Tax Code Section 280E - Cannabis Regulations
IRS tax code Section 280E regulates the cannabis industry. Learn more about the taxation of marijuana sales and purchases below.
“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.”
As marijuana businesses have been legalized in over half of the states, the issues of how these businesses can report their income and pay their taxes are relevant to more tax practitioners than ever before.
Marijuana is classified as a Schedule I drug under the Controlled Substances Act (CSA), which is the statute prescribing federal U.S. drug policy. Under the CSA, the manufacture, importation, possession, use and distribution of certain substances is regulated. Thus, for federal purposes, the sale of marijuana is an illegal business. This position has been substantiated in the Tax Court and affirmed by the Ninth Circuit Court of Appeals (Olive, Martin, (2012) 139 TC 19, affd (2015, CA9)).
Business Expenses and Credits
For tax reporting purposes, the big stumbling block is IRC Sec 280E, which was passed in 1982 during the Reagan administration and which prohibits deductions or credits in connection with the trade or business of trafficking in illegal drugs. This prohibition applies even if the sale of marijuana is permitted under state law. Thus, taxpayers in the business of selling marijuana, whether for medical or recreational purposes, cannot reduce their taxable income through either related deductions or credits.
Cost of Goods Sold
However, while related business expenses, such as those otherwise allowed under Sec 162, are not deductible, cost of goods sold (COGS) is allowed. This is because IRC Sec 61(a)(3) provides that “gross income” includes net “gains derived from dealings in property,” and this property includes controlled substances produced or acquired for resale. These “gains derived from dealings in property” refer to gross receipts less COGS, or the adjusted basis of merchandise sold during the taxable year. This result is necessary to conform to the language of the 16th Amendment to the US Constitution, which gave Congress the authority to tax “income” but not “gross receipts.” When property is sold, only the gain from the sale is income. Gain is well recognized as gross receipts (gross sales price) less the basis (cost) of the property sold (see Section 1.61-3 (a) of the Income Tax Regulations; Sec 1001 (a), Sec 1011 (a), and Sec 1012 (a)); and S. REP. NO. 97-494 (Vol. I), at 309 (1982)). The Senate bill was adopted in conference (CONF. REP. NO. 97-760, at 598 (1982), 1982-2 C.B. 650).
For a business selling marijuana, COGS clearly includes the cost of the marijuana itself. What else might COGS include? Advice from the IRS Chief Counsel (CCA 20150411 (12/10/14)) provides some guidance for determining COGS in this situation, as summarized here:
When Sec 280E was enacted in 1982, an “inventoriable cost” was a cost capitalized to inventories under Sec 471 and its regulations. Thus, for example, a marijuana reseller in that era using an inventory method would have capitalized the invoice price of the marijuana purchased, less trade or other discounts, plus the costs of transportation and other necessary charges incurred in acquiring possession of the marijuana. Similarly, a marijuana producer using an inventory method would have capitalized direct material costs (e.g., marijuana seeds or plants), direct labor costs (e.g., those due to planting, cultivating, harvesting or sorting), indirect costs as listed in Category 1 of Reg Sec 1.471- 11(c)(2)(i) and possibly Category 3 indirect costs as listed in Sec 1.471-11(c)(2)(iii).
Sec 263A was enacted 4 years after Sec 280E; it expanded the types of inventoriable costs compared to the rules under Sec 471. A reseller still is required to treat the acquisition costs of property as inventoriable. However, a reseller also is now required to capitalize purchasing, handling and storage expenses. In addition, both resellers and producers are required to capitalize a portion of their service costs, such as the costs associated with their payroll, legal and personnel functions. Thus, under Sec 263A, resellers and producers of property are required to treat some deductions as inventoriable costs. However, Sec 280E and the flush language at the end of Sec 263A(a)(2) prevent a taxpayer who is trafficking in a Schedule I (such as marijuana) or Schedule II controlled substance from obtaining a tax benefit by capitalizing disallowed deductions. If a taxpayer subject to Sec 280E were allowed to capitalize the additional Sec 263A costs, Sec 263A would no longer affect only timing and would become a provision that converted non-deductible expenses into capitalizable costs. Thus, the Chief Counsel’s office concluded that a taxpayer trafficking in a Schedule I or Schedule II controlled substance is entitled to determine inventoriable costs using Sec 471’s applicable inventory-costing regulations as they existed when Sec 280E was enacted.
Sec 280A Prevents Depreciation and Charitable Deductions
The Tax Court, in February 2021, denied a California-based medical marijuana dispensary’s depreciation deductions. The dispensary, organized as a corporation, claimed that Code Sec. 280E only applies to applicable business deductions under Code Sec. 162, but the Tax Court found that Code Sec. 280E’s application is much broader and applies to depreciation deductions claimed under Code Sec. 167(a)(1). The Court also held that Code Sec. 280E precluded the dispensary from taking depreciation deductions for other non-cannabis related items and services that it sells, such as T-shirts and acupuncture. According to the Court, Code Sec. 280E prevents a dispensary from taking any deductions, even if the dispensary engages in other activities. Further, the Court denied the charitable contributions the business had claimed, reasoning that any charitable contributions made by the dispensary were made through the course of the dispensary’s business, and therefore, Code Sec. 280E applies to the Code Sec. 170 charitable contributions. The taxpayer is appealing the Tax Court’s decision. (San Jose Wellness v. Commissioner, 156 T.C. No. 4)
Seized Items
A taxpayer cannot include cash, or the cost of controlled substances seized by law enforcement in his or her COGS (Beck, Jason R., (2015) TC Memo 2015-149).
Banking Issues
According to federal law, banks and financial services companies cannot knowingly establish accounts with businesses that sell illegal drugs. Banks that handle marijuana money can be charged with money laundering. Businesses restricted to cash are also “targets for assaults” that endanger the public. The lack of banking services can lead marijuana businesses to have problems making federal deposits using the required electronic funds transfer. The business has to make arrangements for its payroll service or another trusted third party to make electronic deposits on its behalf. Some credit unions and small banks that are chartered by their state, not the federal government, have tried to fill the void by offering basic banking services to the cannabis industry.
The IRS has established a payment option for individual taxpayers who need to pay their taxes with cash. In ACI Payments, Inc. OfficialPayments.com/index.jsp and the PayNearMe Company, individuals can now make a payment without the need of a bank account or credit card at certain retail establishments nationwide. There are various limits on the amount and frequency of deposits depending upon the retail establishment participating in the program. Details at: https://www.irs.gov/payments/pay-with-cash-at-aretail-partner
Excise Tax
Many states levy excise taxes on the sale of legal marijuana. According to a Chief Counsel Announcement (CCA 201531016), the taxpayer who pays state marijuana excise tax should treat that expenditure as a reduction in the amount realized on the sale of property under IRC Sec 164(a) – not as part of the inventoriable cost of that property or as a deduction from gross income. In addition, the CCA noted that IRC Sec. 280E doesn’t preclude this treatment because, although it prohibits deductions and credits for marijuana-related businesses, this excise tax is neither a deduction from gross income nor a tax credit.
Multiple Businesses
If a taxpayer selling marijuana is engaged in multiple trades or businesses, just one of which involves the sale of marijuana, only those expenses related to marijuana sales are disallowed under IRC Sec 280E (Californians Helping to Alleviate Medical Problems, Inc, (2007) 128 TC 173). However, sloppy bookkeeping practices can lead to problems in the event of an audit, so it is recommended that each business be operated separately, as the use of separate accounting for each can establish which expenses do not apply to the marijuana trade. Expenses that are shared by the businesses can be allocated by a reasonable method.
Cannabis Business and the Sec 199A Pass Through Deduction
The IRS has not provided any specific guidance to that question. The big concern of course is the limitations imposed by Section 280E, which in part says “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business…” Since the 199A deduction is not predicated on an “amount paid or incurred” the Sec 199A deduction might apply to cannabis trades and businesses.
However, when the wage limitation applies, the Sec 199A deduction considers wages paid by the business. Is that enough to kill the 199A deduction? Only time and the IRS’ and courts’ interpretations will tell. (The IRS passed on the opportunity to take a position in the final Sec 199A regulations released in February 2019.) Also, without being able to deduct business expenses, cannabis business’s QBI is inflated, not something Congress intended. Also see the discussion next of Altman vs Commissioner, TC Memo 2018-83.
Altman vs Commissioner (TC Memo 2018-83)
In the Altman case the taxpayer was appealing a lower court’s decision confirming IRS audit results for disallowing expenses under Sec 280E. What is interesting in the case was the taxpayer was allowed depreciation and Sec 179 deductions. However, the court did not provide an explanation as to why these expenses were deductible, and it appears the court did so based upon the original audit results, so it may have not been an issue before the court. So don’t hang your hat on those results. See 3.28.02 for a different outcome related to depreciation deductions.
PPP Loans
Cannabis businesses did not qualify for the PPP loans (see Chapter 3.30 for more about these COVID-19 pandemic-related loans).
Sec 280A Is Legal
The Tax Court ruled that Code Sec 280E is legal and doesn’t run afoul of the Eighth Amendment that prohibits excess fines and penalties. The taxpayer also tried to convince the Court that because the company was a legal business in California, that they weren’t “trafficking” in a controlled substance, but the Court held that even though the taxpayer is a legal business in California, marijuana is still a Schedule I controlled substance under federal law. (Northern California Small Business Assistants Inc., 153 T.C. No. 4)
Tax Return Preparers and Accountants
Another potential problem is that the Bank Holding Company Act treats accountants and tax-return preparers as financial institutions (16 CFR 313.3(i)(2)(h); 16 CFR 313.3(k)(2)(viii)) for purposes of information disclosure. Tax preparation and accounting firms are listed as financial activities, along with banks, insurance companies and financial firms, in 12 CFR 225.28(b)(6)(vi) and referenced in Sec 4(k)(4)(G) of the Bank Holding Company Act. Does this fact, in conjunction with the banking issues discussed previously, preclude an accountant or tax return preparer from establishing a business relationship with a business that sells illegal drugs?
In the Q&A session at the end of the IRS webinar given 7/19/17 by OPR Director Stephen Whitlock, the question was asked whether it is OK for those covered by Cir 230 to prepare returns for clients who have marijuana businesses in states where selling marijuana is legal. The answer was that as long as the federal tax laws are applied, such as the deduction/credit prohibition of Sec 280E, the IRS won't have a problem with the preparer (i.e., won't consider the preparer as aiding and abetting an illegal activity).
Several State Boards of Accountancy have issued guidance generally agreeing that providing accounting services to a marijuana business is not in itself a discreditable act. The AICPA does not, at press time, have a standard regarding providing accounting services to marijuana businesses.
Malpractice Insurance
All policies generally include exclusions for criminal acts. While the sale of marijuana is still illegal for federal purposes, it would be wise to consult with your insurance carrier related to your coverage when providing services to marijuana businesses.
S Corporations and Reasonable Compensation
Working shareholders of S corporations are required to take reasonable compensation for their services in the form of W-2 wages. However, those wages fall into the category of a business deduction, which, except to the extent allocable to cost of goods sold, a cannabis business may not deduct. Not allowing the business deductions increases the K-1 flow through income. Thus, the stockholder-employee will have to report the W-2 income and the pass-through income, effectively causing his reasonable compensation to be taxed twice. This outcome was confirmed in a case that came before the Tax Court in 2018 (J.M. Loughman, TC Memo. 2018-85).
Hemp Growers
In the 2018 Farm Bill, hemp was defined for purposes of the listing on the controlled substances list as "the plant Cannabis sativa L. and any part of that plant, including the seeds thereof and all derivatives, extracts, cannabinoids, isomers, acids, salts, and salts of isomers, whether growing or not, with a delta-9 tetrahydrocannabinol concentration of not more than 0.3 percent on a dry weight basis." Thus, hemp with 0.3 percent or less THC is no longer considered to be a Schedule I substance. A business growing and selling hemp containing 0.3 percent or less THC is not considered to be trafficking in a Schedule I substance, and thus the business is not subject to Code Sec. 280E and can deduct expenses. (https://www.irs.gov/businesses/small-businesses-self-employed/cannabis-industry-frequently-askedquestions)
No WOTC for Cannabis Business
The taxpayer operated a marijuana business and hired and paid wages to individuals from one or more of the targeted groups of the Work Opportunity Tax Credit (WOTC). The employer was otherwise eligible for the WOTC except for the possible application of Code Sec. 280E. The IRS Chief Counsel’s office advised that Code Sec. 280E prohibited the taxpayer from entitlement to the Code Sec. 51 WOTC for wages paid or incurred in carrying on a business of trafficking in marijuana. (CCA 202205024)
Form 8300
Cannabis businesses tend to be cash intensive business, and owners of cannabis businesses need to be aware of the requirement to file Form 8300, Report of Cash Payments Over $10,000 Received In a Trade or Business. The general rules for filing the 8300 are explained on pages 3.00.03 and 3.00.04. Beginning January 1, 2024, Form 8300 must be filed electronically if the business is required to file at least 10 information returns of one or more type(s) (1099s, W-2s, etc.) other than Form 8300 during a calendar year.
IRS Chief Counsel Memorandum 202409016.pdf (irs.gov) (3/1/2024) addresses questions related to the filing of Form 8300 that have arisen in examinations of trades or businesses involved in the “legalized substance industry,” i.e., the cannabis industry. Although the Chief Counsel’s advice may not be used or cited as precedent, it does provide insight into the IRS’s views on completing Form 8300 (Part 3, Line Item #33), reasonable cause related to penalties, when the suspicious activity box is checked, putting a marijuana business on inadequate records notice, cash payments between related entities in the marijuana industry, prepaid deposits, which individuals’ TINs need to be included on the 8300, verifying information, and other issues.