If you are a cannabis business in the United States, then there is nothing that costs you more than this little rule. More than anything, it distinguishes the bookkeeping of a legal cannabis business from a regular legitimate business. It is what mostly makes it much more expensive to operate a legal cannabis business than a company selling a fully legal product. Section 280E of the Internal Revenue Code officially states:
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.
If you’re having trouble understanding exactly what that tax law means don’t stress, we are here to help provide a little guidance. While this exemption is not good news for cannabis businesses, there are ways to minimize the amount of federal taxes you have to pay as a legal cannabis related business. However, this will largely depend on the individual business activities and business expenses of your firm. Let us break down exactly what the 280-E exemption means. Let us also give a little bit of background to help understand how to effectively and, most importantly, legally bypass it to the greatest extent possible. We will not give you any advice here that is not solidly backed up by US case law. However, for the particulars regarding your business, we still think its always best to consult a CPA or lawyer.
Typical businesses are allowed to deduct from their federal and state income taxes the costs of doing business, or essentially inventory costs. For regular companies, the activities included that can be deducted for tax purposes include many indirect costs and are very expansive. This is not the case for the cannabis industry. Since many of these indirect exemptions were enacted after the 280-E exemption, the Internal Revenue Service (IRS) ruled that cannabis businesses using the 280-E exemption may not make the same ones. This is taken for granted by legal firms, however, the Internal Revenue Code 280-E exemption says explicitly that any income earned by a business from the sale of substances that are illegal under federal law cannot be deducted from federal taxes. Congress passed this tax code, knowing there could be a constitutional challenge to it on a very legitimate basis in tax court. So, as a way of narrowing the scope of the law to not specifically be prejudicial against anything except for the commerce of a substance that is still technically illegal under federal law despite being legal under state law in some states like California and Colorado. In other words, ancillary activities to the sale of the product are legal and deductible, but the actual purchase of the illegal substance or those products containing it is not. So, to illustrate what is permissible and what is not, we first need to explain to you that it is likely you will have to form two separate entities if you want to gain the tailwind of partial deductions for whatever portion of your revenue is derived from activities that are not the sale of cannabis. For example, if you are selling legal glass products that are primarily used for tobacco, you would be able to deduct that. If you have a part of your dispensary that sells CBD, then you should be able to deduct it, right? Not necessarily, this is a particularly complicated question because if your CBD is derived from Hemp (cannabis plants that contain less than 0.3% THC by dry weight), then you would be able to deduct that section of your business (if it’s included in a separate entity).
The key recommendation here, if you do not glean anything else at all from the piece of writing, should be not to try to dupe or in any way be dishonest to the IRS. If you are going to deduct anything as a marijuana business, you will have one section of your business subject to the 280-E exemption and one that is not. These can maintain an official affiliation, and you can even pay salaries to employees from both entities to maximize tax savings. In other words, to get clever, you would inventory employees’ tasks minute by minute and pay them from the exempt entity for tasks not directly involving the sale of cannabis and pay them from the other entity when they are. This can help avoid the consequences the 280-E exemption has tended to have the most, which has been to negatively affect workers’ wages at the bottom of the pecking order rather than discouraging the sale of cannabis. Hopefully, the projected budgetary shortfalls in state, local and federal coffers will lead to equal treatment of non-cannabis and cannabis businesses, particularly when the latter are flourishing and producing high-wage jobs in many cases. Until that day comes, the key to enjoying any financial benefit is honesty and maniacal record-keeping. You need to be able to show the IRS without a doubt that the entity you are operating that is deducting any activities gains absolutely no financial benefit directly from the sale of illegal substances if it is not subject to 280-E.
Cost of Goods Sold Exemption and Calculation
To give this section legs in a world in which the moral and legal justification for continued vigorous prosecution of the War on Drugs has all but evaporated, the authors included an exception that allows businesses to deduct for the ‘cost of goods sold’ even if they are illegal under Federal Law. However, this is quite a shrewd legal move by conservative opponents to state-legal cannabis businesses. Even though it allows some deductions, the IRS applies its definitions more narrowly to legitimate cannabis companies than other businesses. For example, the law does not permit indirect costs to be included in the category of the ‘cost of goods.’ What this effectively means is that to effectively manage a businesses tax exposure, it has been demonstrated that the most successful way to bypass the problematic 280-E exemption is creating a bifurcated business structure with two affiliated entities, one handling 280-E covered business and one handling the ancillary activities that are subject to the standard deduction rules.
Essentially, there are two different methods for calculating the Cost of Goods Sold (COGS), one for businesses using the 280-E exemption and one for those who are not. The COGS for those not using 280-E will result in a more significant amount of activities being covered under the exception and will result in a lower tax burden. The more activities a business conducts that can be accounted for under the non-280-E method, the better.
The Two Business Solution
When you understand the problem, the solution seems simple. Take as much of your business as you legally can and subject it to the standard accounting rules. Then, isolate the sections of your business that are still illegal under federal statute and account for that part of the business separately. This is an onerous solution, and compliance with it will be expensive if you’re doing it correctly. This strategy may end up costing you more if you don’t keep pristine and brutally honest records. This is one of the risks to this strategy. If you do not have the proper expertise and get overly aggressive in your approach, you could be hit with a wave of expensive penalties and back-taxes on recategorized activity.
Here is how the loophole works: the first part of your business should segregate all activities of your company involved with the direct production, refinement, and sale of cannabis. This business will file its tax return without deductions barred by code section 280E.
The second business holds all activities that are legal under federal law and won’t trigger section 280E requirements. This could include patient services (not involving sale), ancillary products like merchandise or other legal items, real estate activities like rent, etc.… All these activities will be filed under the second business. They will be subject to ordinary tax deductions. The more significant your business activities are considered ancillary and not subject to 280E, the larger the savings to your business this strategy will provide. An assessment as to the cost and benefits before engaging in this workaround is essential to making a practical decision.
Is It Legal?
Yes, it is. It has been upheld recently in the notable court case CHAMP v. Commissioner. This is the vanguard case, but mostly what is noteworthy about this case is that the IRS upheld the legality of two businesses operating in close coordination, one with illegal business segments under federal law and one with none. The IRS even seemed to endorse dual wage arrangements whereby employees’ salaries are mutually paid by both entities to maximize the ability of one entity to deduct wages from federal taxes and one entity not being able to do so. However, the execution of this strategy will depend on a high level of record-keeping and the administrative and professional know-how to keep services properly segregated. Otherwise, this loophole can end up costing you a lot of money!