Taxes are one of many conflicts between state and federal laws pertaining to the cannabis industry. States that have legalized cannabis for medical or recreational use treat all business alike, allowing the same deductions and credits for business expenditures. Under federal tax laws, however, most cannabis-related businesses are prohibited from deducting or receiving credits for ordinary and necessary business expenses.
Marijuana remains an illegal controlled substance under federal law. Section 280E of the Internal Revenue Code states, “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year … if such trade or business consists of trafficking in controlled substances … prohibited by federal law.” In application, Section 280E often results in a cannabis business paying more than double in income taxes than it otherwise should.
That brings us to the million-dollar question: How does a cannabis business comply with federal tax laws and still deduct its business expenses? While there is no magic workaround, here are three ways a cannabis business may reduce its taxable income.
- Include certain expenses in COGS. For producers, processors and retailers, gross income is calculated by subtracting the cost of goods sold (COGS) from total sales. Taxable income is gross income less deductions. Because Section 280E prohibits a cannabis business from taking any deductions, it is important to maximize COGS.
Inventory-costing rules require that all costs “incident to and necessary for the production operations and processes” be allocated to items of inventory and included in COGS. A retailer’s COGS should include the price of marijuana, transportation costs and the necessary expenditures in acquiring the product. A producer’s COGS should include all direct production costs, such as materials and labor, and indirect production costs, such as rent and property taxes, repairs, maintenance, indirect labor, indirect materials and supplies, utilities and costs of quality control and inspection. Depending on their financial reports, producers may also include certain taxes, depreciation, employee benefits, administrative costs of production, a portion of the officer’s salaries and insurance costs.
Additionally, Section 263A of the Internal Revenue Code requires the inclusion of purchasing, handling and storage expenses for sellers and the allocable service costs associated with payroll, legal and personnel functions for both sellers and producers. In Chief Counsel Memorandum 201504011, the IRS claims that Section 263A does not apply to cannabis businesses, but the IRS’ position lacks support and the memorandum is not binding. Despite this, cannabis businesses that include these additional expenditures in COGS should expect the IRS to challenge such expenditures if audited.
There are specific expenditures that may not be included in COGS: marketing, advertising, selling, research and distribution expenses, interest, income tax, pension contributions, general administrative expenses and certain salaries paid to officers.
Given the complexity of determining COGS, accountants and CPAs for cannabis businesses need to understand the allocation of expenditures and establish a bookkeeping method that will maximize COGS.
- Treat state excise taxes paid as a reduction of amount realized. States that have legalized cannabis have also imposed substantial excise taxes on its production, processing and sale. Section 164(a) of the Internal Revenue Code allows a taxpayer to treat certain taxes as part of the cost of acquiring the property or a reduction in the amount realized on sale. In simpler terms, the taxpayer can add certain taxes to the cost of a product or subtract it from sale proceeds. State excise tax falls into this category.
The IRS confirmed this when it published Chief Counsel Memorandum 201531016 explaining that Washington state marijuana excise tax payments should be treated as a reduction in the amount realized on the sale of the property. The IRS went on to explain that the excise tax is neither a deduction from gross income nor a tax credit and therefore, does not run afoul with Section 280E.
- Operate a secondary business in the same location. A cannabis business can operate a secondary business that does not involve a controlled substance in the same location using the same resources.
The second business can deduct its allocable portion of the expenses. The second business must be a legitimate business for the purpose of making a profit. The expenses need to be reasonably allocated to each business and easy to identify. For example, if the second business uses one-third of the retail space, one-third of the rent and utilities could be deducted. The books and records for each business should be kept separately.
Jessica McConnell is of counsel in the Portland office of Williams Kastner Greene & Markley. Her practice concentrates on federal, state and local tax controversies, including tax audits, offers in compromise and tax collection matters. She excels at complex audits, offers in compromise, employment tax liabilities and protecting her clients against unwanted and unexpected collection efforts. Williams Kastner publications should not be construed as legal advice. The communication does not create an attorney-client relationship with Williams Kastner or any of the firm’s attorneys.
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