Tax Planning in the Cannabis Industry: Section 280E of the Internal Revenue Code
By Gregory Bryant CPA/ Esq.
Sarah Skinner, Esq.
The green-wave is overtaking America. Cannabis is gradually reaching the masses, and consequently the mass markets, thanks to legalization efforts. As a reminder, marijuana and hemp are both cannabis. However, marijuana and hemp are different varieties of the Cannabis Sativia L. plant. Generally, hemp must contain 0.3% or less total Tetrahydrocannabinol (THC). Hemp is a legal agricultural commodity while marijuana is a federally illegal controlled substance (and still illegal in many states). Although marijuana was once was an illegal countercultural symbol, it gradually became tested to determine the scope of its potential medicinal benefits and is currently being legalized in an increasing number of states for recreational use. As of now, the majority of Americans have access to legal marijuana, whether medically or recreationally. Since 2012, 16 states and Washington, DC have legalized recreational marijuana for adults over the age of 21. A total of 36 states have legalized marijuana in some form. Then, South Dakota has passed legislation, but the law remains mired in legal challenges and opposition from South Dakota’s governor Kristi Noem. Meanwhile, legislatures in New Mexico and Virginia have recently passed legislation but it has yet to take effect.
1 – So long as marijuana is a federally controlled substance, Section 280E of the Internal Revenue Code is a problem for your marijuana business.
If your business plans include taking advantage of the green wave and entering the cannabis industry, one sentence of the Internal Revenue Code is particularly important to you – Section280E:
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade (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.
In other words, this one sentence of the internal revenue code denies a marijuana business the ability to deduct business expenses when calculating its Federal income tax liability. Due to Section 280E’s extreme limitation on marijuana business’ deductions, marijuana businesses face a higher effective tax rate. If tax planning is not done correctly, you could be left with a tax liability higher than your actual profits. By contrast, because hemp and hemp products are legal (so long as they contain less than 0.3% of THC), deductions are not prohibited under Section 280E.
Section 280E affects all business types involved in the marijuana industry: producers, processors, retailers, and management companies (even if the management company does not own any of the cannabis itself). However, retailers are typically hit the hardest. It is possible to diminish the effects of Section 280E. For example, if a marijuana business can demonstrate to the IRS that an expense is related to the cost of goods sold instead of an ordinary and necessary business expense, that expense can be deducted. Why does this work? Section 61 of the Internal Revenue Code defines income as “net gains derived from dealings in things in property” or gross receipts less cost of goods sold. Marijuana businesses can lower their tax burden by classifying as many indirect costs as direct costs and include in cost of goods sold as possible (while remaining in compliance with the Internal Revenue Code).
In addition to maximizing your deductible costs, we recommend keeping your non-deductible costs low. For cultivators, this means keeping your selling, general, administrative, advertising, meals, entertainment, and travel expenses low – those will reduce your cash and not your tax liability. Additionally, we recommend that you do your best to minimize year-end inventory to match market demand. Product that is sitting in inventory rather than flowing through COGS puts your business at a risk of a much higher tax liability. Further, minimize your business rental space. Any space not directly related to growing cannabis should be eliminated as much as possible.
2 – If you have confidence that will be fully declassified from Schedule I and II in the near future, we have a tax planning opportunity for you.
If you believe cannabis will be fully declassified from Schedule I and II, we suggest capitalizing otherwise non-deductible expenses and wait to bill them in the future when they are fully deductible. For example, the management and marketing company can be formed to support the operating company(ies). Under agreements with the operating companies, the marketing company cannot bill its services until cannabis comes off Schedules I and II. At that point, the deferred expenses can be billed and deducted. There is currently a proposal in FDA to reclassify cannabis from Schedule I to Schedule II. Although that will not turn off Section 280E, it does indicate a loosening of restrictions, and a possible removal from Schedule II in the future.
3 – We expect to see IRS audit activity around 280E, making adequate record keeping key for your cannabis business.
We expect to see IRS audit activity around 280E because a lot of companies have been defying the rule as a form of civil protest. A few bad apples can make a mess for the rest. Assume that if you don’t have receipts to support a deduction that the IRS will disallow the deduction. Create a banking atmosphere in your business – create your own cash logs and attach or upload receipts and documentation to every transaction. Clear and concise expense documentation is critical – legal deductions are lost by failing to track and document activities of employees whose work involves production-related activities that qualify as cost of goods sold (COGS) deductions, as well as non-production activities disallowed under Section 280E. Regarding employee records, investigate various time-tracking and attendance software systems to track employee activities and produce records. Document employee activities in job descriptions. It is the employees’ activities which determine whether their labor is deductible under Section 280E (i.e. allocable to COGS) or non-deductible. Not sure if your record keeping will be sufficient in case you are audited by the IRS? Need help establishing an adequate record keeping system? We’d be happy to help.
4 – Adequately addressing Section 280E’s impact on your cannabis business involves more than just maximizing your deductions.
Sufficient tax planning is more than just maximizing your deductions when the tax deadline approaches. The decisions you make about the type of business entity to pursue, how to structure your business, and what accounting method to use all have important tax implications. Re-evaluation of these decisions becomes necessary when new tax laws take effect, such as the proposed changes to the corporate tax rate.
If you are new to the cannabis industry, we can help you determine which business entity will work the best for your situation. From a Section 280E planning perspective, we recommend breaking different business lines into separate business entities. This way, the different business lines will stand on their own as a record-keeping and bookkeeping unit. Having a stand-alone entity increases your ability to successfully demonstrate to the IRS that expense for that separate trade or business are deductible and not subject to Section 280E. Also, consider holding real property in a separate legal entity from your operating entity and then enter into a leasing-type arrangement with your operating entity.
For business structures with multiple related entities, you will need to maintain the proper transfer pricing documentation demonstrating that compensation between the related entities is at “arm’s length.” In other words, the compensation is the same as it would be if you hired a third party to provide similar services. In the case of leasing-type arrangements between your real property holding entity and your operating entity, care should be taken to substantiate the amount of rent charge. Failure to keep transactions at “arm’s length” means the IRS will have the ability to shift profits. We have extensive transfer pricing experience and can help you either set up new transfer pricing arrangements or evaluate the transfer pricing documentation that you currently have in place.
The accounting method you select for your business is also crucial as it will tie heavily into what and when you record your income. Under the cash method, expenses are recorded when cash is received, and bills are paid. Under the accrual basis, expenses are recorded when earned, regardless of whether the bill was paid. The accounting method decision is highly context specific and will rely on your sales volumes, among other factors. We can take a look at your business situation and determine if your current accounting method is working for you.
5 – We can help you navigate Section 280E implications as you develop your growth and/or exit plan for your cannabis business.
If your business growth plans include either the acquisition of competitors or the intent of selling your business to a competitor, be sure to give us a call early on in your merger or acquisition transaction. M&A transactions may include stock, cash and your retention as a key employee. Fully taxed deals can leave you cash poor, when terms could have deferred taxes on stock. There are a lot of moving parts – the sooner we are involved, the sooner we can facilitate discussions on deal structure and numbers. For example, if you are acquiring a cannabis business, we can assess whether Section 280E planning had been successfully addressed in the target business and if not, how to remedy the situation.
6 – No matter whether you are just starting your cannabis business or whether you are planning to sell your cannabis business, tax planning is key.
Stay in a state of perpetual tax planning. If you have or anticipate a high level of profits, consider ways to reinvest in your business – such as building a new greenhouse or setting up a new indoor cultivation site. Not only will the reinvestment grow your company, depending on your situation, it could reduce your tax liability. Need assistance finding reinvestment opportunities that could reduce your tax liability, we can help!
When you acquire new assets for your cannabis business make sure you understand which of those assets will need to be depreciated over time. Cultivators often write off “heavy” assets in a single year – avoid that mistake. IRS regulations require certain assets to be depreciated over their useful life. Also, be sure to investigate sales tax breaks on equipment. Certain states will provide income and sales tax breaks for the purchase of equipment and supplies used in agricultural activities. These sales tax exemptions may also apply to cannabis production, depending on your state. But, keep in mind that sellers must collect tax from you when you purchase agricultural equipment unless you present your exemption certificate to them. Considering a new equipment purchase? We can explore the write off implications of that purchase.
It is also important that you do not forget to file IRS Form 8300 (Report of Cash Payments Over $10,000 Received in a Trade or Business) as needed. Form 8300 assists law enforcement in its anti-money laundering efforts. Transactions where this form may become necessary include escrow arrangement contributions, making or repaying a loan, rental of real or personal property, exchange of cash for other cash, reimbursement of expenses, sale of goods or services, sale of intangible property, and sale of real property. Fines are exorbitant if you fail to file this form. We can help you determine whether or not your business needs to File Form 8300 and help you file.
In addition to federal tax obligations, we can assist you in ensuring your business is meeting all relevant state and local tax obligations such as sales tax, franchise taxes and business licenses. Taxes such as sales taxes are considered “fiduciary,” meaning you collect those taxes on behalf of the state. Even if you are organized as a corporation or LLC, you can be personally liable for those taxes, including penalty and interest, if you are considered a key employee and these taxes are not paid.
7 – What are my next steps?
Section 280E planning is unavoidable if you are, or are planning to enter, the cannabis business. Give us a call at 919.615.3766 to see what steps your cannabis business should be taking!
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
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