While many states now permit legal medicinal or adult use commercial cannabis activity, cannabis remains classified as Schedule I controlled substance under the Controlled Substances Act, or CSA.
This classification transforms a “plant-touching” cannabis business compliant under state law into a criminal enterprise “trafficking in a controlled substance” under federal law; treats otherwise compliant business owners and operators as “drug dealers” pandering drugs deemed equivalent to cocaine and heroin; and subjects such businesses to Section 280E.
Section 280E penalizes traffickers of Schedule I or II drugs by disallowing the deduction of “ordinary and necessary” business expenses—such as below-the-line deductions—after reducing gross receipts by cost of goods sold, or COGS, essentially resulting in federal income tax liability calculated based on gross income, not net income.
In this environment, seemingly simple business decisions like choice of entity, accounting methods, and ownership structure have crucial implications for purposes of risk management. If a cannabis business is not structured carefully and thoughtfully from a tax perspective, the effect of Section 280E’s disallowance of deductions can easily result in effective tax rates and tax bills equaling or exceeding the economic profits of the business, often leaving the business operating in the red.
Worse still, for partnerships, Section 280E exposes upper-tier owners to crushing federal tax liabilities flowing through from their plant-touching cannabis partnerships.
Meanwhile, the IRS has issued little guidance on Section 280E, taxpayer compliance rates are proving low, enforcement of Section 280E has been slow and inconsistent, and the IRS is said to be at least three years behind in its audit programs. All of this means the IRS is barely getting started auditing cannabis licensees, and we taxpayers have yet to see how extensive and deep those audit trails will reach following plant-touching dollars.
Inventory, Cost of Goods Sold for Schedule I and II Drugs
For businesses subject to Section 280E, the calculation and substantiation of COGS are crucial to determine income tax liability. In Chief Counsel Advice 201504011, the IRS indicated a taxpayer trafficking in Schedule I or Schedule II drugs determines COGS by using the applicable inventory-costing regulations under Section 471 as they existed when Section 280E was enacted in 1982.
At that time, “inventoriable cost” meant a cost capitalized to inventories under Section 471, as those regulations existed before the enactment of Section 263A. In other words, the “full-absorption method” of computing COGS under the pre-1987 Section 471 rules, which takes into account both direct and indirect production costs.
The specific regulations are Treasury Regulation § 1.471-3(b) for resellers of property, and Treasury Regulations §§ 1.471-3(c) and 1.471-11 for producers of property.
Primary and Secondary Trades or Businesses
Cannabis licensees operating more than one license type or licensed location would be wise to conduct each activity and location as a separate trade or business.
Similarly, cannabis businesses disproportionately affected by Section 280E might want to seriously consider establishing a separate primary trade or business that is either not plant touching or a more COGS-intensive plant-touching business, such as a small retail shop in the same building as a cannabis manufacturing or cultivation facility operated by the same licensee.
This approach could reduce the effect of Section 280E by permitting deductions for certain ordinary and necessary business expenses that might otherwise be disallowed to a trade or business more heavily affected by Section 280E.
Separate Trades or Businesses
Whether an activity is a separate trade or business is a question of fact that depends on the totality of the circumstances and the degree of economic interrelationship between the two undertakings.
To be respected as truly separate and distinct, each trade or businesses should be operated as a separate business. While considered on a case by case basis, there are certain steps taxpayers can take to improve the likelihood of surviving scrutiny. For example, each business should:
- Prepare and maintain separate P&Ls, financial statements, comprehensive books and records, separate employee time clocks and HR records, separate insurance policies or insurance coverage, and if possible, a separately defined premises or allocation of square footage, and clearly defined areas with different signage.
- Maintain separate job functions and titles with written job descriptions, as well as policies treating each business as a separate employer, like clocking in or out of one business before switching to the other and separate calculations of time worked for break purposes.
- Establish a clearly defined and consistently applied methodology for shared expenses, such as a tenants’ share of common area maintenance charges in multitenant buildings.
Although this analysis is open to interpretation, below are some of the questions that courts have considered in making these determinations:
- How does the revenue from each trade or business compare?
- Are the undertakings conducted at the same place?
- Were the undertakings formed as separate activities?
- Does one undertaking benefit from the other?
- Does the taxpayer use one undertaking to advertise the other?
- To what degree do the undertakings share management?
- To what degree does the management oversee the assets of both undertakings?
- Do the taxpayers use the same accountant for the undertakings?
- To what degree do the undertakings share books and records?
And, specifically for cannabis determinations:
- What is the primary purpose of each trade or business?
- Are the additional services and activities incidental to the provision of cannabis?
- Or is the provision of cannabis ancillary to the primary line of business?
The discrepancy between federal and state law creates significant challenges, risks, and potential pitfalls for cannabis businesses to plan around and guard against, even when operating in compliance with state law.
Chief among these risks is future contingent federal tax liability upon reassessment of Section 280E adjustments in prior year tax returns on audit, which cannabis businesses are generally advised to expect at every level of government.
Cannabis businesses would be wise to routinely assess their Section 280E compliance and promptly amend prior year tax returns to reflect reporting changes.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Irán Hopkins is a partner in Akerman’s LLP’s real estate practice. She is also a regulatory expert in the evolving California cannabis industry and works with key stakeholders in all aspects of state and local licensing, establishing compliant operations across the supply chain and in different jurisdictions, and getting products to market.
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