Tax Issues Facing the Cannabis Industry
The U.S. has come a long way since the State of California legalized medical cannabis in 1996. Many states seeking to generate billions of dollars in related tax revenue have now legalized cannabis. Yet despite its legalization by more than half the states in America, cannabis is still classified as a controlled substance, illegal under federal law. Even where cannabis sales do not cross state lines, it has been ruled illegal under federal law.
As of the November 2016 elections, 28 states plus Washington, DC have legalized cannabis. The illustration below highlights cannabis legalization amongst the states:
Regardless of legality, the Internal Revenue Code (the “Code”) states that all income from whatever source derived is taxable.1 Additionally, under the Code, businesses are allowed to deduct ordinary and necessary expenses incurred in carrying on a trade or business.2 However, the tax code prohibits certain business deductions.3 One of the exceptions listed in Section 280E deals with illegal drug sales. Section 280E was enacted in 1982 in response to a tax court ruling which allowed a drug trafficker to deduct cost of goods sold (“COGS”) and general and administrative (“G&A”) expenses.4 Section 280E states “no tax deduction or credit is allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if the trade or business consists of trafficking in controlled substances which is prohibited by federal law or the law of any State in which such trade or business is conducted.5 ”
Business expenses such as G&A do not appear to be allowable under Section 280E. However, if the business operates a “legal” business under the same roof as an illegal business, the courts appear to be more forgiving. For example, a cannabis dispensary in California was allowed to separate its G&A expenses related to cannabis sales (which were disallowed) and other services such as educational classes and social services, which were allowed to be deducted.6 The court essentially stated there can be more than one line of business under the roof of the dispensary and the mere presence of one illegal business does not negate the expenses related to the legal business.
IRS regulations state that all facts and circumstances must be taken into account to ascertain whether business undertakings are more than one activity.7 The Tax Court expands on the regulations and has applied various factors in deciding whether a taxpayer's characterization of 2 or more undertakings as one activity is unreasonable, such as whether:
- the undertakings share a close organizational and economic relationship;
- the undertakings are conducted at the same place;
- the undertakings are part of a taxpayer's efforts to produce revenues;
- the undertakings are formed as separate businesses;
- one undertaking benefits from the other;
- the taxpayer uses one undertaking to advertise the other;
- the undertakings share management;
- one person oversees the assets of both undertakings;
- the taxpayer uses the same accountant for the undertakings; and
- the undertakings share books and records.8
A cannabis business should take into account the above when seeking to separate expenses between cannabis sales and other businesses operating under the same roof.
The illustration below highlights the differences in allowable expenses when multiple lines of businesses are operating under the same roof:
|Cannabis Reselling Expenses||Unrelated Business|
|Invoice cost of cannabis sold||-300|
|Utilities, salaries, quality control||0||-500|
As illustrated above, the reseller can deduct indirect expenses from its separate unrelated business. If the 2 businesses operations had been comingled, the indirect costs would have been nondeductible.
Note: The “multiple lines of business” argument above is not a guaranteed defense upon examination; it has been both upheld and rejected by the tax court in two unrelated tax court cases.9
Despite the fact Section 280E limits cannabis businesses deductions, past legislative history indicates the IRS will allow COGS deductions that cannabis companies incur.10 These expenses would need to meet the definition of COGS under the Internal Revenue Code.11
In 2014 the IRS released Chief Counsel Advice (“CCA”) 201504011. This CCA finally shed light on which cannabis-related expenses can be assigned to COGS. The CCA states a taxpayer may deduct wages, rents, and repair expenses attributable to its production activities, but would not be permitted to deduct wages, rents, or repair expenses attributable to its G&A or its marketing activities.
The CCA also addresses Section 263A as it applies to cannabis businesses. Section 263A requires “resellers and producers of merchandise to treat as inventoriable costs a proper share of those indirect costs that are allocable (in whole or in part) to that property.” Cannabis businesses would be inclined to capitalize their expenses into inventory under Section 263A, thereby converting previously nondeductible G&A expenses into deductible COGS expenses. However, the CCA clearly states Section 263A doesn’t apply to businesses that fall under the classification of Section 280E and therefore cannabis business cannot capitalize expenses under Section 263A. The IRS is relying on Section 263A(a)(2) which states “any cost which could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described.” Essentially the IRS is allowing a taxpayer to only include in its COGS costs required by Section 471 determined at the time Section 280E was enacted in 1982 (not 1986 when Section 263A was added to the Code).
Cannabis Businesses on the Cash Basis Method of Accounting
Contrary to the above, a cash basis cannabis business would, by definition, have no inventorial costs. When Section 280E is applied, the cash basis producer’s taxable income for each year would be significantly higher than it would have been on the accrual basis under an allowable inventory method. The accrual basis business could have recouped its production costs through COGS. Therefore in this situation, the cash basis business is at a disadvantage as compared to an accrual basis business. The IRS does provide some relief in CCA 201504011, which states “when examining a cash basis cannabis business, it has the authority to permit the taxpayer to deduct from gross income its costs that would have been inventoriable had the taxpayer been on the accrual method.” Accordingly the IRS has discretion to allow cash basis cannabis businesses to deduct additional expenses as if it had been on the accrual method.
An issue faced by these businesses is that vast majority of banks refuse to conduct business with cannabis companies due to banking regulations. These businesses cannot open bank accounts and are forced to transact almost exclusively with cash. An additional complication faced by cannabis business is that taxes are required to be remitted online through the IRS portal (EFTPS), which requires a bank account to enroll with their service. As a result of banks refusing to open accounts for cannabis businesses, many companies have resorted to paying their tax obligations with cash at local IRS offices. Remitting payroll taxes with cash at an IRS office will typically trigger a 10% IRS penalty for failure to pay employment taxes via the IRS EFTPS website. The IRS has abated these penalties in the past, but there is no guarantee they will in the future.
Potential Tax Planning Opportunity
A potential tax planning opportunity exists when a cannabis business produces financial statements under Generally Accepted Accounting Principles (“GAAP”). IRS regulations state that if a business produces GAAP basis financial statements, it may include in inventory additional costs that are properly allocated under GAAP. Examples of these additional expenses are:
- Employee benefits, and
- Administrative expenses.12
The illustration below highlights the positive effect of producing GAAP basis financial statements:
without GAAP financials
with GAAP financials
|Tax Return||GAAP||Tax Return|
|Gross receipts||$ 1,000||$ 1,000||$ 1,000|
|Invoice cost of cannabis sold||-300||-300||-300|
|Utilities, salaries, quality control||-150||-150||-150|
A cannabis business should consider engaging an accounting firm to prepare GAAP basis financials statements in order to benefit from the additional tax deductions.
The cannabis industry is currently presented with a dichotomy: Many states have given the industry its blessing to conduct business, but the federal government and the IRS still treat the sales as illegal activities. However, as illustrated above, the IRS and the tax courts have shown (in limited situations) they are willing to work with taxpayers. This is an ever changing area of tax and what is certain is more change in the future. As such, it is imperative to consult a qualified professional when conducting business in this area.
1 I.R.C. §61(a).
2 I.R.C. §162(a).
3 I.R.C. §261.
4 Edmondson v. Commissioner, T.C. Memo. 1981-623.
5 I.R.C. §280E.
6 Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 173.
7 Treas. Reg. 1.183-1(d)(1).
8 T.C. Memo 1999-328.
9 Olive v. Commissioner, 139 T.C. 2 and CHAMP, Inc. v. Commissioner, 128 T.C. 173.
10 Olive v. Commissioner, 139 T.C. 2.
11 Treas. Reg. § 1.61-3.
12 Treas. Reg. § 1.471-11(c)(2)(iii).