Legalized Marijuana? Not So Fast: The Penalty of IRC §280E Continues for Cannabis Companies

Think of the most heinous crime that you can make money doing. For me, it’s human trafficking. Let’s say you get arrested for this crime, and spend five years in prison. In the meantime, you didn’t claim any of the income you made from human trafficking. The IRS comes knocking with a Notice of Deficiency (NOD) stating the amount you owe the government in taxes. Then you find yourself in Tax Court. Any expense that you incurred during your crime, is 100% tax deductible.

Let’s apply the same rule to cannabis. In the states where cannabis is legal, to get into the business is as simple as getting a license. The ordinary and necessary business deductions are deductible to the state, but since cannabis is a Schedule I narcotic, there is a special penalty that cannabis business owners have to pay. Section 280E states:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted

Cannabis is a federally illegal controlled substance. All that can be deducted, which is ultimately not a deduction, but a reduction in gross revenue is Cost of Goods SOLD (COGS). COGS is basically any cost that it takes you to sell your product. There have been ways around Section 280E, but they are ever evolving, and what worked two years ago, may not work anymore.

In Loughman v. Commissioner T.C. Memo 2018-85, the Court issued an interesting ruling. The Loughman’s owned a cannabis company that was taxed as an S-Corporation. The S-Corporation took a deduction for the wages paid to the shareholders. The Loughman’s correctly claimed the wages on their personal tax return, and the difference of the S-Corporation profit on Page 2 of Schedule E. As part of an examination the IRS disallowed the deduction for compensation of officers and the case ended up in Tax Court, because the plaintiff contended that disallowing the deduction for wages on the corporate return, was essentially taxing the income twice.

Honestly, there is no surprise there. The Court stated that S-Corporations were established to allow shareholders to be taxed once on income. However, with 280E in the way, the shareholders are being taxed twice.

The Federal Government, has been slow to test the medicinal properties of cannabis. The reason, is they didn’t have crop to test. They had to grow their own. However, many universities across the country are conducting their own studies.

The argument to federally legalize cannabis is that it can be taxed. NEWSFLASH, it already is, unfairly I might add. For instance, let’s say you own a dispensary that grossed $2 million. Your COGS is 50% of that or $1 million. As a C-Corporation you would pay $210,000 in federal tax.

The IRS has issued limited guidance on cannabis companies, so we are left to interpret it as narrowly as the Courts do. In CHAMPS v. Commissioner, we learned that it was okay to run two businesses under one roof. The Courts will go along with a separate business, as long as that business can stand on its own. In a recent Tax Court Case Alterman v. Commissioner, their argument was that they had a separate business. The separate business in the dispensary sold cannabis paraphernalia and T-shirts. These sales made up for less than 5% of their total sales. The other argument to get workers wages be deductible by Alterman, was saying the workers “trimmed” the cannabis that came in for sale. Interestingly enough, trimming a flower or bud, is typically done by the growers. They turn the trimmings into edibles and other things. Then there is the simple fact of how do you keep track of trimming? What if I was a worker trimming and a customer came in the dispensary, do my wages then become non-deductible? Keeping track of employees that roll cannabis or trim is impractical, and not normally done.

IRC §280E is a penalty imposed on the cannabis industry and not a tax.