by Rachel Kennerly, CPA
280E – the most feared and hated number/letter combination in the legal cannabis industry.
IRS Section 280E is the US tax code that prohibits businesses involved in the “trafficking of a controlled substance” from deducting expenses from their income. And while medical cannabis is legal in more than half the states around the country the federal government still classifies it as a Schedule 1 drug making it subject to Section 280E. So legal cannabis businesses, already hamstrung with intense regulation, face yet another challenge by having their tax deductions limited to only Cost of Goods Sold (COGS). This means that even when cannabis companies operate at a book loss they very likely will still owe federal income tax because their ordinary and necessary business expenses like advertising, occupancy costs or officer salaries are either nondeductible or not fully deductible.
280E was enacted 36 years ago in response to the tax court case Edmondson v Commissioner. Jeffrey Edmondson was a Minneapolis drug dealer who sold marijuana, amphetamines, and cocaine. When the IRS assessed him with additional taxes related to unreported income from the sale of these illegal drugs in 1974, he responded by reconstructing records for the cost of the drugs bought and resold, telephone expenses, automobile expenses, and even a portion of the rent on his apartment which was his primary place of business. The Tax Court allowed these deductions on the basis that they were ordinary and necessary in Mr. Edmondson’s line of work – even though it was an illegal enterprise. The decision came down in 1981, and Congress who had been busy waging a war on drugs for a decade was appalled that the Tax Court allowed these deductions. In response they passed a new tax law – 280E – disallowing the ordinary and necessary expenses of those selling substances classified as a Schedule 1 or 2 drug.
Congress intentionally left intact the ability of “drug traffickers” to deduct COGS in order to avoid a Constitutional challenge to their new tax law. Fortunately, this is an area where legal cannabis companies can leverage accounting rules to their advantage. Ordinarily cannabis companies operate on a cash basis (income is recognized when received and expenses are recognized when paid), but if a cannabis company operates on a full accrual basis (income is recognized when earned and expenses are recognized when incurred) and follows UNICAP rules, then some expenditures that would normally be considered nondeductible overhead expenses can be capitalized into inventory and then deducted as COGS. The items that can be capitalized are spelled out in §1.471 of the United States tax code.
Another strategy for maximizing deductible expenses can be found in a 2007 tax court case – Californians Helping to Alleviate Medical Problems (CHAMP) vs. Commissioner. CHAMP was a palliative care company that offered healthcare services including cannabis to individuals suffering from chronic or terminal illnesses for a monthly membership fee. In this case the Tax Court ruled that since CHAMP operated a distinct and separate business of providing caregiver services in addition to running a dispensary, the company could deduct expense incurred in the operation of that non-cannabis business. So a percentage of otherwise nondeductible expenses were now allowable deductions. Be aware that several subsequent tax court cases involving cannabis companies have provided some guidance as to the definition of “separate business”. The Tax Court has held that the sale of complementary products (like pipes or other cannabis consumption paraphernalia) is not a separate business, and they recently decided that the sale of t-shirts or hats with your cannabis company’s logo on them also did not qualify.
There are two key factors to successfully employing both of the tax saving strategies above – keeping immaculate, detailed records and hiring a qualified, knowledgeable professional to oversee the implementation of the accounting procedures. The case of Alterman vs. Commissioner which was decided in June of 2018 is a cautionary tale of a cannabis company who failed miserably at both. Their records were a shamble, and in an effort to try to save money they didn’t hire an accounting/tax firm that specialized in cannabis. The result of their IRS tax case? The majority of the business deductions on their original 2010 and 2011 tax returns were disallowed, and they were assessed almost $500,000 in additional taxes and penalties.
Don’t let your cannabis company become another cautionary tale. Keep good records, and find a qualified cannabis accountant that can help you maximize your legal deductions per 280E.