By Scott Levy
Most entrepreneurs who enter the marijuana business are well aware of the fact that it is still considered an illegal activity by the federal government, regardless of state laws.
What they may not be aware of is how this will affect their relationship with the Internal Revenue Service, and most importantly, the filing of their annual federal tax returns.
In 1982, Congress enacted Internal Revenue Code Section 280E. This law states that anyone in the business of “trafficking” controlled substances, as defined by the Controlled Substances Act, is not allowed to deduct any ordinary business expenses on their tax returns.
So items like rent, wages, utilities and more are not allowed to be deducted against your gross income if you fall under this law. Unfortunately, the IRS has made it clear that, as far as they’re concerned, state-legal marijuana businesses ARE subject to Section 280E.
The effect this has on marijuana businesses is devastatingly high effective tax rates, in some cases as much as 70-80 percent.
As you might imagine, this has many in the industry up in arms, and there are several ongoing tax court cases that could set precedent in determining whether or not 280E should apply to state-legal marijuana businesses or not. The most relevant case to date was Californians Helping to Alleviate Medical Problems (CHAMP) vs IRS, in which a California cooperative challenged the IRS on Section 280E.
It was ultimately decided that CHAMP was allowed to separate out “non-trafficking” expenses, for things like their counseling offices, from “trafficking” expenses directly related to their storefront. It was decided that only about 20 percent of their expenses were directly related to “trafficking,” and so only those amounts were disallowed under 280E.
Although this case did not set a precedent and only applied to CHAMP, the tax court’s decision opened up a whole new strategy for tax preparers to think about — the separation of trafficking versus non-trafficking expenses.
This has resulted in a variety of different tactics, whether that’s limiting customer-accessible areas to minimal amounts of space, opening up secondary businesses under the same roof, or other unique ideas. To date though, the IRS is still taking a rigid stance and applying 280E to all marijuana businesses, regardless of their creative strategies.
One important 280E loophole to mention is that it does NOT apply to “cost of goods sold.” This has been upheld by the tax courts, and so that means the IRS cannot disallow the cost of producing, obtaining and storing inventories.
Naturally, tax preparation strategies have been focusing on this area as well. This fact also means that growers will not get hit as hard as retailers when it comes to 280E, since the majority of a grower’s expenses can be attributed to their cost of goods sold.
If you are considering entering the marijuana business, or are already in it, then it is imperative that you work with your tax preparer to devise a strategy for handling Section 280E and have a plan in place before the IRS comes knocking at your door.
Scott Levy is a certified public accountant in Arizona. His family’s firm, Levy and Levy, CPAs, has been serving clients since 1991 and is dedicated to working with the emerging recreational cannabis industry.