Saturday, September 16, 2017
You might think that starting a retail marijuana business (in a state where it's legal of course) could be a great way to earn lots of money. You might be right. But in a cannabis-related business, a prudent entrepreneur needs to do some extra planning to see whether or not income taxes will eat up the profits.
See, the Federal government has something of a split personality where marijuana is concerned. On the one hand, it's still illegal under the Federal Controlled Substances Act. On the other hand, the Internal Revenue Service doesn't care whether income is derived from legal or illegal activities (James v. United States, 366 U.S. 213, 218 (1961)) - they expect income taxes regardless.
Of particular interest to canna-businesses is IRS regulation "IRC section 280E", which disallows otherwise legitimate business expenses if the income is generated from the "trafficking", or sales, of certain controlled substances, including marijuana. This means that a state-legal cannabis business cannot deduct normal operating expenses, such as rent, payroll, and utilities. Consequently, the business ends up paying income tax on these expenses. Unfortunately, without careful planning, one could find that the tax bill to the IRS is greater than the net profits!
In his article “Five Steps for Cannabis Businesses to Minimize Punitive 280E Taxation”, Daniel Rahill outlines some possible strategies to reduce the tax burden caused by section 280E. Rahill notes that this section does not allow ordinary business deductions, but it does allow a business to deduct its cost of goods sold (COGS) from gross sales:
The history of cannabis taxation leaves us with the important premise that, while IRC Section 280E disallows any deduction for ordinary and necessary business expenses for illegal controlled substance businesses, COGS is not considered an expense, but rather an adjustment taken into account in arriving at gross income. Under Treasury Reg. Sec 1.471-6(a) and -11, taxpayer must include as inventoriable costs all direct (e.g., the cost of inventory and delivery, and the cost of materials and labor for manufactured inventory) and indirect production costs (i.e., rent and utilities related to inventory). While a taxpayer cannot use IRC Section 263A to turn IRC Section 280E non-deductible expenses into ultimately deductible items, taxpayers should nonetheless be diligent in maximizing the proper expenses that should get allocated to inventory, and ultimately, COGS.
Rahill also notes that a typical cultivator would normally allocate most of its expenses to COGS, whereas a typical dispensary would have far more typical business expenses that are disallowed under 280E. He recommends diversifying the retail business activity to legitimately allocate normal business expenses into business activities (such as counseling services, or retail sales of non-cannabis products) that do not involve "trafficking" a controlled substance. By doing this, the other business activities can deduct the expenses on their income, reducing the overall income tax burden on the entrepreneur.
~ Zackery D. Artim