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 is 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 could not do 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.
What is the Controlled Substances Act?
The Controlled Substances Act (CSA) is the law that paves the way for 280e. It is 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 most operating costs. In short, it taxes cannabis businesses 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 most cannabis expenses cannot be deducted, section 280e does allow for cost of goods sold (COGS) to offset revenue. However, this is not ideal for most businesses and comes with a risk of an IRS audit if the federal tax is not properly accounted for.
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 is 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 reduce their tax burden through proper planning.
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 laws. Because federal law takes priority over state law, companies must determine whether a violation exists in their respective states.
In many cases, cannabis operations comply with the 280e tax code by splitting their marijuana companies into two entities. By operating two entities under one roof, some deductions become 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 merchandise and accessories can also be sold by this business.
The second related business handles cannabis directly. This can involve growing, curing, and packaging cannabis. It should include minimal overhead-related expenses. The main expense 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 cannabis business should consider its corporate structure carefully. S-Corps and LLCs face unique restrictions under this code.
Cannabis businesses in the U.S. should consider incorporating as a C-corporation to reduce their corporate tax liability and simplify accounting. C-corp business operators get taxed on their salary and dividends. Since this is a different structure, you can reduce how your cannabis business pays taxes. You might only need to use this strategy for the second business if you use the split strategy.
How to Reduce Taxes Under 280e
You cannot completely avoid paying taxes under this code. But deductions are possible if you know how to properly calculate cost of goods sold (COGS).
What is Cost of Goods Sold
Cost of goods sold is a business expense that applies to most retailers. 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 offsetting some of these tax limitations.
COGS are deductible under this code, but the specifics vary 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.
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 as well.
However, everything else is subject to this code's limitations. You cannot deduct employee salaries, advertising costs, rental fees, and similar overhead expenses.
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 even millions of dollars.
Properly handling taxes and documenting everything gives marijuana operations the ability to scale successfully. But most of the time, it is easy for cannabis business owners to push their obligations to the back of their minds until tax season arrives.
This is why we recommend using fractional CFO services. These services are especially beneficial to operations that do not need a full-time CFO in-house and prefer the flexibility of outsourced financial leadership.
A qualified cannabis CPA or fractional CFO can review your corporate structure, optimize your COGS classification, prepare audit-ready documentation, and ensure you are capturing every legitimate deduction available under the law.