[Noozhawk’s note: This article is presented for information purposes only and is not to be construed as tax or legal advice. Readers should seek the counsel of competent experts in the legal and accounting professions for advice on their specific situation.]
Recent permits for cannabis dispensaries in Santa Barbara offer some compelling opportunities, both for cannabis operators and for consumers in our market. However, the challenges presented by IRS 280E and additional California taxation for the cultivation and excise taxes are formidable.
Operators need to understand their available options regarding these complexities to reduce taxes and increase potential profitability.
IRS 280E is a law passed by Congress that requires any business or individual generating revenue from operations involving Schedule I or Schedule II drugs to pay taxes on every dollar of revenue generated.
As they say, there are two certainties in life — death and taxes. The IRS, even if the revenue is illegal according to federal law, wants its money.
The key challenge with Section 280E of the Internal Revenue Code is that it forbids businesses from deducting otherwise ordinary business expenses, such as employee salaries, rent and utilities from gross income associated with the “trafficking” of Schedule I or II substances, as defined by the Controlled Substances Act.
The IRS has subsequently applied Section 280E to state-legal cannabis businesses, since cannabis is still a Schedule I substance.
Section 280E is a throwback from President Ronald Reagan’s administration, and originated from a 1981 court case in which a convicted cocaine trafficker asserted his right under federal tax law to deduct ordinary business expenses.
In 1982, Congress created 280E to prevent other drug dealers from following suit. It states that no deductions should be allowed on any amount “in carrying on any trade or business if such trade or business consists of trafficking in controlled substances.”
California, 32 other states and the District of Columbia have passed laws broadly legalizing marijuana in some form.
Ten states — California, Alaska, Colorado, Maine, Massachusetts, Michigan, Nevada, Oregon, Vermont and Washington — and the District of Columbia have adopted the most expansive laws legalizing marijuana for recreational use.
Michigan voters recently approved a ballot measure permitting adults age 21 and over to purchase and possess recreational-use marijuana. Vermont in 2018 became the first state to legalize marijuana for recreational use through the legislative process, rather than via a ballot measure. Vermont’s law allows for adults age 21 and over to grow and possess small amounts of cannabis. It does not permit the sale of nonmedical cannabis, however.
Some other state laws similarly decriminalized marijuana, but did not initially legalize retail sales.
Most other states allow for limited use of medical marijuana under certain circumstances. Some medical marijuana laws are broader than others, with types of medical conditions that allow for treatment varying from state to state.
Louisiana, West Virginia and a few other states allow only for cannabis-infused products, such as oils or pills. Other states have passed narrow laws allowing residents to possess cannabis only if they suffer from select medical illnesses.
Section 280E is applied to state-regulated cannabis businesses far more often than it is to the types of illegal drug dealers the provision was intended to penalize. For most cannabis businesses, taxation on 100 percent of gross revenue is a company killer, especially given the added risk of federal seizures that are still a legitimate threat, as long as cannabis remains a Schedule I drug.
So, what can cannabis operators do to address the taxation challenges of IRS 280E?
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 (COGS), even if the goods are illegal (like cannabis) under federal law. The components of COGS include inventory costs, such as the cost of the product, the cost to ship it, direct labor costs for cultivation, packaging, shipping, etc., in and any other directly related expenses.
Even though the COGS is deductible under 280E, the IRS applies its definition of COGS more narrowly with regard to cannabis operations. For example, it does not allow the use of tax changes that allow more indirect costs to be included in COGS 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.
Some operators are establishing two (or more) separate operating entities — one that houses all operations directly relating to cannabis (illegal revenue generating activities and all related expenses), and another entity (or more than one) that houses all legal operations.
The effectiveness of this strategy will depend on how the business is structured, and whether the operation is strictly a cultivation operation, a distributor, a retail dispensary or some combination.
Weighting all expenses as heavily as possible in COGS will also maximize tax deductions and thereby maximize potential profits. For example, if an operation has employees who serve in dual roles, with one role dealing directly with a COGS expense, and another with retail sales, the compensation for that employee can be weighted as heavily as possible toward the direct COGS role. Of course, this split of duties must be reasonable so it will stand up to possible IRS scrutiny in the event of an audit.
With regard to possible audits, an IRS audit is a civil action, not a criminal one, but that does not mean that cannabis businesses are not at substantial risk from a potential audit.
Technically, in order to impose any penalty for a violation of 280E, the defendant must be proven to have illegally trafficked a controlled substance prohibited under federal or state law. The IRS has been conducting random audits of cannabis companies, even those that are fully in compliance with their state’s tax laws.
One area of compliance the IRS has focused on is the timely and accurate filing of Form 8300 — the form required for cash deposits of $10,000 or greater amounts. One key reason for this focus is that the IRS wants to ensure that cannabis operators are reporting 100 percent of their revenues.
The above discussion of IRS Form 8300 underscores a key issue, which is meticulous and accurate accounting. Cannabis operators must ensure that their accounting records are spotless.
Any decisions regarding how to categorize expenses, especially those to be included in COGS, must be well-reasoned to withstand IRS scrutiny in the event of an audit. Any missteps with regard to those decisions, or the accuracy and comprehensive maintenance of accounting records can have very serious implications.
With regard to the two-company model outlined above, this approach (using two or more legal entities to split operations) has been upheld legally. The legal precedent is CHAMP (Californians Helping to Alleviate Medical Problems) v. Commissioner of Internal Revenue. In this case, the taxpayer successfully argued that their caregiver services were a distinct business from cannabis-related operations.
Many other operators have tried to use CHAMP to justify deductions, most of which have been unsuccessful. While in many of these cases, including CHAMP, the operator had a single legal business entity, it is advisable to establish (at least) two separate legal entities — one for the cannabis operations and another for all other “legal” operations, like caregiving, T-shirt and other consumer items, etc.
Clearly, there are many considerations cannabis entrepreneurs must consider before opening their business. With the complications involved in the permitting process, coupled with tax challenges as outlined herein, it is critical that entrepreneurs think through these issues prior to risking their capital (or investors’ capital).
Beyond federal taxation requirements, California also has a cultivation tax and an excise tax. While it appears that the cultivation tax may be deductible against federal taxes, it is not a settled issue at present. The excise tax appears to be a pass-through — a tax charged to the consumer that is not counted as revenue for tax purposes, but again, this is not a settled issue.
I would expect cannabis to eventually be removed from Schedule I, which would alleviate these federal taxation challenges, but there is no way to know when or if this will occur. Until or unless the law is changed, cannabis entrepreneurs must work within the law and use creative but appropriate and acceptable accounting methods to navigate IRS Section 280E to build successful businesses.
— Craig Allen, CFA, CFP, CIMA, is president of Allen Wealth Management, and has been managing assets for foundations, corporations and high-net worth individuals for more than 25 years. He can be contacted at craig@craigdallen.com or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.