the information you give them, so garbage info in, garbage tax returns out. So having solid systems and competent bookkeepers can really improve the position of your tax returns because you will have more accurate financial records to construct a thoughtful and reasonable tax return.
So the big takeaway here is that simply hiring a professional to prepare an income tax return, without giving the professional necessary information or relying on his or her advice, does not absolve a taxpayer from liability for a penalty.
So where do we go from here?
From this ruling, it is obvious that 280E is going nowhere.
The IRS and US Tax Court are in a clear agreement of their understanding and implementation of 280E and CoGS calculations when it comes to dispensaries and retail operations. They are making it very clear who is a reseller vs. who can qualify as a producer, so any flexibility is being shaken out of the system.
If you need help with your cannabis business accounting or tax filings, then please reach out to us today.