As a supporter of the decriminalization of marijuana and the benefits the industry will bring, including natural medicines and a larger tax base, the last thing I want to see is new entrepreneurs in the space get snagged for preventable issues. As the cannabis industry has expanded rapidly with legalization in certain states, the questions of tax implications tend to rear their head. But with just a little advance planning, along with the understanding of some codes, cannabis entrepreneurs can take proactive steps to reduce their tax liabilities. If our experience with clients in the cannabis space has taught us one thing, it’s if you’re going start in one place, it’s Section 280E.
26 U.S. Code Section 280E is the federal statute that states that a business engaging in the trafficking of a Schedule I or II controlled substance (cannabis!) is barred from taking tax deductions or credits. In short, cannabis entrepreneurs must pay taxes on all of their revenue without the benefit of being able to use business expenses to reduce their taxable income.
The ‘Cost Of Goods Sold’ Exception
When Congress passed Section 280E, it feared possible constitutional challenges to the law. To prevent such challenges, it added an exclusion that allowed a deduction for the cost of goods sold even where the goods are illegal under federal law. “Costs of goods sold” is essentially inventory costs, including the cost of the product, the cost to ship it in and any directly related expenses.
Even though the cost of goods sold is still deductible, unfortunately, the IRS applies its definition more narrowly to cannabis companies. For example, it does not allow the use of tax changes that allow more indirect costs to be included in costs of goods sold because those were made after Section 280E went into effect. This means that cannabis companies may not be able to use the same accounting methods as other businesses, which could result in less favorable treatment by the IRS.
Working Around 280E To Maximize Deductions
It’s great to learn from what successful companies are doing, especially with these complicated tax laws. Really though, it’s simple. Accountants for cannabis companies are getting around Section 280E with smart business structuring. That is, the business is divided into two separate businesses.
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The first business is directly responsible for producing and distributing cannabis. The first business files a tax return without the deductions barred by Section 280E.
The second business holds any activities that are legal under federal law and would not trigger Section 280E. This might include care services, selling ancillary products such as T-shirts or owning and managing the building that the first business operates in. The second business files a tax return claiming all ordinary deductions.
The net effect is that the two companies pay fewer taxes than if they operated as a combined company entirely subject to Section 280E.
Is This Kind Of Loophole Legal?
Good question! In fact, the two-business strategy has been upheld in federal court. The most notable case is CHAMP v. Commissioner.
In CHAMP and other cases, two cannabis-related businesses operated in close coordination — one with the federally illegal activities and one with the legal activities. In some cases, the IRS has even upheld arrangements where employees worked for minimum wage for the company that was barred from deducting wages under Section 280E but also received a higher wage from the company able to deduct wages.
The key is that these businesses worked with their tax and legal advisers to create a solid legal structure and then used immaculate record keeping to prove that they were operating as they stated.
The Canna Care Case
In Canna Care v. Commissioner, a cannabis company argued that Section 280E should not apply to cannabis companies given legalization.
In doing so, it also tried to have the Tax Court overturn CHAMP and the two-business strategy. The taxpayer had failed to properly follow the two-business strategy and was forced to pay back taxes on business deductions disallowed under Section 280E. The Tax Court made three key findings, upholding the previous cases as well as the application of Section 280E to cannabis companies:
- Cannabis is still a controlled substance under federal law.
- Despite California laws, federal law still holds that cannabis companies are still engaging in trafficking for the purposes of Section 280E.
- A taxpayer engaged in the trade or business of selling cannabis falls under Section 280E and cannot claim business deductions other than the cost of goods sold.
In establishing these facts and confirming that the taxpayer failed to properly follow the two-business strategy, the business was not entitled to the deductions. But had they followed the two-business strategy, the court stated the business holding the legal activities would have been entitled to its full deductions. As a cannabis entrepreneur, it provided the clarity you need in understanding how you can legally minimize your tax liabilities.
Don’t Forget The States
While Section 280E has created a clearer federal ruleset for cannabis entrepreneurs, many states that have legalized marijuana are taking a different position than the federal government when it comes to tax deductions. Some states will even allow you to deduct your full business expenses, a benefit for entrepreneurs but one that adds additional complications.
In short, Section 280E severely restricts what deductions cannabis companies may take as they must pay full income taxes. However, careful (and legal!) accounting can separate cannabis activities from unrestricted activities so that the taxpayer can claim some federal deductions. This is even before you consider state taxes and their unique deduction rules.
When you’re in the middle of building a business, taxes feel like the last area of focus. But not giving it sufficient attention can end up costing a fortune in interest and penalties. If you need help or to maximize deductions correctly, seek advice and support from a qualified attorney or accountant.
Good luck cannabis entrepreneurs!What Cannabis Entrepreneurs Should Know About Tax Section 280E