Roughly 27% of American adults use cannabis products on a monthly basis (2019). In light of its legalized popularity, many small business owners have found great success in the cultivation and sale of marijuana and marijuana-related products. There is a lot of potential revenue in this booming industry. Since the spring of 2021, for example, states with legalized marijuana had a combined income of $7.9 billion in tax revenue.
With more money comes more problems. Marijuana businesses, for instance, have higher rates of audit relative to other businesses. Many of the current laws are complicated to the point of being in direct conflict with one another. Not to mention, these laws are subject to change as this relatively new industry is still working itself out. All of this has created a perfect storm of confusion for mistakes that may end up costing a cannabis business greatly.
To better understand the laws themselves it’s good to understand where they came from.
History of Marijuana Tax Laws
The first IRS Code regarding illegal substances was created in 1982, following a court case involving a convicted cocaine trafficker. The drug trafficker, like many of us, was hoping to save some money on his taxes. In Jeffery Edmondson vs. Commissioner, Edmondson won his right under federal law to deduct expenses from his cocaine business as ordinary business expenses.
Coincidentally, this also happened during the Reagan Administration’s “war on drugs” campaign. To take a stand and prevent this from happening with future drug traffickers, the IRS created tax code 280E. Since then, the IRS has continued to use Code 280E, making it a major thorn in the side for cannabis business owners.
What is Code 280E?
The IRS code known as section 280E “disallows all deductions or credits for any product paid or incurred in carrying on any trade business that consists of illegally trafficking in a Schedule I or II controlled substance within the meaning of the federal Controlled Substance Act”. In other words, 208E penalizes cannabis businesses, even when they are regulated and in full compliance with state law. It forbids companies from deducting business expenses for gross income associated with the trafficking.
This means that, unlike most businesses, cannabis companies are not allowed to deduct things like employee’s salaries, rent, equipment, and electricity. As a result, cannabis companies must pay tax on gross income at rates up to 70% higher than other businesses, no pun intended.
The Cost of Goods Sold
It turns out, there is a small exception to the rule, the cost of goods sold (COGS) that allows for an exclusion for all deductions of COGS, even for products illegal under federal law.
COGS mostly refers to inventory cost and includes the actual product, the cost of shipping (to retail location), and any directly related expenses. Before you get too excited, consider how the IRS applies its definition of “cost of goods sold to the cannabis industry. By default, the IRS completely ignores any tax changes made after section 280E, which would allow more indirect costs to be applied to the overall concepts of COGS. Therefore, any expenses related to distribution cannot be included in COGS.
What does distribution cover? Basically that all outbound and some inbound shipping, rent, overhead, payments to contractors, maintenance and repairs, health insurance, marketing, and advertising, utilities, and employee costs. Thus COGS includes only purchases of the seed, soil, water, and nutrients for planting and cultivation.
In addition to federal laws, each state has customized excise taxes regarding legalized recreational marijuana. While most states tax based on the price, a few other states also tax marijuana based on weight or THC content.
Cannabis business owners face many obstacles when it comes to navigating tax laws and making deductions. Despite the serious negative impact that the 280E has had on cannabis business owners, all hope is not lost. There are ways to help lessen the tax burden. To learn more, check out our blog on – Top 10 money-saving tax tips for marijuana businesses.
If you have any questions regarding marijuana tax laws for your business or potential business venture, feel free to reach out to Herman & Company – Accounting & Consulting with any questions or concerns.