Introduction: What is Section 280E?
IRC Section 280E is the subsection of the Internal Revenue Code which dictates the taxation of medical marijuana and provides for the following: “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.”
Despite the fact that it is legal in 29 states and the District of Columbia, marijuana is still classified as an illegal Schedule I substance according to the Federal government. This classification is what allows the IRS to apply the tax code at a FEDERAL level to any business that handles the cannabis plant, regardless of state laws.
Avoid IRC Section 280E:
Most consider IRC Section 280E tax code to be arcane and outdated and difficult to navigate, and yet, you still need to be prepared when tax returns are filed.
Mitigating the 280E Tax Law is no simple task. Too many times, we’ve heard horror stories of cannabis companies getting hit with 70-90% effective tax rate (see accompanying table) due to lack of information or lack of knowledge about the tax saving strategies that are available!
If you own a cannabis company, the best thing you can do for your business is to hire a CPA with the industry knowledge and expertise to navigate the 280E tax code; there are strategies that you can implement immediately to mitigate the punitive impact of this provision.
How it’s Hurting State-Level Cannabis Businesses
The 280E tax code was not meant to be applied to legal businesses. The tax code was passed in response to a 1981 Tax Court case involving a convicted drug trafficker, Jeffrey Edmonson. During this time, Edmonson reported income and expenses from the sale of cocaine, amphetamines and cannabis. He presented exceptionally detailed records of his reported income and his cost of goods sold, leading to the court ruling in his favor.
Because of this tax court loss, Congress passed IRC Section 280E the following year to prevent other illegal drug traffickers from doing the same. Today, the state-level legalization of cannabis has led to the tax code being applied to more legitimate businesses than its intended illegal drug traffickers.
Take a look at the impact the 280E tax provisions has on the dispensary.
|Operating Expenses (280E)||$100,000||$0||$<100,000>|
|Tax Rate (30%)||$22,500||$52,500||$30,000|
|Effective Tax Rate||30%||70%||+40%|
|After tax Profit||$52,500||$22,500||$<30,000>|
Despite both companies reporting identical results, the dispensaries profits are cut by more than half because they traffic in controlled substances.
We can’t stress enough the importance of educating yourself and finding a CPA with industry knowledge to help maneuver the 280E tax code.
Mitigating IRC 280E: Actionable Steps for Your Business
Step 1: Document Everything
It may seem attractive to keep some transactions off the books, but it isn’t worth it. All of the remaining steps are dependent on diligent documentation and cannabis companies are more likely to be audited by the IRS than the general population.
Step 2: Leverage CHAMP
In 2007, Caregiving Californians Helping to Alleviate Medical Problems (CHAMP) was allowed to take business deductions from the patient care portions of their medical marijuana business. CHAMP provided counseling, medical supplies, internet, meals and exercise programs. Therefore, the Tax Court agreed that CHAMP was two separate organizations, allowing deductions on business expenses to be made that were otherwise not included by 280E.
Ultimately, CHAMP made it possible for cannabis companies to operate multiple businesses under one roof.
What does this mean for you? Add additional services to your cannabis business such as food, coffee, apparel, counseling, yoga classes, or medical supplies in order to take advantage of additional COGS deductions.
Having a second business will allow for you to separate the working hours between businesses, so you can deduct your additional services hours from your COGS.
For example, your sales and marketing teams may allocate 4 hours a day towards your cannabis business and another 4 towards your counseling services. This allows you to deduct the payroll and payroll expenses from your counseling services.
You may even want to take this a step further and offer minimum wage while working for the cannabis company, and make up the difference from your other service. Or If you are in the medical cannabis industry, why not charge a monthly fee for caregiving services commensurate with the patient’s diagnosis? You could offer different packages like Silver, Gold, and Platinum. If the patient is prescribed a potent and more expensive strain of cannabis, you simply charge them more for the caregiving. The cannabis you just give away alongside the caregiving services.
Please note that this second business has to be legitimate and only works if you’re already incorporating step one, which is to document everything!
Step 3: Reduce Your 280E Footprint
IRC Section 280E scrutinizes employee salaries, utilities, health insurance premiums, marketing and advertising, and repairs and maintenance. Finding ways to cut down on these costs can slowly add up to increase profit margins.
Additionally, you should be looking to capitalize your indirect costs and deduct them under COGS. These expenses can include the square footage used for storing your inventory, new locks for protecting your product, storage facility maintenance costs and more depending on your business.
Step 4: Capitalize your indirect costs into inventory
Cannabis businesses should be entitled to include in COGS all costs that may be included in COGS under all capitalization rules other than IRC §263A. The fact that IRC §263A requires the capitalization of particular costs does not preclude such costs from capitalization under other rules. Capitalization must be decided based on the IRC §471 regulations as currently written, and IRC §280E has no impact on capitalization requirements. Taxpayers should calculate COGS “using applicable inventory-costing regulations under IRC §471 as they existed when IRC §280E was enacted”, (or pre-enactment of IRC §263A).
Step 5: Consider the Research and Development Credit
To the extent that the taxpayer expands its business to include research and development within the construct of IRC Section 174 and those activities do not fall within the scope of IRC Section 280E, another consideration. A research credit study documenting the permissible activities allocation of expenses and calculation of the research credit would be highly recommended.
Step 6: Understand the state tax implications of your location
From a state planning perspective, the difference between federal and state tax treatment of expenses under IRC §280E should also be considered. Certain states specifically allow for a state deduction of IRC §280E expenses, therefore contradicting the federal disallowance. The ever-changing state tax laws should always be considered during planning and preparation to minimize any state income taxes (some which come with hefty surcharges).
Step 7: Find an Experienced Tax Attorney and CPA
This arguably could be the first step, but we’ve decided to save the best for last.
In this article, we’ve provided you with a few actionable steps for your business, but in the end, each business operates differently. Finding a CPA that has experience in the cannabis industry will be one of the business investments that you make.
An experienced cannabis CPA can help uncover ways to protect your profit, specific to your business that you just can’t find online.
At CPAMD, we are industry experts and specialize in the taxation of the medicinal cannabis industry.
As your partner in medicinal cannabis tax and business needs, we work with cultivators and dispensaries throughout the U.S. We guide cannabis clients in navigating the complex world of IRC Sec 280E, IRC Code Sec 263A and to secure the lucrative Research and Development tax credits to minimize federal and state income taxes and surcharges.
If you have any questions or inquiries please contact me, Bryan McDonald, CPAMD at (844)-471-1166 X28.