We’ve all heard the about the green rush. One thing that surely amazes me is the number of entrepreneurs that are rushing to get into the cannabis industry despite the numerous risks and challenges associated with this emerging industry. The more you dive into understanding the industry, the more challenges you will discover. One of the greatest challenges (aside from being federally illegal, and not being able to bank your money) is Internal Revenue Code Section (IRC) 280(E).
IRC 280(E) provides that “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.”
What this means is that State legal cannabis businesses that manufacture, cultivate, distribute or sell cannabis, cannot deduct any business expenses except for the Cost of Goods Sold (“COGS”). Since marijuana is listed as a Schedule 1 drug under the Federal Controlled Substance Act (“CSA”), it is illegal for anyone to manufacture, cultivate or distribute under Federal law despite being legal under State laws. Therefore, for purposes of paying your federal taxes, the IRS considers the manufacture, cultivation or distribution of cannabis that is legal under it’s state laws, illegal trafficking in controlled substances and subject to IRC 280(e).
IRC 280(E) was enacted by Congress in 1982 as a reaction to the United States Tax Court case Jeffrey Edmondson v. Commissioner. In Edmondson, the Court 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. Congress acted by passing IRC 280(E) to deny other drug dealers from being able to deduct business expenses – it was never intended to prohibit State legal business from being able to deduct their expenses.
If you have ever had your own business or taken an accounting course, you know that federal income taxes are based on a fairly simple mathematical equation: gross receipts – business expenses = taxable income. Under 280(E), cannabis businesses are severely limited on what they can deduct as business expenses; as stated, they can only deduct the COGS.
The National Cannabis Industry Association provided the following examples to help illustrate how IRC 280(E) has applied to typical cannabis businesses:
Example 1 is a 1065 tax filing from 2014 from a medical cannabis dispensary in Seattle, Washington. Gross income from this business totaled $154,469 for 2014, and the business had $101,100 in expenses. If this business were a regular business, it would be taxed on its earnings, which were $53,369. In order to comply with IRC 280(E), however, the business was unable to take these deductions, and instead it paid taxes on $154,469. The business’ tax payment totaled $46,340, which equates to 87% of its true earnings. The business owner had only $7,029 to either invest back into his business or keep as profit.
Example 2 is a 1065 and Statement of Activities and Changes In Net Assets from a medical marijuana dispensary in Arizona. The business produced $876,420 in gross receipts and was permitted to deduct $319,386 in Cost of Goods Sold, but could take no deductions for its other expenses. The business, thus, was taxed on its gross income, which was $557,034. Like many startup businesses, however, the dispensary had significant first-year expenses, which totaled $867,863. These operating expenses were nondeductible under IRC 280(E). So while the business actually lost a total $310,829 for the year, its tax bill was still $189,781. Despite bringing in $876,420, the business ended up more than half a million dollars in the red.
There are certain strategies a cannabis business can employ to help reduce its IRC 280(E) exposure. For example, strategically determining what actual expenses can be included as COGS. Unfortunately, recently the IRS announced that it was further limiting what cannabis business could include as COGS. Therefore, it is imperative that any cannabis entrepreneur consult a professional who is experienced with IRC 280(E) before setting up and launching its business. Although many accountants have made a decision not to represent cannabis businesses due to the complexities of IRC 280(E), others welcome the challenge and have done significant research to advise and consult clients. At Clifton Cannabis Law, we work locally with Chris Telfer, CPA and former State Senator, who is specializing as a consultant in IRC 280(E).
Despite the many challenges that cannabis businesses face, the demand for the market exist, and the opportunities are expansive. The key to success is to make sure you have the business intelligence you need on your team before diving in. This will help differentiate your business from the others and set you up for a lucrative exit strategy in the future.
Jennifer Clifton is the founder of Clifton Cannabis Law, LLC. At CCL, we represent cannabis entrepreneurs in Oregon and California in all corporate matters, from startup counseling and general corporate matters to angel and venture capital financings to mergers, acquisitions and sales of businesses. e. firstname.lastname@example.org/ p. (541)797-9995