What Is the Section 280E Tax Code?
Tax Code Section 280E originates from a 1981 court case. A cocaine dealer tried to claim a tax deduction on business expenses for his cocaine selling business. As a result, Section 280E prevents any business that trafficks in a Schedule I or Schedule II-restricted substance from deducting any business expenses.
The only tax deductions permitted under Section 280E are those directly related to the 'Cost of Goods Sold' which means the cost of maintaining your inventory. This can sometimes result in creative accounting to define the cost of goods sold. However, strict enforcement may create back-taxes for those who try.
Section 280E denies cannabis businesses the right to federal tax deductions. With these limitations, a cannabis business can be charged more than double the tax burden. So it's easy to see why the industry is on alert about this enforcement.
How 280E Impacts Cannabis Businesses
So how, exactly does Section 280E impact a cannabis business? The rules are very specific to ensure that it is enforced fairly and in line with the constitution. However, strict adherence cuts both ways. The IRS has made it clear that they plan to very precisely audit cannabis tax deductions to ensure that only the cost of goods sold is included.
Any business that trafficks (creates or sells) a federally controlled substance (cannabis) cannot file for any tax deductions other than the direct cost of sold inventory. The cost of sold inventory can include growing, curing, and packaging.
All other tax deductions including wages and benefits, facility and utilities, and business overhead are barred and full taxes must be paid because the business itself trafficks in cannabis.
State Laws Caveat
It should be mentioned that state taxes do not apply under Section 280E because 280E is part of the federal tax code. States each have their own approach to taxing a cannabis business and some don't have any special rules or restrictions at all. Your federal taxes will need to be managed with 280E in mind. However, your state business taxes and income taxes will need to be calculated based on the state laws where you are located. Every state is different.
Strategies to Manage 280E Cannabis Taxes
Fortunately, the cannabis industry isn't taking this increased tax burden lying down. Enforcement of Section 280E has created an interesting financial terrain for cannabis businesses, but there are ways around bearing the brunt of the restrictions. Discovered by other cannabis businesses and similar industries with controlled substances, these strategies can allow your business to thrive despite the financial burden.
Split Your Business in Half
With a corporate lawyer to consult with, the cleverest move is to split your cannabis business right down the middle and run two entities under one roof. Business number one handles all the business expenses. Business One owns or rents the building, it provides transportation and storage. Further, Business One provides employment benefits, maintenance services, and hosts company events. It also sells all non-cannabis products like pipes and t-shirts.
The second business works directly with cannabis. Business Two grows, cures, and packages the cannabis if you cultivate. Business Two bud-tends and sells the cannabis directly to the customers. Further, Business Two includes as little of the total business overhead as possible, so that the mass of Business Two's expenses are the inventory itself and, thus, included in the 'Cost of Goods Sold'.
Done correctly with legal guidance (and in accordance with your state laws), the two-business approach is a court-approved way run one non-cannabis, non-280E business that can file normal tax returns, and one highly focused cannabis businesses with limited expenses to match its limited deduction capabilities.
Incorporate as a Corporation
Most cannabis businesses are inclined to incorporate as an S-corp or an LLC. These are most suited to small businesses and usually include generous allowances for tax deductions. However, due to the unique restrictions of a cannabis business under 280E, the 'phantom income' that is generated by the S-corp and LLC is then double-taxed.
In order to reduce your corporate tax burden, it's smarter to incorporate your business as a C-corp. A C-corporation owner is taxed on their own salary and/or dividends. It's a different structure that changes and reduces the way your cannabis business will pay taxes. But remember, you may only need a C-corp for the second business in a split pair.
The IRS has openly said that they will be picking over Cannabis business taxes with a fine-tooth comb. The intent to enforce 280E as strictly as the law allows, which means they intend to reject many tax returns and demand back-taxes for any cannabis business that does not perfectly pass inspection.
So be ready to perfectly pass inspection. Have a lawyer and other necessary consultants on-hand. Build your business structure carefully and, most importantly, keep meticulous records.
Calculate the Exact 'Cost of Goods Sold'
The first step is to calculate very precisely what your 'Cost of Goods Sold' is. Determine how much acquiring, packaging, and selling your products has cost the business and create a receipt-record of that cost. You can deduct small related costs, but they have to be directly related. The final number will equate your total tax deductions for the cannabis business.
Be Precise With Job Task Tracking
Second, track job tasks very closely. If an employee does things related to 'trafficking' cannabis, these hours need to be tracked separately. Many cannabis business owners who use the split-business trick actually hire their employees with both businesses and pay them from each. Your employee's time cultivating, producing, or selling cannabis can also be included in the cost of goods sold.
Are you ready for Section 280E enforcement? Do you need financial or legal guidance for your cannabis business? Thus, contact us today for a friendly consultation and your financial plans for the future.
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