With tax deadlines rapidly approaching, I have received a flurry of questions from legal cannabis companies. Confusion around the tax code arises for many reasons, and the current tax laws for legal cannabis companies are extremely difficult to navigate.
First, federal and state tax laws vary significantly. Second, federal tax rules for legal cannabis companies are substantially different than those of other for-profit businesses. But most importantly, federal tax laws make it very difficult for legal cannabis companies to generate a profit due to the heavy tax burden that is imposed.
The Dreaded 280E
As states legalize cannabis, these companies are treated like other for-profit businesses at a state level. However, at the federal level, cannabis companies are still considered illegal. Hence, the dreaded Section 280E of the federal tax code comes into play. The heart of Section 280E sets forth the tax code for businesses that are associated with trafficking Schedule I or Schedule II drugs, according to the Controlled Substances Act. Because marijuana is still a Schedule I substance, state-legal cannabis companies must report their income as illegal at the federal level. This triggers a series of tax rules that must be followed.
To illustrate the impact of Section 280E, see the following simplistic example:
Revenue $1,000,000
COGS ($300,000)
Other Expenses ($400,000)
____________________________________
Net Income $300,000
Gross Profit $700,000
Federal tax rate 35%
For a non-cannabis business, tax is based on the net income of $300,000, therefore the federal tax obligation is $105,000, resulting in a net income after taxes of $195,000 and an effective tax rate of 35%.
For a legal cannabis business, tax is based on the gross profit of $700,000, therefore the federal tax obligation is $245,000, resulting in a net income after taxes of $55,000 and an effective tax rate of 82%.
The legal cannabis company ends up paying an additional $140,000 in taxes, which reduces its overall net income by the same amount, creating a significant disadvantage.
Reporting under Section 280E starts with classifying income as “illegal” on the federal tax return and also disallows the majority of expenses associated with legal cannabis companies. There is confusion over what “disallowed” really means, but in the simplest terms, most businesses pay taxes on their net income (revenue minus expenses). However, for legal cannabis companies, only the cost of goods sold (COGS) are permitted for deduction.
COGS include only the expenses associated with the production of a product. For cannabis producers, that means costs such as seeds, soil, water and nutrients and expenses related to the cultivation and harvesting of the plant are deductible.
However, costs associated with distribution, sale, administration, management, promotion, advertisement, overhead and support are not allowable. These include rent, shipping, most employee expenditures, most contractor expenses, legal, management, accounting, overhead, compliance, etc.
For most companies, costs that do not fall into COGS comprise a large percentage of the overall costs of the organization. Paying taxes on gross profit creates a significant tax burden, which, in many cases, can make a company unprofitable.
Best Practices
What can legal cannabis companies do to minimize their tax burden? The first step is to have an intricate understanding of Section 280E or hire an accountant who is well versed in this area. The next is to keep accurate and complete financial information.
In the event your deductions are scrutinized, you will need to not only produce good financial records, but provide a sound basis for what expenses fall into COGS versus non-COGS expenditures. Making quarterly tax payments assists with the annual tax burden and reduces the risk of penalties.
If a legal cannabis company produces multiple products, then accurate and complete books and records should be kept for each product.
Section 263A of the Internal Revenue Code allows for some indirect expenses to be allocated to COGS under defendable allocation methodologies, so it is important to work with a knowledgeable accountant to set up an appropriate allocation method. This will allow the company to allocate a certain percentage of indirect expenses as COGS, which will help minimize tax liabilities.
Finally, developing a solid system to track expenses by category is critical. For example, all cultivation costs are deductible. However, if records are not appropriately maintained, you may lose the deductibility.
Until there is a shift in tax law, legal cannabis companies need to continue following the strict tax code. While Section 280E puts legal cannabis companies at a disadvantage, they can minimize their tax burden by following the steps outlined above. But for long-term success, the industry must advocate for fair tax laws so these businesses can prosper and grow.
Kim Gladkowski is a partner in New Agrariae, LLC, a full-service consulting firm committed to parity in the agricultural supply chain. The company provides equitable solutions from seed to shelf and can provide all aspects of consulting, including C-suite services, corporate social responsibility planning, fundraising, expertise and consulting in farming, research and development, regenerative agriculture, reduction in carbon footprint, vertical supply chain integration and all aspects of operations, production and sales. She is also the owner of EBalance, a full-service accounting firm, and can be reached at kim@newagrariae.com.