The cannabis industry is an unprecedented industry and subject to constant scrutiny and monitoring. Following the November 2020 election, fifteen states and Washington DC legalized adult cannabis use, a number that will continue to rise as legalization slowly becomes more widely adopted in other states. Beyond that, an ever-growing number of states allow residents to purchase legal medicinal cannabis, and many have decriminalized adult use as well. However, it still remains a Schedule I substance under the Controlled Substances Act and is therefore illegal in all respects at the US federal level, creating a number of problems for companies in the cannabis industry. operating properly in the states where it has been legalized.
Not only is it difficult for cannabis companies to avail of alternative banking solutions, but there are also barriers preventing these companies from taking advantage of significant tax deductions. The main obstacle is section 280E of the Internal Revenue Code (IRC).
What is article 280E?
Section 280E is a relatively short section of code, only 77 words to be exact, but it carries significant weight and can have a debilitating effect on taxable marijuana income. [sic] related businesses (MRB). IRC section 280E prohibits taxpayers who traffic in certain controlled substances, including cannabis, from deducting typical business expenses associated with those activities. Section 280E, which was enacted in 1982 during the “war on drugs” era, has become increasingly relevant to cannabis companies. The cannabis industry has grown significantly in recent years, with annual market values expected to reach $ 30 billion by 2025.
However, while Section 280E severely restricts tax deductions for legal cannabis businesses, there is some reprieve. Current IRC provisions allow legal cannabis businesses in a state, including growers, producers, wholesalers, or retailers, to deduct cost of goods sold (COGS) in their U.S. federal tax calculation. on income, despite the application of section 280E.
Impact of article 280E on businesses
What does Section 280E mean for cannabis companies today? It aims to prevent resellers from claiming tax deductions for their business expenses, interpreted to include legal cannabis businesses, reduced deductions that result in increased taxable income and MRBs will face higher federal tax rates. students.
The IRC rejects any deduction or credit paid or incurred in a tax year if those deductions or credits relate to trafficking in controlled substances. The courts have taken the position that the term “trafficking” in this case means “to engage in a commercial activity, that is, to buy and sell regularly”. Simply put, the law denies cannabis companies any deduction from US federal income tax for ordinary and necessary business expenses, despite being duly licensed as a legal business in their operating state.
Typically, the ability to deduct ordinary business expenses means that a business is subject to federal tax on its net income (i.e. gross revenue minus expenses). However, the definition in Section 280E and the classification of cannabis as a Schedule I substance severely precludes legal cannabis companies from taking advantage of tax deductions for actual economic expenses incurred in the ordinary course of business, resulting in results in a significantly higher effective tax rate because compared to other businesses.
Legal actions and challenges to section 280E
There have been legal challenges and concessions to section 280E. Specifically, the 2007 court case Californians Helping Alleviate Medical Problems, Inc., v. Commissioner. This court case has reinforced the precedence that section 280E does not apply to cost of goods sold. The Internal Revenue Service (IRS) defines cost of goods sold as “the expense necessary to acquire, construct, or mine a physical product that is to be sold.” Usually, for a retail MRB, this means the direct cost of acquiring cannabis products for resale. Deductions for rent, utilities, wages, insurance and other operating costs common to ordinary businesses are generally denied. New York State has specifically indicated that it intends to follow Section 280E for its own income tax calculations, denying these same deductions from New York taxable income.
Tax Court and Article 280E
The Tax Court of Canada has also been aggressive in curtailing efforts by MRBs to separate cannabis-related and non-cannabis activities. The courts maintain that these distinct activities constitute a single trade or enterprise when they share a close and inseparable organizational and economic relationship. Additionally, the risk that cannabis-related activities adversely affect a taxpayer’s other business concerns exists if services or employees are shared between an MRB and a non-MRB. The allocation of expenses to cost of goods sold, as well as any allocation of costs between MRB and non-MRB entities, should be well thought out and supported by defensible tax and accounting positions.
The future of MRBs and section 280E
All indications point to an increased frequency of IRS audits of MRBs compared to audits of non-cannabis companies. Therefore, documenting the methodology behind the cost of goods sold calculation is even more important for MRBs. It is essential to consult a tax advisor to ensure that you are maximizing cost of goods sold deductions and that you prepare the best possible documentation to support your 280E tax positions.
Disclaimer: The information presented in this article should not be construed as legal advice or advice and does not create an attorney-client relationship between the author and the reader. If the reader has legal or accounting questions, it is recommended that you consult their lawyer or accountant.