In 1970, the Controlled Substances Act declared cannabis illegal. Cannabis was placed on Schedule I, meaning it had a high potential for abuse and no medicinal properties. Less than 30 years later, in 1996, California passed Proposition 215, which legalized the medicinal use of cannabis in the state and several other states soon followed suit. In 2012, Colorado and Washington went further and legalized recreational marijuana.
Today, 38 states have legalized the medical use of marijuana, and 18 have legalized its recreational use. However, it still remains illegal at the federal level.
A crucial component of owning and operating a cannabis business is understanding the state and federal regulatory guidelines that you must follow. In particular, people in the cannabis industry must be aware of Section 280E of the Internal Revenue Code in order to maintain compliance.
We describe what this section is and how it may apply to you. Our team of knowledgeable cannabis attorneys here at Newburn Law can help you understand how this Section affects you and how to stay compliant. Contact us today so that we can answer any questions you might have.
How Cannabis Businesses Are Different
According to the IRS, all income, even money made from unlawful activities like selling illegal drugs, must be reported as income when filing taxes. However, that does not mean the IRS will treat all businesses equally. Most companies are allowed to deduct ordinary business expenses from their taxes. Section 26 USC § 162 defines typical business expenses, which include payments made for:
- Traveling expenses,
- Office supplies, and
- Other business-related expenses.
Accordingly, one would think that taxpayers in any of the 38 states that have developed a legal market for cannabis would be able to take advantage of this beneficial provision. However, they are not. This is because of 26 USC § 280E (“Section 280E”).
This section of the Internal Revenue Code prohibits taxpayers engaged in the trafficking of controlled substances, as defined by schedules I and II of the Controlled Substances Act, from deducting typical business expenses.
So, despite their businesses being legal in their state, cannabis businesses are prohibited from deducting ordinary business expenses due to the illegality of cannabis at the federal level.
The Origins of Section 280E
Before Section 280E was passed, courts would deny deductions to taxpayers engaged in illegal businesses through the "frustration of public policy doctrine," the idea being that the law should not be construed in a way that frustrates the objectives of other laws.
The logic behind the policy is that they did not want to create a statute to incentive ‘drug dealing.' Congress sought to prevent courts from applying the frustration doctrine by passing the Tax Reform Act of 1969, which explicitly listed which types of unlawful conduct could not be deducted. As a result, when Edmondson v. Commissioner was decided in 1981, the frustration of public policy doctrine was not applied.
The court convicted Jeffrey Edmondson of trafficking cannabis, cocaine, and amphetamines. He was later approached by the IRS and filed a tax return for 1974 as part of a jeopardy assessment made by the Tax Commissioner.
His cost of goods sold was found to be $105,300, but the Tax Commissioner denied him a deduction for rent and for the equipment and expenses used in running his business. Likely due to the Tax Reform Act's intended curtailment of the frustration of public policy doctrine, the Tax Court allowed these deductions to be both ordinary and necessary expenses in the operation of Edmondson's business.
Less than a year later, Congress responded to the Tax Court's decision by passing Section 280E. Its legislative history finds that Congress enacted it to codify a sharply defined public policy against drug dealing.
Challenges Caused by Section 280E
Many aspects of the Cannabis Industry are shaped by Section 280E. For example, Section 280E is why cannabis businesses are typically run as all-cash operations. Mainstream banking institutions won't do business with the cannabis industry due to the federal illegality of marijuana. Many banks fear federal actions charging them with money laundering or “aiding and abetting” in the commission of federal crimes.
As a result, most cannabis businesses rely on state-chartered banks or credit unions for their banking needs.
Another challenge Section 280E brings to the cannabis industry is a disproportionately high effective tax rate compared to non-cannabis businesses. A business' effective tax rate is the rate paid on its pre-tax profits.
While all companies can deduct the cost of goods sold from their gross revenue when determining gross profit, Section 280E prohibits cannabis businesses from deducting any of the expenses permitted by Section 162. So, while non-cannabis businesses can further reduce their tax liability before calculating their net income, cannabis businesses are not.
Accordingly, the effect of Section 280E is that cannabis businesses are effectively taxed on the full amount of their gross profit. For example, assume the corporate tax rate is 21% and a cannabis and non-cannabis business both have $1,300,000 in gross profit and $1,000,000 in ordinary business expenses. With these parameters, the non-cannabis company will be able to reduce its gross profit by the amount of its ordinary business expenses for a net income of $300,000. At a 21% tax rate, the non-cannabis' tax liability will be $63,000, resulting in after-tax profits of $237,000.
However, due to Section 280E, the cannabis business will not be allowed to reduce its gross profit by the amount of its ordinary business expenses. Thus, the cannabis business' net income is $1,300,000, and at a 21% tax rate, it will pay $273,000 in taxes, resulting in after tax profits of only $27,000.
It is also important to note that while ordinary expenses are not allowed to be taken as a deduction, the company still needs to pay them, and they pay them from gross profits. Thus, the business is left with $27,000 as net profit after taxes and ordinary business expenses are paid in this scenario.
What is Cost of Goods Sold?
To clarify what constitutes costs of goods sold ("COGS"), COGS are the costs directly related to the company's production of goods. Due to constitutional concerns that Section 280E was an overreach of Congress' powers under the Sixteen Amendment to lay and collect taxes, Cannabis businesses can deduct COGS. Accordingly, what qualifies as part of COGS becomes very important and will depend on what type of cannabis business is being operated.
If the cannabis business is a cultivator, COGS would include all labor associated with taking care of the plants, packing the finished product into wholesale bags, and the seeds, nutrients, and any grow media used. Additionally, suppose the cannabis cultivator produces financial statements in accordance with the Generally Accepted Accounting Principles. In that case, companies can deduct employee benefits, like worker's compensation, profit sharing, and health insurance as well.
While COGS allows cultivators to deduct various expenses, cannabis retailers are not so lucky. In Harborside v. Commissioner, the U.S. Tax Court clarified the distinction between retailers and cultivators. Concerning retailers (i.e., those who do not have an ownership interest in the cannabis products, did not create them, did not maintain tight control over it, or take possession of everything that was produced), the court determined that COGS was the price paid for inventory and transportation plus other necessary charges incurred to take possession of the goods.
Finally, for cannabis processing businesses, COGS includes the costs related to creating the derivative products, including the use of specialized machinery. Cannabis processing businesses are responsible for extracting cannabinoids from the marijuana plants and using them to create derivative products like edibles, oils, and medicinal capsules. If a state regulatory body will have to review the derivative cannabis products to determine if they are safe for public consumption before entering the market. The costs incurred by the processor to determine whether their products will pass inspections and quality control tests from state regulators are also included in COGS.
How to Maximize Deductions
Cannabis companies that want to keep more of their earned money should be aware that workarounds and loopholes for Section 280E are not easy. Further, given the IRS' pattern of aggressively auditing cannabis companies and harshly punishing even the slightest mistakes, it is inadvisable to pursue any risky accounting strategies to avoid this provision.
In fact, given the regulatory environment, cannabis businesses should expect to get audited at some point. The best strategy for maximizing permissible deductions while creating an ironclad defense is to have accurate accounting. A non-exhaustive list of practices would include having an electronic method of managing documentation for inventory, workforce, and spending and reporting all cash transactions.
Cannabis companies may also want to consider entering into a shared services agreement where the business operations are split between two separate business entities. One would be responsible for all cannabis-related activities and fall under the purview of Section 280E. The second would be able to take advantage of ordinary deductions concerning rent, utilities, administration, and marketing.
As a cannabis business owner, you may find it confusing to navigate the complex rules and regulations that apply to cannabis companies. We here at Newburn Law take the time to ensure we continuously stay up-to-date with changing regulations and ensure we advise our clients to understand what they need to know to maintain compliance.
By understanding Section 280E, your business can determine what expenses can and cannot be deductible. If you have any questions, contact us today for a free consultation.