Ask any cannabis entrepreneur what the bane of their business is, and they will likely say it’s the IRC 280e Tax Code. Regardless of its irksome nature, cannabis sellers must abide by it or risk losing everything – not to mention possible jail time for money laundering. No one wants that, so here are a few facts to get you started in calculating tax costs.
What is IRC 280e?
First, a brief overview of what 280e is. It all started in 1981 with Jeffrey Edmonson v. Commissioner. This was a court case in which a cocaine, amphetamine, and cannabis trafficker (Edmonson) fought to deduct “ordinary business expenses” from his taxable income. The court ruled in his favor – he was allowed to deduct the majority of his expenses, including the cost of goods sold (packaging as well as phone, home, and vehicular expenses).
Less than a year later, though, the decision was overturned, and business owners selling controlled substances were barred from the right to deduct expenses from their illegal businesses. These businesses were originally made illegal under the Controlled Substances Act (CSA), signed by Richard Nixon, and classified as Schedule I and Schedule II controlled substances. Ronald Reagan later expanded this “War on Drugs” by enacting harsher penalties for drug-related crimes, culminating in the passing of IRC 280e.
Section 280e forbids businesses from deducting expenses from their gross income when it involves “trafficking Schedule I and II controlled substances”. This also prevents businesses from taking credits. Federally, marijuana is still considered an illegal (Schedule I) controlled substance. What that means for cannabis sellers is that, despite its medical and recreational legality across the states, they are forced to pay taxes on all of their business income. In addition, they’re prohibited from writing off most business expenses to minimize their taxable income.
How Much Do I Owe?
When 280e was passed by Congress, they added an exclusion to prevent future changes to the law. This exclusion allows cannabis entrepreneurs to deduct the cost of goods sold (COGS). This means that even federally illegal products can be claimed for a deduction. The cost of goods sold refers mainly to inventory costs. This means the cost of shipping to the retail location, the cost of the product, and any directly related expenses.
However, this doesn’t offer the cannabis seller much in terms of a tax break. The IRS ignores any tax changes made after section 280e, which allow more indirect costs to be applied. Essentially, anything expense related to distribution can’t be included under COGS. That includes rent, outbound shipping and some inbound shipping, health insurance premiums, maintenance and repairs, marketing/advertising, employee expenditures, and utilities. In practical terms, business owners can deduct little more than the seeds, soil, water and nutrients essential to plant and cultivate the cannabis.
Because cannabis business owners must pay taxes on gross rather than net income, they end up paying tax rates that are 70% or higher. That’s quite a bit more than the rates paid by non-cannabis business owners, whose rates tend to be closer to 30%. Paints a pretty good picture of how the cannabis industry is affected overall in terms of tax rates.
How Can I Maximize Deductions?
For new business owners, it’s advisable to set up as a C-corporation. This allows the business owner to only pay taxes based on their salaries and dividends. Consider looking into a shared service agreement as well – which splits your business into two entities. The first structure would handle cannabis production and distribution, whereas the other would deal with legal responsibilities. That includes counseling, care, selling related (but not cannabis-infused) merchandise, and management of the retail space. This means only the first structure would be responsible for compliance with the 280e tax code and its definition of COGS. The second entity can then deduct ordinary expenses such as rent and utilities, payroll, sales, administration, marketing/promotion, and some distribution. However, be sure to consult with experts who specialize in cannabis compliance. Doing this before you get started with a shared services agreement will help you avoid any violations.
It’s important to keep impeccable records. The danger of neglecting this area is not just in loss of business, but potential jail time. To stay in the clear, document everything. Audits can come at any time – more often for cannabis businesses since it’s a federally illegal substance. Sales, wages, and vendor payment should be accounted for, and everything should be well organized.
Professional advice is paramount. An expert CPA can provide guidance regarding how to record detailed COGS deductions and what will and won’t qualify. Electronic records for managing documentation for workforce, spend, inventory, etc are crucial. Report all cash transactions, including deposits, payments, and single cash sales over $10,000.
For tax purposes, track employees’ tasks and time spent on each. It’s essential to do this to provide accurate reports on employees’ salaries as well. A part-time cultivator and part-time budtender fall under different tax codes. For employees who perform multiple tasks, it’s important to track the time they spend on each task. This helps you determine how many hours are deductible under the 280e tax code. To make this simpler, you can designate specific responsibilities for each employee, or consider investing in employee time and attendance software for cannabis to keep track of everything.
There’s a lot that goes into being a cannabis entrepreneur during tax time, but with expert guidance, cannabis business owners can relax and enjoy the work. That’s one less thing to worry about – happy growing!
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