Aug 15 Taxed to Death: The Background on Cannabis Companies’ Tax Challenges
For most businesses, taxes can range from an inconvenient to unpleasant experience. For those in the cannabis industry, taxes can be a life-and-death experience. While nearly all states have either decriminalized or legalized recreational cannabis, cannabis remains illegal at the federal level. Under the Controlled Substances Act, cannabis has been classified as a Schedule I controlled substance, which plays an integral part in its tax status. It is because of this classification that IRC 280E has an impact on the industry. 280E, a one-line sentence in the tax code, says the following:
”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.”
Congress enacted 280E in 1982 after a drug trafficker won a tax audit the previous year, allowing him to deduct all his standard “business” deductions. The purpose of this new tax code section was to cripple the profits of those working in the illicit market and prevent them from taking ordinary business deductions. However, this would only be effective if everyone involved in the illicit market was paying their taxes in the first place.
Meanwhile, medical marijuana first became legal in California in 1996, and recreational cannabis first became legal in Colorado and Oregon in 2012. Companies in these newly established industries all paid their federal taxes, paying onerous amounts under the tax code. It is not uncommon to see a cannabis operator paying as much in taxes as they made in pre-tax income. 280E was crafted to cripple the illicit market but instead has severely damaged the legitimate market and allowed the illicit market to survive and thrive.
Under 280E, companies are unable to take most of their ordinary expenses, such as rent, utilities, payroll, and other costs necessary to run a business. Cannabis companies are limited to only deducting costs that can be included under cost of goods sold. The impact of this ranges widely throughout the supply chain. Cannabis cultivators and manufacturers can allocate a wider range of costs to their cost of goods sold with careful tax planning. In contrast, cannabis retailers are limited more to purchases of products and delivery charges.
Over the many years, several tax strategies have been attempted to avoid 280E or significantly reduce its impact. In that same time frame, the IRS has challenged each one of those strategies and has won on every challenge except for one. In 2007, the tax court ruled in favor of the taxpayer, Californians Helping to Alleviate Medical Problems (CHAMP), that they should be able to deduct expenses that could reasonably be separated from the cannabis sale activities. This meant that a company could potentially allocate costs between cannabis sale activities and non-cannabis activities. The costs allocated to the non-cannabis activities would be deductible.
Since then, other taxpayers have attempted similar strategies, and the tax court sided with the IRS. While those taxpayers had a similar general framework as CHAMP, they were unable to prove profit motive within the non-cannabis activities and did not have proper record keeping justifying their allocation of expenses. While still a possible tax strategy, there are significant hurdles to overcome to justify splitting the expenses amongst different activities.
Companies have attempted other strategies outside of the CHAMP tax strategy. One such company attempted to have a related management company operate on behalf of the cannabis retailer. By doing so, they believed all the expenses on the management company would be deductible. The tax court ruled in favor of the IRS, and the company was forced to pay taxes on the income received through the retail store and the management fee income received by the management company. Essentially, this tax strategy forced the company to pay taxes twice on the same income without ever deducting any of their standard business costs. In another case, the tax court ruled in favor of the IRS, stating that the taxpayer in question could not deduct their charitable contributions.
All cannabis companies must understand that 280E can be planned for and minimized, but there is no escaping it. It has survived multiple tax court challenges that attempted to strategize around it and has survived two constitutional challenges. 280E remains a massive financial burden to cannabis companies for the foreseeable future.
While a part of the reason to legalize cannabis amongst the various states was to end the illicit market, 280E has allowed that very same illicit market to remain a strong competitor to the legitimate market. To maximize every justifiable deduction, it is imperative that cannabis companies partner with CPAs who can best walk them through careful tax planning and help them survive the eventual tax audit.
About the Author
Adam Holzberg, CPA is a Senior Manager at Sax and focuses on increasing the overall operational efficiencies, financial reporting best practices, and internal controls for clients. As a member of the Sax Cannabis Practice, Adam supports companies from seed to sale in a variety of areas including but not limited to innovation and growth strategies, attestation services, tax compliance, and pre-licensing consulting. He can be reached at [email protected].
