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Cannabis Ordinary Business Expenses

February 27, 2020

The recreational cannabis industry is taking off in many states in the U.S. At present, ten states and the District of Columbia have already legalized recreational marijuana. As we discussed in a recent post, the State of New York may soon join the ranks and legalize recreational weed. If it does, New York’s cannabis retailers will have to contend with state and federal income taxes. Sole proprietors and others will comply with federal tax rates for individuals; cannabis corporations will contend with corporate tax rates. In any case, those with income derived from cannabis sales will have to deal with the strictures of Internal Revenue Code Section 280E. This section of the tax code is among the most impactful for those with a marijuana business. Why? Because it states that cannabis ordinary business expenses are NOT tax deductible on a federal tax return.

Sec 280E and Cannabis Ordinary Business Expenses

In this post, we will discuss the various ways in which Section 280E impacts the recreational cannabis industry. As we will see, this part of the tax code has an immense impact on state legal recreational cannabis businesses. That’s because such businesses, under federal law, are considered to be trafficking in controlled substances. In fact, the impact is so severe that there’s a good chance that a challenge to overthrow or amend Section 280E will likely be attempted. Let’s explore Sec 280E, the controlled substances act and cannabis ordinary business expenses in detail.

Section 280E Inflates Taxable Income

In order to maximize profits, companies take tax deductions for ordinary and necessary expenses paid or incurred in operating their business. Most businesses incur a wide range of expenses and take a deduction or credit for them. This is just as true for marijuana dispensaries as it is for any other type of business. One major expense is simply the cost of goods sold (COGS). In order for a cannabis business to have product to sell, it must first acquire that product. And that involves costs to the business. COGS typically includes both the cost of the inventory itself and other costs directly involved with the acquisition of the inventory. Businesses also take other deductions as well, such as those for mileage, fees for professional services, salaries and wages, furniture and equipment, independent labor, and others.

Section 280E changes this business deductions landscape, however, because it restricts the deductions a business can take. Under 280E, the federal government limits deductions to COGS. What this does is inflate taxable income. Without 280E, a given cannabis business might have taxable income of $100,000. But with 280E that same business may now have taxable income of $200,000 because it can’t take deduct ordinary expenses from its gross income.

Taxes Can Eat Away at Profit Margins

Given the fact that Section 280E inflates taxable income, what ends up happening is that many taxpayers engaged in a cannabis business see meager profits. If we continue with the above example, a business which has taxable income of $200,000 instead of $100,000 will have a much thinner profit margin. This is because its effective tax rate will be substantially higher. This business may face a tax rate which is 50 percent, 60 percent or even 70 percent! Suppose that this hypothetical business with taxable income of $200,000 pays a tax bill of $60,000. If we say that this business’s true taxable income is $100,000, then the tax rate is effectively 60 percent! Even though the business is taxed on $200,000, it only has $100,000 after all the expenses it incurred. If this situation happens often enough, we might see a big change to Section 280E in the near future.

Cannabis Businesses May Avoid Federal Taxes

If enough state legal cannabis businesses face effective tax rates of 50 percent or more, we may start to see widespread avoidance of federal income taxes. In effect, we may start to see a kind of “passive tax revolt” as these businesses avoid filing taxes in order to preserve profits. If this happens on a large enough scale, Section 280E may have the unintended effect of driving away a substantial portion of the tax revenue from state legal cannabis businesses. Section 280E was conceived back in 1981, long before the arrival of a legal state cannabis industry. Even though cannabis is still a “controlled substance,” the law may need amendment for ordinary business deductions at the state level for those carrying on any trade related to legalized cannabis.

Contact MC&C for Additional Information

If New York does in fact legalize recreational cannabis, Section 280E may become a very hot topic here. New Yorkers may end up leading the charge to amend Section 280E to allow ordinary business deductions. At Mackay, Caswell & Callahan, P.C., we strive to keep on top of important developments in the tax and finance world. We will continue to feature articles and updates on the current state of New York tax law on recreational cannabis. If your trade or business consists of a legal cannabis business and you have questions about Sec. 280E, don’t hesitate call. One of our top New York City tax attorneys is here to help.

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Comments

State Cannabis Taxation Rules – Mackay, Caswell & Callahan, P.C. 7 months ago

[…] we’ve talked quite a bit about legalized marijuana taxes. We’ve talked about Section 280E, for instance, and the tax issues raised by this important tax code section. We’ve also talked […]

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Comments

State Cannabis Taxation Rules – Mackay, Caswell & Callahan, P.C. 7 months ago

[…] we’ve talked quite a bit about legalized marijuana taxes. We’ve talked about Section 280E, for instance, and the tax issues raised by this important tax code section. We’ve also talked […]

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