It is no secret that cannabis businesses must deal with substantially more rules and regulations as compared to most other businesses. Internal Revenue Code Section 280E is one of the biggest complications for businesses operating within the cannabis industry, causing an increased tax burden for cultivation facilities, medical marijuana manufacturers and dispensaries because of cannabis’ status as a Schedule I controlled substance.
Recently, however, there has been official talk from the Department of Health and Human Services of reclassifying cannabis from Schedule I to Schedule III. In this scenario, 280E would no longer apply, providing significant relief to the industry.
Our cannabis group is following these developments closely.
Until then, we recommend that you educate yourself on what expenses are deductible under IRC Section 280E, and which are not, to help your cannabis business make better financial decisions. Section 280E would no longer apply in the year in which rescheduling occurs therefore, we recommend cannabis operators plan on saving enough cash to cover their tax liabilities assuming rescheduling occurs in 2025. This would be a more conservative approach to ensure that enough cash is set aside for making estimated tax payments during 2023 and 2024.
What is Section 280E?
The IRS deems state-compliant cannabis businesses as being federally illegal and requires this to be reflected on the federal tax return. Section 280E of the tax code states that businesses that traffic in controlled substances cannot deduct any expenses incurred in carrying on the production, distribution, and sale of controlled substances. This means that businesses operating within the cannabis industry cannot deduct certain expenses, many of which are deductible for businesses operating within a legal industry.
One exception to this law is for costs of goods sold (COGS). COGS are an offset to taxable income, and only account for expenses associated with producing the product. Deductible expenses include such items as seeds, soil, water, nutrients, and expenses related to the cultivation and harvesting of the plant. Expenses that are part of the distribution process are not deductible, and include such items as rent, shipping, overhead and employee expenditures.
Because of Section 280E, most overhead costs associated with doing business in the cannabis industry are not deductible, resulting in cannabis businesses paying taxes essentially on gross profit instead of net income. This is a big challenge and means cannabis operators must achieve sufficient profitability or end up paying taxes that exceed net income.
The example below outlines the impact of Section 280E for a corporation:
Less: Cost of Goods Sold – 600,000
Gross Profit 1,400,000
Less: Other Selling, General & Administrative Expenses – 1,100,000
Net Income $ 300,000
Federal Income Tax Rate = 21%
- Net income of $300,000 taxed at 21% = $63,000
- Results in net income after taxes of $237,000 and an effective tax rate of 21%
- Gross profit of $1,400,000 taxed at 21% = $294,000
- Results in net income after taxes of $6,000 and an effective tax rate of 98%
Thus, as a result of 280E, the state legal cannabis company ends up paying an additional $231,000 in taxes.
What Can I Do About Section 280E?
The best defense against Section 280E and other tax implications of the cannabis industry is to work with an experienced team of accountants and advisors. Anders has a team of CPAs and advisors well-versed in the industry who can help ensure your financial information is up to par with evolving regulations and your tax burden is minimized. Learn more about the Anders Cannabis Group or contact an Anders advisor below to find out how we can help you keep more money in your business.
Virtual CFO Guillermo Rodriguez contributed to this article.All Insights