Cannabis Taxes and Section 280E

Cannabis Taxes and Section 280E

As I’m sure you’ve noticed, a lot of changes have been going on in the cannabis space and a lot needs explaining. If you’re looking ahead to tax time, you might need help deciphering some codes – and that’s what we are here for! Allow me to explain one of the latest changes most relevant to Nomad and cannabis finances. There’s a lot of information below, but let me guide you as you navigate the treacherous waters of Cannabis taxes. Here we go!

Cannabis Taxes and Section 280E

Even though cannabis has gained acceptance in many states, such as California and Colorado, it still remains illegal under federal law. Therefore, cannabis businesses are treated as illegal activities under federal tax law even if they're in full compliance with state law. The primary impact of this is not being able to claim deductions that other businesses might be able to take.

What Is Section 280E and Why Does It Stop Deductions?

26 U.S. Code Section 280E is the federal statute that states that a business engaging in the trafficking of a Schedule I or II controlled substance (cannabis!) is barred from taking tax deductions or credits. In short, cannabis entrepreneurs must pay taxes on all of their revenue without the benefit of being able to use business expenses to reduce their taxable income.

Wait, but What Is Cost of Goods Sold and Why Is It Still Deductible?

When Congress passed Section 280E, it feared possible constitutional challenges to the law. To prevent such challenges, it added an exclusion that allowed a deduction for the cost of goods sold even where the goods are illegal under federal law.

Costs of goods sold is essentially inventory costs. This includes the cost of the product, the cost to ship it in, and any directly related expenses.

It’s important for us to note that even though cost of goods sold is still deductible, the IRS applies its definition more narrowly to cannabis companies, unfortunately. For example, it does not allow the use of tax changes that allow more indirect costs to be included in costs of goods sold because those changes were made after Section 280E went into effect. This means that cannabis companies may not be able to use the same accounting methods as other businesses, and this could result in less favorable treatment by the IRS.

How Are Cannabis Companies Getting Around 280E?

Like we mentioned in a previous post about mastering the industry, it’s great to learn from what successful companies are doing, especially with these complicated tax laws. Really though, it’s simple. Essentially, accountants for cannabis companies are getting around Section 280E with smart business structuring. That is, the business is divided into two separate businesses.

The first business is directly responsible for producing and distributing cannabis. The first business files a tax return without the deductions barred by Section 280E.

The second business holds any activities that are legal under federal law and would not trigger Section 280E. This might include care services, selling ancillary products such as t-shirts, or owning and managing the building that the first business operates in. The second business files a tax return claiming all ordinary deductions.

The effect is that the two companies pay less taxes than if they operated as a combined company entirely subject to Section 280E.

Is This Kind of Loophole Legal?

Good question! In fact, the two-business strategy has been upheld in federal court. The most notable case is CHAMP v. Commissioner.

In CHAMP and other cases, two cannabis-related businesses operated in close coordination -- one with the federally illegal activities and one with the legal activities. In some cases, the IRS has even upheld arrangements where employees worked for minimum wage for the company that was barred from deducting wages under Section 280E, but also received a higher wage from the company able to deduct wages.

The key is that these businesses worked with their tax and legal advisers to create a solid legal structure and then used immaculate record keeping to prove that they were operating as they stated.

What Happened in Canna Care?

In Canna Care v. Commissioner, a cannabis company argued that Section 280E should not apply to cannabis companies.

In doing so, it also tried to have the Tax Court overturn CHAMP and the two-business strategy. The reason being that the taxpayer had failed to properly follow the two-business strategy and was forced to pay back taxes on business deductions disallowed under Section 280E.

The Tax Court made three key findings upholding the previous cases as well as the application of Section 280E to cannabis companies:

1. Cannabis Is Still a Controlled Substance Under Federal Law

The taxpayer argued that cannabis should no longer be considered a controlled substance under federal law since it is legal in the taxpayer's state, California. The court found that only federal law applies for Section 280E purposes.

Because Congress has the authority to set federal law on controlled substances and the federal Drug Enforcement Administration still lists cannabis as a Schedule I controlled substance, the court found that cannabis is still a controlled substance under federal law.

2. Cannabis Companies Engage in Trafficking for the Purposes of Section 280E

Similarly, the taxpayer argued that its actions were legal under California law, which meant it did not constitute trafficking. The court again relied solely on federal law to hold that the production and distribution of cannabis constitutes trafficking under federal law.

3. A Taxpayer Engaged in the Trade or Business of Selling Cannabis Falls Under Section 280E

The court found that because the taxpayer's trade or business involved the sale of cannabis, Section 280E applied to the taxpayer, and the taxpayer couldn't claim business deductions other than cost of goods sold.

The court also found that the taxpayer failed to properly follow the two-business strategy. It explicitly said that if the taxpayer had, the business holding the legal activities would have been entitled to its full deductions.

Conclusion

Okay – so that was a lot of information. In short, Section 280E severely restricts what deductions cannabis companies may take even though they must pay full income taxes. However, careful (and legal!) accounting can separate cannabis activities from unrestricted activities so that the taxpayer can claim some deductions. To do so correctly, it is definitely a smart choice to seek advice from a qualified attorney or accountant. Especially now, with the latest update being that States that have legalized marijuana are taking a different position than the Federal Government. It appears the States that have legalized marijuana will allow you to deduct all the business expenses. So, good luck Cannabis entrepreneurs!

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