Over the years, cannabis has been criminalized and then decriminalized, only to be criminalized again. Cannabis has now been legalized statewide in California. With legitimate businesses popping up left and right, it's safe to say that it will remain decriminalized.
There's just one caveat: While it may have been legalized for medical and/or recreational use statewide, it's still technically illegal.
Because of this, cannabis entrepreneurs are left navigating through hell and high water to keep their legally illegal businesses afloat. If it sounds confusing, it's because it is. Especially around tax season with the 280e tax code that plagues their overall revenue. Fortunately, there's help out there. Keep reading to learn more about the 280e tax code and how to navigate it.
The 280e Tax Code and its Challenges
The 280e tax code is a thorn in the side of cannabis entrepreneurs all over the United States. It all goes back to a time when Ronald Reagan declared the war on drugs. More specifically, the IRS tax code 280e itself came about in 1981. During this year, in particular, there was a tax court case during which a convicted cocaine, amphetamine, and cannabis trafficker fought for his rights under the federal tax law.
The rights he was fighting for were the rights to deduct "ordinary" business expenses from his overall "taxable" income.
The tax court case is better known as Jeffrey Edmondson vs Commissioner, and the court ruled in his favor. He was then allowed to deduct most business expenses. This included the cost of goods sold. I.e., packaging, home expenses, phone expenses, and vehicular expenses relating to his illegal business.
By the following year, the Jeffrey Edmonson decision was overturned. Any business owners selling Schedule I and/or II controlled substances were denied the right to deduct any business expenses related to their illegal businesses. Under the Controlled Substance Act (CSA), Schedule I and II controlled substances are defined as drugs that have no medical use and also have the potential for abuse.
Unfortunately today, the 280e tax code is still penalizing cannabis business owners.
What Exactly is Section 280e?
The 26 U.S. Code Section 280e is the federal statute mandated by the IRS opposing "illegal" business. In other words, Section 280e forbids businesses from deducting any expenses from their gross income when it involves "trafficking" schedule I and II controlled substances. This includes taking any credits as well.
Marijuana is still classified as a Schedule I controlled substance. Therefore it's federally illegal. Despite its recreational and medical legality across the states, in the eyes of federal law, all cannabis businesses fall into the category of drug trafficking. What this means is that all cannabis entrepreneurs are forced to pay taxes on all of their business income. They are more or less prohibited from writing off business expenses to minimize their taxable income.
The Cost of Goods Sold
The cost of goods sold (COGS) is the exception to the rule—but not by much. When Section 280e was passed by Congress, there were fears of constitutional challenges to their new law. To combat any future challenges, they added a small exclusion to this law. This exclusion allows for the deduction of the cost of goods sold, even for products illegal under federal law.
The cost of goods sold mainly refers to inventory costs. This would include the cost of the actual product, the cost of shipping (to the retail location), and any directly related expenses.
Of course, it's not much of an exception considering how the IRS applies its definition of "cost of goods sold" to the cannabis industry. For example, the IRS completely ignores any tax changes made after section 280e, which would allow more indirect costs to be applied to the overall concept of the cost of goods sold. In other words, any expenses related to the distribution process cannot be included under the cost of goods sold.
That would include outbound shipping and some inbound shipping, rent, overhead, payments to contractors, maintenance and repairs, health insurance premiums, marketing and advertising, utilities, and employee expenditures. In fact, the cost of goods sold more or less only applies to the purchases of seeds, soil, water, and nutrients for planting and cultivation.
How the Cannabis Industry is Affected Overall
Thanks to section 280e, the cost of doing business in the cannabis industry means giving away most of your money. Cannabis entrepreneurs have to pay taxes on their gross profit rather than net income. More often than not, cannabis business owners end up paying tax rates that are 70% or higher. That's almost triple, if not more, than the tax rates paid by non-cannabis business owners.
For example, Compare a cannabis business and a non-cannabis business with a gross revenue of $1,000,000. The cost of goods sold is $650,000, which would yield a gross income of $350,000. The difference is in the deductible business expenses.
Where the non-cannabis business owner claims $200,000, the cannabis business owner cannot claim anything. This leaves the non-cannabis business owner with a taxable income of $150,000 and the cannabis business owner still at $350,000
With an average tax rate of 30 percent, the non-cannabis business owner only pays $45,000 in taxable income. At that same tax rate, 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. The effective tax rate for the cannabis business is 70 percent. That's a 40 percent discrepancy between two legal businesses.
You also have to factor in rent, utilities, employee salaries and benefits, and so on. All of those things can't be deducted as business expenses. Taking all of this into consideration, you realize that this is something that can render a business unprofitable.
How to Effectively Maximize Deductions
The 280e tax code has a seriously negative impact on the cannabis industry. However, there are ways to lessen the tax burden. It all starts with proper accounting and compliance. Here are a few things to take into consideration:
Determine a Better Corporate Structure
When new business owners set themselves up, they have a choice between three different corporate structures. Those corporate structures are C-corporations, S-corporations, and Limited Liability corporations (LLC).
Most lawyers would advise cannabis entrepreneurs to set up as a C-corporation. The C-corporation structure allows business owners to only pay taxes based on their salaries and dividends.
Look into a Shared Services Agreement
A shared services agreement means you'll essentially be splitting your business into two entities. Since the 280e tax code involves the trafficking of Schedule I and II controlled substances, it's a good idea to create two business structures.
The first structure would be responsible for cannabis production and distribution. The second structure handles legal responsibilities. Legal responsibilities would include care, counseling, selling related (but not cannabis-infused) merchandise, and the management of the actual retail space.
With a shared service agreement, only the first structure is responsible for compliance with the 280e tax code and their idea of the cost of goods sold. The second structure has the advantage of ordinary deductions in relation to payroll, rent and utilities, sales, administration, promotion and marketing, and some distribution.
It's important to consult with professionals who specialize in cannabis compliance. This will help you to avoid any violations.
Designate Employee Responsibilities
Part of remaining in compliance with cannabis business laws is providing accurate reports on employees' salaries. When you start taking on employees, you want to designate their positions within the company and pay them accordingly.
A part-time budtender and part-time cultivator will fall under different tax codes. If you have employees who perform multiple tasks, you'll have to track their time spent on each task. This will help you determine how many hours are deductible under the 280e tax code.
Be Ready For Audits
You're running a business based on a federally illegal substance. Therefore, you're subject to more audits.
It's in your best interest to thoroughly document every penny involved from farming to sales and everything in between and thereafter. Keep all of your receipts—even for the tiniest transactions—as organized as possible. The more details the better, especially for your costs of goods sold. Any failure to prove your deductions will result in a fine.
You're Going to Need Help
Navigating your tax requirements under the 280e tax code can be confusing and overwhelming. Luckily, there are experts on the subject who can walk you through it and provide you with all of your HR needs. From payroll to taxes and beyond, find out how we can help you remain compliant and in business. Contact us today to find out more about how we can help.