With so many states reforming their marijuana laws, cannabis has achieved widespread acceptance as a legitimate industry. However, the state of marijuana business finances belie this reality.
Most state-legal cannabis businesses function on a cash-only basis since financial institutions are hesitant to provide their services to an entity dealing with a federally illegal substance. While some state-chartered banks and credit unions have stepped in to fill the void, access to basic financial services remains a huge challenge for cannabis businesses.
This isn’t the only serious financial disadvantage faced by cannabis businesses.
The Internal Revenue Service (IRS) Tax Code 280E puts extra tax obligations on marijuana businesses that companies in other industries needn’t worry about.
IRS Code 280E applies to marijuana businesses so long as cannabis remains a Schedule I controlled substance under federal law, but this doesn’t mean there aren’t steps that cannabis business owners can take to potentially reduce their tax obligations.
However, getting it wrong puts cannabis businesses at an even greater risk of an IRS audit. These audits are significantly more common for cannabis businesses than for other companies. In Colorado, one in five marijuana businesses have been audited, which is nearly ten times the national average.
So, it’s important to be informed and stay compliant, but also to not overpay.
Nothing in this guide constitutes personal tax advice. Be sure to consult with certified marijuana law, tax and accounting professionals to properly manage cannabis business tax obligations under 280E.
What is IRS Code 280E?
Ordinarily, a business will take its gross income and deduct operational expenses such as rent, payroll and marketing to arrive at its net income, or operating profit. This is the amount the business will then pay tax on.
Under Section 280E of the Internal Revenue Code (IRC), these deductions are not possible for state-legal cannabis businesses.
IRC 280E prohibits any business connected with the trafficking of a Schedule I or II controlled substance from deducting operational business expenses from their taxable income:
“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.“
In essence, this means cannabis businesses pay tax on their gross income, and this typically results in a tax bill that’s two or three times higher than that of a business taxed on its net income.
While marijuana businesses typically pay between 40 to 80 percent in federal taxes, other businesses pay the flat 21 percent corporate tax rate. And that’s without even considering state marijuana tax rates.
This puts cannabis businesses, especially small ones, at a huge financial disadvantage. Their onerous tax obligations means they are unable to use a good chunk of their revenue to reinvest in the business.
History of IRC 280E
IRC 280E was passed by Congress in 1982 in response to the outcome of a court case that asserted the right of a renowned drug trafficker to deduct business expenses from the taxable income derived from his illegal business.
Anti-drug hysteria, including for cannabis, was perhaps at its peak in the US during the 1980s.
Today, the situation is a lot different. Eighteen states have legalized recreational sales of marijuana and 36 permit some form of medical cannabis use, yet IRC 280E continues to be interpreted to include state-legal marijuana businesses.
In the landmark case Canna Care, Inc. v. C.I.R in 2015, the tax court ruled that Canna Care, which operated a legal medical marijuana dispensary under California state law, could not deduct its operating expenses from its tax bill due to marijuana’s status as a federally controlled substance.
This reaffirmed the force of IRC 280E and the primacy of federal law, despite the momentum of state marijuana legalization.
Types of Cannabis Businesses Affected by IRC 280E
IRC 280E refers to drug trafficking, so its impact is most keenly felt by cannabis retailers.
That said, other marijuana businesses can be affected as well so it’s crucial to understand the seed-to-sale structure to determine tax obligations under IRC 280E.
Marijuana business verticals are divided up according to the following functions:
- Processing, infusions and extractions
- Vertically integrated, meaning the company grows, processes and sells its own cannabis products
A cannabis cultivator that wholesales its product to a vendor may be subject to 280E. To potentially avoid this as a cultivator, it may be a good idea to separate expenses relating to the cultivation of cannabis from any sales expenses such as transport.
Tax Deductions and Deductible Expenses Under IRC 280E
There are some exceptions to IRC 280E. It is possible to deduct the costs of goods sold (COGS):
“To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill.”
This includes the cost of the cannabis product itself, packaging and labeling for the cannabis product, as well as, for instance, electricity costs for marijuana inventory areas but not sales areas.
Working out which expenses may be deducted as COGS could significantly reduce the tax bill of a cannabis business.
As mentioned, marijuana cultivators and processors should be aware that their COGS for wholesale products could be subject to 280E, but if it is a vertically-integrated operation this may not be the case, except for transportation and delivery costs.
The types of IRC 280E COGS for cannabis cultivators may include cleaning, trimming, curing, packaging and inventory as well as for raw materials and supplies. Certain indirect costs may also be deducted, such as equipment maintenance, utilities used for cultivating marijuana, management salaries, and quality control and inspection costs.
To be certain and remain compliant, it’s important to go through a list of potential deductibles with a specialized marijuana accountant.