By Matt Walstatter
As I sit and write this column, my calendar reads April 16. And like most business owners, I spent a significant part of the last week dealing with taxes.
Of course nobody likes to pay taxes, and I realize that businesses from all industries pay their share. But in the world of cannabis, we have a little something known as Internal Revenue Code Section 280E, which complicates the process of paying taxes and increases the amount we pay substantially.
This formerly obscure provision was added to the Internal Revenue Code by Congress in the early 1980s after the media started running stories about a cocaine dealer who was attempting to pay federal income taxes (as even drug dealers must). He decided that since he was paying taxes, he ought to be entitled to take some deductions, including for expenses like his yacht and several sports cars.
When the media got wind of this, it became the story of how drug dealers were taking tax deductions for their yachts. Congress responded by passing 280E.
Section 280E reads as follows:
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.
Because cannabis remains a Schedule I controlled substance under federal law, any business that sells cannabis is subject to 280E, even if that business is operating lawfully within its state.
What 280E means for cannabis businesses is that we may deduct cost of goods sold, but no other expenses.
The cost of goods sold are the direct costs attributable to the manufacture or purchase of a product, including the materials used to make a product, sums paid for labor in order to produce a product and sums paid for the direct purchase of a product that will be sold. Expenses like packaging and labs are considered part of the cost of the product and are therefore fall under cost of goods sold.
At Pure Green, when we talk about whether something qualifies as cost of goods sold, we often talk about inventory expenses (costs of good sold that are deductible) and selling expenses (cost of good sold that are not deductible). Marketing is a classic example of a selling expense which would not be deductible under 280E.
Because producers and processors are manufacturers, most of their expenses can be classified as cost of goods sold. As a result, producers and processors can deduct most of their expenses, outside of marketing and administrative costs. Retailers and wholesalers face greater challenges. Because a larger portion of their expense comes from selling, as opposed to buying or producing, they are able to deduct far less.
For example, in a cultivation business, electricity is a direct input into your product. As a result, it would be considered a cost of goods sold. In a retail setting, electricity is not attributable to the manufacture or purchase of products. Therefore, electricity does not fall under cost of goods sold for a dispensary, and the dispensary may not deduct the cost of electricity.
The upshot of all this
The result of all of this is that cannabis firms are severely limited in terms of what and how much they may deduct. This creates extraordinarily high effective tax rates for cannabis firms, particularly retailers. Let’s look at an example to see how this plays out.
Imagine that a store that’s not in the cannabis industry has $1 million in revenue for the year. Let’s say that store spent $600,000 on cost of goods sold (inventory, packaging etc.) and another $300,000 on operating expenses (payroll, rent, marketing etc.). That would leave a profit of $100,000. If the tax rate for that shop was 30 percent, the firm would pay a tax equal to 30 percent of $100,000 or $30,000.
Now let’s say that store happened to be a dispensary. The dispensary would deduct the $600,000, but could not deduct any of the $300,000 in expenses that didn’t qualify as cost of goods sold. As a result, the 30 percent tax would be assessed on $400,000 rather than the actual profit of $100,000. This would create a tax bill of $120,000, making the effective tax rate 120 percent. The business would owe more in tax than it actually earned as profit.
This represents an extreme case, but this scenario is playing out in every jurisdiction where cannabis is legal. Cannabusinesses are paying double, triple, even quadruple the tax paid by members of other industries, all because of 280E. Some businesses find they owe more in taxes than they actually earned. Other businesses find that they owe taxes even though they have been operating at a loss.
What can you do?
If you are in the Cannabis Industry, you must deal with 280E. There is simply no way around it, but there are some strategies that can help you mitigate the damage caused by this punitive provision.
- Start by making sure you are prepared. Many people don’t even know that 280E is out there, so just being aware of the provision and what it means for your business represents an important first step. Being prepared also means saving money for taxes, so when the bill comes due you are able to pay.
- Find trained, experienced professionals to help you develop and implement your 280E strategy. Make certain your team knows the Cannabis Industry in general and 280E in particular. These rules are complicated and arcane and the stakes are high. A mistake here could cost you your business, your home, even your freedom if criminal liability arises.
- Once you have assembled your professional team, they should analyze your specific business in light of the tax code in order to create a comprehensive strategy to address the issues caused by 280E. The goal of the 280E plan is to reduce your tax liability as much as possible. This is accomplished primarily by finding ways to classify as much of your expenses as legally permissible as cost of goods sold.
There are a number of strategies that can be employed here. Please keep in mind that I am neither an attorney nor an accountant. Always consult with your professionals before implementing any tax strategy.
In a retail setting you might do a time study to determine how much time your employees spend dealing with inventory as opposed to selling. If your employees deal with inventory half of the time, you may be able to deduct that half of their compensation.
Another tactic is to determine what portion of your property is used for inventory, as opposed to sales and administration. You may be able to deduct the portion of your rent and utilities that cover the inventory areas of the facility.
What specific strategies will work for your business depends on a number of factors, including the type of business, the volume of sales and the rules of your jurisdiction.
280E unfairly penalizes lawfully operating, compliant businesses in a single fledgling industry. I expect that in the next couple of years we will see some relief in the form of a change to the tax code or an exception for state-authorized cannabis firms.
In the meantime, anyone who owns or operates a cannabusiness must be aware of 280E and mindful of its implications and effects. 280E is a nightmare, one that can cause serious, real-life consequences. But with the right team to plan and execute the right strategy, you can succeed despite the challenges imposed by this particular law.