Benefiting from Non-Deductible IRC 280E Expenses in an S-Corp

Date December 12, 2019

Internal Revenue Code section 280E prevents businesses engaged in the trafficking of a Schedule I or II controlled substance* from taking federal income tax deductions for ordinary and necessary business expenses—allowing deductions only for costs of goods sold. However, in certain situations, S corporation shareholders may receive a tax benefit from these otherwise non-deductible expenses due to stock basis ordering rules.

Generally, losses may be deducted by a taxpayer only to the extent of their basis, that is, the amount invested. Basis is adjusted in the following order: (1) income, (2) non-dividend distributions, (3) non-deductible expenses, and (4) losses.

When a shareholder’s loss or deduction items are disallowed due to basis limitations, they are suspended and carried over to the succeeding taxable year. The suspended losses and deductions are treated as incurred in that succeeding year, are added to the shareholder’s loss and deduction items actually incurred during that year. Under Treas. Reg. 1.1367-1(g), however, a shareholder can elect to have basis adjusted in a different order: (1) income, (2) non-dividend distributions, (3) losses, and (4) non-deductible expenses. The effect of the election is that any unused non-deductible expenses are carried forward until they are used to reduce stock or debt basis. Once the election is made, the shareholder must continue to use that ordering rule unless the IRS approves a change back to the standard rule. The election may be made on an original return or an amended return.

Consider the following illustration:

George is the sole shareholder in an S corporation. At the beginning of the year, he has $100,000 in basis. The company has a taxable loss of $250,000 for the year, plus $600,000 of non-deductible expenses.

If the shareholder makes—or has previously established—a 1.1367-1(g) election, they can apply $100,000 of taxable loss to their basis first. The loss will be taken on their individual return and the remainder—$150,000 of losses and $600,000 of non-deductible expenses—carries forward to the next year.

If the shareholder has not made the election, the $100,000 of beginning basis will be reduced by $100,000 of the non-deductible expenses. The entire $250,000 loss is then carried forward to the next year. However, the $500,000 of non-deductible expenses exceeding the basis are not deductible and do not carry forward. By making the election, the shareholder receives a tax benefit even though the expenses are in theory non-deductible.

Election under 1.1367-1(g) Stock Basis Ordering Rules
Beginning basis 100,000 100,000
Non-deductible expenses (600,000)
Non-deductible expenses in excess of basis – not carried forward 500,000
Stock basis before losses 100,000 0
Losses incurred (250,000) (250,000)
Suspended losses carried forward 150,000 250,000
Stock basis before non-deductible expenses 0
Non-deductible expenses (600,000)
Suspended non-deductible expenses carried forward 600,000
Ending stock basis 0 0
Suspended losses carried forward 150,000 250,000
Suspended non-deductible expenses carried forward 600,000

On the surface, the 1.1367-1(g) election seems like a good idea. It allows the use of a tax-deductible loss now instead of a future year. However, making the election could have negative consequences for S corporation shareholders, as any deductions for non-deductible expenses that aren’t used up due to basis limitations are lost.

These rules affect all S corporation shareholders, but it’s particularly important for cannabis companies because under the limitations of the Controlled Substances Act they tend to have large amounts of non-deductible expenses. Taking advantage of the stock basis ordering rules is an involved process requiring many considerations; it is critical to use a tax preparer familiar with these rules. Making a 1.1367-1(g) election without considering the consequences, or being unaware of the carryover rules and tracking non-deductibles incorrectly, could be extremely costly. Make sure you have a CPA who knows the rules and can apply them to your benefit.

* The Controlled Substances Act (CSA) is the statute establishing federal U.S. drug policy under which the manufacture, importation, possession, use, and distribution of certain substances is regulated. It was passed by the 91st United States Congress as Title II of the Comprehensive Drug Abuse Prevention and Control Act of 1970 and signed into law by President Richard Nixon.[1] The Act also served as the national implementing legislation for the Single Convention on Narcotic Drugs.

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