Section 280E poses serious problems to people conducting state-legal cannabis businesses. The Section can considerably dent the bottom line of your cannabis business. But with good planning and foresight. Your business can make a reasonable profit.
What Is Section 280E And How Did It Come About?
Congress enacted Section 280E in 1982 to prevent taxpayers from selling illegal drugs from deducting regular business expenses on their income. This came about after a tax case involving a self-employed illegal narcotics dealer. The Tax Court upheld that the dealer could take deductions on the income derived from the narcotics business. So, Congress passed section 280E to overturn the Court’s decision.
Operating your cannabis business within the constraints of section 280E
Unfortunately, section 280E still persists in the Internal Revenue Code to today. And appears to conflict with its intended purpose. Whereas the initial purpose was to prevent illegal drug dealers from taking deductions on their income. Now it seems to punish people doing legal cannabis business.
This creates a rather confusing scene. On the one hand, you are doing legal business. But on the other hand. You are placed in a tax regime that treats you as if you are doing illegal business. Cannabis businesses. Therefore, operating under conflicting federal and state laws.
At the federal level, cannabis is a schedule 1 drug according to the Controlled Substances Act (CSA) and therefore illegal. But, several states have legalized medicinal and recreational cannabis. This means it is legal to conduct cannabis businesses.
How Section 280E Affects State-Legal Cannabis Business
Section 280E forbids businesses from deducting regular expenses arising from income associated with the selling of Schedule I or II drugs. And since cannabis is a schedule 1 substance, cannabis-related businesses must file their tax returns under Section 280E of the US Internal Revenue Code.
The IRS uses a simple formula to tax businesses. The taxable income is what remains after you deduct business expenses from the gross income. That is what happens with regular businesses. But for the cannabis business. The gross income is considered as the taxable income because. You are not allowed to deduct expenses.
The net effect is that a cannabis business that has the same costs and expenses as a regular business pays 50 — 70% more tax. This places the cannabis business at a disadvantage. It will have less money to reinvest in the business or to undertake other corporate responsibilities.
What Should You Do To Keep Your Cannabis Business Afloat?
There are some strategies that you can apply to reduce the taxable income and keep your cannabis business afloat.
Here are some of them.
Capitalize On Indirect Costs
Cannabis businesses are allowed to deduct their Cost of Goods Sold (COGS) and costs of non-cannabis business activities on their taxes. So, capitalize on the indirect costs such as inventory, administrative costs, and cash paid as state excise taxes then deduct them under COGS. These indirect costs can be substantial and can make your business collect a small profit.
Select a Cannabis Business with A High Margin Of COGS
Generally, growers have a higher margin of COGS compared to manufacturers and dispensaries in the cannabis industry. So they will pay less tax since the amount they deduct as COGS is high. So if you are thinking of starting a business in the cannabis value chain. You will pay less if you select operations that lean more towards the growing side.
Another strategy you can use is to shift some costs to the growing side of the business. This is only possible where the business involves both growing and selling cannabis.
Operate More Than One Business If Allowable
Section 280E disallows the business expenses of a business that only sells cannabis. So you can reduce your cannabis business taxable income if you also operate another line of business. The IRS considers that a business that sells cannabis plus other items has two businesses or trades. In such a case, 280E will not apply to the other items. This gives you a leeway to allocate the business expenses to the other lines of the business not subject to Section 280E. And take deductions under section 162 of the Internal Revenue Code.
Section 280E can be a thorn in every state-legal cannabis business. However, with the right tax planning and foresight, a business can mitigate the negative impacts of the tax code and make profits. It is always advisable to hire a cannabis tax attorney to help you navigate this section of the law.