One of the hurdles in operating a cannabis business is Section 280E of the Internal Revenue Code—a federal statute that forbids businesses dealing with Schedule I or II controlled substances from deducting ordinary business expenses from their taxable income. These ordinary expenses include costs associated with payroll, rent, distribution, promotion, sale, support, administration, and management.
Put simply, most businesses pay their taxes on net income, or revenue less business expenses. For state-legal cannabis business, meanwhile, only the cost of goods sold (COGS) may be subtracted from the taxable income as marijuana remains a Schedule I drug. The COGS only include costs directly related to the production such as seeding, planting and cultivating.
Based on a report by the National Cannabis Industry Association (NCIA), cannabis companies pay a tax rate of up to 3.5 times higher than regular businesses due to the provision in Section 280E. But, with proper accounting and compliance in place, your business can lower your tax burden. Here are some steps that can help you:
Determine the right corporate structure
There are three entity options when setting up your corporate structure: C-Corporation, S-Corporation, and Limited Liability Corporation (LLC). Most lawyers prefer a C-Corporation structure for cannabis companies amidst Section 280E, since it is a tax-paying entity. This means the owner only pays tax based on his salaries or dividends. S-Corporation and LLC, meanwhile, are typically better for small businesses.
Consider shared services agreement
Since Section 280E deals with businesses that involve Schedule I and II drugs only, some companies opted to divide their services and structure into two. The first company deals with the production and distribution of cannabis, while the second is responsible for activities that are legal under the federal law such us providing care services or counseling, selling related but not marijuana-infused merchandise, and managing the place where the business resides.
Under the said setup, the first company complies with Section 280E, such that the cost of goods sold is the only allowed deduction. The second company, meanwhile, enjoys other ordinary deductions related to payroll, rent, distribution, promotion, sale, support, administration, and management. When combined, the taxes of the two companies are significantly lower than they would be if they operated as one entity.
This shared services agreement has been upheld by the federal court in the 2007 Californians Helping to Alleviate Medical Problems (CHAMP) case. Take caution, however: make sure that you are setting up a legitimate second company, with real purpose and revenue, to avoid violations. Do not set up a shared services agreement just to navigate through Section 280E. Always consult with compliance experts if you’re not sure how to go about it.
Take note of employees’ tasks
Employee job descriptions are essential not only for having an organized internal process, but for accurate reports on salaries as well. You have to track the employees’ tasks and time spent on each to determine how many hours of wages are deductible under Section 280E of the tax code.
For example, there might be instances where your cultivator will work as a part-time budtender. The cultivation task is directly involved in the production of cannabis. Thus, it is deductible and included in the cost of goods sold. The budtenders wages, meanwhile, are not deductible.
Your cannabis business is subject to more audits than other businesses since you are operating with a federally illegal substance. Therefore, it is important to be ready for an audit at all times.
To deal with 280E and be audit-ready, you must document all expenses and revenue from seeding and cultivation to marketing and sales. You should have a receipt for every transaction—even those that involve the smallest bill—to avoid submitting an inaccurate tax return. Keep in mind that the IRS will ask for a detailed documentation of your COGS, and you may face a fine if you fail to show how you came up with the deductions.
Seek experts’ advice
Taxes and regulations, Section 280E in particular, can be confusing and a single loophole could result in violations and hefty fines. To avoid these, consider working with compliance and accounting experts. They can give you reliable insights so you can make better business decisions.
Compliance and accounting experts have advanced knowledge of the ins-and-outs of the highly-regulated industry. They can help you stay calm and focused amidst the provision of Section 280E.
Want to learn more about minimizing your cannabis tax burdens in the face of IRS tax code Section 280E? Schedule a free consultation with our cannabis accounting and compliance experts today!