Craig Smalley was a Featured Expert Contributor in the February 2017 issue of Marijuana Venture Magazine
Anybody involved in the cannabis industry has probably heard about Internal Revenue Code Section 280E, which was originally developed in response to a famous U.S. Tax Court case.
In the 1981 case that led to Section 280E, Jeffrey Edmondson v. Commissioner, the petitioner was considered self-employed, having sold amphetamines, cocaine and marijuana. He received 1.1 million amphetamine tablets, 100 pounds of marijuana and 13 ounces of cocaine on consignment in 1974. Edmondson did not have a beginning inventory, but had an ending inventory of eight ounces of cocaine. He did not keep any books or records of sales and expenses. However, he reconstructed his income and expenses for the purposes of filing his 1974 tax return in response to a jeopardy filing made by the IRS in 1975. He claimed $105,300 in cost of goods sold (COGS) in 1974, in addition to other expenses.
In the opinion of the court, the judge allowed the COGS, as well as telephone, auto and rental expenses. However, due to this case, Congress enacted Section 280E in 1982, which allowed COGS as the only deduction for federally illegal activities. This was a knee-jerk reaction to the War on Drugs. It was common for drug dealers, after serving their prison terms, to get audited by the IRS, which would reconstruct the drug dealers’ income. Congress didn’t want anything other than COGS to be allowable for deductions.
The textbook definition of COGS is: “Cost of goods sold is the accumulated total of all costs used to create a product or service, which has been sold. These costs fall into the general sub-categories of direct labor, materials, and overhead. In a service business, the cost of goods sold is considered to be the labor, payroll taxes, and benefits of those people who generate billable hours (though the term may be changed to “cost of services”). In a retail or wholesale business, the cost of goods sold is likely to be merchandise that was bought from a manufacturer.”
For the typical cannabis retailer, COGS would include the marijuana that was purchased and the percentage of rent and utilities paid for the portion of the establishment that houses the inventory.
In the 2007 case of Californians Helping to Alleviate Medical Problems (CHAMP) Inc. v. Commissioner, the U.S. Tax Court held that a business operating a marijuana dispensary and providing caregiving services to patients could divide its business expenses and deduct the expenses associated with the caregiving activities, even though Section 280E prevented it from deducting any of the expenses associated with its dispensary operations.
In effect, the Tax Court held that Section 280E only applied to expenses related to the activity of selling marijuana, rather than to all expenses of any business that sold marijuana. Following this case, marijuana sellers were advised to allocate as many expenses as possible to caregiving services, and deduct the expenses associated with such services fully.
In addition, because COGS are deductible under 280E, a marijuana seller can try to allocate as much of their expenses to COGS as possible. If a marijuana seller is vertically integrated — growing the marijuana they sell — then opportunities to shift expenses to COGS are multiplied, since cultivation costs are properly classified as costs of goods sold. That opened up the deduction of such expenses as advertising, legal services, taxes and wages as a deduction. Only those expenses allocated to the retail operations would be disallowed under Section 280E. The rest would be deductible as a part of COGS.
Cannabis businesses that sell more than marijuana, like paraphernalia, can deduct the total costs of those expenses. Splitting off the other business endeavors from the main marijuana dispensary would be the best way to deduct these expenses.
Four quick tips from tax expert Craig W. Smalley
1. Consider Your Corporate Structure
If you have Section 280E issues, you may want to consider being taxed as a C corporation, which is favored by most small businesses, instead of an S corporation. For instance, if your business is just a dispensary, you would only be able to deduct the inventory. If you are taxed as a C corporation, you deal with the taxes at the corporate level and do not expose your personal income to any taxes. If you can’t afford to pay your income taxes, you simply file for bankruptcy.
2. Innovate
One way around 280E issues is to form another business that operates under the same roof. This business can sell T-shirts, provide medical care or sell anything other than marijuana. You could then pay your employees minimum wage under the company that has 280E issues, and make up for the difference in pay with the company that has nothing to do with the marijuana business.
3. Keep Good Records
Make sure that you keep good records, especially if you split off your businesses. You should be able to specify the expense and determine under which business the expense was incurred.
4. Expect an Audit
The odds of being audited are pretty good if you are in the marijuana industry and employ any strategy to avoid federal taxes. You need to have a team on your side that is familiar with audits, appeals and the U.S. Tax Court.