February 4, 2019 | By Gio Brackbill
Marijuana remains illegal under federal law. Despite this, eleven states fully legalized it, including for recreational use. Fifteen states chose to keep it illegal. The remaining twenty-four fall in between, some which have begun decriminalizing it and others partially legalizing it for medicinal use. As marijuana gains broader legal status each year, cannabis entrepreneurs have jumped at the chance to enter the market and capitalize on the new opportunities that the industry brings. Regardless of its legality, the IRS still expects cannabusinesses to pay federal taxes on all of their revenue. But under Section 280E, cannabis entrepreneurs are not entitled to the same benefits when writing-off business expenses as other companies that are unrestricted by Section 280E.
Section 280E Tax Provisions and Cannabis Entrepreneurs
Congress enacted Section 280E of the tax code in 1982. It applies to expenditures in connection with the illegal sale of drugs. Even if a cannabis company is given legalization by the state, cannabis is still a controlled substance under federal law. Businesses that fall under this category cannot claim deductions, except for the cost of goods sold. This means that cannabis entrepreneurs need to be conscious of the law and take steps to prevent this accounting nightmare before tax season rolls around.
How to Claim Federal Deductions with the Two-Business Strategy
Smart accounting can help cannabis companies to comply with the law while also claiming their deductions. The business structuring strategy that has been upheld in federal court in the case CHAMP v. Commissioner allows companies to maximize deductions by dividing the business according to 1) activities that are unrestricted under federal tax law and 2) activities, such as producing and distributing a controlled substance, that are not deductible under the law. Essentially, dividing the business accounts creates a loophole and allows the legal side of the business to claim deductions that would not be allowed if the activities were all under one entity.
The Short End of the Stick for Cannabusinesses
Cannabis companies that do not follow the two-business structure may face detrimental consequences as a result of the 1980’s tax code while predates the legalize marijuana reform that is sweeping the nation. Without the ability to deduct business expenses, many companies will operate at a loss and be forced to close their doors before they ever have a fighting chance to get off the ground.
Some states with legalized marijuana are approaching the issue by passing legislation to make it easier for entrepreneurs in this industry to deduct full business expenses. However, this creates complications for companies that want to take advantage of the state laws. While a marijuana company may benefit from the state law, unfortunately they are soon to face the federal barricade head on. The IRS responded to states with a memo clarifying that when there is conflict between state and federal law, they must follow the federal law. Hence, cannabusinesses that do not separate their legal and illegal activities are doomed to face the unforgiving federal tax code.
See the case below for an example of a worst case scenario that can befall a cannabis company facing the tax courts for a Section 280E violation.
In Canna Care v. Commissioner, the court held that all of the cannabis company’s arguments for why they should be allowed deductions were irrelevant, moot or meritless. Canna Care failed to use the two business strategy, therefore they were considered to be trafficking a controlled substance for the purposes of Section 280E and effectively not entitled to any business deductions other than the cost of goods sold. Let this case be an example to other cannabis companies on how not to structure their business if they want to deduct normal business expenses.
Consider Yourself Warned, Cannabis Entrepreneurs
Take it from Senior Partner at Cannabis Practice Group, Jonathan Barlow. He regularly advocates the importance of compliance at the state and federal level to entrepreneurs who are interested in entering the industry. While the startup costs are high, compliance is an absolute must because you can not escape the regulatory tax or legal requirements. You must be strict with auditing and keeping up with the rules. “Otherwise, don’t go into this business,” Barlow advises.
The last thing you want for your cannabis startup is to be forced to pay penalties and the back taxes on business deductions that were not allowed under Section 280E.
Sources:
- https://www.irs.gov/pub/irs-wd/201504011.pdf
- https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=10586
- https://disa.com/map-ofmarijuana-legality-by-state
- https://marijuanaretailreport.com/irs-code-section-280e-means-cannabusinesses/
- https://www.forbes.com/sites/theyec/2018/07/24/what-cannabis-entrepreneurs-should-know-about-tax-section-280e/#4f7727937377
- https://www.forbes.com/sites/meimeifox/2018/04/20/two-cannabis-entrepreneurs-share-their-secrets-for-success/#3e40293e4fbd
- https://theaccountingpath.org/accounting-careers-marijuana-industry-exploring-cannabusiness/
I know that another issue cannabis entrepreneurs face is in banking. I wonder, with money flowing to, from, and in between multiple entities, can the entrepreneur use second “legitimate” business to hold cash in federally insured banks? I am sure this could raise a whole plethora of other potential legal questions, but it might be something work thinking about!
Since according to the tax code cannabusiness can’t deduct anything except for the cost of their goods sold. So should I assume that in order to avoid scrutiny cannabusiness can’t even deduct their employee salaries, rent, advertising, marketing and operating expenses etc?
Great post. I know very little about the Cannabis Industry, so this write-up was very informative for me. Let’s hope the federal government catches up to the states in regards to cannabis law; otherwise, the growing number of cannabis entrepreneurs will continue to have a hard time. I also thought it was great that you really hit home the importance of compliance for these ‘cannabusinesses’ — there isn’t a lot of room for error, so this was much needed.
Your website itself looks fantastic. Great job!
Gio,
The information on the two business strategy upheld in CHAMP v. Commissioner is very helpful for my independent study. Your blog does an excellent job at breaking down what entrepreneurs in this industry should be aware of when it comes to taxation.