When dealing with prohibition era politics and laws, it is important to remember that Al Capone did not go to prison for racketeering or for bootlegging; he went to prison for tax evasion. The marijuana industry can learn a lot from Mr. Capone when it comes to federal taxes.
In addition to their many other challenges, cannabis businesses must also contend with punitive federal tax rules. In 1982, Congress enacted Section 280E of the Tax Code as a way to punish drug traffickers. Specifically, Congress wanted to prevent drug dealers from taking deductions for their AK-47s and yachts yielded from illegal drug running. This provision of the Tax Code disallows all deductions and credits for business expenses related to the trafficking of illegal drugs. Since the federal government classifies marijuana as a schedule I narcotic, marijuana falls under this regulation. In 2007, in Californians Helping to Alleviate Medical Problems Inc. (CHAMP) v. Commissioner of Internal Revenue, the U.S. Tax Court ruled that IRC 280E applies to cannabis businesses operating legally pursuant to state law.
IRC 280E negatively impacts just about all marijuana businesses. Take, for instance, a marijuana business with deductible expenses of $100,000. If the IRS does not allow that business to deduct these expenses, that business will see an increase in its federal tax bill of at least $22,000. Congress enacted IRC 280E well before states began allowing regulated medical and adult use cannabis industries.
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Despite the foregoing, marijuana operators are able to mitigate some of the impact of 280E in two ways, costs of goods sold (COGS) and deductions for non-trafficking services and expenses.
Per the CHAMP case, marijuana businesses can still take COGS. Namely, COGS should amount to those costs that go into the production and/or manufacturing of the cannabis. But it has never been clear what the IRS will actually accept as cannabis COGS.
On January 23, 2015, the IRS released an internal legal memorandum outlining how Section 280E should be applied in the cannabis industry. Though this memorandum may not be used or cited by taxpayers as precedent, it outlines how some IRS officials analyze Section 280E and how to determine COGS.
In the IRS memorandum, marijuana retailers and producers are required to compute COGS under inventory rules that predate the enactment of Section 280E. According to the memorandum, a retailer can include in COGS the invoice price of cannabis, less trade or other discounts, plus transportation and other “necessary charges” incurred in acquisition.
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A producer may also include in COGS direct material costs (such as seeds) and direct labor costs (such as planting, harvesting, sorting, and cultivating). Indirect costs can also be included so long as they are “incidental and necessary for production.” In addition, certain other indirect costs may be included (such as depreciation, excise taxes, factory administration expenses, and insurance), depending on accounting treatment. Ultimately, the memorandum outlines a very narrow reading of the costs that can be included in COGS by suggesting that the IRS will not allow cannabis businesses to allocate purchasing, handling, storage, and administrative costs to COGS.
In addition to COGS, CHAMP also dictates that a marijuana business that provides other non-cannabis related services, like yoga, massage, or education, can deduct expenses related to those other lawful services. In turn, marijuana businesses can manage their businesses in a few different ways to take advantage of this non-trafficking “exception.” For example, a cannabis business can maximize the physical floor space it devotes to other services and minimize the floor space it devotes to cannabis sales. It could give employees not directly involved in cannabis distribution job tasks that do not involve cannabis. This way, the marijuana business can place the greatest amount of expenses in the “deductible” column, resulting in a smaller tax hit.
These mitigation techniques will not help every marijuana business since many are not geared to provide “other services.” Trying to shift expenses to capture COGS will increase accounting costs and breed uncertainty. As marijuana businesses seek to capture as many deductible expenses as they can, they run the real risk of the IRS disagreeing and finding themselves audited or hit with a penalty.
Despite the Cole Memo from August 2013, the opinion of the Department of Justice regarding how to treat the criminal investigation and prosecution of marijuana businesses has no bearing on how the IRS treats income generated from cannabis businesses. Cannabis businesses will only attain full relief from Section 280E when Congress amends the Tax Code or when Congress re-schedules or decriminalizes marijuana.
Hilary Bricken is an attorney at Harris Moure, PLLC in Seattle and she chairs the firm’s Canna Law Group. Her practice consists of representing marijuana businesses of all sizes in multiple states on matters relating to licensing, corporate formation and contracts, commercial litigation, and intellectual property. Named one of the 100 most influential people in the cannabis industry in 2014, Hilary is also lead editor of the Canna Law Blog. You can reach her by email at [email protected].