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Amidst all the excitement of a greener and more prosperous future for the cannabis industry, there’s one hurdle that seems to be frozen in time: The IRS’ stronghold on its tax regulations regarding “illicit” substances. Namely, the Section 280E Tax Code.
Even if cannabis were to be de-scheduled tomorrow, the proper accounting procedures that would serve as the industry norm would still take time to implement. In the meantime, all cannabis business owners must become familiar with the 280E Tax Code.
What is Section 280E?
Congress passed the Section 280E Tax Code in 1982 to end taxpayer deductible expenses concerning the sales of illicit substances such as amphetamines and cannabis.
While these substances were 100 percent illegal, there was still a large and uncontrolled market for them. There were also plenty of legal loopholes that allowed for entrepreneurs within this unregulated and highly illegal industry to fake an honest living on paper for tax purposes, including a laundry lift of deductible expenses such as packaging, transportation costs, shipping, and even equipment like the scales used to weigh the substances and the bags used to contain them.
The thought process behind the 280E tax code was: Well, if we can’t catch you, we’re at least going to get our cut. Once the code went into effect, there were essentially no more business-related write-offs.
Section 280E and cannabis
Today, the lines are still legally blurred. Medical cannabis is legal almost everywhere on a state government level. But it’s still not legal under federal law, which creates an overlap with a legal obligation for cannabis business owners to pay federal income taxes on their business profits.
The primary issue comes from the “discernibility” of whether the source of a cannabis business owner’s total income has been generated legally.
Put simply, the IRS itself doesn’t differentiate between legally and illegally-sourced income regarding the selling of cannabis under federal law. What this means is that while you can legally own and operate a medical and even adult-use cannabis business if your state legally allows it, under federal law, you’re still technically “trafficking” an illegal substance.
Therefore, there are no business expenses you can legally write off — with one recently amended exception: The cost of goods sold (COGS).
COGS refers to any expenses directly related to the production of the plants for growers and the amount paid for cannabis products for dispensary owners.
Lessons from prior court cases
As a budding entrepreneur or even an established cannabis business owner, the legal implications for being found non-compliant regarding the Section 280E Tax Code laws can severely impact your livelihood.
You’ll see that there’s one major common denominator regarding why these cannabis companies ended up in legal trouble — and it’s that no one seems to understand precisely how the 280E Tax is Code works. Of course, this is mainly due to the illegal nature of the industry.
Since cannabis businesses cannot take the regular deductions or credits as traditional companies can, they have to rely on the IRC 471 to determine which expenses they can allocate from cost accounting to inventory and COGS. It’s the only way to reduce tax liability in an incredibly complicated process that so many business owners end up getting wrong anyway.
Now, let’s take a look at where others have gone wrong and what the consequences were:
The Sweet Leaf 2019 Case
The owners of this Colorado-based dispensary chain were knowingly trying to outflank the general cannabis laws, resulting in four major compliance issues and jail time.
Their major crime was allowing certain customers to enter into a looping scheme, buying up the maximum amount of product multiple times per day, and turning around and selling it themselves.
The “Olive Versus Commissioner” Case
In 2015, the Olive medical dispensary followed the common recommendation of bundling together their caregiving services with the sale of their medical cannabis.
In theory, this would allow the expenses associated with the caregiving services to be deductible under IRC 162, which would help reduce the dispensary’s tax liability by allocating their shared expenses. However, the company didn’t make a clear separation of ‘trade and business,” i.e., a separate business account for each type of expense.
Olive ultimately won their case. However, the Tax Court disagreed with the expenses estimated and decided on its own that the company’s expenses were not tax-deductible as the company’s “misinterpretation of 280E” could be placed on running an illegal underground business of trafficking cannabis.
Harborside Case of 2018 That Lasted Until 2021
Another more recent and essential case for the cannabis industry is the Harborside vs. Commissioner case. The court found the business to be “trafficking illegally,” as with most other cannabis businesses that make mistakes when accounting for their COGS.
The lawsuit brought against them alleged that the property rented by Harborside for its operations was subject to forfeiture because they used it to “commit the distribution cultivation, and possession of cannabis in violation of 21 USC sections 841(a) and 856.”
However, in the case of Harborside vs. Commissioner, the company filed an appeal in which they explicitly found the IRC 280E Tax Code unconstitutional. Harborside’s goal was to abolish the tax code, which was unfortunately rejected, costing millions of dollars.
So, what have we learned?
The common theme here is that as long as cannabis remains a scheduled substance under federal law, the 280E Tax Code will not budge in favor of these businesses deemed eligible to exist but not operate normally.
As a cannabis business owner, your COGS are appropriately accounted for. Otherwise, you could stand to lose a significant amount of money, your entire business, your operational permits, and face jail time.