Cannabis Companies Switching to GAAP Accounting

Date April 6, 2022
Categories
The Internal Revenue Code (IRC) contains a provision limiting tax deductions for cannabis companies to the cost of goods sold (COGS). To maximize COGS, companies must comply with the relevant tax accounting rules. To complicate matters, book accounting (best practices employ generally accepted accounting principles, GAAP) has its own rules for inventory accounting. A March 2022 U.S. Tax Court ruling limited a cannabis company’s deduction for COGS to direct costs since that company’s tax accounting method did not reflect income because it failed to conform with GAAP. Consequently, cannabis companies not using GAAP for reporting purposes risk the IRS reducing their COGS deduction, thereby increasing its income tax with assessable penalties and interest. According to the Court’s ruling, the accounting system used to report COGS deductions must accommodate two directives: it must conform to best-practices accounting for that business or industry, and it must “clearly reflect income.” To clearly reflect income, the business’s accounting system must pass another two-part test, it must: be applied consistently and conform with GAAP. The inventory tax accounting regulations allow cannabis companies to treat certain indirect costs as inventoriable costs, increasing inventory and COGS resulting in a decrease in gross profits for tax purposes. Since cannabis companies compute their Federal income tax based on gross profit and other income, reducing gross profit reduces Federal tax liability. Businesses keeping records for tax purposes that don’t accommodate the new court ruling, upon IRS audit, likely will see their COGS deduction reduced. The result will be increased income taxes with potential penalties and interest. Cannabis businesses are advised to move to GAAP accounting and maintain their financial records in conformity with the GAAP rules most appropriate for this industry. This can yield the lowest legitimate Federal tax liability with the highest probability for success against the IRS. HBK Cannabis Solutions can help. We were among the first CPA firms to specialize in the cannabis industry and have worked beside entrepreneurs in all industry segments—cultivators, processors, retailers—from a single facility to multi-location and vertically integrated operations. We can assess your current accounting system, advise and install accounting that complies with GAAP and IRS rules.

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Is There Relief in Sight for Undesirable Results of Supply Chain Interruptions?

Date November 1, 2021
Authors James Dascenzo
Categories

Many manufacturing companies, and other businesses, have long accounted for their inventory on the last-in-first-out (LIFO) basis. LIFO assumes that inventory acquired most recently is sold first, usually resulting in matching higher-cost inventory with current sales. A company with LIFO inventory that experiences a decrease in their inventory levels may often recognize additional taxable income as a result of the LIFO decrement. A LIFO decrement is the excess of the prior period ending inventory minus the current period ending inventory. Decrements result in a reduction of LIFO layers created in earlier years, thereby creating taxable income. In other words, the capitalized lower-cost products are not being deducted in the cost of goods sold, resulting in higher taxable margins.

Many conditions related to the COVID-19 pandemic severely limited manufacturing capacity and caused major interruptions in the global supply chain. In addition, some businesses exhausted current inventory to assist relief efforts during the early stages of the pandemic. These events made it extremely difficult for U.S. companies to maintain their inventory levels in 2020, often resulting in a substantial reduction in inventory levels. These difficulties have continued into 2021 and, in many instances, have intensified. While the overall economy has rebounded strongly since last year, the spread of the Delta variant has added a great deal of uncertainty to many businesses that may have liquidated their inventory in the past eighteen months.

As a result of these circumstances, many companies are likely to see a decrement in their LIFO inventories and will realize additional taxable income and the associated tax liabilities. This will further exacerbate the recovery efforts of these companies, as the additional cash outlay may prove to be an undesirable drain on their finances.

Sec. 473 of the Internal Revenue Code provides relief for eligible taxpayers that experience liquidations of LIFO inventories as a result of a “qualified inventory interruption.” Sec. 473 can be applicable if a business has had an interruption in the ability to obtain replacement inventory due to a trade embargo or other international event. Under Sec. 473, the company would have three additional years to replenish the liquidated inventory. A “qualified inventory interruption” occurs under Sec. 473(c)(2) when the Treasury Secretary, “after consultation with the appropriate Federal officers, determines that…any embargo, international boycott, or other major foreign trade interruption has made it difficult or impossible to replace any class of goods for any class of taxpayers during the liquidation year, and the application of Sec. 473 to that class of goods and taxpayers is necessary to carry out the purpose of Sec. 473, he shall publish a notice of such determinations in the Federal Register, together with the period to be affected by such notice.”

The AICPA has written two letters, in April and August 2021, including detailed examples, requesting that the Department of the Treasury and the Internal Revenue Service apply the relief measures afforded in Sec. 473 for businesses that were unable to maintain their prior inventory levels due to the effects of COVID-19 on the global supply chain. Specifically, the letters requested a safe-harbor method and expedited relief in this scenario. In particular, the AICPA recommended that the safe harbor provide that the taxpayer would disregard the liquidation for this year and would retain the LIFO layers related to the opening inventory. This would alleviate the burden of paying additional taxes on the related income.

As of this date, there has not been a response from the Department of Treasury or Internal Revenue Service. However, taxpayers should be aware of these potential consequences due to the disruption of the global supply chain and reduced inventory levels.

Please contact HBK Manufacturing Solutions if you would like to discuss the possible effects of a LIFO inventory reduction and any potential relief.

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Background on the R&D Tax Credit

Date April 5, 2021
Categories

The Research & Development (R&D) tax credit is a federal tax credit available to businesses of all sizes that conduct Research & Development activities domestically in the United States. The definition of R&D is broad and applies to nearly every industry, not just your typical science labs. The R&D tax credit was first introduced in 1981 as a way of rewarding businesses that were investing in American innovation to boost the economy. When first introduced it was only intended to be a two-year credit, but due to its success, it has been extended every year since. Over the years there have been many changes to the R&D Credit, but most notably in 2015 as part of the PATH Act, it was overhauled and established as a permanently available tax credit. This has allowed more businesses to fully utilize the credit without fear that it will be unavailable in the future.

What Activities Qualify for the R&D Tax Credit?

The Internal Revenue Code (IRC) Section 41 and the related regulations help define what types of activities qualify for the R&D tax credit. Next, we are going to break it into two sections, what activities qualify as R&D and what expenses of the R&D activity qualify for the R&D tax credit.

To qualify as R&D according to IRC section 41, the taxpayer must show that the activities:

  • Are intended to discover information to remove technological uncertainty that exists at the outset of the project or initiative related to the capability or methodology for developing or improving the business component or the appropriate design of the business component.
  • Rely on hard science, such as physical science, biological science, computer science, or engineering.
  • Relate to the development of a new or improved business component, defined as new or improved products, processes, internal-use computer software, techniques, formulas, or inventions to be sold or used in the taxpayer’s trade or business.
  • Substantially all R&D activities must contain elements of a process of experimentation.

Once we determine what activities qualify for R&D, next we need to determine what expenses are considered Qualified Research Expenses (QRE). As a reminder, only expenses incurred domestically in the U.S are eligible QREs.

  • Wages paid to employees for qualified services.
  • Supplies used and consumed in the R&D process.
  • Contract research expenses paid to a third party for performing Qualified Research Activities on behalf of the taxpayer, regardless of the success of the research, allowed at 65% of the actual cost incurred.
  • Basic research payments made to qualified educational institutions and various scientific research organizations, allowed at 75% of the actual cost incurred.

How is the R&D Tax Credit Calculated?

There are two distinct ways to calculate the R&D tax credit. The first of which is the Regular Method and the second is the Alternative Simplified Method. Both methods are similar in that the credit is determined by comparing your current year QREs to the base amount. The difference in the methods come into the details of how the base amount is determined and the percentage of the credit. When using the Regular Credit, the base amount is determined by calculating the QREs as compared to gross receipts from 1984 to 1988 (the original years the credit was available) or by applying the start-up company rules that create a formula based on the years that R&D activities began with a limit based on 50% of the current year QREs. The Alternative Simplified Credit takes an average of the past three years and is adjusted each year. The Regular Credit yields a credit of 20% whereas the Alternative Simplified Credit yields a 14% credit.

In determining which method is the most beneficial there are several factors to consider as this decision is permanent. Some of these factors include the amount of R&D activity that will be completed in the initial years compared to the lifetime of the company, the availability of historic information needed to determine the base periods under the Regular Method, when the business or owners be able to utilize the credits, and the cost of having a formal study completed.

With both methods, there is also another election to consider, which is commonly referred to as the 280C Election. This election is required and permanently based on the first filing containing the R&D tax credit. Without this election, the business must remove the gross amount of the credit from their deductions when determining taxable income. With the 280C election, the credit is further reduced by the tax impact of the credit to simplify the reporting requirements.

As an added incentive for start-up companies to take advantage of the credit, the IRS has granted the ability to use the credit to offset payroll taxes. The credit is still nonrefundable in the event it exceeds payroll tax liability, but any excess can be carried forward. To qualify as a start-up, the company must be within the first five years of operations, have current year gross receipts of less than $5 million, and not be included in a controlled group that does not meet either of the first two requirements.

Summary

The R&D tax credit is a vital tool in generating cash flow while investing in a growing business that is overlooked by many businesses. The R&D credit often yields a cash return on investment of approximately 5-7% of the QREs. In addition to a federal tax credit, many states offer a modified version of the credit that can be easily calculated alongside the federal calculation.

If you have any questions or would like to discuss further, please contact your HBK Advisor.

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CARES Act and Economic Relief Provisions for Businesses

Date May 29, 2020
Authors Cassandra Baubie, JD
Categories

The Senate through the Coronavirus Aid, Relief and Economic Security Act (“The CARES Act”) has brought with it several economic relief provisions as well as expansions and modifications to several areas of the tax code in an attempt to provide relief to taxpayers during the COVID-19 pandemic.

Among the provisions included in the CARES Act is a modification of the excess business loss (“EBL”) limitation imposed under Internal Revenue Code (“IRC”) §461(l). The Tax Cuts and Jobs Act of 2017 (“TCJA“) created §461(l) which disallows the deduction of EBL’s by non-corporate taxpayers (e.g. individuals, trusts, and estates) starting in the 2018 tax year. The modification under the CARES Act retroactively eliminated the loss limitation for the 2018 and 2019 tax years and suspends the limitation until tax years beginning after December 31, 2020. This allows taxpayers to fully deduct business losses without taking into consideration the limitations imposed under §461(l).

Under TCJA, EBL’s are calculated by looking at the aggregate trade or business deductions compared to the aggregate trade or business gross income/gain. The aggregate of these deductions is taken over the sum of the aggregate gross income attributable to the trade or business and limited to an allowable loss of $250,000 for single filers or $500,000 for married filers that file a joint return. Any excess loss would be carried over as a net operating loss (“NOL”). This change provides an opportunity for taxpayers to amend their 2018 and 2019 (if filed subject to the limitation) tax returns to benefit from the previously disallowed losses. If the 2019 tax return has not yet been filed, the EBL limitations will no longer apply.

Through the CARES Act the current NOL rules from TCJA have been amended for the 2018-2020 tax years, allowing losses that arose in those years to be carried back five years. Additionally, there has been a suspension of the provision which limits NOL’s to only 80% of a taxpayer’s taxable income through tax years ending before 12/31/2020. This may permit taxpayers to fully offset taxable income by carrybacks or carryforwards. These changes together may provide opportunities for taxpayers to receive a refund of income taxes that have been paid in those prior years and receive an influx of cash to help mitigate the losses incurred by the pandemic interruptions.

Along with these opportunities, the CARES Act also includes a technical correction to the TCJA provisions of the EBL. Under the CARES Act, any excess business loss shall be “determined without regard to any deductions, gross income, or gains attributable to any trade or business of performing services as an employee.” This disallows W-2 wages from being included as business income for purposes of an EBL calculation when the limitation returns in the 2021 tax year. Previously, the tax forms used to calculate the EBL limitation drafted by the IRS allowed W-2 income to be included in business income. Additionally, the CARES Act noted that capital gains are included in the computation of EBL only up to the lesser of gains and losses attributable to a trade or business, or the net capital gain income of the taxpayer. The CARES Act also provided technical corrections to the language of §461(l) clarifying that EBL’s are calculated without including §172 or §199A deductions, and net capital losses are not included in the EBL calculations.

Taxpayers should also be mindful of their state tax implications/liabilities arising from these changes. There are several types of IRC conformity laws that a state may have adopted, for instance static conformity states conform to the updated IRC provisions from a set date, which may not include these changes under the CARES Act. States that have rolling conformity will conform to the current IRC that applies federally, and there are some states which have selective conformity which only adopt specific provisions of the IRC.

As taxpayers are looking to file their 2019 returns, these updates should be taken into consideration and changes to their 2018 returns may be beneficial. Please reach out to your HBK Tax Advisor to discuss how these changes may impact you.

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

Date December 12, 2019
Categories

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
Basis:
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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