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Prepared for the named operator under a limited-scope diagnostic. Facts are as reported by the operator and are not independently verified in a fixed-fee diagnostic — verification is part of any downstream engagement.
This memo is not a signed return, a filed refund claim, or an audit defense. Those are scoped and engaged separately under an engagement letter and, where representation is involved, a Form 2848.
Exposure figures are computed on a full-flow-through basis and represent an upper bound. Treas. Reg. §1.471-11(c) capitalizes indirect production cost into inventory, which reduces taxable income only as that inventory sells; the ending-inventory adjustment is not modeled here.
Cannabis scheduling and IRS guidance are changing rapidly; positions are verified against current authority before any return is signed.
A sample cultivation operator runs a mixed medical and adult-use business in California alongside a small adult-use retail license and a non-plant-touching holding entity. On the books as filed, the operating cultivation entity carries a materially under-absorbed cost-of-goods-sold position: indirect production costs that §1.471-11(c) permits a producer to absorb into inventory are instead booked to selling, general and administrative expense, where §280E disallows them outright. That single treatment accounts for the whole of the recoverable exposure identified here. Cash-reporting hygiene under §6050I is live but secondary; no active IRS matter was reported.
| Tax year | Reclassifiable cost | Rate | Overpaid tax |
|---|---|---|---|
| FY 2023 | $418,165 | 21% | $87,815 |
| FY 2024 | $489,254 | 21% | $102,743 |
| FY 2025 | $551,979 | 21% | $115,916 |
| Total | $1,459,399 | — | $306,474 |
How it was calculated: each of the seven indirect-cost accounts is multiplied by its production-allocation percentage, summed per year, then taxed at 21% under IRC §11(b).
A California cultivation operation running roughly 10,000 sq ft of canopy within a 12,800 sq ft facility, from a single location. Cultivation and retail sit in separate licensed entities; a third entity holds real estate and brand IP and touches no plant. The operating entity is taxed as a C corporation.
Three-year average ≈ $2,853,333 — well inside the small-business inventory threshold (see 04).
The operating entity holds both medical and adult-use cultivation designations; a separate microbusiness license covers retail. Both licensed entities are plant-touching; the holding entity is ancillary and non-plant-touching, so it sits outside §280E. §280E is read entity by entity — it applies to the trade or business that traffics, not the group.
Cash-intensive, as is typical for the segment. Books are maintained in QuickBooks and reconciled against POS and bank records; the reconciliation is partial and reconstructed. Form 8300 filing history is incomplete on the records supplied — whether individual receipts exceeded $10,000 could not be determined.
IRC §280E denies deductions and credits to a trade or business trafficking in a Schedule I/II controlled substance. Cannabis is federally Schedule I, so ordinary operating deductions are disallowed. What survives is cost of goods sold — and as a producer, the operator's inventoriable costs are governed by the full-absorption method of Treas. Reg. §1.471-11(c). Direct production costs are captured correctly; the indirect production costs are booked entirely to SG&A.
| Category | Driver | As booked (SG&A) | Reclassifiable |
|---|---|---|---|
| Indirect labor | Time study | $210,000 | $168,000 |
| Rent | Square footage | $180,000 | $145,000 |
| Utilities | Square footage | $126,720 | $102,040 |
| Depreciation | Square footage | $70,000 | $56,350 |
| Repairs & maintenance | Square footage | $45,540 | $36,660 |
| Insurance | Square footage | $58,016 | $26,700 |
| Security | Square footage | $54,864 | $17,229 |
| FY 2025 total | $745,140 | $551,979 |
Illustrative sample figures — not drawn from a real engagement.
Cost of goods sold rises by $551,979 — from $1,227,600 up to $1,779,579 — while disallowed SG&A falls by that same $551,979, from $1,097,184 down to $545,205. It is one figure moving out of the disallowed column and into the column that survives §280E.
| Driver | Categories (FY 2025) | Reclassified to COGS | Share |
|---|---|---|---|
| Square footage | Rent · utilities · depreciation · repairs · insurance · security | $383,979 | 69.6% |
| Time study | Indirect labor | $168,000 | 30.4% |
| Total reclassified | $551,979 | 100% |
This is the same $551,979 moved into COGS in the return effect above — now split by the driver used to allocate each category (FY 2025). Floor-area categories total $383,979; indirect labor totals $168,000; together $551,979. Each share is that driver ÷ $551,979.
§471(c) eligibility. Average gross receipts of $2,853,333 fall well below the ~$31M threshold, so the operator is eligible to elect the small-business inventory method — addressed in the return/disclosure workflow.
Cash / §6050I. Records don't evidence a Form 8300 filing log; penalties escalate sharply where failure is intentional. Not quantified on the facts supplied.
Payroll / §6672 & Collections / §6321–§6331. Deposits appear current and no assessed balance was reported; both read low and are monitored rather than engaged.
Transition — Schedule III. If cannabis reschedules, §280E stops applying going forward. Position now: maximize reclassification under §1.471-11(c) while §280E still binds, prepare the books, and evaluate an amended return. Retroactive relief is contested and the Service is pushing back — verify current status.
| Issue | Authority | Exposure | Likelihood | Priority |
|---|---|---|---|---|
| Under-absorbed COGS — indirect cost reclassification | §1.471-11(c) | $306,474 recoverable | High | Act now |
| Amended-return / refund posture (open years) | §6501 | up to $306,474 | Medium | Act now |
| Cash reporting — Form 8300 gaps | §6050I | Not quantified | Medium | Address |
| Schedule III transition timing | Rescheduling | Timing risk | Medium | Position |
| Payroll trust-fund exposure | §6672 | Low | Low | Monitor |
| Federal lien / levy exposure | §6321 · §6331 | None assessed | Low | Monitor |
Priority reflects what the file can move this year, not the size of the number alone.
| Engagement | What it does | Expected outcome | Priority |
|---|---|---|---|
| §1.471-11 cost study + §471(c) election | Reclassify indirect production cost into COGS with driver support | Recover ≈ $306,474 | 1 |
| Amended-return evaluation | Test refund claims for open years against the §6501 window | Refund vs. audit-risk call | 2 |
| §6050I / Form 8300 remediation | Reconstruct the cash log; assess filing gaps | Cut penalty exposure | 3 |
| Books & records readiness | Rebuild reconciliation to METRC and bank | Audit-defensible file | 4 |
| Monitoring | Watch §6672 and §6321/§6331 triggers | Early warning | Ongoing |
Examination representation (Form 2848), Appeals, and any litigation posture are scoped separately if and when a notice arrives — they are not part of a diagnostic engagement.
The reclassification is an upper bound until the ending-inventory adjustment is modeled and the drivers are substantiated contemporaneously. That work converts the estimate into a defensible position.
This is an illustrative sample that demonstrates the deliverable format. It is general COGS methodology for planning — not advice on a specific return, a filed refund claim, or an audit defense. Figures are an upper bound on a full-flow-through basis and are not independently verified. Cannabis scheduling and IRS guidance are contested and evolving; positions are re-checked against current authority before any return is signed.
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