Kaveh Newmen Sheds Light on Cannabis Tax Rules

by | Mar 2, 2022 | News

Originally published on cannabisindustry.org.

Tax Rules For Cannabis Companies

The cannabis industry has grown exponentially as an increasing number of states have relaxed state law prohibitions on the use of cannabis for medical and recreational purposes. However, under federal law, cannabis remains classified as a Schedule I controlled substance under the Controlled Substances Act (CSA). This means that the production, distribution, and possession of cannabis remains illegal on the federal level.

Schedule 1 Status of Marijuana: State-Legal Cannabis Businesses and Application of Internal Revenue Code Section 280E

Cannabis businesses are treated differently from many other businesses for tax purposes. Under Internal Revenue Code (IRC) §280E (“280E”), which applies to a federal income tax filing, denies deductions and credits for amounts paid or incurred in carrying on the trade or business of cannabis. Cost of goods sold is allowable because it is not considered a deduction, rather it is a reduction of gross receipts (revenue) to arrive at gross profit.

report published in March 2020 by the U.S. Treasury Inspector General for Tax Administration examined California and found that over 50% of marijuana companies had likely underpaid the IRS under IRC§ 280E. The report confirms the IRS is preparing to increase marijuana industry audits nationwide in response.

Currently, the method by which cost of goods sold may be deducted for producers is to use IRC §471(a). This provision discusses how to clearly reflect income by using an inventory method.  Therefore, cannabis producers have less of a 280E problem than retailers and distributors.

After the passage of the Tax Cuts and Jobs Act (TCJA), effective for tax years beginning January 1, 2018, a provision was passed in the IRC §471(c). There are various opinions with advisors in the industry on whether this code section and method can be used for retailers and distributors.  The idea behind IRC 471(c) is that “certain small businesses” can meet the gross receipts test of this subsection for any taxable year in which the corporation’s or partnership’s average annual gross receipts do not exceed $25,000,000 for the 3-taxable-year period ending with the taxable year that precedes such taxable year. Pursuant to IRC §448(c)(1), this type of small business may be able to use a “books and records” method for deducting all costs – rather than being limited to cost of goods sold only. In other words, if one uses 471(c)(1)(B) as an accounting method, in theory, they may also be able to deduct selling expenses and all other costs that were previously not allowed as deductions.

For further discussion on this topic see the following articles: Bloomberg Tax – Cannabis Taxpayers Find Flaws in New Accounting Method Rules and The Tax Cuts and Jobs Act: A Comparison for Businesses

Assembly Bill 37, codified in §17209 of the California Revenue and Taxation Code

Each state in the U.S. is autonomous in that it has the authority to decide whether its income tax laws conform to §280E or not. On October 12, 2019, Governor Newsom signed into law AB 37, which overrides §280E through the following provision:

For each taxable year beginning on or after January 1, 2020, and before January 1, 2025, Section 280E of the Internal Revenue Code, relating to expenditures in connection with the illegal sale of drugs, shall not apply to the carrying on of any trade or business that is commercial cannabis activity by a licensee. – (CAL. REV. & TAX CODE § 17209 (2020).  CAL. REV. & TAX CODE § 17209 (2020).

However, AB 37 only applies to state filings with the Franchise Tax Board and is currently only available until January 1, 2025. AB 37 has no impact on federal tax filings, which is where a majority of cannabis entities pay their income taxes with effective tax rates as high as 25% for corporate taxes and up to 37% for individuals.

The IRS Lacks Guidance for Cannabis Tax Payers 

The IRS has not published nationwide guidance to taxpayers and tax professionals in the cannabis industry. In addition, cash-intensive business issues unique to the cannabis industry such as IRS §280E and banking limitations will remain unresolved unless and until there is uniformity through federal legalization. As a result, compliance-related issues continue to grow and negatively affect cannabis business owners who operate legally under individual state law.