Amidst all of the excitement about the ongoing “Green Rush”, many people are unaware of one of the biggest struggles the marijuana industry is still facing.
Under current federal tax law, state-licensed marijuana businesses that are operating legally are not allowed to deduct their necessary expenses on their annual tax returns. The effect of complying with this law can result in federal income tax rates as high as 70% for some of these businesses. Obviously, that can take a large chunk out of a company’s profits, or make it impossible for them to continue operating at all.
The law in question is Internal Revenue Code Section 280E.It was enacted by Congress in 1982 and states that anyone in the business of “trafficking” controlled substances, as defined by the Controlled Substances Act, is not allowed to deduct any ordinary business expenses on their tax return. So items like rent, wages, utilities, and more are not allowed to be deducted against your gross income if you fall under this law. Oddly enough, you are allowed to deduct Cost of Goods Sold, and that has been upheld in tax court. So you can deduct the wholesale cost of all the marijuana you sell, but not the cost of the store and employees who sell it for you.
Unfortunately, the Internal Revenue Service has made it clear that, as far as they’re concerned, state-legal marijuana businesses are subject to Section 280E, and they are actively enforcing it. The normal IRS audit rate of the general business population is around 1%. Anecdotal evidence from attorneys and accountants suggests the rate of marijuana businesses currently under audit is as high as 10%.
Not surprisingly, this has the industry up in arms. There are several ongoing tax court cases that could set precedent in determining whether or not 280E should apply to state-legal marijuana businesses or not. The most relevant case to date was Californians Helping to Alleviate Medical Problems (CHAMP) vs IRS, in which a California cooperative challenged the IRS on Section 280E. The court decided that CHAMP was allowed to separate out “non-trafficking” expenses, for things like their counseling offices, from “trafficking” expenses directly related to their storefront. It was decided that only about 20% of their expenses were directly related to “trafficking,” and so only those amounts were disallowed under 280E.
Although this case did not set a precedent and only applied to that one business, the tax court’s decision opened up a whole new strategy for tax preparers to think about: the separation of trafficking vs non-trafficking expenses. This has resulted in a variety of different tactics, whether that’s limiting patient-accessible areas to minimal amounts of space, opening up secondary businesses under the same roof, or other unique ideas. However, the IRS is still taking a rigid stance and applying 280E to all marijuana businesses, regardless of how creative their strategies are.
There are also many businesses who simply choose not to comply at all with 280E when preparing their tax returns. Whether it’s because they simply can’t stay in business if they do, or just because they want higher profits, they roll the dice and hope they don’t get audited.
And then there are a small number of businesses who don’t comply with the law because they (and in some cases their tax preparers too) were not even aware of it. Imagine their shock and horror when they end up having the IRS disallow expenses from several years of tax returns and hand them a six or seven-figure tax bill.
Still, there are several reasons to be hopeful that things could change in the near future. There are a number of ongoing tax court cases, any of which could set a precedent. The federal government could pass a law that changes the status of marijuana on the controlled substances list, which would effectively remove it from falling under 280E. The IRS could amend Section 280E, or stop actively enforcing it on state-legal businesses. Or any number of other things could happen. Like so many aspects of the marijuana industry, the federal tax situation is constantly evolving and difficult to predict. The only thing that’s certain is that marijuana businesses have a difficult decision to make every year when it comes time to file their taxes.