12 Feb 20 Audra Walter
The IRS and US Government might inadvertently be causing a detriment to our economy by continuing to treat cannabis as a controlled substance regarding the taxation of businesses in this industry. In this article we will discuss some of the negative effects Section 280E could be having on otherwise compliant companies.
Back in 1981, a court case took place which involved a cocaine trafficker who attempted to assert his rights to deduct ordinary business expenses under federal tax law. Section 280E was created as a direct response to this case. As we’ve discussed in our previous post, IRC Section 280E forbids businesses which generate income from the sale of “controlled substances” from taking deductions for ordinary business expenses. Since the creation of Section 280E, many states have legalized cannabis for either medical or recreational purposes, or both. Because of this development, Section 280E is now causing many state legal cannabis business to pay a very large amount in taxes when compared with their true taxable income. Ultimately, Section 280E could cause many cannabis businesses to avoid paying federal income taxes. A strong case can be made that Section 280E needs to be amended to permit ordinary business deductions for state legal cannabis businesses.
Let’s explore how Section 280E impacts the cannabis industry in detail and then discuss why this section needs to be rethought as a matter of fairness to state legal cannabis businesses. As we will show, the financial impact of Section 280E can be quite severe, and it may end up causing many otherwise compliant businesses to avoid federal income taxes.
Expenses Disallowed Under Section 280E
Presently, cannabis businesses are able to deduct the “cost of goods sold” (COGS) from their gross income. This makes intuitive sense, because businesses cannot sell anything without first spending money to acquire their product, including “controlled substances.” Under Section 263A of the IRC, state legal cannabis businesses may still be able to deduct certain costs which are closely associated with the acquisition of their cannabis product. However, even though some of these costs may be deductible, there are still plenty of other expenses which are forbidden under Section 280E. Here is a list of expenses which are contested under Section 280E:
Marketing and advertising costs
Facility rental fees
Repairs and maintenance costs
State excise taxes
Depreciation of cannabis
This list is not exhaustive. In short, if a cannabis business attempts to deduct any of these costs, those attempts may be shut down by Section 280E. When added together, these expenses can add up to a very significant sum.
Concrete Example of 280E’s Impact on Cannabis Businesses
Let’s crunch the numbers in a hypothetical scenario to give readers a clearer sense of Section 280E’s impact. Federal tax liabilities are computed from a business’s “taxable income.” Taxable income is the remainder when a business takes its gross income and deducts all allowed deductions. This includes COGS and the other deductions which are ordinarily permitted for standard business expenses. Consider an example: a cannabis business has gross revenues of $800,000 and COGS amounts to $300,000. This brings its taxable income down to $500,000. The business has expenses of $250,000 (typical for a business with gross revenues of this amount), and so its true earnings are only $250,000. However, when it files taxes, it will be taxed on $500,000. Suppose this translates to a federal tax liability of $175,000. If we compare this federal tax liability to the true earnings of the company, we arrive at a tax rate which is an alarming 70%. This example could very likely be a true case from real life. Many cannabis businesses have reported tax situations similar to the one described here.
Strict Enforcement May Lead to More Tax Evaders
If cannabis businesses continue to face situations in which they face true tax rates of 50% or greater, we may start to see higher rates of tax dodging. Very often, Section 280E eats away a substantial portion of the profits of cannabis businesses; in order to avoid this, some cannabis businesses may simply resort to ignoring their federal tax liability altogether. Because of its harsh effect, in other words, Section 280E may end up generating less revenue in the future because it will deter many businesses from filing taxes. One way that the Congress can avoid this unfortunate possible scenario is to amend Section 280E to provide fairness to state legal cannabis businesses.
Contact Boxelder Consulting for Additional Resources
This is a lot of information. We’re aware of this. If you’d like further information about Section 280E or cannabis business taxation strategies, get in touch with Boxelder Consulting today. The team at Boxelder Consulting can help you understand all the nuances of Section 280E. If you’re a cannabis business owner, we can also help you structure your business so that you’re able to extract the maximum profits from your revenues. Give us a call today at 303-317-6111.