Marijuana Taxation 101
The legal marijuana industry is booming: many states have legalized cannabis for either medical or recreational use. But surprise surprise, under federal law, cannabis is a controlled substance, and the IRS hits the industry hard with a well-known tax law provision – Section 280 E
Before getting into the industry, one should know the tax issues and how they can legally minimize their tax burden.
Federal law considersmarijuana a Schedule I controlled substance so you technically can’t buy it or sell it anywhere in the United States. Right now, however, there’s a compromise in place between conflicting federal and state marijuana laws. In 2013, the Justice Department issued a directive known as the ·Cole memo. In it, the Justice Department agreed to not enforce federal marijuana laws against those participating in and complying with a “strong and effective state regulatory system.” The Cole memo does not have the effect of law. It is only a Department of Justice policy. The legal marijuana industry will remain illegal until Congress moves to change the status of marijuana under the Controlled Substances Act.
Congress enacted Section 280E in 1982 at the beginning of the Reagan administration’s ‘War on Drugs" in response to a Tax Court decision that upheld deductions claimed by a drug dealer for both cost of goods sold and other business expenses. The IRS has issued no regulations or other interpretations of Section 280E. The only guidance on what it means includes a few Tax Court cases (which constitute authority) and a Chief Counsel Advice issued in 2015 (which does not constitute authority). Congress was clear on one thing, however: Section 280E does not prevent those trafficking in controlled substances from deducting their cost of goods sold.
Income. You must pay tax on all your income, regardless of source. All income from selling marijuana is taxable, even though its sale is illegal under federal law.
Deductions. Here’s where it gets bad: Thanks to Section 280E, The IRS denies all ordinary and necessary deductions against your marijuana sales income. You must pay federal income tax on your gross income, and you can only reduce it by the Cost of Goods Sold.
Cost of Goods Sold Technically, the cost of goods sold isn’t a deduction-it is an adjustment taken into account to determine gross income. In plain terms, COGS is the money you paid for your inventory and expenses associated with its procurement. Under the law. a cannabis business can deduct COGS , ONLY if they use an appropriate inventory method of accounting. Inventory Method of accounting happens when you:
• capitalize eligible direct and indirect expenses of producing the inventory,
• recognize income when you sell the inventory,
• recognize the allocated inventory expenses as cost of goods sold when you sell the inventory, and
• deduct non-capitalized expenses based on your method of accounting (cash or accrual).
The IRS issued advice to its examiners that marijuana businesses can’t use Section 263A, but instead must use the Section 471 rules as they existed at the time of enactment of Section 280E in 1982. This advice does not constitute authority, but it is something you need to consider when determining how to calculate your cost of goods sold.
Tax Tricks to Maximize Deductions.
If you want to decrease your taxable income, you need to stick as many costs in COGS as you legally can:
• Increase the space allocated to inventory storage, then you will increase the pro-rata expenses for that space (rent, utilities, etc.) that you can put into cost of goods sold.
• Labor is always a large business expense. With clearly defined job descriptions and detailed hours tracking, you can maximize the amount of employee wages allocated to inventory management (and, thus, deductible as cost of goods sold).
Multiple Business Lines
Section 280E limitation applies only to trafficking of controlled substances. If your marijuana business, for example, sells non-cannabis products, or provides unrelated to cannabis services, then those business lines potentially won’t be subject to Section 280E, according to the Tax Court.
Whether or not your other business lines and services are separate business activities depends on your facts and circumstances.
In Olive. Martin Olive wanted to treat his Vapor room as a caregiving business that would not be subject to Section 280E and the other part as a marijuana dispensary business. The Tax Court disagreed and ruled that the vapor room and his medical marijuana dispensary were one business and disallowed all tax deductions.
In CHAMP, the court treated the medical marijuana business and the caregiving business as separate businesses for tax purposes. Tax deductions from the caregiving business were allowed.
Though there is no official guidance on how to deduct the expenses of other unrelated to cannabis business lines, you likely can deduct:
• all the direct expenses of the other lines of business, and
• a proportion of the indirect expenses based on square footage, labor hours, or another supportable allocation method, perhaps even the relative amounts of gross receipts.
Example. If 8 percent of the 100K gross receipts were from the sale of non-marijuana items and gross receipts were the supportable method for allocation, you could likely deduct $8,000 of the business expenses otherwise disallowed under Section 280E.
In order to maximize your ability to deduct the expenses of other business lines, consider:
• Increase gross receipts by charging market-rate prices for the goods and services provided in the other lines of business.
• Maintain excellent accounting records that clearly and accurately allocate income and expenses between the lines of business.
• Separate the logistics of the businesses as much as possible.
Your State May Not Agree
Since almost all states conform to the federal tax code to determine your state taxable income, Section 280E can hit you again at the state level. But if your state has legalized marijuana, it may be more forgiving when it comes to taxing your business profits. Colorado, for example, allows you to take any normally deductible expenses disallowed by Section 280E when computing your Colorado taxable income.
You could make a lot of money in the legal marijuana industry, but thanks to Congress, the IRS can take a lot more of it in comparison with what it takes from other businesses. Although the lack of IRS and court guidance makes navigating marijuana tax issues more difficult, you can generally lower your tax hit by:
• Allocating as many expenses as you can to cost of goods sold, and
• Having non-marijuana lines of business that create deductible expenses allocable to those lines of business.
And, remember, many states with legal marijuana sales may permit the disallowed Section 280E expenses for state purposes. Don’t forget this adjustment if available; otherwise, you could be paying thousands of dollars in tax that you don’t owe.