280E

I.R.C. §280E

Key Federal Tax Developments

While the sale of cannabis is legal in California as well as in a growing number of states, cannabis remains a Schedule 1 narcotic under Federal law, the Controlled Substances Act. As such businesses in the cannabis industry are not treated like ordinary businesses. Despite state laws allowing cannabis, it remains illegal on a federal level but cannabis businesses are obligated to pay federal income tax on income because I.R.C. §61(a) does not differentiate between income derived from legal sources and income derived from illegal sources.

Federal Government Constitutionally Prohibited To Tax “Gross Receipts”

The Sixteenth Amendment of the U.S. Constitution prohibits the Federal government from taxing “gross receipts”. In Edmondson v. Commissioner, 42 T.C.M. (CCH) 1533 (T.C. 1981), the Tax Court decided that Jeffrey Edmonson, self-employed in the trade or business of selling amphetamines, cocaine, and cannabis, was permitted to deduct his business expenses resulting from his trade. Discomforted by this outcome, the following year Congress enacted I.R.C. §280E, disallowing all deductions and credits for amounts paid or incurred in the illegal trafficking in drugs listed in the Controlled Substances Act.

I.R.C. §280E – No Deduction Of Business Expenses

Under I.R.C. §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law. Cannabis, including medical cannabis, is a controlled substance.

Unsuspecting and a mere paragraph in length, this tax code provision is easily overlooked by the majority, however for those operating in the cannabis industry, I.R.C. §280E stands larger than any thousand-year-old Redwood. Yet in the years since enactment, I.R.C. §280E has become an unsightly mess in the absence of proper pruning.

Almost 40 years after the enactment of I.R.C. §280E, the landscape of the cannabis industry has changed dramatically. To date, thirty-three states and the District of Columbia have all since passed laws legalizing cannabis for medical purposes. The District of Columbia and eleven states have adapted even more expansive laws legalizing cannabis for recreational use. Yet despite the fact that 1) state-legal medical cannabis did not exist as a category at the time I.R.C. §280E was passed; and 2) many businesses presently operating in the state-legal cannabis space are highly diversified enterprises that do not fit under the I.R.C. §280E “drug trafficking” rubric, the IRS continues to indiscriminately apply I.R.C. §280E to all state-legal businesses involved in the cannabis industry.

What this means is that dispensaries and other businesses trafficking in cannabis have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses.

Avoiding Tax Pitfalls

While I.R.C. §280E disallows cannabis-related businesses to deduct “ordinary and necessary” business expenses, it would be unconstitutional for the IRS to disallow businesses to deduct Cost Of Goods Sold when calculating gross income. This concept was first applied in the Tax Court case of Olive vs. Commissioner Of Internal Revenue, 139 T.C. 19 (2012).

Check out the following example of a cannabis-related business with monthly gross receipts of $100,000 ($1,200,000 annually):

	With No Tax Planning	With Tax Planning
Gross receipts	$1,200,000	$1,200,000
Cost Of Goods Sold	-0-	$780,000
Gross Profit	$1,200,000	$420,000
Taxes at 35% on Gross Profit	$420,000	$147,000
Ordinary And Necessary Business Expenses	$900,000	$120,000
Your Net Profit <Loss>	<$130,000>	$153,000

You can see how important it is that the business be able to capitalize as much of these expenses into inventory which will show a higher Cost Of Goods Sold and hence lower taxes which equates to higher profits. For cannabis businesses involved in cultivation or manufacturing, the proper planning and recordkeeping could result in a much higher Cost Of Goods Sold thus saving you in income taxes.

Cannabis Tax Audits & Litigation

It is no surprise that cannabis businesses are proliferating as more States legalize cannabis and make available licenses to grow, manufacture, distribute and sell cannabis. The IRS recognizes this and it is making these cannabis businesses face Federal income tax audits. IRC §280E is at the forefront of all IRS cannabis tax audits and enforcement of §280E could result in unbearable tax liabilities.

Proving deductions to the IRS is a two-step process:

• First, you must substantiate that you actually paid the expense you are claiming.

• Second, you must prove that an expense is actually tax deductible.

Step One: Incurred And Paid The Expense.

For example, if you claim a $5,000 purchase expense from a cannabis distributor, offering a copy of a bill or an invoice from the distributor (if one is even provided) is not enough. It only proves that you owe the money, not that you actually made good on paying the bill. The IRS accepts canceled checks, bank statements and credit card statements as proof of payment. But when such bills are paid in cash as it typical in a cannabis business, you would not have any of these supporting documents but the IRS may accept the equivalent in electronic form.

Step Two: Deductibility Of The Expense.

Next you must prove that an expense is actually tax deductible. For a cannabis businesses this is challenging because of the I.R.C. §280E limitation; however a cannabis business can still deduct its Cost Of Goods Sold (“COGS”). Cost of goods sold are the direct costs attributable to the production of goods. For a cannabis reseller this includes the cost of cannabis itself and transportation used in acquiring cannabis. To the extent greater costs of doing business can be legitimately included in COGS that will that result in lower taxable income. You can be sure the IRS agents in audits will be looking closely at what is included in COGS.

In addition to IRS audits, state cannabis audits are also complex and thorough and generally include all taxes specific and nonspecific to the cannabis business. Potentially at risk is the cannabis license that enables the business to operate. State audits will focus on records regarding sales and use tax, excise taxes, and seed-to-sale tracking records.

Now if your cannabis IRS tax audit is not resolved, the results may be challenged and litigated in the U.S. Tax Court or Federal District Court. The U.S. Tax Court has jurisdiction to hear disputes over federal income taxes before final assessment and collections while the Federal District Court generally requires taxpayers to first pay the liability then seek repayment through a refund request.

California Breaks Away From I.R.C. §280E

Assembly Bill 37 signed into law in 2019 provides that “in determining taxable income for California State Income Taxes” for each taxable year beginning on or after January 1, 2020, and before January 1, 2025, I.R.C. §280E shall not apply to the carrying on of any trade or business that is commercial cannabis activity by a licensee. Section 17209 of the California Revenue and Taxation Code.

What Should You Do?

California like a growing number of other states may well be a cannabis-friendly state, but it is still possible to face a criminal prosecution at the Federal level and given the uncertainty regarding federal limitations and complex compliance regulations it is critical to have the proper legal counsel. Having access to a Board Certified Tax Attorney-CPA with more than 30 years of experience in advising businesses in tax compliance and planning, accounting systems and cash management can help you meet your challenges to minimize your taxes and conduct business in a manner that avoids prosecution by the Federal authorities and meets State laws and regulations. Don’t delay call us today!