There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.
Jeremy Wells: Every business needs to spend money in order to generate income in general. Now, there might be some kinds of businesses where an individual can just make some money, uh, without having to invest much monetarily [00:00:30] into their operation. But in general, there's almost no business that doesn't have to pay some money to be able to generate the revenue. Even the simplest business you can think of someone maybe selling subscriptions online, they're going to have some payroll, they're going to have some processing costs and payment processing costs. They're going to have some technology costs. They're going to need some sort of equipment to be able to do that kind of work. In general, every business has [00:01:00] cost that it has to pay in order to generate revenue, and those particular costs go by the name cost of goods sold. But there's a lot of confusion about what actually constitutes cost of goods sold. Part of that confusion is because we mean different things by that term in different contexts. And in particular we can have different meanings for that term between [00:01:30] accounting, financial accounting, financial statements and especially cost accounting, the way companies manage their internal records and financial reporting. And what we mean by cost of goods sold for tax. If you have prepared returns for small businesses, then you may have come across returns where certain costs paid by that business were reported as cost of goods sold. [00:02:00] You may have seen where the financial statements have certain costs listed as costs of goods sold, and you weren't sure whether or not that should also be reported as cost of goods sold on the tax return.
Jeremy Wells: It can get a little confusing. And so in this episode, I'm going to break down. What exactly do we mean by cost of goods sold for tax purposes? What kinds of businesses have cost [00:02:30] of goods sold, and therefore what kinds of businesses don't have cost of goods sold for tax purposes? Why it matters what the difference between cost of goods sold and operating expenses are, and how this can make a pretty significant difference for different kinds of businesses. So cost of goods sold is a special kind of cost that businesses pay, because it's actually not a normal operating expense. It's actually part of the definition of [00:03:00] gross income when it comes to tax. And I'll talk about what that means a little bit later on. Normally when we think about business finances and reporting that for tax purposes we think about gross receipts, the money that the business collects, if it's a cash basis taxpayer or the revenue accrued, if we're talking about an accrual basis taxpayer and then we think about expenses, either those costs that are paid or incurred that are ordinary and necessary [00:03:30] and part of the operation of that business. But there's actually a third category of costs that's important here, cost of goods sold. And they although the financial statements will usually present that somewhere in between revenue and expenses for tax purposes, it's important to realize that cost of goods sold is actually part of income.
Jeremy Wells: It's not just a special kind of expense. And once you think about it that way, it makes a lot more sense. Why only certain kinds [00:04:00] of businesses report costs of goods sold, and why cost of goods sold actually is important to understand and to track. In general, for tax purposes, I've seen a lot of tax returns prepared for new clients coming into my firm, where the returns were either self prepared or prepared by another firm that reported cost of goods sold for a particular business. When I knew that that business should not have reported cost of goods sold. I knew that that business didn't [00:04:30] qualify. I knew that reporting cost of goods sold wasn't really the right treatment there. But sometimes we're in a position where we're trying to make the return match the financial statements as much as possible. We're trying to make the return match what the client expects as much as possible. And I've even had some pushback from new clients when we prepare that first tax return, where the prior returns had cost of goods sold reported. The return I prepared doesn't, and the taxpayer actually notices and [00:05:00] questions that. It's important to be able to understand why this matters and to be able to explain that to the taxpayer. Why? Actually, in a lot of these cases, it's correct not to have cost of goods sold reported for those businesses.
Jeremy Wells: Now to the question of, you know, why does this matter? Doesn't it all reduce taxable income anyway? And to an extent, that's correct. However, there are other things that could happen on a return, [00:05:30] or there are particular types of activities that might depend on accurately understanding what cost of goods sold are and what that definition of gross income actually is. Errors in cost of goods sold can actually affect the way a business's taxable income is reported, and it can actually be really important for certain kinds of businesses. So in [00:06:00] this episode, we're going to look at a couple of pivotal tax court cases and some other court cases. We're also going to break down what the code, what the Treasury regulations say about gross income and cost of goods sold, and why and how all of this can matter, why this isn't just a financial reporting decision, why this can actually be a lot more important than that. So let's look at a particular case that is going to give us an example of why [00:06:30] understanding this distinction is not just good accounting practice, it's not even good tax reporting practice. It's actually critical. It's essential to understand the difference. This case is Californians helping to alleviate medical problems or champ v Commissioner. This is 128 tax court 173. This was a case held by the Tax Court in 2007. So it's a little bit of an older case, but I think it's a really good illustration [00:07:00] of why this concept is important.
Jeremy Wells: And it's actually a concept that, as of the time of recording, has come back in terms of being an important concept for understanding in the tax profession. So in champ v Commissioner, the taxpayer, this would essentially was a business that operated a medical marijuana dispensary in California that also provided caregiving services [00:07:30] for elderly and ill patients. Anytime we have two different revenue streams operating in the same business, then we're going to introduce some complexity into not only the financial reporting, but probably also the tax reporting. What's really interesting about this case is that these are two completely different kinds of operations. From the perspective of how the financial [00:08:00] information is reported for tax purposes. And because both of these revenue streams occurred in the same business, the IRS actually looked at this business as just one and focused on one particular part of the business while almost kind of ignoring the other side. So in this case, the business, uh, prepared its returns based on, uh, the caregiving [00:08:30] part of the business. Irs disagreed and instead interpreted the business based on the marijuana dispensary part of the business, when in reality, the business was doing both at the same time. What this meant was that the IRS essentially disallowed the ordinary and necessary business expenses that were deducted for this taxpayer because of IRS section 280 cap [00:09:00] E.
Jeremy Wells: If you work or have worked, or you operate a business that focuses on marijuana or cannabis products, then you should be familiar with IRC section 280. Cap e this section tells us that a business that is selling in the business of selling, uh, producing or selling illicit, uh, products, [00:09:30] basically, uh, can't deduct its expenses that its taxable income is based on its gross income, not on its net income. In other words, if you operate a business that for taxable that for federal tax purposes is not legally allowed to produce and sell that product. You don't get to deduct ordinary expenses. So [00:10:00] your taxable income is the same as your gross income. The question then is what do we mean by gross income. And this is really where it gets important to understand for tax purposes what we mean by gross income and therefore what we mean by cost of goods sold. The taxpayer here. This this champ argued that certain costs should be allowable because they reduced gross receipts as cost of goods sold rather than as deductions. And when I say gross receipts, that [00:10:30] is a distinct concept from gross income. For a lot of businesses, they're going to be roughly the same. However, for particular kinds of businesses, there will be a difference between gross receipts or the amount of payments that are either collected or the amount of revenue accrued and then cost of goods sold. The case is a really good illustration of the boundary between how we measure and define [00:11:00] income for tax purposes, and then how we think about whether expenses are deductible or not.
Jeremy Wells: So let's get to it. What is cost of goods sold in general? Like I said at the top of the episode, every business incurs what I prefer to call direct costs in generating revenue. Now, I don't typically like to use the term [00:11:30] cost of goods sold for all businesses. Because of what I'm explaining in this episode, cost of goods sold is actually a much narrower concept than what I think of as direct Costs. In other words, to me, every business has direct costs. These are the costs that a business has to pay in order to generate its revenue. As a personal [00:12:00] example here, my firm uses a particular type of tax software. It's called Pro Connect that this software, we have to buy individual credits in order to be able to either file or print tax returns that we prepare for our clients. And that's one of the most important services that we offer our clients. It's one of the most common services that we offer [00:12:30] for them. And so a lot of my firm's revenue is based off preparing and filing tax returns for clients when we have a new client that wants us to prepare and file their tax returns. We then have to go into our tax software and purchase credits in order to be able to file or print, if we have to paper file for some reason, uh, those tax returns.
Jeremy Wells: So we can specifically identify [00:13:00] how much it costs us to be able to prepare and file tax returns for our clients. So if we know that a combination of individual and business tax returns, if we know that we're going to file 200 of those for our clients, then we're going to need 200 of those credits from our tax software. So we can specifically identify [00:13:30] not only the quantity of tax returns, but also based on that, we know how much each credit cost, and therefore we know what the direct costs of being able to provide that revenue generating service, of preparing and filing tax returns to our clients is, to me, that is a great example of direct costs. Now, not every business has that clear 1 to 1 ratio of this is the service we provided to a particular [00:14:00] client. And here is the cost that we had to pay in order to be able to provide that service to that client. Sometimes, for various reasons, those costs are either part of a package. And so there is no specific 1 to 1 purchase of a credit or a unit. Uh, rather, the business is paying for maybe a subscription to software, but that software is critical [00:14:30] for that business in order to generate its revenue. In those cases, we still have direct costs. There's just not a 1 to 1 connection between the amount that was paid for that direct cost and then each individual client.
Jeremy Wells: But that's fine. It's still direct costs. It's still cost. The business has to pay in order to be able to generate that revenue. Now, when I say has to pay, I'm not saying that there's only one option. There might be other options in order to, uh, decide how we're [00:15:00] going to actually be able to deliver that service or product. Uh, we might have alternatives in the marketplace we choose. My firm chooses a particular kind of tax software. We could choose a different software. And that different software might have a different way that it provides access to its software. So for example, we use a software that is pay per return. Like I said, we're buying individual credits and each credit represents one return. A lot of tax software, uh, you purchase licenses and so that [00:15:30] license is unlimited. And once you own that license, you can prepare and file as many tax returns as you need or want to within that software. Usually for a given tax year other software you might have to purchase individual user licenses. So you might have 4 or 5 people on your staff that are using that software, and you need an individual user license per individual. However, that [00:16:00] direct cost is determined or priced by the vendor, and however that relates to the number of clients or customers you have or the kinds of services you offer.
Jeremy Wells: You know, all of that is going to depend on each individual business. But the general principle here is that every business has these costs. Every business has to pay these direct costs. Now, tracking those direct costs for [00:16:30] the business can provide them with useful information about the The profitability of particular revenue streams. And this is where we start to get into the cost accounting or the managerial accounting for businesses. Certain kinds of businesses need to know what their direct costs are in relation to the revenue generation of particular products, [00:17:00] services, revenue streams. If that's important to that business, then it's very important for them to accurately track these direct costs and separate them in terms of record keeping from all of the other expenses that the business incurs. So from a financial accounting perspective, we might only be focused on net income. How much profit is the business overall making? But from a cost or managerial accounting perspective, we might [00:17:30] be interested in how a particular product performs in terms of what the direct costs are for that product versus what the what it sells for, for example. Now, once we produce a good or a service as well, a lot of this works for both. The thinking process might be a little bit different. It might not be, uh, physically possible to, uh, you know, tangibly see [00:18:00] that service, uh, being produced and being sold. But really the logic is the same when that good or that service, uh, is in production, we call that work in progress.
Jeremy Wells: Uh, or, uh, we put it into inventory. And at this point we have not experienced any cost of goods sold yet. At this point, what we have is an item on the balance sheet. And so that, uh, particular good or service is essentially [00:18:30] waiting to be sold. And at that point it's inventory or work in progress that's sitting on the balance sheet. Now, once it's actually sold, then we take the cost that's allocated to that particular unit of that good or service, and we move that off the balance sheet and onto the income statement as cost of goods sold. Cost of goods sold includes just the [00:19:00] costs that are necessary to create that particular good or perform that service sold. It's important that we're not capturing a lot of other kinds of expenses. So usually we have some complicated rules about how we allocate costs, particularly in a manufacturing context, because if we have a production facility like a factory, we've got to account for the utilities, we've got to [00:19:30] account for the depreciation of the building. We've got to account for the general labor as opposed to the specific labor that was, uh, you know, directly responsible for producing that. Good. And all of this gets even a little bit more difficult to ascertain and allocate when we're talking about services. But in general, we need to separate the costs that are directly responsible for the good or service that's generating revenue.
Jeremy Wells: And then the other costs that are necessary for actually operating, uh, [00:20:00] the business. I'm going to throw this in here. Just as an aside, I'm planning on a separate episode eventually down the road that will look at, uh, what it means to value inventory and when, uh, inventory, when costs become inventoried and how we evaluate that and how we eventually expense that. Those rules were changed a little bit, especially for small businesses with the Tax Cuts and Jobs Act [00:20:30] of 2017, we got an exception for qualifying businesses. There are a few different requirements. The main one there is the gross receipts test of less than $25 million. I'm going to do a separate episode talking about that, but it's important to keep that in mind as well. Uh, because if we're looking at certain kinds of businesses, they may be able to skip that step. I mentioned earlier of where costs are first captured on the balance [00:21:00] sheet as work in progress, or as inventory before they're expensed as, uh, or included in cost of goods sold. But in general, that's the way, uh, cost of goods sold works for financial cost, managerial accounting. But now for tax, we have a slightly different approach here. So IRC section 61 defines gross income very broadly as income from whatever source derived. Uh, this is a classic phrase. [00:21:30] If you work in tact, you should keep that definition of gross income or really that that sort of meaning of gross income.
Jeremy Wells: Uh, there's it's there's a lot more to it. Section 61, uh, relatively long. And the regulations around 61, uh, relatively long, in particular. Treasury Regulation 1.6 13A right off the bat tells us that for particular kinds of business, there are three kinds of business here that we're focusing [00:22:00] on manufacturing, merchandizing and mining businesses. Gross income equals gross receipts minus cost of goods sold. No other kind of business has that formula described in terms of gross income. No other business has that definition of gross income. Only businesses in those three categories manufacturing, merchandizing and mining. And [00:22:30] if you think about some common examples of these three kinds of businesses, it becomes kind of clear what we mean by cost of goods sold. It's a relatively traditional context, uh, you know, way of thinking about cost of goods sold, manufacturing fairly obvious. A production facility needs to purchase raw goods, put that into work in progress, create inventory from that, and then sell the inventory. That is a very traditional, uh, conceptualization of cost [00:23:00] of goods sold. That's sort of a textbook example of how cost of goods sold is taught in cost and managerial accounting, college courses, merchandizing fairly similar. Uh, you know, here instead of raw product, we're looking at finished product. But in general, the store has to purchase the product. It needs to hold it in inventory, it needs to put it out on display and it needs to sell it.
Jeremy Wells: Mining. Uh, I don't work with mining clients, but I'm assuming mining [00:23:30] has a similar way of operating as well. So cost of goods sold here is determined before any deductions under IRC section 162 are considered. Irc section 162 is ordinary and necessary business expenses. And this is really important to keep in mind for these kinds of businesses. Manufacturing, merchandizing and mining. There is the calculation [00:24:00] of gross income, gross receipts minus cost of goods sold and that's gross income. We do that first. Then we look at ordinary necessary business expenses under section 162. This is really important to understand and to keep in mind because I think there is a a bigger concept here. So first of all, Congress, you know, one of the things that we say in tax law is that we get, uh, expenses [00:24:30] due to legislative grace. This is the phrase that pops up in a lot of court cases, right? Expenses are deductible due to legislative grace, meaning that Congress gets to decide whether deductions are allowed or not. However, what section 61 of the tax code and what the regulations under that tell us is that Congress doesn't get to change [00:25:00] the definition of gross income, at least not to, uh, challenge the economic reality of what is happening and the economic reality, the way the courts interpret this is that cost of goods sold is not just another expense.
Jeremy Wells: Rather, cost of goods sold is a return of capital rather than a tax benefit rather than a [00:25:30] tax deduction. And I think this is really key to understand that when a manufacturing, merchandizing or mining business sells something that it has produced, part of the gross receipts is not just income, it's not just revenue that is generated as a result of selling something, but rather at least a portion of that is recapturing the capital [00:26:00] that it initially invested into producing or acquiring whatever it was that it sold. This is it's it's a bit of a, of a complicated and almost more of a, of a philosophical way of thinking about the accounting. It's a little bit over my head, but the way the courts explain this, I I think is really important to understand when it comes to why cost of goods sold is an important concept to really understand from a tax perspective, [00:26:30] that it's not just another kind of special set of expenses to report on the tax return. Rather, it's a fundamentally different concept from just ordinary, necessary business expenses. So again, which which kinds of businesses get to report cost of goods sold, manufacturing, merchandizing and mining businesses? Those are the ones listed in Treasury Regulation 1.613 that actually have cost of goods sold for tax purposes. Any [00:27:00] other kind of business doesn't actually have cost of goods sold, meaning there should not be any cost of goods sold reported for these businesses for tax purposes.
Jeremy Wells: Now, this is where we need to distinguish between how a business reports its finances for tax purposes versus how it reports it for financial accounting purposes. Back to the point. I've, you know, made a few [00:27:30] times here already. Every business has direct costs. I think the financial reporting should display those direct costs, and it should separate them from otherwise indirect costs, or the ordinary and necessary expenses that aren't directly responsible for revenue generation. However, for tax purposes, we need to not report direct expenses as cost of goods sold [00:28:00] unless that business is in the manufacturing, merchandizing or mining industries and especially pure service businesses do not have cost of goods sold. Now I will see, uh, income statements or profit and loss statements where, uh, cost of goods sold is renamed cost of sales or even cost of services. I produced reports with those as well. I think that's really, uh, good. I think it's helpful. Uh, and it it reflects [00:28:30] as best we can, uh, through financial reporting, the way a lot of modern, uh, businesses operate, especially those that are operating mainly online. So, for example, I work with, uh, a lot of content creators, coaches and, uh, service businesses, professional firms, they might have a couple of different revenue streams that they want to report separately on their financial statements, especially, [00:29:00] uh, you know, you think about a business coach that primarily works with its clients online.
Jeremy Wells: That business coach might generate most of its revenue through, uh, what we would call service revenue, the actual, uh, direct coaching costs and fees that it collects. But they might also have some digital products that they sell. They might have some ebooks, they might have some online courses, and they want to track the revenue from those separately. And so that might be sales revenue. And you might see on the PNL for that business, two separate [00:29:30] lines service revenue versus sales revenue. I would also expect to see direct costs for each of those revenue streams reported separately as well. So I would want to see cost of services separately from cost of sales. And both of those I would want to see separately from all of the other ordinary necessary business expenses on that company's internal financial reporting. For tax purposes, though, I would only expect [00:30:00] to see gross receipts and then ordinary necessary expenses. I would not expect to see any cost of goods sold for that business, because it's not a manufacturing, merchandizing or mining business in champ in this particular court case, the Tax Court allowed cost of goods sold which the IRS had attempted to deny. Remember, this is a business that is doing both caregiving services but also operating [00:30:30] a marijuana dispensary. So it has both a service component as well as a merchandizing component. The tax court allowed the cost of goods sold, but only for the inventory producing activity, only for the merchandizing part of the business.
Jeremy Wells: The marijuana medical dispensary part not for the caregiving services. The presence of that dispensary [00:31:00] business actually helped out quite a bit, because that allowed that business to at least claim some of the costs in the form of cost of goods Sold, which is actually a reduction of gross income, thereby reducing at least a little bit its taxable income. Now, an important thing to keep in mind is that the presence of inventory alone doesn't justify including [00:31:30] unrelated operating costs in cost of goods sold. And this is something that the tax court had to figure out in this case and in other similar cases as well. There has to be an allocation. What costs truly belong in cost of goods sold and therefore are a reduction of gross income as opposed to are just ordinary operating expenses. And what expenses belong to the, uh, to the merchandizing part of the business versus the [00:32:00] service part of the business? So on that point, what do we actually include in cost of goods sold for a qualifying business for tax purposes? And for that, we need to look at the way we calculate cost of goods sold from an accounting perspective. Cost of goods sold starts with beginning inventory. We add purchases of inventory and then if there are any production costs, [00:32:30] any direct labor, uh, or any sort of, uh, freight costs that go along with the raw materials or the inventory.
Jeremy Wells: And then from there we subtract ending inventory. Now that's a very simplified approach to cost of goods sold. Very simplified way of calculating that if this were a managerial or cost accounting, uh, course, which I wouldn't be teaching that because I don't do any of that. Uh, then we [00:33:00] would probably spend an entire series of episodes talking about cost of goods sold and what all goes into calculating that. What all goes into inventory? Into inventory Cause all of that. That's beyond the scope of what we're talking about here. But in general, when you look at how cost of goods sold is calculated for tax purposes, it's really that straightforward. Beginning inventory and purchases and production costs subtract out inventory, ending inventory that [00:33:30] essentially gives us cost of goods sold for tax purposes. Now the cost that we would include in inventory are things like raw materials, direct labor, and then any production related overhead. Again, this is what cost managerial accountants do is they work really hard to make sure that those overhead costs are correctly allocated and applied to cost of goods sold, as opposed to ordinary expenses. Now [00:34:00] IRC section 263 cap A requires certain indirect costs to also be capitalized into inventory for producers and some resellers, there are some very specific rules in 263 cap A. I don't work with, uh, many businesses that have to worry about this so much either, uh, because they're not in these lines of businesses where they would actually have cost of goods sold or, uh, [00:34:30] because they would fall under the small business exception that came out with Tax Cuts and Jobs Act.
Jeremy Wells: But if you work with those kinds of businesses, it's important that you understand what those requirements are, for which kinds of costs need to be included in cost of goods sold, and then finally selling general and administrative expenses. Uh, those are what often get called G&A, uh, in accounting classes. Uh, those don't belong in cost of goods sold, even if they're, uh, you [00:35:00] know, necessary to operate the business. And, you know, this is where we get at. What do we really mean by ordinary and necessary under section 162? Again, beyond the scope of this particular episode, but those kinds of general, uh, administrative costs of the business, they don't belong in cost of goods sold. What some of these court cases have had to deal with, especially involving the marijuana and cannabis businesses, is where the business [00:35:30] will attempt to include as much of the selling, general and administrative expenses, or the ordinary and necessary business expenses in cost of goods sold as they can. In order to circumvent that limitation of section 280 cap E, the Tax Court will usually look at this and say that some of these expenses don't belong in cost of goods sold and are therefore nondeductible. They're not. They can't be included in cost [00:36:00] of goods sold and reduce gross income like that.
Jeremy Wells: Now in champ, in this particular case, the court allowed cost tied directly to the acquisition of the marijuana inventory that it was selling in the dispensary, but then excluded all of the other costs, the cost of operating the dispensary, as well as the costs related to the caregiving services that it was providing to patients. Now, quickly, I just want to mention [00:36:30] inventory valuation. Again, I'm planning a separate episode on this topic inventory valuation and accounting methods. It's it's something that I'm going to go into detail on later, but it's important to understand within the context of thinking about cost of goods sold, that the way inventory is valued and reported is going to be important here, because it's going to affect the way cost of goods sold is calculated. So IRC section 471 [00:37:00] governs inventory valuation and requires inventories to clearly reflect income. The permissible valuation methods include first in, first out or Fifo, last in, first out, or LIFO. There are some specific requirements for the ability to use LIFO. And then there's also average costs. So those are some of the accounting methods and valuation methods that we have. Inventory valuation is going to directly affect ending inventory and [00:37:30] therefore cost of goods sold. So it's important to keep that in mind. If you're working with a retail business or any kind of manufacturing business, the consistency in the valuation methods is required. It's not okay for a taxpayer to change its inventory valuation methods year after year, just to try to produce the best result that it can.
Jeremy Wells: Now, this is important for [00:38:00] particular kinds of businesses. There's a broader implication here as well Because even if you don't work with manufacturing or mining or merchandizing businesses, you may have clients who dabble or trade cryptocurrencies or other digital assets. And a lot of the inventory rules that apply to traditional merchandizing and manufacturing businesses, [00:38:30] they also apply to the way we think about digital assets. And for the taxpayers that are trading those digital assets, we need to be very careful about the way we're applying the valuation methods, especially when it comes to the decision of Fifo versus LIFO versus specific identification, and how that's going to affect that taxpayer. Now, [00:39:00] cost of goods sold rules apply I, regardless of whether the taxpayer uses cash or accrual method of accounting. But whether they use cash or accrual method is going to affect how the inventory is valued and therefore the amount of cost of goods sold. Uh, for any given tax year, I want to take a moment to think about a another concept that was brought up in a related court case. This is in Atkinson v Commissioner. The [00:39:30] taxpayer attempted to classify operating expenses as cost of goods sold, and the Tax Court rejected the taxpayer's characterization because the costs weren't directly tied to inventory, production or acquisition. The court emphasized that economic reality controls over labels used on tax returns or financial statements, and I think this is key when courts are going to [00:40:00] look at Whether expenses are either including cost of goods sold or they are, uh, should be reported as ordinary expenses.
Jeremy Wells: What really matters is the economic reality of what happened. Just because you label costs a certain way in a financial statement or on a tax return, doesn't really govern what's actually happening there. The economic reality does. In general, you know, for a lot of businesses, [00:40:30] especially if the businesses aren't even eligible for cost of goods sold anyway, because it's not a manufacturing, mining or merchandizing business, then it really doesn't matter, other than those businesses just shouldn't be reporting cost of goods sold anyway. But the overall principle here is if you work with small businesses and you're preparing returns based on the financial statements that those businesses provide to you, just because those financial statements report cost of goods sold or cost of sales or [00:41:00] costs of services or anything like that, that is on that financial statement reported separately from all the rest of the ordinary expenses. There still should not be any cost of goods sold reported on the return. Again, I've seen returns where this was done. I've talked with tax professionals who think this is actually a good thing, because it gives us consistency across the financial statements and tax returns, and in the end, it's all a reduction of taxable income [00:41:30] anyway.
Jeremy Wells: So what does it matter? Well, again, I think in terms of making sure that we're accurately reporting things and that we accurately report, we accurately understand the concepts involved in the way we're reporting transactions. I think it's a very important, uh, that we recognize that certain businesses, uh, don't report any cost of goods sold and that just because we want to have consistency across the financial [00:42:00] statements and the return doesn't mean that we have to report everything on those financial statements in the same place, under the same heading, under the same label, on the return, especially when we know it's not the correct place to report those items on the return. Now, where it really matters in, in particular in, in one, uh, kind of situation here, as I mentioned, um, and this is true in this, uh, champ court case, IRC 280 cap e tells [00:42:30] us that businesses that, uh, are involved in, uh, trafficking in schedule one or schedule two controlled substances and marijuana is still one of those as of recording. Those are not allowed to take any deductions or credits on their returns. So it's absolutely Critical for these [00:43:00] businesses to understand that ordinary and necessary business expenses are non deductible. And this is why it's important to go back to understanding for tax purposes what the definition of cost of goods sold is. It is a reduction of gross income. The way the courts have interpreted it is it's a return of capital.
Jeremy Wells: It is not a deduction. It is a reduction of gross income. [00:43:30] Section 280 cap E doesn't disallow cost of goods sold. Again, because cost of goods sold is not an ordinary deduction it is a reduction of gross income. So marijuana businesses really actually should be doing if they're not already. Most of them do a really good job of tracking their cost of goods sold. On the flip side though, what can get them in trouble and has in several [00:44:00] court cases is they attempt to report as much as they can. Uh, sometimes too much in cost of goods sold as opposed to ordinary business expenses. Now, focusing heavily on cost of goods sold is really the only way that they have to be able to reduce taxable income, because with no deductions and credits allowed, that essentially means gross income equals taxable income for these businesses. [00:44:30] So the only way to reduce taxable income is to reduce gross income. The only way to do that is to increase cost of goods sold. Um, as much as possible. Now, if marijuana was removed from schedule one and there have been, uh, there's always rumors and claims and hopes and wishes, uh, depending on which community you're in, Depending on how you feel about the subject, that marijuana would be removed [00:45:00] from schedule one, that would essentially, uh, make it make the entire marijuana and cannabis industry no longer subject to section 280 cap E. Uh, that section would no longer apply to those businesses, and that would allow those businesses to deduct those ordinary business expenses.
Jeremy Wells: The question or a question that I've seen tossed around is how might [00:45:30] that affect prior tax years? It probably wouldn't, um, unless there was included along with that change in the way marijuana is scheduling, there was some, uh, statement included that this affected that that change affected prior tax years, but it's very unlikely, um, that something like that would happen. Instead, it would probably be an effective date, probably beginning as of, uh, you know, January 1st of the tax [00:46:00] year in which that rescheduling happened. Uh, and so probably for that tax year, uh, you would see ordinary business expenses being deductible because now, uh, marijuana is no longer a scheduled substance and therefore, uh, would 280 cap e wouldn't apply anymore. Uh, but as of recording, none of that's happened yet. So 280 cap still does apply to marijuana and cannabis. Uh, for, uh, those, uh, businesses. It's [00:46:30] important to keep in mind that we're talking about federal tax law here and with some exceptions with some important exceptions. But those are specific exceptions. In general, federal tax law and state law are two separate things, especially with regard to IRC section 280 KP. Regardless of what states do in terms of the legalization [00:47:00] of marijuana or any other kind of substance. Irc 280 KP is going to apply to those substances as long as they remain schedule one or schedule two controlled substances under federal law, and so no amount of changing laws at the state level is going to affect that.
Jeremy Wells: And in fact, there have been court cases about that particular point as well, because [00:47:30] once states began decriminalizing marijuana, there was an idea that that should somehow make expenses related to those businesses, therefore deductible. But that's not how federal tax law works. And that's especially not how section 280 KP of the Internal Revenue Code works. Now, when it comes to substantiating cost of goods sold. These rules are effectively the same as any other kind of business expense. [00:48:00] Taxpayers still bear the burden of proving that those costs included in cost of goods sold were actually incurred. That they were properly classified and that they were valued correctly. So courts can allow estimates under the Cohan rule, the same Cohan rule that we use for other kinds of business expenses, but only after the taxpayer establishes that the qualifying costs actually existed. And [00:48:30] if there are costs included in cost of goods sold that have strict substantiation requirements, such as those under IRC section 274, then those substantiation requirements are going to apply, whether those expenses are included in cost of goods sold or whether they're reported as ordinary expenses and to a degree, cost of goods sold is going to get a little bit stricter scrutiny in terms of substantiation requirements, especially when we're dealing with a kind of [00:49:00] business that is has its other expenses disallowed, like those operating under IRC section 280 cap e now, because the definition of, or the calculation of cost of goods sold relies on measuring inventory, unsupported beginning inventory, or reconstructed cost figures often lead to IRS income reconstruction methods.
Jeremy Wells: In [00:49:30] other words, if the taxpayer has to do work to estimate or recalculate or reconstruct its valuations of inventory or purchases or costs that are included in inventory and therefore cost of goods sold. That's going to be prime, uh, opportunities for IRS to challenge and review and probably even revise those calculations. And some of these, uh, [00:50:00] court cases deal with resolving those differences in valuation and different methods. So if you have a business that truly has cost of goods sold, how should these be reported on the tax return? If it is a sole proprietorship or a single member LLC, that's a disregarded entity. It's going to be reported on schedule C, and there is uh, specifically on uh, page two of the schedule C in part three, there [00:50:30] is a specific section to report cost of goods sold and that, uh, uses the formula. We've been discussing reporting, beginning inventory purchases, other additions into inventory, other inventory costs and then subtracting out inventory in order to to arrive at cost of goods sold. Corporations and some other entity types. And this includes s corporations are going to report cost of goods sold on form 1125 [00:51:00] A. That form looks very similar to part three of schedule C in terms of uh, showing that, uh, formula and that worksheet for calculating cost of goods sold.
Jeremy Wells: And taxpayers have to maintain good records, uh, supporting inventory quantities, valuation methods and cost components. Uh, one source of frustration, uh, that I usually have with businesses that do have inventory reporting, uh, in [00:51:30] their financial statements and on their tax returns is, uh, same as last year figures. We ask what their inventory is, uh, and we get the same number, their ending inventory, and we get the same number as last year's ending inventory, or we get round numbers. This is especially true with the handful of restaurants that we've worked with. We ask them what their ending inventory, especially with the beer, wine and liquor or with the, uh, you know, raw ingredients, this sort of [00:52:00] stuff. And, you know, we get an estimate of $1,000 worth of beer, wine and liquor for a restaurant that's doing a few million dollars of revenue, uh, every year. Well, they're probably that. I don't think that's an accurate reflection of their inventory. I seriously doubt that it's an even amount like that. I seriously doubt that it's the exact same amount of inventory that they had a year ago. But what's important is educating the client, educating the taxpayer on the need to keep good records, [00:52:30] and even to help them understand the way cost of goods sold is calculated, and why it's important to keep those good records in case that's ever questioned, uh, by the IRS, because inadequate reporting and records and substantiation is really going to weaken the taxpayer's position in case of an audit or if the situation goes further than that, into into litigation.
Jeremy Wells: So to wrap up, cost of goods sold is an important concept [00:53:00] to understand, even for tax. Even when we tend to think of cost of goods sold like any other expense is just a reduction of taxable income. And really, that's a bad way to think about cost of goods sold. Cost of goods sold is actually part of the definition of income for tax purposes. It is a reduction of gross income. It is not just a reduction of taxable income. Courts will carefully work to break down what actually [00:53:30] is cost of goods sold, what should actually be included in that, as opposed to what is just ordinary, uh, business expenses? Champ is a good case for understanding the importance of cost of goods sold for tax reporting, and how not accurately understanding that concept, and also how operating multiple different kinds of businesses in the same entity can really be problematic [00:54:00] for a taxpayer, especially if that entity is operating in activities that are covered under IRC section 280 cap E. So practitioners really should be careful about how they are treating cost of goods sold when there are reporting, uh, businesses for tax purposes. Just because the financial statement shows cost of goods sold doesn't mean the tax return should or even can [00:54:30] have cost of goods sold reported.