280e Tax Code Insight

August 30, 2021 280E, Cannabis Business, COGS, Entrepreneurs

Section 280e is notorious in the cannabis industry. This tax code inhibits most cannabis businesses to report their profits and gain recognition from the IRS.  

Section 280e has been a roadblock for many operators in the industry. It has made it hard for these businesses to succeed. However, it’s certainly not impossible.

Despite cannabis’s status as a Schedule I Controlled Substance, it’s possible for cannabusiness owners to write some cannabis business costs off. The internal revenue code is a hindrance for cannabis entrepreneurs. But it’s possible to reveal deductible costs with the right insight.

In this article, we provide insight into Section 280e. We explain what it is, what cannabis businesses should expect, how to avoid an IRS audit, and more.

Looking for expert financial services to maximize your tax deductions? Northstar is here to guide you!

Contact us now for more information on how we help cannabusinesses relieve the tax burden of 280e.

section 280e tax code impacts cannabis money

What is Section 280e?

Section 280e is an IRC that dictates how the cost of goods sold and other business expenses work for the cannabis industry. It serves as a legal basis for the IRS to tax dispensaries on their profits because they believe it’s a trade or business without ordinary income or loss.

What is the History of the 280e Tax Code?

The 280e tax code was created in 1982. It was a time of intense public debate over drug laws. The 1980s War On Drugs prompted the implementation of stricter laws for marijuana and other substances.

The Reagan Administration created Section 280e after a court case during which a convicted cocaine trafficker claimed he should be allowed to deduct ordinary business expenses under federal tax law. Then, in 1982, Congress implemented 280e to ensure other drug dealers from doing the same. Through this law, no deductions are allowed “in carrying on any trade or business if such trade or business consists of trafficking in controlled substances.”

This was before the legal cannabis industry existed; a time when drug smugglers and kingpins were earning millions of dollars through the black market drug trade daily. The federal government used the 280e Tax Code to ensure that an illicit operation involved in trafficking could not obtain tax deductions.

However, some members of Congress now believe the government has taken Section 280e too far. They feel that it has had an “adverse effect” on legitimate cannabis businesses. But the bill is still in place.

Loving this article? Make sure to check out our other post about 280E tax deductions for CBD companies before you leave!

What is the Controlled Substances Act?

The Controlled Substances Act (CSA) is the law that paves the way for 280e. It’s one of the federal government’s most commonly used tools to criminalize cannabis.

Through the CSA, the federal government regulates the manufacture, possession, use, and distribution of certain drugs. This system considers cannabis in the same category as heroin and LSD.

The Act created five schedules to classify controlled substances based on their risk for abuse: Schedule I drugs are deemed highly addictive with no medical value; whereas Schedule V drugs have a low potential for addiction and accepted medical uses.

Cannabis, however, has been placed in the most restrictive category: Schedule I. This puts every legitimate cannabis business in violation of federal law. And with Section 280e in place, legitimate cannabis business owners have accounting difficulties that stem from what would normally be considered ordinary business expenses.

What Does Section 280e Do?

Section 280e prevents cannabis businesses from deducting business expenses when filing taxes. This includes cost of goods sold. In short, it taxes cannabusinesses on their gross profit.

This is different from a normal business. A normal business can deduct its operating costs and other expenses under section 162 of the internal revenue code (IRC). Although cannabis cannot be deducted, section 280e allows for some cost deductions. However, it’s not ideal for most businesses and comes with a risk of an IRS audit if the federal tax isn’t appropriately accounted for.

state legal cannabis dispensary 280e damages

Why Is 280e Harmful to State-Legal Cannabis Businesses?

One of the biggest reasons why marijuana businesses would rather not have 280e in place is because it taxes them at a higher rate than normal businesses. This makes it difficult for legitimate cannabis business owners to compete with unlawful operations and other industries in the marketplace.

There’s a relatively simple formula to determine federal income taxes. You begin with gross income, minus business expenses to determine taxable income, and then pay taxes on this money.

However, for a cannabis business, the operations must pay taxes on gross income. Generally speaking, this results in legitimate cannabis industry business operators paying tax rates of 70% or more. This is nearly double the amount the business actually earns in some cases.

How Does 280e Tax Code Apply to Cannabis?

Section 280e makes it harder for legitimate marijuana businesses to succeed. It prevents legal cannabis business owners from deducting expenses for producing, purchasing, or distributing their products.

In most cases, this results in a higher tax rate than the normal 25%. Because of this, some cannabis industry leaders have begun pursuing legislative solutions to change the code and allow deductions.

Tax Code 280e for a Legal Cannabis Business

Legal adult-use or medical marijuana operations are working with a controlled substance. At least, according to federal law. But just because cannabis companies work with cannabis does not mean they cannot avoid the tax court.

How to Avoid a 280e Tax Code Violation

Avoiding a tax code violation as a state legal operation means a cannabis company must stay in compliance with its state’s laws. Because federal law takes priority over state law, this means companies must determine whether a  violation exists in their respective states.

In many cases, cannabis operations are complying with the 280e tax code by splitting their marijuana companies in half. By operating two entities under one roof, some deductions are achievable.

Business One owns or rents the building. This involves handling the storage and transportation. It also offers employment benefits, hosts company events, and covers maintenance services. Non-cannabis products like t-shirts, keychains, and pipes can also be sold by this business.

The second related business handles cannabis directly. This can involve growing, curing, and packaging cannabis. It also should include minimal overhead-related expenses. The main expense that should be included in this operation should be the inventory itself.

Steps to Resolve 280e Tax Code Violations

To ensure your taxable year has as many deductible expenses as possible, your cannabusiness should avoid incorporating as an S-Corp or an LLC. This is because of the unique restrictions this code pushes on these U.S. operations.

Cannabusinesses in the U.S. should reduce their corporate tax liability and facilitate accounting by incorporating as a C-corporation. C-corp business operators get taxed on their salary and/or dividends. Since this is a different structure, you can reduce how your cannabusiness pays taxes. But you might only need to use this strategy for the second business if you use the split strategy.

How to Avoid Paying Taxes from Gross Income Under 280e

You cannot completely avoid paying taxes under this code. But a deduction or credit shall be possible if you know how to calculate goods sold COGS (Cost of Goods Sold).

What is Cost of Goods Sold

Cost of goods sold is a business expense that applies to most retailers. It’s an important accounting measure for companies like Canna Care Docs. COGS helps cannabis businesses keep track of how much they pay for individual products and materials.

COGS allows business operators to handle the indirect costs of doing business while bypassing some of these tax limitations.

Which Expenses Are Deductible Under 280e the Tax Code?

COGS are deductible under this code. But this varies throughout the marijuana industry.

Expenses directly related to your operations can be deducted. For instance, as a cannabis cultivator, raw materials and supplies are directly related to your operations.

But inventory costs should also be considered for cannabis entrepreneurs.

You can deduct COGS. But this is limited to the cost of the product and the costs related to obtaining your merchandise. You can deduct electric bills for inventory areas, too.

However, everything else is subject to this code’s limitations. You cannot deduct employee salaries, advertising costs, rental fees, etc.

Financial Services to Handle IRC 280e Issues

We recommend getting professional assistance. The right financial services have the potential to save some marijuana operations thousands, hundreds of thousands, and, yes, even millions of dollars.

Appropriately handling taxes and documenting everything gives marijuana operations the ability to scale successfully. But, most of the time, it’s easy for cannabusiness owners to push their obligations to the back of their minds until the season comes along.

This is why we recommend using our fractional CFO services. These services are especially beneficial to operations that don’t need a full-time CFO in-house and would prefer the flexibility we offer.

Looking for expert financial services to ensure your net income gets the best effective tax rate possible? Northstar is here to guide you!

Contact us now for financial services that will scale your marijuana business and guarantee your success in case of a tax audit.