Are Your Cannabusiness Profits Going up in Smoke?

With tax season starting, questions from both legal and illegal cannabis companies begin to arise. Truthfully, the current tax laws for cannabis companies are tough to comprehend.

Federal and state tax laws vary significantly. Also, federal tax rules for canna-businesses are different than those of other for-profit businesses. Most importantly, federal tax laws make it very difficult for cannabis companies to generate a profit due to the heavy tax burden that is imposed.

280E: A Canna-Business’ Nightmare

As states legalize cannabis (recreational or medical – makes no difference), these businesses are treated like other for-profit businesses at a state level. However, at the federal level, cannabis companies are still considered illegal. In fact, it’s a Class 1 Felony, just like heroin. Hence, Section 280E of the federal tax code comes into play. It’s important to know and understand Section 280E. For Federal purposes, assume state-legal cannabis companies must report their income and expenses differently.

Reporting expenses under Section 280E disallows the majority of expenses associated with legal cannabis companies. There is confusion over what “disallowed” really means, but in the simplest terms, most businesses pay taxes on their net income (revenue minus expenses). However, for legal cannabis companies, only the cost of goods sold (COGS) are permitted for deduction.

COGS include only those expenses associated with the production of a product. For cannabis growers, this means that costs such as seeds, soil, water and nutrients and expenses related to the cultivation and harvesting of the plant are deductible.

However, costs associated with distribution, sale, administration, management, promotion, advertisement, overhead and support are not allowable. These include rent, shipping, most employee expenditures, most contractor expenses, legal, management, accounting, overhead, compliance, etc.

If you have two or more related business expenses, then there may be payroll tax issues.

For most companies, costs that do not fall into COGS comprise a large percentage of the overall costs of the organization. Paying taxes on gross profit creates a significant tax burden, which, in many cases, can make a company unprofitable.

Best Practices 

What can legal cannabis companies do to minimize their tax burden? First, you need to make sure that you have a tax professional that understands the ins and outs of 280E, how to set up your business when you may have an ancillary shop (i.e., one that offers counseling, munchies, or even paraphernalia) and to handle any issues that arise with the IRS or the state.  The states have indicated that they WILL audit every business every few years and they have. The IRS will also come in to audit a business to question as to what went into the 280E numbers claimed on the return.

In the event your deductions are scrutinized, you will need to not only produce good financial records, but provide a sound basis for what expenses fall into COGS versus non-COGS expenditures. Making quarterly tax payments assists with the annual tax burden and reduces the risk of penalties.

If a legal cannabis company produces multiple products, then accurate and complete books and records should be kept for each product.

Finally, developing a solid system to track expenses by category is critical. For example, all cultivation costs are deductible. However, if records are not appropriately maintained, you may lose the deductibility.

For long-term success, the industry must advocate for fair tax laws so these businesses can prosper and grow.

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Jeffrey Schneider, EA, CTRS, NTPI Fellow has the knowledge and expertise to help you reach a favorable outcome with the IRS. He is the head honcho at SFS Tax & Accounting as well as an Enrolled Agent, a Certified Tax Resolution Specialist and Advanced Crypto Tax Expert.
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Author of the Now What? Help! series. Jeff defines and deconstructs the scary and confusing letters in a fashion that mixes attention to detail with humor and an intricate clarification of what is what in the world of the IRS.

The books are available in paperback and eBook on Amazon.
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