with research and support from Brad Bachman

In 1961, the United States Supreme Court held that even income generated from illegal activity is subject to federal taxation, which means cannabis businesses must pay federal income taxes, just like federally-legal businesses. However, because the possession, manufacture, and distribution of marihuana [1] remains illegal under federal law, cannabis businesses are subject to unique tax rules. This is the first of two blog posts covering the unique tax law restrictions applicable to businesses operating in the cannabis industry.

As mentioned above, cannabis businesses pay federal income tax, even though the sale of cannabis remains illegal under federal law. However, The IRS Tax Code treats cannabis businesses differently from other businesses that are legal under federal law. Specifically, Section 280E of the IRS Tax Code prevents cannabis businesses from deducting “ordinary and necessary business expenses” for purposes of determining gross taxable income. To be clear, Section 280E is not specific to the cannabis industry, but prevents tax deductions for any trade or business that consists of trafficking in controlled substances. Thus, while a federally-legal business can deduct ordinary and necessary business expenses like advertising, bank fees, meals and entertainment, general employee wages, rent, office supplies, payroll etc., pursuant to Section 162 of the IRS Tax Code, a business that sells, grows, or produces cannabis cannot take advantage of this corporate tax deduction.

While cannabis businesses generally cannot deduct business expenses from their gross income, they may exclude “Costs of Goods Sold” (“COGS”). COGS includes direct expenses for the production of goods, meaning things like seeds, plants, packaging, and labor related to the growing and maintenance of cannabis plants. In 2012, the U.S. Tax Court held that COGS for a cannabis grower included: (1) the price paid for marijuana; (2) labor costs related to growing the marijuana; and (3) the cost of incidental materials and supplies. The IRS Office of Chief Counsel has offered a more expansive view of the COGS deduction, allowing cannabis producers to deduct wages, rents, and repair expenses attributable to production activities. However, deductions are not allowed for wages, rents, and repair expenses related to general business and/or marketing activities. For cannabis retailers, COGS is limited to the invoice price of purchased cannabis (less any discounts), and transportation or other costs necessary to gain possession of the cannabis inventory.

Cannabis businesses often pay an effective federal income tax rate of about 70%, compared to the typical corporate tax rate of about 30% for federally-legal businesses, so the IRS is quick to scrutinize cannabis company tax returns. In order to ensure a favorable outcome in the event of an IRS audit, cannabis businesses must remain transparent regarding business operations and tax methodologies. Given that cannabis businesses are significantly more likely to face an IRS audit, the importance of remaining in good standing with the IRS cannot be overemphasized.

If you would like additional information on compliance with federal tax laws, please feel free to contact us.

Sources:
The Controlled Substances Act uses the term “marihuana.”
26 U.S.C. § 280E.
Olive v. C.I.R. 139 T.C. 19 (2012).
Chief Counsel Advice (CCA), 201504011.

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