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As small businesses across the United States prepare for tax season, cannabis businesses grapple with staying compliant with the confusing state of cannabis tax law.
Like any business, a licensed cannabis enterprise is subject to taxation and must pay all applicable state and local sales taxes, state and local business/franchise taxes, payroll taxes, state corporate income taxes, and even federal income taxes.
Unlike other businesses, cannabis companies can’t reap benefits in the federal tax code. Most businesses “write off” a wide variety of expenses. These expense deductions lower a business’s income and taxes due. Cannabis businesses cannot deduct these expenses and end up paying substantially more taxes than standard businesses.
This discrepancy is just one of many that cut into the profits of cannabis businesses, and highlights the problems that arise due to cannabis being legal in many states, but illegal at the federal level.
What is a Write-Off?
A tax “write-off,” is any necessary and ordinary business expense. Expenses are deducted from a business’s income and therefore lower the taxable income due on their tax return. In the U.S., businesses can write off a wide range of expenses, including salaries, benefits, contractor payments, travel, meals, rent, insurance, and utilities.
Yet, due to the federal illegality of cannabis in the U.S., cannabis businesses cannot deduct standard business expenses, according to Internal Revenue Service Section 280E. This leads to an unusually high effective tax liability that can significantly impact profitability.
IRS Section 280E
Section 280E of the Internal Revenue Code forbids businesses from deducting otherwise ordinary business expenses from gross income associated with the “trafficking” of a Schedule I substance, including cannabis. Section 280E prevents cannabis business owners from taking deductions for business expenses that nearly every other type of business can benefit from, except for expenses directly related to cost of goods sold (COGS).
Without the ability to write off general business expenses outside of COGS, cannabis companies are saddled with enormous tax liabilities that shrink profit margins. COGS refers to costs that are directly related to producing goods, including the cost of the materials and labor required to create the goods. It does not include indirect costs related to distribution, sales, marketing, and other overhead that businesses face.
The History of 280E
According to Attorney Lauren Vázquez, Legal Department Chair for Oaksterdam University, the history of IRS Section 280E dates back to the early 1980s, directly tied to a landmark case and subsequent Tax Court opinions.
Edmondson v. Commissioner (1981)
Section 280E was enacted by Congress in 1982 as a response to the case of Jeffrey Edmondson, a drug dealer who claimed deductions related to his illegal drug trafficking business. In the case of Edmondson v. Commissioner, 42 T.C.M. (CCH) 1533 (1981), the Tax Court allowed certain deductions for business expenses claimed by Edmondson, who was engaged in the sale of amphetamines, cocaine, and cannabis. This decision highlighted the possibility that drug dealers could use the tax code to deduct expenses related to illegal activities, which Congress found undesirable.
Internal Revenue Code Section 280E was meant to counteract the implications of the Edmondson case. This section specifically disallows deductions and credits for amounts 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 Schedules 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.
IRS Opinions and Guidance
The IRS has issued guidance to clarify the application of Section 280E in light of state laws legalizing cannabis for medical or recreational purposes. Here, Vazquez outlines case law that contributes to interpretation of 280E:
CHAMP, Inc. v. Commissioner (2007)
Californians Helping to Alleviate Medical Problems, Inc. (CHAMP) v. Commissioner, 128 T.C. No. 14 is often cited in discussions of 280E.
CHAMP operated a facility that provided caregiving services, including medical cannabis, as part of its care packages for individuals with debilitating diseases like HIV/AIDS. In addition to distributing marijuana, CHAMP offered its members a range of other services, such as meals, yoga classes, and various forms of therapy. The Tax Court’s decision in the CHAMP case was particularly noteworthy for a couple of reasons.
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Separation of Business Activities. The court recognized that CHAMP provided two distinct services: (1) the sale of medical marijuana and (2) caregiving services. This differentiation was critical because it allowed CHAMP to argue that not all of its business expenses were subject to the limitations of Section 280E.
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Deductibility of Non-Marijuana-Related Expenses. The court allowed CHAMP to deduct expenses related to its caregiving services, which were not “trafficking in controlled substances” and thus not subject to the disallowance of deductions under Section 280E. This included expenses for the non-marijuana-related services provided to its members.
The CHAMP case demonstrates that a business involved in both the sale of cannabis and the provision of other, legally permissible services might be able to segregate its expenses and deduct those not directly tied to the trafficking of controlled substances. However, the application of these principles is highly fact-specific, and businesses attempting to navigate this area must carefully document their activities and expenses.
Other Relevant Rulings
Olive v. Commissioner (2012)
Context: A California medical cannabis caregiver collective sought to deduct business expenses.
Issue: Could expenses related to the dispensary operation be deducted despite Section 280E?
Holding: No, Section 280E prohibits deductions for businesses “trafficking in controlled substances,” even if legal under state law. However, cost of goods sold remained deductible.
Canna Care Inc. v. Commissioner, T.C. Memo (2015)
Issue: The Tax Court addressed the issue of whether a medical cannabis dispensary could deduct business expenses, such as rent, salaries, and utilities, from its gross income.
Holding: Under IRC Section 280E, the IRS disallows such deductions for businesses engaged in trafficking controlled substances that are prohibited by federal law, even if such activities are permitted under state law.
Martin Olive v. Commissioner (2015)
Context: This was an appeal of the 2012 Olive case mentioned above.
Issue: Did the Ninth Circuit uphold the Tax Court’s decision regarding expense deductions?
Holding: Yes, the Ninth Circuit affirmed the earlier ruling, highlighting the applicability of Section 280E to the caregiver collective’s operations.
Patients Mutual Assistance Collective Corporation v. Commissioner (2018)
Context: Harborside Health Center, a California medical cannabis dispensary, challenged Section 280E.
Issue: Can businesses legally selling controlled substances deduct various business expenses?
Holding: No, Section 280E generally disallows such deductions even for legal operations. The case also addressed inventory valuation methods.
Alterman & Gibson v. Commissioner (2018)
Context: This case involved partnership income related to a marijuana business.
Issue: Does Section 280E apply to partners’ income from such businesses?
Holding: Yes, Section 280E limits deductions for partners involved in businesses trafficking in controlled substances.
Consult a Cannabis Tax Professional
Taxation is an area of compliance where business owners can benefit from the advice of experts and should find tax professionals experienced with IRS 280E. They can help set up the business’s accounting, bookkeeping, and chart of accounts to maximize the legal expenses and prepare to defend an IRS 280E audit.
Attorney Dale Schafer is one of these experts. Schafer, a faculty member of Oaksterdam University’s legal and compliance department, has a long history of helping cannabis businesses navigate the ever-evolving business landscape.
Based in the foothills of Northern California, Schafer works with a firm of accountants and Enrolled Agents who do cannabis-specific tax preparation and defense for cannabis businesses.
“I deal with it on the daily,” he says. “IRS Code 280E has a history that is now changing which makes it even more difficult to predict how tax returns need to be dealt with.”
Learn more about IRS 280E and the unique facets of operating a cannabis business in Oaksterdam University’s Business of Cannabis Certification Course.
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