Like many issues in the emerging Cannabis industry, the taxation of the production, sale and distribution of state-legalized marijuana is complicated and burdensome on the cannabis business owner. Despite significant advances in state legalization last year, tax woes continue for the cannabis industry on the federal level this tax season.
The challenges can be traced back all the way to 1982, when Code Section 280E was enacted to prevent traffickers of illegal substances from deducting ordinary business expense. Fast forward almost 40 years, when medical marijuana is legal in the majority of states, and the same tax code still applies to those who produce, distribute and dispense cannabis products.
The code states:
Since marijuana is a schedule 1 substance, many of the federal deductions that are available to companies in every other industry are not available to cannabis businesses. This includes deducting expenses such as advertising, insurance, rent, repairs, salaries, state taxes, utilities and the Section 179 deduction, potentially resulting in hundreds of thousands of dollars of lost tax deductions for a mid-sized cannabis business and a disproportionately higher effective tax rate than their counterparts in other industries.
From a tax perspective, cannabis is the proverbial poison ivy. Those who “touch” the cannabis plant are prohibited from federal business expense deductions, while those who do not “touch” it are exempt. Section 280E applies to growers, cultivators, wholesalers, retailers, transporters and other “plant-touchers.” Those who do not “touch” the cannabis plant and are exempt from the limitations of Section 280E include landlords, suppliers, industrial hemp growers and farmers and CBD companies where the CBD contains less than .03% THC.
For companies that are subject to Section 280E, it is essential to find workarounds to avoid an extremely large tax obligation at tax time. One strategy can be found in Internal Revenue Code Section 162(a), which allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including the cost of goods sold (COGS). By deducting these costs, a cannabis company can recoup some of their missed tax savings.
COGS refers to both the direct costs and indirect expenses of producing the goods that a company sells. While deducting ordinary business expense in the cannabis industry is an ongoing tax court issue – which the cannabis industry has challenged to no avail – there is legal precedent for deducting COGS. The courts have specified exactly how this should be done.
In one of the most recent cases (Harborside), one of the largest U.S. cannabis dispensaries decided to apply IRC 263A to its COGS calculation instead of IRC 471, which is narrower in its definition of what qualifies as a deductible direct or indirect cost. While the court ruled that an IRC 471 calculation is required, its decision did recognize that the dispensary operated legally “within this confusing environment [by applying IRC 263A instead of IRC 471].”
IRS 471, known as the full absorption method, includes the direct and indirect costs that can be capitalized into inventory. Generally speaking, direct costs under this calculation method include materials, supplies, labor and subcontract costs directly related to production of the goods, while indirect expenses include those incurred through repairs, rent, maintenance, indirect labor, quality control and salaries.
In another blow to the industry, the court in Harborside ruled that businesses whose main sales are cannabis will be denied ordinary and necessary business expense deductions on their non-cannabis products and services. However, in cases where the non-cannabis product or service was determined to be the primary business (based on space and employee allocations), the splitting of expenditures by business was allowed for tax purposes. (Californians Helping to Alleviate Medical Problems, Inc., Petitioner v. Commissioner of IRS, Respondent)
Unlike industrial hemp and CBD, which are not classified as schedule 1 substances, it appears that the cannabis industry will continue to be severely limited in its available tax strategies, despite recent wins on the state level. Add these tax challenges to other industry obstacles, such as the disallowance of federal bankruptcy for plant touchers and limited funding options for the industry overall, and the importance of maximizing the COGS deduction becomes even more essential to the financial health and growth of a cannabis business.