In 1981, the IRS denied $30,341.69 in costs of goods sold (COGS) and business expenses reported by Minnesota drug seller Jeffrey Edmondson and determined a $17,303.45 deficiency. At trial, Edmondson presented detailed testimony of the cost of his expenses. The U.S. Tax Court ruled in favor of Edmondson, holding the expenses were made in connection with his trade or business and were thus ordinary and necessary.
In 1982, in response to the Edmondson case, Congress passed Section 280E of the Internal Revenue Code. While 280E bars businesses from deducting otherwise allowable ordinary business expenses from gross income related to the “trafficking” of any Schedule I or II substances under Controlled Substances Act, the legislative history illustrates that Congress did not apply 280E’s ban to COGS deductions (Schedule I substances, including both heroin and cannabis, are deemed to have no medical benefit and a high risk of addiction).
To illustrate 280E’s severe effect:
Business 1 Business 2
Gross Revenue $800,000 $800,000
COGS (-) $500,000 $500,000
Gross Income (=) $300,000 $300,000
Qualified Deductions (-) $200,000 $0
Taxable Income $100,000 $300,000
Tax (21%) $ 21,000 $ 63,000
Times have since changed. Currently, most states and U.S. territories have some form of adult-use, medical-use or CBD/low-THC cannabis program in place. Despite widespread state/territorial legalization of cannabis, it remains unlawful under federal law and continues to be a Schedule I substance, so 280E remains in effect.
Federal taxation is calculated simply: Section 61 defines “gross income” as “all income from whatever source derived,” including “gross income derived from business.” From gross revenue, COGS is subtracted to determine gross income. COGS are the accumulated total of every cost used to make or acquire the products or services sold, including costs for products/raw materials, storage, direct labor and factory overhead. Next, qualified deductions, which reduce the amount of income subject to tax and include deductible business expenses, are subtracted from gross income. The result is taxable income.
Section 280E bars businesses with gross income stemming from cannabis from deducting ordinary and necessary business expenses from gross revenue.
Despite being nearly 40 years old, 280E guidance is limited. Most of the relevant guidance has come in the form of case law stemming from COGS or non-cannabis business line cases.
In 2007, a taxpayer providing both medical marijuana and non-marijuana-related counseling and caregiving services, petitioned for redetermination of deficiency and penalty arising from the IRS’s 280E-based disallowance of all ordinary and necessary business expenses.
Relying upon the 280E legislative history and record, the court held that the taxpayer, who provided prohibited and non-prohibited goods/services through separate legal businesses for a single fee, was able to deduct the allocated portion of business expenses stemming from its non-prohibited business division. This ruling provided legal support for taxpayers who engage in cannabis sales to distinguish, allocate and deduct business expenses attributable to non-prohibited business.
In 2012, a taxpayer petitioned for redetermination of deficiencies and penalties stemming from the taxpayer’s failure to substantiate COGS or expenses. The taxpayer had structured its business to provide both medical marijuana and free ancillary goods/services. It had no significant costs associated with the non-marijuana services and used the same employees to sell the marijuana and provide the free services.
The court reaffirmed a taxpayer’s ability to deduct COGS but barred the taxpayer from deducting operating expenses associated with its free goods/services because they were provided “incidental” to the sale of marijuana. The court also denied the deductions for reason that the non-prohibited goods/service lines were so “close and inseparable” with the marijuana lines that they did not comprise a separate business.
In 2015, the IRS chief counsel issued Advice Memorandum 20150411. The memo, which generally may not be cited as precedent, offered insight into the IRS’s perspective on cannabis-business COGS methodology. The memo concluded that cannabis businesses are entitled to determine COGS using Section 471 (less-inclusive COGS regulations for resellers) as they existed when 280E was enacted in 1982. The memo renders Section 263A (more-inclusive subsequent COGS regulations for producers) off limits to cannabis businesses.
Subsequently, Harborside, a California medical marijuana dispensary, which had used the 263A COGS regulations and held no ownership in the marijuana plants themselves, took the IRS to court in an attempt to invalidate 280E.
The taxpayer argued 280E was unconstitutional and should not apply because its activities were not solely dealing in controlled substances, that it should be allowed to deduct non-prohibited business expenses, and that it should be allowed to determine COGS using the more preferential 263A regulations. In 2018, the court disagreed but waived the taxpayer’s substantial accuracy-related penalties for reasons of good faith, limited available guidance, lack of IRS 280E regulations and the fact that no COGS guidance for cannabis business had existed prior to the 2015 memo. The case is currently on appeal to the 9th U.S. Circuit Court of Appeals.
What can cannabis businesses operating lawfully under state law do? First, cannabis businesses should understand that tax law compliance does not safeguard against government intervention. In Harborside, the taxpayer provided evidence suggesting it was highly tax compliant. As the March 30, 2020 Treasury Inspector General for Tax Administration (TIGTA) report on cannabis entity taxpayers in three states suggests, the IRS will be increasingly scrutinizing cannabis entities in an effort to ensure voluntary tax compliance, proper income reporting and revenue.
Second, cannabis tax law is a highly complex and nuanced field. It is essential when engaging in such a business to enlist the assistance of a qualified professional to help plan, establish and operate your business in accordance with tax law from the outset.
In many 280E cases, documentation, records and business structure/operation are key. Further, proper structuring, operation and documentation of non-prohibited business lines is essential to ensure they are recognized and treated as separate by the IRS.
Daniel Knudson is special counsel at Falcon Rappaport & Berkman PLLC, where he practices in the Taxation Group. He has worked with regulated substance businesses to plan, establish and operate their businesses. He also assists regulated substance businesses to become tax compliant and resolve any tax problems and controversies they face. He graduated from the University of Montana School of Law and Georgetown University Law Center and holds legal certificates in both international tax and state and local tax. He is licensed in Colorado, Montana, Minnesota, North Carolina, North Dakota, New York, South Carolina, Utah, Washington, Wyoming, the District of Columbia and numerous tribal courts.