Editor’s note: This article is the first installment of a three-part series; stay tuned for Parts 2 and 3 in the coming days!
Following the 2016 elections, marijuana is now legal in some capacity in 28 states. However, even though it’s legal in certain states, the federal government considers the drug an illegal Schedule I narcotic. Resultingly, business owners in the marijuana industry have hit a wall with IRC §280E, which states:
“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
IRC §280E will no longer apply to cannabis businesses if and when cannabis is no longer classified as a Schedule I or Schedule II controlled substance.
When IRC §280E was enacted in 1982 to overturn the result in the Tax Court case Jeffrey Edmondson v. Commissioner, it held that the taxpayer, who was engaged in an illegal drug dealing business, was entitled to deductions for “telephone, auto, and rental expenses” that he incurred in his business. The Senate report makes clear that IRC §280E was intended to overturn the decision in Edmondson and deny deductions to illegal drug dealing businesses. However, for Constitutional reasons, Congress did not attempt to prevent taxpayers from using cost of goods sold (COGS) to compute gross income. Thus, IRC §280E denies all deductions from gross income in computing taxable income, but illegal drug dealing businesses are permitted to take COGS into account in computing gross income.
Avoiding the pitfalls of Section 280E
In 2007, there was a U.S. Tax Court Case that involved Section 280E. There was a dispensary operating as both a dispensary of cannabis and a caregiving facility. The Court found that the dispensary operated with a dual purpose. Its primary purpose was to provide caregiving services to its members, while its secondary purpose was to provide its members with cannabis. Thus creating “two businesses under one roof.” The Court then proceeded to allocate the expenses between the two businesses, which lead to a commonly used strategy today of allocating various expenses among dispensary use and the act of caregiving.
However, in another Tax Court Case, the Court held that the owner of a medical cannabis dispensary was not entitled to any business deductions for expenses associated with caregiving services that were provided alongside the cannabis business. In 2004, the Vapor Room Herbal Center opened in California. In addition to selling medical marijuana, the dispensary provided vaporizers, games, books, and art supplies for customers to use and also held regular activities, such as yoga classes, massages, and movie showings — all free of charge.
The IRS audited the Vapor Room’s tax return and concluded that the taxpayer was not allowed to deduct expenses in connection with COGS or the other reported business expenses. The case ended up in Tax Court. While admitting that a business can have multiple activities that are taxed differently, the Tax Court found that the Vapor Room’s sale of medical marijuana was inseparable from the other services provided.
The case ended up in Appeals Court. Judge Graber, who wrote for the three-judge panel, affirmed the Tax Court’s decision. First, to determine whether the Vapor Room’s ordinary and necessary business expenses would be tax deductible under §280E, the court considered whether the Vapor Room was a “trade or business” that “consisted of” trafficking marijuana. Taking these contested phrases in turn, the court stated that “the test for determining whether an activity constitutes a ‘trade or business’ is ‘whether the activity was entered into with the dominant hope and intent of realizing a profit. Applying this test, the court found that the only “trade or business” of the Vapor Room consisted of the selling of medical marijuana, because although the Vapor Room provided other services — such as food, drink, movies, and counseling — the selling of medical marijuana was the only income-generating activity of the business.
The IRS has weighed in on the matter and has concluded that although marijuana-related businesses are permitted to determine COGS, they must do so using Section 280E, as it was enacted in 1982, and Section 471, which allows the use of inventories to determine business income. When §280E was enacted in 1982, an ‘inventoriable cost’ referred to any costs that could be capitalized to inventories under §471.
To capitalize something simply refers to the manner in which something is expensed. Capitalization simply means delaying the recognition of an expense by treating the item as a fixed asset rather than recognizing the cost in the period that it was incurred. Capitalization is generally only used by companies that operate on the accrual basis of accounting.
In addition, the IRS concluded that cannabis businesses are not permitted to calculate COGS using the more recent IRS regulations which can be found in Section 263A, which permitted the inclusion of additional expenses, namely purchasing, handling and storage expenses, and service costs.
This has set up a dichotomy. For resellers, the costs that they normally incur in the purchase of cannabis may not be deducted as COGS under the rules of Section 280E. These costs are directly related to the trafficking of cannabis. This means that only the actual invoice price of the cannabis is deductible. Not including the transportation costs and other costs that are normally associated with gaining possession of inventory.
For cannabis production businesses, like growers, there are significantly more opportunities to claim items as COGS. Production-related wages, rents, and repair can be considered as COGS upon the sale of the inventory for accrual-basis taxpayers and immediately for cash-basis taxpayers that are cannabis-production businesses. However, marketing and general business expenses remain nondeductible.
Indirect production costs that may be considered as COGS include:
- Repair expenses;
- Indirect labor and production supervisory wages, including basic compensation, overtime pay, vacation and holiday pay, sick leave pay (other than payments pursuant to a wage continuation plan under section 105(d)), shift differential, payroll taxes, and contributions to a supplemental unemployment benefit plan;
- Indirect materials and supplies;
- Tools and equipment not capitalized; and
- Costs of quality control and inspection.
The IRS has also permitted producers to claim some additional COGS deductions, as long as the company makes sure to produce financial statements that are in accordance with Generally Accepted Accounting Principles (GAAP). GAAP is basically the accrual method of accounting whereby income is recognized when earned and expenses when incurred.
These expenses include:
- Taxes deductible under §164, other than state, local, and foreign income taxes;
- Depreciation and depletion;
- Deductible employee benefits, including pension and certain profit-sharing contributions, workers’ compensation expenses, stock bonus plans, premiums on life and health insurance, and miscellaneous employee benefits such as safety, medical treatment, cafeteria, recreational facilities, and membership dues;
- Costs pertaining to strikes, rework labor, scrap, and spoilage;
- Administrative expenses related to production;
- Officers’ salaries related to production; and
- Insurance costs related to production.
What are the effects of Section 280E?
The effect of 280E is that those in a legal cannabis business are reporting that they have up to a 70 percent tax liability. Let’s say that you own a regular business, and you have $1 million in sales, you have $600,000 in COGS, $100,000 in salaries, $50,000 in rent, and $200,000 in other business expenses. The result would be that you would have to pay taxes on $50,000. If the tax rate was 30 percent then the taxes owed would be $15,000.
If this were a cannabis business, you would be paying taxes on $400,000 ($1 million minus the COGS at $600,000) and would not be able to deduct anything else. If you were in the 30 percent tax bracket, you would pay $120,000 in taxes. That is a $105,000 shift for a company operating in the cannabis industry
As you can see, taxation for the cannabis industry is a complete mess. In the next installments of this series, we will discuss strategies to get around Section 280E, the challenges of the banking system, and how to run an all-cash business.