By Michael Harlow, CPA, Partner
To quote Benjamin Franklin, “In this world nothing can be said to be certain, except death and taxes,” and people in the cannabis industry are certainly experiencing heart palpitations when it comes to the federal tax code.
In a 1981 court case, a convicted drug trafficker successfully asserted his right under Federal tax law to deduct ordinary business expenses of his illegal activities against his illegal income. And so birthed, in 1982, Internal Revenue Code (“IRC”) Section 280E, which states that someone engaged in illegal activity can only deduct their Cost of Goods Sold (“COGS”), i.e their direct costs of acquiring/producing the illegal substances.
Specifically, Section 280E of the IRC prohibits cannabis growers, processors, distributors, and retailers from deducting otherwise ordinary and necessary business expenses (“non-COGS business expenses”) from the gross income associated with the “trafficking” of Schedule I or II controlled substances.
Given that cannabis is still a Schedule I substance under the Controlled Substance Act, 280E applies to all cannabis businesses, including state-regulated businesses, that engage in the cultivation, sale or processing of the cannabis plant. Not being able to deduct such ordinary deductions when computing taxable income has a significant impact on the net after-tax profitability of a company and puts the cannabis businesses at a competitive disadvantage. Since cannabis businesses are unable to deduct their non-COGS business expenses, cannabis businesses face higher effective tax rates than businesses in any other industry.
Cannabis businesses often pay effective tax rates that are 70% or higher which creates challenges to the industry and inhibits growth of the market.
Common disallowed expenses:
- Wages and Salaries
- Utility costs such as electricity, telephone service and internet
- Health insurance
- Marketing and Advertising
- Repairs and maintenance
- Business meals and entertainment
- Payments to Contractors
- Rental fees for facilities
CohnReznick is well aware there are tax preparers and operators that would argue that 280E does not apply to state-regulated cannabis businesses; however, we do not believe that such an argument can be supported by any authority, be it the statute, current regulations or case law.
The additional burden related to 280E compliance may be even greater than some operators have anticipated. For example, non-compliance with 280E will significantly impact future business valuations because of the unknown federal tax liability, and in some cases state tax liability assumed by a potential buyer. New partnership audit rules, which assess tax deficiencies, penalties and interest at the partnership level, mean that an investor that joins the business could pay for the sins of past investors if a future audit discovers an underpayment related to prior years. Businesses and taxpayers that are being overly aggressive or careless with 280E compliance may see themselves pay a lower effective tax rate today, but at the risk of severe future penalties, interest and a dramatic impairment in the business valuation.
In short, 280E will continue to stymie the growth of the industry until there is some legislative fix at the federal level. The industry’s best bet is to carefully comply with 280E, control non-Cost of Goods Sold expenses as best as possible, and budget accordingly.
Non-plant-touching businesses have better news. For such “ancillary” businesses in the industry, there are a variety of federal and state tax opportunities and incentives that are not being utilized to their maximum benefit. In future bulletins, we will discuss some of the following overlooked tax opportunities and incentives such as:
- Cost segregation studies
- Bonus depreciation
- Section 199 Domestic Production Deduction
- Research and Development (R&D)
- Work Opportunity Tax Credits
- Energy credits and incentives
- State incentives
We will also highlight in the future proposed legislative changes that may impact the industry. Lower rates would generally be favorable to operators impacted by 280E, but those lower rates will likely come at the cost of losing several of the opportunities/incentives mentioned above that are favorable to non-plant touching business.
For a summary of the House proposed Tax Cuts and Jobs Act click here: