Federal Tax Law Compliance for Cannabis Businesses: Section 280E
In 1961, the United States Supreme Court held that even income generated from illegal activity is subject to federal taxation, which means cannabis businesses must pay federal income taxes, just like any other federally-legal business. However, because the possession, manufacture, and distribution of “marihuana ” 1 remains illegal under federal law, cannabis businesses are subject to unique tax rules.
While cannabis businesses must pay federal income tax, the IRS Tax Code treats cannabis businesses differently because of a provision known as Section 280. Section 280E of the IRS Tax Code prevents cannabis businesses from deducting “ordinary and necessary business expenses” for purposes of determining gross taxable income. To be clear, Section 280E is not specific to the cannabis industry, but prevents tax deductions for any trade or business that consists of trafficking in controlled substances. Thus, while a federally-legal business can deduct ordinary and necessary business expenses like advertising, bank fees, meals and entertainment, general employee wages, rent, office supplies, payroll etc., pursuant to Section 162 of the IRS Tax Code, a business that sells, grows, or produces cannabis cannot take advantage of this corporate tax deduction.
Although cannabis businesses generally cannot deduct business expenses from their gross income, they may exclude “Costs of Goods Sold” (“COGS”) for purposes of determining gross taxable income. The U.S. Tax Court has noted that excluding “COGS” for purposes of calculating gross taxable income is not technically a tax deduction, and there is no legal precedent that would support a finding that cannabis businesses should be treated differently, at least in this regard. Generally speaking, COGS consists of direct expenses for the production of goods, meaning things like seeds, plants, packaging, and labor related to the growing and maintenance of cannabis plants.
In 2012, the U.S. Tax Court held that COGS for a cannabis grower included: (1) the price paid for marijuana; (2) labor costs related to growing the marijuana; and (3) the cost of incidental materials and supplies. The IRS Office of Chief Counsel has offered a more expansive view of COGS, allowing cannabis producers to deduct wages, rents, and repair expenses attributable to production activities. However, deductions are not allowed for wages, rents, and repair expenses related to general business and/or marketing activities. For cannabis retailers (dispensaries), COGS is limited to the invoice price of purchased cannabis (less any discounts), and transportation or other costs necessary to gain possession of the cannabis inventory.
It is important to understand that businesses who sell cannabis and non-cannabis goods or services cannot avoid Section 280E altogether. In 2007, a case involving an organization known as Californians Helping to Alleviate Medical Problems (“CHAMP”) concerned the application of Section 280E, as CHAMP provided caregiving and counseling services to patients, which sometimes included distribution of medical cannabis to patients. CHAMP argued that Section 280E did not apply to the portion of the business providing caregiving services, which accounted for a substantial amount of revenue generated by the business. The U.S. Tax Court ultimately agreed, finding that the caregiver services were extensive enough to establish the existence of two separate businesses: One business involved medical cannabis and was therefore subject to 280E, while another involved caregiving and counseling services and was not subject to 280E. Unfortunately, many took this to mean that it is possible to avoid Section 280E by selling non-cannabis goods or services, thus establishing a second line of business like in the CHAMP case. However, as the Tax Court has repeatedly emphasized, a second (non-cannabis-related) business must be able to “stand on its own,” which requires diligent accounting and record keeping to show two distinct business operations.
The application of 280E to state-legal cannabis operations is a hard pill to swallow, as cannabis businesses often pay an effective federal income tax rate of about 70%, compared to the typical corporate tax rate of about 30% for federally-legal businesses. It should come as no surprise that the IRS is quick to scrutinize cannabis company tax returns, so it is best to anticipate and prepare for an IRS audit sooner rather than later. Additionally, cannabis businesses should remain transparent regarding business operations and tax methodologies in order to ensure a favorable outcome. Given that cannabis businesses are significantly more likely to face an IRS audit, the importance of remaining in good standing cannot be overemphasized.
1 The Controlled Substances Act uses the term “marihuana.”
2 26 U.S.C. § 280E.
3 Olive v. C.I.R. 139 T.C. 19 (2012).
4 Chief Counsel Advice (CCA), 201504011.