At Green Valley Tax Services, Inc, we are dedicated to helping you make the best decisions for your business. Our services include tax planning resolving tax authority problems and audits. When we consult with our business owner clients, one issue that comes up is which business entity is best for them, and it varies with each client. We help you with the Cannabis Industry to make the best decisions.
The Battle of Who is in Charge
The battle of who is in charge between states and the federal government goes back before our official founding. States have always wanted to be viewed as separate entities, united only for defense and shared cultural norms.
These traditions are being challenged right now in a relatively surprising way. Marijuana has always had a sordid past in this country. Even when it was marketed as candy in the late 1800s to early 1900s, it was still considered suspicious by some who viewed any drug as dangerous.
Those feelings are changing right now. The vast majority of the United States believe marijuana to be relatively harmless, especially in the case of medical application. That has led numerous states to legalize cannabis products for both medical and recreational use. Court battles are cropping up left and right as more people dive into the cannabis business.
The primary challenge is related to business more than the plant. A dispensary operating somewhere like Maine or Colorado is entirely legal according to the state. Yet, when it comes to having a bank account, they cannot get approved because these institutions follow FDIC guidelines which consider cannabis to be illegal.
The same is true for taxes. The IRS doesn’t recognize an illegal activity as a valid business, contrary to all the mafia movies you may have seen. The compromise to this rule is tax code Section 280E.
What is 280E?
Section 280E was enacted by Congress in 1982 as part of the Comprehensive Drug Abuse Prevention and Control Act. 280E was designed to prevent drug traffickers from deducting expenses related to their illegal activities, such as manufacturing materials and supplies, wages for employees, rent, utilities, etc. It does not include other business expenses such as advertising or marketing.
In other words, marijuana businesses can only claim the cost of goods sold as a deduction rather than write off legitimate business expenses such as rent and employee salaries. This means the tax obligation of a legal business at the state level is disproportionately higher than a similar business at the federal level. Luckily, the demand for cannabis-related goods is significantly higher than a restaurant with similar gross receipts.
Section 280E requires three elements to be present for it to be applied. These include:
1 | Presence of a Controlled Substance
A Schedule I controlled substance is a drug or other substance with a high potential for abuse and has no currently accepted medical use in treatment in the United States. This includes, but is not limited to LSD, heroin, marijuana (cannabis), 3-4 methylenedioxymethamphetamine (ecstasy), methaqualone, peyote, hallucinogenic frogs (psilocybin mushrooms), mescaline cactus, and methylphenidate.
2 | Trafficking Potential
To be convicted of trafficking under 280E, you must be proven to have engaged in a business with the intention of selling Schedule I or II controlled substances. The first element is that the company must be trafficking in a Schedule I or II controlled substance. The second element is that the business must profit from selling Schedule I or II controlled substances.
So what does this mean for an industry like cannabis? Is it illegal for a dispensary owner (or anyone else) to sell marijuana for money?
No! Marijuana has been legalized by popular vote in many states across the country, and selling it within those states is absolutely legal.
However, if your state has not legalized marijuana yet—or if you are operating somewhere without legalization at all—then you may have some issues with 280e as long as you profit from your sales.
3 | Trade or Business
Have you been running a business or trade with continuity of activity over a measurable period of duration that would be considered actively selling?
How does Section 280E Affect Legal Cannabis Businesses?
While some might think that Section 280E would only affect illegal marijuana dealers, it also applies to legal cannabis businesses and those not yet legal. For example, medical cannabis dispensaries are still considered illegal under federal law and fall under 280E's strict guidelines.
Similarly, hemp businesses also fall under the scope of 280E if they're conducting business with any other company that sells or distributes marijuana—even if both companies aren't doing anything illegal. This is because hemp is defined by the DEA as being related to or derived from plants of the genus Cannabis sativa L., which includes both industrial hemp and its illicit cousin marijuana (which contains high levels of tetrahydrocannabinol).
This means you cannot make deductible business expenses as a legal (by the state) cannabis business.
Let’s make a comparison. Say you own a medical dispensary in Arizona, and your brother runs a non-cannabis business. Both of you have a million USD in annual gross revenue. Both of you can deduct $650,000 as COGS (cost of goods sold). The result is you are $350,000 left in gross income.
So far, so good, right? Fair is fair, and you are operating a business.
Here’s where things get rough. Your brother running a non-cannabis business can take further business deductions from marketing, advertising, rent, employees, and other items, reducing his taxable income by another $200,000.
The remaining difference is you have a taxable income of $350,000 to deal with, and your brother has $150,000. So you will end up paying, assuming a 30% tax rate, roughly $105,000, and your brother will pay $45,000.
This changes the effective tax rate of your business to 70% of your taxable income, while your brother sits at only 30%.
What are the Exceptions to Section 280E?
Fortunately, there are exceptions to Section 280E. First and foremost, Section 280E does not apply to any business that is not trafficking in controlled substances.
This means that if your company isn't engaged in the sale or distribution of cannabis-derived products, then you're exempt from its requirements. You can also be exempt if the controlled substance is for a medical or scientific purpose—but only if it's part of an FDA-approved clinical research program.
What About COGS?
To fully understand 280E, and how it impacts your business, there are several terms that you should be familiar with. First, the term "cost of goods sold" (COGS) is an accounting term that refers to the difference between the amount paid for an item and its cost in your business.
COGS may also be referred to as gross receipts or gross profit margin.
There have been judicial rulings and new IRS clarity on COGS related to the marijuana business.
The general guideline is costs are deductible if a cannabis operator can prove that business expense is necessary for the production of goods.
How does this help? Businesses that cultivate cannabis will experience the most benefit. That is because they can deduct things like management of crops, rent, security, utilities, insurance, technology seeds, depreciation of farming equipment, and anything else related to the product's actual growth and cultivation as COGS.
Strict retailers can deduct the cost to procure the cannabis product and get it delivered to their facility. This might be travel, shipping, packaging, or storing of the product. That is nowhere near the level of deductions a non-cannabis business can make, but it is helpful at least a little.
Looking to the Future
While the impact of Section 280E is significant, there are ways to mitigate its effect on your business. The first step is understanding exactly how Section 280E works and how it affects your business. The next step is understanding the regulations that apply to cannabis businesses. Finally, if you have any questions about this complex law or need help planning for a potential audit by the IRS, contact one of our experts at Green Valley Tax Services.
Our expert team can help organize your business financial situation and prepare you for quarterly or annual tax obligations, so you minimize your taxable income as best as possible. We stay updated on any new regulations affecting this industry and can help you navigate the complex issues, so your business grows. Call us today to schedule a consultation.
The future of cannabis is looking bright. With the recent decision from the President to pardon federal “simple possession” and direct the Attorney General and Secretary of Health and Human Services to consider reclassifying marijuana, there is a good chance the tax code will again shift. In the meantime, contact our team to ensure you are compliant and prepared for the future.