IRS 280e Tax Code Impact on a Cannabis Financial Model

IRC-280E really reduces the profitability of cannabis dispensaries. The cannabis businesses are allowed to deduct the cost of goods sold (COGS) from gross receipts under IRC 280E. Most cannabis entrepreneurs or operators face financial hurdles when it comes to defining the complex structure of  “280E” and its impact on the taxes of the cannabis business.

Most of the Cannabis businesses are all-cash businesses because mainstream, national banking institutions are not eager to back a federally illegal industry.

There are several small state-chartered banks and credit unions that offer financial services but still, it is a significant challenge to manage the financials when it comes to paying actual taxes.

There are major frustrating financial challenges are related to IRS Tax Code 280E, which states that “no deduction or credit shall be allowed in running a business that consists of trafficking a controlled substance.”

This section harms cannabis businesses across the nation, causing irrelevant financial and operational stress.

Before discussing the 280E pitfalls we need to understand the background of the IRC 280E.

History and Background of the IRC-280E

According to Federal Laws, cannabis is considered a Schedule 1 Controlled Substance alongside other substances like heroin, LSD, and Ecstasy.

IRC-280EIn 1982, Congress decided to form Section 280E of the Internal Revenue Code (IRC). The aim of the act is to penalize businesses that deal with illegal substances.

But this act is losing its relevance in the modern era because many of the states have legalized cannabis businesses. However, because of this act, the cannabis businesses are forced to pay higher taxes which is not appropriate in the modern establishments dealing with medical marijuana and adult-use cannabis, which additionally have to bear the burden of paying taxes for daily business expenses.

Objectives of IRC-280E Policy

  • The major objective of IRC-280E is to prevent drug dealers from declaring tax deductions for their trade expenses
  • Interpreted to include state-legal cannabis enterprises.
  • Reduction of deductions results in increased taxable income
  • Due to this act, Marijuana companies were forced to face higher federal tax rates: 40 – 80% vs 21% corporate tax

Many believe that “weed” businesses are swimming in profits. But the reality is a bit different. However, because of this code a major portion of dispensary revenues are susceptible to tax, preventing these licensed establishments from being able to invest in office improvements, reimbursements, benefits, operational expansions, giving back to the community, and so much more.

IRC-280E Tax Deductions – COGS

IRC-280e tax deductions do not apply to COGs.  What are COGs? Beginning inventory + Purchases + Inventory Costs – Ending Inventory = COGS

The 280E Internal Revenue Code permits cannabis companies to deduct specific expenses related to inventory as COGS (costs of goods sold). A cannabis operation will show its gross income on its tax returns, but not all deductions commonly taken by businesses will net out.

The calculation of COGS is a tricky process, if you are a startup then consult CPA or industry experts to figure out the correct and acceptable way of the calculation of COGS. This is definitely an unsettled area in the eye of Federal law.

We have figured out some specific tips just meant to safeguard a cannabis business from the unnecessary tax burden.

280e Cannabis retailers are allowed to claim deductions for:

  • Invoice price for cannabis, less trade, or other discounts.
  • Electric bills for designated inventory areas (electricity used in sales areas cannot be deducted as COGS).
  • Transportation (the cost of travel to purchase cannabis, transportation, and legal shipping costs of cannabis).

Cannabis cultivators can claim deductions for:

  • Raw materials and supplies (e.g. seeds, soil, clones, fertilizer).
  • Direct labor before the sale (e.g. cleaning, trimming, curing, packaging, inventory).
  • Indirect production costs, such as:
    • Repairs, maintenance, and rent for production and storage
    • Utilities (water and electricity used to grow cannabis)
    • Indirect materials and supplies (grow supplies and packaging)
    • Indirect labor (supervisory wages)
    • Costs of quality control and inspection

Section 280E is only a few lines but carries a significant impact on the cannabis industry. The law reads as such:

“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 or 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.”

Three Common Elements of IRS280E

Section 280E applies where three elements are present: (1) a controlled substance; (2) trafficking; and (3) a trade or business.

I. Specific Standard regarding Controlled Substance.

Section 280E does not allow deductions and credits for amounts paid or incurred during the trade or business of trafficking controlled substances (within the meaning of Schedules I and II of the CSA), in violation of federal or state law. Despite legalization in at least 21 states (and the District of Columbia) and approval for medical use in nine states, federal law continues to classify cannabis as a “controlled substance” under schedule I of the CSA.[14] Section 280E, therefore, prohibits tax deductions and credits attributable to the trade or business of trafficking in cannabis.

II. Specific Categorisation about Trafficking Issues.

The Federal Government has defined the term “trafficking” by reference to the verb “traffic,” taking the definition from Webster’s Third New International Dictionary to mean “to engage in the commercial activity: buy and sell regularly.” Thus, the purchase and sale of cannabis constitute trafficking even when permitted by state law. By defining “trafficking” in this manner, the court has cast a wide net. Indeed, most, if not all, commercial activity with respect to cannabis would appear to fall under section 280E’s definition of trafficking.

III. Specific Standards about Trade or Business.

Whether a taxpayer’s activities constitute a trade or business is an issue that draws upon a host of case law precedents and generally looks to the level of activity, continuity of that activity, and the period over which the taxpayer has engaged in that activity.

Although a cannabis business is illegal under federal law, a taxpayer is nonetheless required to pay federal income tax on the taxable income derived from a cannabis trade or business.

Section 61(a), in other words, does not differentiate between income derived from legal sources and the income derived from illegal sources.

RELATED: How to Make Financial Projections for your Cannabis Dispensary

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Thomas Howard

Business Lawyer & Consultant

At Collateral Base we help clients get organized, licensed, capitalized and exert their rights in court. We have #GoodProblems

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