Recently, an enormous sigh of relief was heard from business owners, and their CPAs, in the cannabis industry as the Drug Enforcement Agency (DEA) formalized its process to reclassify cannabis under the Controlled Substance Act (CSA). This sigh of relief has nothing to do with personal views on cannabis and its medical or recreational use, but rather everything to do with improving the business landscape and lowering taxes for businesses in the cannabis industry.
The Backstory
Impact analysis of federal taxes on the cannabis industry by Whitney Economics determined that cannabis operators paid over $1.8 billion in 2022 and $2 billion in 2023 in taxes above what they would have under regular business tax rules. This excess tax is not due to special, industry specific taxes, but rather from ineligibility of the industry to benefit from deductions and credits that are allowed to most other industries as part of their regular course of business.
As an effect of the DEA’s potential reclassification of cannabis as a “lower risk” Schedule III drug, instead of a “higher risk” Schedule I drug, the cannabis industry would no longer be subject to IRC 280E. This is a massive win for the cannabis industry – changing certain aspects of day-to-day operations including access to FDIC insured banks, and allowing the industry to benefit from deductions and credits generated in their ordinary course of business which will reduce their tax liability.
Over the last 40 years, since 1982, the cannabis industry has faced a unique tax hurdle – Internal Revenue Code (IRC) Section 280E. This code section governs the allowance, or rather disallowance, of certain benefits to companies involved with products that are stratified on the Controlled Substances Act.
Understanding IRC 280E
IRC Section 280E states that no deduction or credit is allowed for any amount paid or incurred during the tax year if such trade or business consists of trafficking in controlled substances with the meaning of Schedule I and Schedule II of the Controlled Substances Act. Thus, companies cultivating, processing, or selling these substances, regardless of state legality, cannot deduct ordinary business expenses from their gross income. The reclassification of cannabis as a Schedule III, not Schedule I, drug would exempt the industry from IRC 280E subject to state determination on legality of cannabis.
Ordinary Deduction – No help here.
Section 280E is aimed at discouraging illegal drug trafficking by increasing the tax liability and decreasing the profitability of such activities. The government has historically used tax evasion to charge nefarious characters otherwise able to skirt the law. By making it more undesirable to be involved in the industry, the government hoped to curb illegal drug trafficking. The issue is that legal businesses, otherwise in good standing with the law and the government, have been caught in the crosshairs.
Imagine running a business and being unable to deduct overhead expenses – rents, salaries, utilities, communication, technology, security, or shipping costs. That is the current reality for businesses subject to 208E based on their involvement with cannabis. While certain costs can be allocated to Cost of Goods sold and deducted as such (more on this later), it doesn’t do enough to properly recognize and allow deductions on all business expenses.
For instance, a cannabis distributer incurs significant costs for administrative staff, security, and bookkeepers. Without a shadow of doubt, these are necessary and ordinary expenses of the business that allow it to function. However, under Section 280E these expenses would not be deductible for tax purposes, leading to a higher tax bill.
Cost of Goods Sold: Close but no cigar.
The only saving grace for these businesses is the concept of Cost of Goods Sold (COGS). COGS represents expenses directly incurred in the production of an item for sale. These expenses are deductible, but due to increased IRS scrutiny, need to be extremely well documented and tracked. Depending on what facet of the cannabis industry a business is involved in, the COGS would vary. On the production side, a farmer would be allowed to include the cost of seeds, fertilizer, and labor directly involved in cultivation and processing. On the distribution side, COGS would mainly consist of the price paid for the flowers, as there is less opportunity to assign costs away from overhead.
The lines between deductible (COGS) and non-deductible expenses can be blurry, especially when it requires allocation of a cost. A warehouse that doubles as a sorting facility and store front would require the rent expense be allocated to reflect a cost assigned to the sorting facility as COGS thus deductible, versus the store front as a non-deductible cost.
Credits
The limitation also affects the eligibility to claim tax credits the cannabis industry would be otherwise eligible for, including R&D credits which could come from researching and developing new strains of the crop. Other credits including Work Opportunity Tax Credit, Energy Efficient Commercial Buildings, and Clean Vehicle Credits are not currently available to cannabis businesses, but if rescheduled to Schedule III, could benefit from if otherwise qualified.
Impact on Financial Statements & Taxes
The inability to include certain expenses as deductions, and the inability to claim tax credits, artificially inflates the taxable income for the companies within the cannabis industry and results in a higher tax bill than if the business was related to any other crop not identified as a Schedule I or II drug under the CSA.
States have the choice to conform with the IRS position by following IRC 280E or to decouple – and allow these deductions. Decouple has been done by some states and allows businesses to take deductions otherwise prohibited at the federal level, as a state deduction. States that currently conform to the IRS position on IRC 280E would automatically allow the deduction upon change at the federal level unless they choose to decouple.
Conclusion
Operators and producers in the cannabis industry have long argued that IRC Section 280E is unconstitutional and they should be allowed the same tax treatment as other businesses. The pending cannabis schedule change does plenty to offer reprise to the industry but is by no means a done deal for unwinding IRC 280E from the cannabis industry. Potentially, operators in the industry have an opportunity to better integrate & leverage financial systems, raise capital, and unlock deductions for owners that was otherwise lost under IRC 280E. This levels the playing field for businesses in this industry with those in unrelated industries and provides owners with cash in place of excess tax.