The Cannabis Industry and the Qualified Business Deduction §199A
The Tax Cuts and Jobs Act (TCJA) contains the most significant changes to the tax code since 1986. One of the many far reaching changes of TCJA was the creation of Section 199A (§199A), also known as the Qualified Business Deduction. §199A allows a 20% deduction from qualified business income of an eligible business, operated directly or through a pass-through entity (S corporation or partnership). The creation of §199A has led to the question: Are cannabis business owners eligible to claim the §199A deduction?
The rules of §199A contain a list of businesses that are ineligible for the §199A deduction, mainly consulting and service businesses. A detailed discussion of §199A can be found here. Prior to the release of the Treasury regulations regarding §199A, the American Institute of CPA’s requested clarification on the interplay between §280E (which limits the tax deductions for the sale of certain controlled substances to cost of goods sold (COGS) and §199A. The Treasury declined to comment on the issue in its proposed and final regulations on §199A. The lack of guidance leaves important unanswered questions that significantly impact cannabis businesses which are passthrough entities.
An analysis of whether a cannabis business owner can claim the §199A deduction must consider several issues:
- One of the legislative purposes of §199A was to create more tax rate fairness between C corporations (now taxed at 21%) and pass-thru entity owners taxed at up to 37% (or 29.6% after the §199A deduction)
- Since a cannabis business operating as a C corporation is taxed at the flat 21% rate, why shouldn’t an owner of a pass-thru entity be taxed at a lower rate as well?
- §280E denies a tax deduction or credit for non-COGS expenses paid or incurred from trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal or state law.
- The §199A deduction is neither “paid” nor “incurred” by a taxpayer.
- The §199A deduction is not claimed at the entity level but on the owner’s personal tax return.
- It is not completely clear if §280E applies only at the business level, or whether it should be applied again on the pass-thru owner’s level.
- Cannabis businesses (such as dispensaries and growers) are not specifically listed as an ineligible trade or business under the final 199A regulations.
Taking each of the foregoing into consideration, it is possible to conclude that the pass-thru taxpayer of a cannabis business should be eligible for the §199A deduction (assuming all other statutory criteria is met). However, the IRS and the Tax Court have been very strict in their interpretation of §280E.
Recently, in Harborside, a major cannabis dispensary in California was denied a significant amount of tax deductions due to the application of §280E. There are no reported cases, or IRS guidance, resolving this issue currently.
Note: if a business owner improperly claims the §199A deduction, the owner may be subject to a lower threshold for accuracy related penalties upon exam by the IRS under §6662.
Given the complexity of §280E and §199A, a qualified tax professional should be consulted to determine potential eligibility for this important tax deduction. If you have any questions, please contact your tax advisor at EisnerAmper.