Marijuana legalization may be continuing apace across the US, but cannabis industry finances are still stuck in the 1980s.
This isn’t just because many financial institutions are reluctant to service state-legal marijuana businesses because of cannabis’ federally-illegal status. It’s also because of Internal Revenue Service (IRS) Tax Code 280E.
This code means marijuana businesses have significantly heavier tax burdens than companies in traditional industries – as much as two to three times more.
While Internal Revenue Code (IRC) 280E puts marijuana businesses at a serious financial disadvantage compared to other companies, there are still ways for cannabis business owners to legally reduce their tax obligations.
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.
A Breakdown of IRC 280E
Under the Reagan administration, IRC 280E was introduced in 1982. It prohibits any business connected with the trafficking of a Schedule I or II controlled substance, like cannabis, 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.“
Typically, a business will deduct operational expenses like rent, payroll, and advertising from its gross income. What’s left is the business’ net income, and this is what it will pay tax on.
Since cannabis businesses can’t do this under IRC 280E, they are essentially paying federal tax on their gross income. On top of this, marijuana businesses also have to consider state cannabis tax rates, which are often higher than for other industries.
This means that while most businesses pay a flat 21 percent corporate tax rate, marijuana businesses in effect pay anywhere between 40 to 80 percent.
Despite marijuana legalization in the US, IRC 280E is still very much interpreted to include state-legal cannabis businesses.
In 2015, the federal tax court in California ruled in Canna Care, Inc v. C.I.R that Canna Care, a medical cannabis dispensary, was not permitted to deduct its operating expenses from its tax bill owing to marijuana’s classification as a federally controlled substance.
This ruling reaffirmed IRC 280E’s force and the primacy of federal law over state law.
The Costs of Goods Sold
There is one exception to IRC 280E. The costs of goods sold (COGS) may be deducted from a cannabis business’ gross income.
“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.”
COGS refers to direct costs pertaining to the marijuana product itself. This includes packaging and labeling, electricity used in inventory areas, as well as water, seeds, soil and nutrients.
COGS does not include any indirect expenses related to the distribution of cannabis, such as those previously mentioned as well as shipping, maintenance and repairs.
The line between COGS and indirect expenses can be blurry, but understanding exactly which expenses may be deducted could reduce a cannabis business’ tax bill.
How to Maximize Your Deductions
As a cannabis business owner, there are other additional steps you can take to maximize your deductions. Here are a few to consider.
1. Reevaluate your corporate structure
There are three corporate structures available to business owners: C-corporations, S-corporations, and Limited Liability corporations (LLC).
It might be advisable to structure your cannabis business as a C-corporation as this allows you to only pay taxes based on your salary and dividends as a business owner.
2. Distinguish between staff responsibilities
Different staff positions within your business fall under different tax codes. Some roles may be eligible for deductions, such as a cultivator, while others, such as a budtender, are not.
Of course, employees often perform multiple roles and tasks within one position, so it is a good idea to track how much time is spent on each task to work out exactly how much you may deduct.
3. Consider a shared services agreement
A shared services agreement is when a business is split into two entities.
The first would handle marijuana production and distribution. The second would manage the retail space and sell non-cannabis products which are nonetheless related.
The first structure would fall under IRC 280E, and COGS deductions could be made. The second structure would not be affected by IRC 280E and could deduct ordinary operational expenses, like payroll, rent and utilities.
Establishing a shared services agreement is complex though, so be sure to consult with a professional in order to stay compliant.
4. Prepare for an audit
Marijuana businesses are audited by the IRS much more regularly than traditional businesses. In Colorado, one in five cannabis businesses have been audited, which is almost ten times the national average.
So, it’s crucial to track, record and organize all of your financial flows, from seed to the shop floor, especially if you intend to deduct COGS or implement a shared services agreement.
Any gaps or discrepancies in your records could result in a fine.