As of today, 33 states have legislations allowing for cannabis use in some form. As the legalization for medical use of cannabis products has been sweeping across the US, it’s being seen as the “next-big-thing” for entrepreneurs and investors.
What we must be reminded of is that cannabis is still illegal under the federal law. As a result, cannabis businesses are subject to an unfavorable federal tax rule that has significant impact on your bottom line and puts cannabis businesses on a disadvantage compared to other commercial businesses.
Generally, any business is permitted tax deductions for ordinary and necessary expenses such as advertising, rent, employee salaries, and insurance. The difference with a cannabis business is that, under Section 280E of the Internal Revenue Code, it states that “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.”
Simply, Section 280E does not allow expense deductions and credits for businesses that are “trafficking” controlled substances, including cannabis, which is listed under Schedule I of the Controlled Substances Act. “Trafficking” in the context of the section is not limited to the large-scale activities of drug cartels, it also includes the operations of licensed businesses engaged in commercial activities which are legal under state laws such as cannabis deliveries and dispensaries that are legally providing medical cannabis as prescribed by a doctor.
Cannabis businesses have challenged the application of Section 280E but have largely been unsuccessful.
However, cannabis businesses that are involved in more than one trade have had some limited success in challenging the section of the application which pertains to their legal, non-cannabis related businesses.
For example, the Tax Court has determined that a community center for members with debilitating diseases was actually operating two distinct businesses – one that dispensed medical cannabis, and another that provides caregiving services. As a result, Section 280E does not exclude business expense deductions that are part of the caregiving services. The determination of whether particular activities are unrelated activities that are not disallowed is both a question of fact and of law.
Despite the impact of Section 280E, cannabis businesses are allowed to offset certain expenses from their income. Because Congress’ authority is limited to taxing income rather than revenue, businesses that are subject to Section 280E may still offset their gross receipts by their COGS (Cost of Goods Sold). COGS represent costs in acquiring inventory and certain other direct related expenses which varies according to whether the business is involved in production or resale.
The Internal Revenue Code Section 280E is a major hurdle for cannabis businesses because of its disallowance for deductions on related business expenses. Business owners need to understand this challenge, determine whether expenses are for unrelated activities and monitor legal developments. Given that cannabis is being legalized on state level, business owners hope that subsequent developments will reduce the related federal income tax burdens that currently exist.