There are many factors that set the cannabis industry apart from other business sectors–chief among them, the unique tax treatment that puts cannabis business owners at a distinct financial disadvantage to their counterparts in other industries.

Understanding Section 280E

This inequity is caused by Section 280E of the Internal Revenue Code (IRC), which disallows many federal deductions for taxpayers who produce, distribute, dispense or otherwise “touch” illegal substances. Originally enacted in 1982 to prevent drug traffickers from deducting ordinary business expense, the legislation is still affecting business owners who operate in states where medicinal and/or recreational marijuana use have long since been legalized.

Because marijuana is a federally classified Schedule 1 substance, those who “touch” the cannabis plant in the course of business are prohibited under Section 280E from deducting expenses such as advertising, insurance, rent, repairs, salaries, state taxes and utilities, as well as from claiming the Section 179 deduction. This could result in hundreds of thousands of dollars of lost tax deductions for a midsized cannabis business and a disproportionately higher effective tax rate than corporate taxpayers in other industries.

Those who do not “touch” the cannabis plant and are exempt from the limitations of Section 280E include landlords, suppliers, industrial hemp growers and farmers, and cannabidiol (CBD) companies where the CBD contains less than .03% tetrahydrocannabidiol (THC).

The financial burden imposed by Section 280E is compounded by the industry’s limited sources of capital, inadequate banking options and restrictions on credit card transactions, making tax planning and mitigation strategies an even more crucial component of a cannabis company’s business plan.

Latest IRS Guidance

The rules and legislation that govern the tax treatment of cannabis companies can be so confusing that the IRS created a dedicated Marijuana Industry webpage and a Marijuana Industry Frequently Asked Questions (FAQs) webpage to guide taxpayers.

In September 2020, the IRS updated this guidance, which mostly confirms the tax obligations and ineligibility of cannabis companies for federal tax deductions under Section 280E. This position is supported in the FAQ by the case law in United States v. Oakland Cannabis Buyers' Co-op., 532 U.S. 483 (2001) and N. California Small Bus. Assistants Inc. v. Commissioner, 153 T.C. 65 (2019).

However, the FAQ also includes practical reminders for taxpayers dealing with the complexities and burdens of this unique tax treatment, including:

Payment options. The IRS guidance reminds taxpayers of the payment plans and other options available to marijuana companies to pay outstanding taxes over time. Depending on the taxpayer’s specific tax situation, payment options include a short-term payment plan (full payment made in 120 days or less) or long-term payment plan (installment agreements paid in more than 120 days). Accrued penalties and interest will apply until the payment is made in full.

Sole proprietors and independent contractors should apply for a payment plan as an individual, not business. Existing payment plans may be modified to change monthly payment amount, due date or payment method.

Cash payments. The FAQ also provides best practices for reporting cash payments over $10,000 in a single or related transaction(s)–a common occurrence in the cannabis industry, where many credit card processors will not allow transactions involving illegal substances in their networks.

In accordance with Section 6050I of the IRC, all trades or businesses, including marijuana-related businesses, must comply with this reporting requirement and develop policies and procedures to identify and report cash receipts. The FAQ clarifies that businesses should include in their policies and procedures the requirement to obtain and verify customer information. They are also instructed to retain all copies of forms filed for a period of five years.

Federal Form 8300 is used to report receipt of these cash payments over $10,000. It must be filed by the 15th day after the date the transaction occurred.

Tax deductibility. The FAQ reminds taxpayers of an effective tax mitigation strategy that maximizes the deduction of cost of goods sold (COGS)–one of the few tax benefits available to cannabis businesses.

IRC Section 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including the cost of goods sold (COGS). COGS refers to both the direct costs and indirect expenses of producing the goods that a company sells.

There is legal precedent to support and guide cannabis businesses in the deductibility of COGS to help them recoup some of the missed tax savings. But like most of the regulations in the Cannabis industry, this benefit comes with strict rules.

In the 2019 Harborside case (Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Commissioner) one of the largest U.S. cannabis dispensaries tried to apply IRC 263A to its COGS calculation instead of IRC 471, which is narrower in its definition of what qualifies as a deductible direct or indirect cost. The court denied this treatment and ruled that an IRC 471 calculation is required.

IRC 471, known as the full absorption method, includes the direct and indirect costs that can be capitalized into inventory. Generally speaking, direct costs under this calculation method include materials, supplies, labor and subcontract costs directly related to production of the goods, while indirect expenses include those incurred through repairs, rent, maintenance, indirect labor, quality control and salaries.

This requirement to use the IRC 471 method was affirmed more recently in 2020 by the court’s decision in Richmond Patients Group v. Commissioner.

The court in Harborside also ruled that when a business’s main sales are cannabis, it will be denied ordinary and necessary business expense deductions on their non-cannabis products and services. If the non-cannabis product or service is the primary business (based on space and employee allocations), the splitting of expenditures by business is allowed for tax purposes. (Californians Helping to Alleviate Medical Problems, Inc., Petitioner v. Commissioner of IRS, Respondent)

Penalties. The FAQ also addresses penalties and additions on adjustments made during an income tax audit. The marijuana industry is subject to the same penalties and additions to tax as any other business, including those incurred by late filings or payments, failure to make sufficient estimated tax payments, inaccuracies and fraud.

In addition, failure of a marijuana company to keep adequate books and records was cause for a negligence penalty under Section 6662 in Olive v. Commissioner, 139 T.C. 19 (2012), aff'd, 792 F.3d 1146 (9th Cir. 2015).

Other Tax Strategies

While tax planning strategies will likely remain limited in the Cannabis industry as long as marijuana is classified as a federal illegal substance, there are other tax benefits these businesses can consider in addition to deducting COGS.

Section 199A deduction. The Section 199A deduction, introduced in the Tax Cuts and Jobs Act of 2017, is a 20% deduction on qualified business income of an eligible pass-through entity. The deduction is taken on the individual partner level on a personal tax return.

While partners in some businesses, such as consulting and other service-based firms, are ineligible for the deduction, cannabis partnerships have successfully utilized and maximized Section 199A benefits.

Qualified opportunity zones. Similarly, there is nothing prohibiting cannabis business owners from investing capital gains into Qualified Opportunity Zones (QOZ), the tax program created in the TCJA to incentivize private, long-term investment in economically distressed communities. As long as they meet the program requirements and timeline, these investors will reap the same tax deferral, tax mitigation and basis step-up benefits afforded to investors operating in any other industry.

Section 1202. IRC Section 1202 yields additional tax savings opportunities for shareholders of C corporations by allowing them to exclude from capital gains the greater of $10,000,000 or 10 times their basis in the C–corp on the sale of eligible qualified small business stock (QSBS), as long as the QSBS been held for more than five years.

Because Section 1202 excludes the gain from recognition, it is not a “deduction or credit” as prohibited by Section 280E, making it a highly valuable tax benefit for cannabis shareholders when it comes time to sell their interests in the company.

The CPA’s Role

While the impact of these tax strategies will vary widely based on the individual business owner’s or investor’s unique tax situation, the importance of a strategic tax plan that takes all available opportunities into consideration is crystal clear. Add to this the need for highly accurate documentation, strict compliance standards and clear policies and procedures, and the CPA’s role and services is absolutely crucial to any cannabis company’s ability to overcome the industry’s tax and financial disadvantages.

John V. Pellitteri, CPA, is a partner at Grassi and leads the firm's Healthcare and Cannabis Service Practices. Possessing over 25 years of experience in accounting, auditing, tax planning and business consulting, John is now applying his talent to the burgeoning cannabis industry. John possesses comprehensive accounting and taxation knowledge, which combined with his healthcare consulting experience, allows him to provide an all-inclusive assessment of practices and medical facilities. He uses these proven strategies to enhance clients' businesses in a multitude of industries, including medical cannabis, not-for-profit, architectural, real estate, veterinary, and professional service firms. John has the expertise needed to help companies navigate through the many challenges those in the cannabis industry face. With much to be developed, he has already worked with clients, including medical cannabis dispensaries, cannabis technology companies, cannabis landowners, as well as, private equity firms and family offices in this space. John helps guide his clients through complicated regulations and complex tax structures.

John is an active member of the AICPA and NYSSCPA where he currently serves on the executive board of the Nassau Chapter and served on the Federal Taxation Committee and the New York State & Local Taxation Committee. In addition, he serves as Chairman of the Medical and Professionals Committee. Additionally, John is also active in philanthropic organizations and serves on the board of the Medical Resource Group (MRG) and the Health and Business Alliance (HBA) where he also serves as the treasurer. He was also selected as one of 2005's 40 Under 40 Rising Star professionals in the Long Island area by the Long Island Business News. John is also a monthly contributor to the Profit Express Radio Show segment “The Bottom Line Benefit.” John received his Bachelor’s of Business Administration from Hofstra University.