09 Feb How Does IRS Tax Code Section 280E Hurt Cannabis Businesses?
While many states have legalized cannabis for medical and/or recreational use, it’s still considered illegal at the federal level. Due to this, cannabis-related business owners continue to be challenged with operating their businesses. Securing banking relationships to support business practices like payroll and benefits and complying with IRS Tax Code 280E are just some examples of hurdles every owner and operator face. In this post, we define Section 280E and discuss how it negatively impacts cannabis and cannabis-related businesses.
What is Section 280E?
Congress created IRS Code Section 280E in 1982, one year after a convicted cocaine trafficker asserted his right under federal tax law to deduct ordinary business expenses related to his illegal business. The government wanted to prevent other drug dealers from following suit, so they created Section 280E, specifically forbidding businesses from deducting business expenses from gross income associated with “trafficking” Schedule I or II substances, which are defined by the Controlled Substances Act.
Since cannabis is still considered a Schedule I substance, cannabis businesses must follow Section 280E and pay taxes on all of their business income. They are prohibited to write off business expenses; however, they can deduct cost of goods sold (COGS) to help minimize their tax impact.
Types of COGS
Cost of goods sold for cannabis businesses mainly refers to costs associated with:
Cannabis cultivators may claim deductions for:
- Raw materials and supplies
- Equipment maintenance
- Utilities needed to grow cannabis
- Manufacturers or Producers can deduct all inventoriable costs
As a “reseller” the deductions are more restrictive, retail stores and dispensaries may claim deductions for:
- Acquisition costs
- Utilities for inventory areas
- Transportation and shipping costs necessary to purchase product
Please note: Laws are always changing and may be different state to state. Work with a certified cannabis law, tax, and accounting expert to manage 280E and its legal deductions.
How does Section 280E hurt cannabis businesses?
While cannabis businesses may be able to deduct COGS from their revenue, they are still unable to deduct ordinary expenses from their income such as rent, employee salaries, benefits, and utility costs and maintenance not directly associated with the acquisition of cannabis products. Owners of non-cannabis businesses are often able to take advantage from these types of business deductions. However, cannabis businesses must pay taxes on their gross income and without deducting ordinary and necessary business expenses, and often pay tax rates that are often 70 percent or higher!
The National Cannabis Industry Association provides a simplified model below that illustrates the tax structure for cannabis businesses compared to non-cannabis businesses. In this example scenario, a non-cannabis business’ taxable income is $150,000, while the cannabis business is taxed on $350,000, despite having the same costs and expenses.
|Non-Cannabis Business||Cannabis Business|
|Cost of Goods Sold||$650,000||$650,000|
|Deductible Business Expenses||$200,000||$0|
|Effective Tax Rate||30%||70%|
With an average tax rate of 30 percent, the non-cannabis business owner only pays $45,000 in taxable income and the cannabis business owner is subject to pay $105,000. This means the effective tax rate for the non-cannabis business owner is only 30 percent and for the cannabis business is 70 percent—a 40 percent discrepancy between two legal businesses.
What can be done to resolve the cannabis tax problem?
With many states legalizing cannabis and operating legal businesses, it makes sense to remove cannabis from the Controlled Substances Act so that cannabis businesses are taxed like their non-cannabis counterparts and can better invest in their business and community. However, making this change would require modifying or even repealing Section 280E, which would take years to pass in Congress, if even considered.
Knowing the difficulties in changing Section 280E, cannabis advocates are creating bills as workarounds like The Small Business Tax Equity Act, which exempts a trade or business that conducts marijuana sales in compliance with state law from a provision in the Internal Revenue Code that prohibits business-related tax credits or deductions for expenditures in connection with trafficking in controlled substances. This bill was introduced in the 116th Congress (2019-2020).
Work with Cannabis Tax Experts to Maximize Deductions and Comply with Section 280E
Until legislation removes cannabis from the Controlled Substances Act or modifies Section 280E to tax legal cannabis businesses fairly, cannabis businesses will continue to be heavily impacted (financially and operationally) by current tax laws. While the industry waits for tax reform, it is important for cannabis and cannabis-related businesses to work with a partner with the HR and legal expertise to keep your business compliant and more profitable.
You need a trusted advisor and partner to protect both your employees and business.
Contact us today.